The most widely used emerging market stock index is the MSCI EM Index. For the 12 months ended in September 2011, this index returned ‐16% in dollar terms. Over that same period, the S&P 500 returned +4%. The spread between the two – almost 20% – is not insignificant for investors, many of whom have 10%‐20% in EM stocks in their globally allocated portfolios.

Yet gross domestic product (GDP) looks likely to grow only about 1.5% this year while the economies of the BRIC emerging countries (Brazil, Russia India and China) will grow collectively somewhere in the 7% range. This is a large difference and one that is likely to continue.

Ups and Downs

Why are emerging market stocks going down if the economies are doing so well? This apparent paradox underscores several important tenets of investing. First, investors don’t invest in economies; they invest in stocks, bonds and other securities. Second, markets – especially stock markets – are forward looking. And third, valuation matters.

In 2010, as we began to scale back emerging market exposure in our portfolios, some clients, understandably, asked us why. We offered several reasons:

–Many emerging economies were overheating, posing the risk of burgeoning inflation. The natural reaction by EM central banks would be an attempt to cool down the economy through tighter monetary policy. This, we suspected, could hurt stocks.

–Fund flows had gotten overly one-sided. From June 2010 through December 2010, total fund assets in EM stock mutual funds rose from $143 billion to $202 billion. That’s a 40% gain in just six months and indicative of an unsustainable move. By September of this year, assets were back down to $171 billion.

–We began to develop some particular worries related to China. Specifically, a property bubble seemed to be emerging that had/has the potential to damage the nation’s banking system. And China has been a credit-fueled success story if there ever was one, so if a tightening of credit were to occur, it would not be likely to have a positive impact. Additionally, we began to detect a pattern of increasing IPOs directed at US investors as well as growing corporate fraud at Chinese-listed companies. It had a dot‐com feel to it.

–Finally, with Ben Bernanke in charge of the Federal Reserve, we bet that monetary policy would stay easy here at home, encouraging a weaker dollar and better trade terms for large US corporations that sell globally to developed as well as emerging market countries. In many ways, the record earnings that US corporations posted earlier this year reflected the Fed’s implicit weak‐dollar policies and helped to bolster US stock prices.

Improved Metrics

A number of metrics that we use to indicate valuation for emerging market stocks as a whole have become more attractive. For example, the dividend yield of emerging market stocks is now as attractive as it’s been since 2008, and above its long-term average.

Similarly “cheap” readings are found when we look at EM price to earnings ratios, price to book value ratios, and company cash flow relative to market price. And, given our still generally bright outlook for these economies as a whole, we are more inclined to add back EM exposures to our portfolios once we see the dark clouds currently looming over the global economy and China begin to give way to clearer skies.

This article was prepared by Contango Capital Advisor’s Investment Strategy Group. Contango Capital Advisors is an affiliate of Zions Direct.

IMPORTANT NOTE: Wealth management services are offered through Contango Capital Advisors, Inc. (Contango), a registered investment adviser and a nonbank subsidiary of Zions Bancorporation. Investments are not insured by the FDIC or any federal or state governmental agency, are not deposits or other obligations of, or guaranteed by, Zions Bancorporation or its affiliates, and may be subject to investment risks, including the possible loss of principal value of the amount invested. Some representatives of Contango are also registered representatives of Zions Direct, which is a member of FINRA/SIPC and a nonbank subsidiary of Zions Bank. Employees of Contango are shared employees of Western National Trust Company (WNTC), a subsidiary of Zions Bank and an affiliate of Contango. CCA1011-0177

At the time of this writing President Obama and congressional leaders of both parties have evidently agreed to a framework for a budget deal that would cut trillions of dollars in federal spending over the next decade and clear the way for an increase in the government’s borrowing limit.

While this move enables the country to skirt a default, most of the damage has already been done, at least as far as the investment community is concerned. A technical default would have been terrible, of course: We have commented before on the likely negative consequences, both for asset values and for the real economy, that would follow. But, more fundamentally, the circus of the last months has demonstrated that our political process is incapable of generating an intelligent consensus on tax and expenditure.

The implications are profound. Investors in US obligations, as well as in US-guaranteed obligations such as agency bonds, now anticipate a variety of problems. Chief among them are the potential for the US to be viewed as a second-tier lender, a perception that could impair liquidity and increase the prospect of runaway deficits that could trigger real defaults or, more likely, prompt efforts to eliminate debt by allowing inflation to surge. The US, in short, has lost credibility, while its debt has lost credit quality. Thus, we expect the US to pay higher interest rates across the entire yield curve in the future. And, because all other domestic interest rates are based on Treasury rates, every borrower in US dollars will pay more to borrow.

Higher Hurdles

Let’s estimate roughly what this extra cost might be. Total non-financial debt (the debt of all households, companies and local, state and federal governments) is about 240% of today’s gross domestic product (GDP). If the extra borrowing cost is only 1% – although we fully expect it to be more – then this adds 2.4% of GDP to interest paid. Remember, on average (that is, not during a recession), total federal revenues are a little less than 20% of GDP. This extra burden