The Daily Reckoning PRESENTS: What will be the event that sends our economy into a down spiral in 2006? According to Gary Shilling, the bursting of the housing bubble will start a chain of events that won’t be pretty for anyone... HITTING THE SKIDS
by Gary Shilling A year ago, I believed three investment themes would work in 2005: a rallying of the dollar, spreading deflationary expectations and a flattening of the yield curve. Three more might commence in 2005 but could start later: a bursting of the U.S. housing bubble, falling American stock prices and a hard economic landing in China. So what happened? The dollar did rally. Deflationary expectations spread beyond autos and into appliance stores, department stores, computers and recreational vehicles. The yield curve flattened and, late in December 2005, inverted. While the housing bubble didn’t burst, that market has definitely cooled. U.S. stocks didn't decline like they did in the 2000-2002 bear market, but major stock indices last year registered only tepid gains, if at all. And China’s efforts to cool her overheated economy ran into difficulties. What’s ahead for stocks and the economy in 2006? Setting aside unknown elements like major terrorist attacks, natural disasters or a bird flu pandemic, I believe six phenomena are shaping the investment climate this year. The world is awash in financial liquidity mainly due to rising house values, the negative U.S. corporate financing gap and the American balance of payments deficit. Inflation remains low despite higher energy prices. As a result, investment returns are low. Speculation remains rampant despite the earlier bear market. So, investors are accepting more risks to achieve expected returns. And then there’s the insatiable U.S. consumer, who, thanks to the booming housing market, continues to spend freely. In this climate, I foresee 10 investment themes, seven of which are likely to unfold in 2006, while three will probably work - but maybe not until next year: 1. The housing bubble will burst this year. This once red-hot market is already cooling, with sales declining and inventories rising. The boom has largely been driven by investors’ zeal for high returns, ample cheap mortgage money and lax lending standards. Unlike earlier U.S. housing booms and busts that were driven by local business cycles such as the rise and fall of the oil patch along with oil prices in the 1970s and 1980s, this one is national and, indeed, global. Since houses are much more widely owned than stocks, the bubble’s likely demise will shake the economy more than the earlier bear market in stocks. And if house prices collapse, that could change the good deflation of excess supply I foresee to the bad deflation of deficient demand. 2. The Federal Reserve will tighten until the housing bubble bursts, and seriously invert the yield curve in the process. An inverted yield curve, which occurred in late December 2005, foretells recessions much as the fact that Federal Reserve rate-raising campaigns usually end in recessions. Such a campaign started in June 2004, and continues. I’m betting that the bursting of the housing bubble beats the Fed to the recessionary punch, but if not, the central bank will, as usual, do the job. Once housing is in a shambles, either falling from its own weight as I expect or due to central bank action, the Fed, of course, will do its patriotic duty and ease as the economy hits the skids. 3. U.S. stock prices will fall this year, perhaps below their October 2002 lows, in the midst of a major recession. A major decline in housing prices and activity will almost surely precipitate a full-blown recession. That, in turn, will send corporate profits down. Without robust corporate profits, stocks are vulnerable. And note that they’ve have muted gains for the past two years, even in the face of exploding corporate earnings. 4. China will suffer a hard landing due to domestic cooling measures and the U.S. recession. China is attempting to cool her white-hot economy, but is having difficulty. Her economy is more and more market-driven, but still is state-controlled in many aspects. Therefore, her policymakers lack the sophisticated tools to effect an economic soft landing. After all, if the Federal Reserve, with all of its skills and operating in a largely market-drievn U.S. economy, has only pulled off one clear-cut soft landing in 11 tries in the post-World War II era, why would the Chinese somehow succeed? Their futile efforts - coupled with a U.S. recession that will reduce Chinese exports as Americans buy less of everything - spell certain trouble for China’s economy this year and for China’s other trading partners. Of course, a Chinese business slump this year doesn’t mean an actual decline in real GDP there. A cut from the current 9%-10% growth rates to 4% or 5% would be severe since more than those growth rates are needed to employ the hordes that continue to stream in from the hinterland to the coastal cities in search of better jobs and incomes. 5. The weakness in United States and China will spread globally, dragging down stocks universally. China’s economy is closely linked to the United States, so an American recession combined with Chinese domestic economic restraint measures insure a global downturn. Other major economies - in Asia and Europe - simply can’t pick up the slack. Japan won’t be able to do the job. While her stock market has been celebrating Japan’s emergence from 15 years of deflationary depression as banks are being cleaned up and Prime Minister Koizumi institutes various free market-enhancing changes, it’s still unclear whether businesses and consumers can be coaxed into borrowing and spending. And I’m not looking to the Eurozone to take up the slack either. The Continent remains export-led, with exports accounting for its meager growth in recent years while domestic economies stagnate. 6. Treasury bonds will rally. The yield on long-term Treasuries is now about 4.5% and I expect it to decline this year and reach 3% when deflation becomes irrefutably established, as I’ll discuss later. Downward pressure on Treasury yields will also result when the Fed reverses gears and eases once housing is clearly in retreat and a recession is evident. 7. The dollar will remain strong since the United States is a global safe haven. The buck rallied strongly in 2005 after having been all but written off as dead. The United States is the world’s growth leader, which should benefit her currency. In addition, America lacks the language barriers, labor immobilities and productivity-robbing socialistic tendencies that hinder Euroland economies. I expect the dollar to remain strong this year primarily because in times of trouble, the United States is a safe haven. America, with all her speculative excesses to be corrected, will probably remain the best of a bad lot. 8. Global and chronic deflation may commence in 2006. With a global recession collapsing commodity prices and the robust deflationary forces already at work, major goods and services price indices in the U.S. and abroad, such as the CPI, will no doubt fall this year. But that doesn’t guarantee chronic deflation. Inflation usually recedes in recessions, so it’s the action in the following recovery in 2007 that will tell the tale. If price indices continue to fall then, true deflation will have arrived. I foresee the good deflation of excess supply, driven by new tech productivity and excess capacity, as in the late 1800s and in the 1920s, not the demand-deficient deflation of the 1930s. Still, the transition to good deflation may be rough since few are prepared for it and have oversized debts that need to be drastically reduced. Unlike inflationary periods, when the real value of debt falls, it rises in deflation. Furthermore, a very severe collapse in the housing boom, which is found in many countries throughout the world, could destroy enough net worth to spawn bad deflation. 9. U.S. consumers could start a long-run saving spree this year, reversing their 25-year borrowing and spending binge. Consumers have no intentions of becoming big savers. Spending money at malls has become the national pastime, and as long as they have assets against which to borrow and eager lenders here and abroad, they’ll keep shopping. Few have the perspective to quit while they’re ahead - or at least have some remaining borrowing power - but will play till they lose, and lose big. A renewed bear market in stocks and a collapse in house prices will eliminate the two major sources of consumers’ buying power. The fall in house prices, especially, will rob U.S. consumers of borrowing power. Incomes won’t support robust spending since they’re likely to remain subdued. 10. Deflationary expectations may surge and spread widely in 2006. Deflationary expectations spread and intensified in 2005 as consumers waited for lower prices for cars, airline tickets, telecom fees, even general merchandise before buying. That leaves producers with excess capacity and inventories that force them to cut prices. Those cuts only fulfill consumer expectations and encourage them to wait for even lower prices. These deflationary expectations make discounts - such as in the auto industry - difficult to end. Regards, Gary Shilling
for The Daily Reckoning Editor’s Note: Can’t get enough 2006 forecasts and predictions? Never fear, we have what we think will be the 11 hottest financial trends of 2006, right here: Want Big Profits in 2006? Forget Wall Street! Dr. Gary Shilling is president of A. Gary Shilling & Co. Inc., an investment advisory and economic consulting firm and publisher of the monthly INSIGHT newsletter. Prescience has empowered Dr. Shilling to beat the stock market by a wide margin over many years while providing consistently accurate forecasts to his subscribers. Twice ranked as Wall Street's top economist by polls in Institutional Investor, Dr. Shilling was also named the country's No. 1 commodity trader adviser by Futures Magazine. And in 2004, MoneySense ranked him as the third best stock market forecaster, right behind Warren Buffett. A regular columnist for Forbes magazine, Gary Shilling appears frequently on radio and television business shows and has written six books, including Is Inflation Ending? Are You Ready? In 1983 and, more recently, two books detailing his forecast for the new world order and its consequences for your wallet. For his very latest research, see: INSIGHT --- Advertisement --- ---------------------
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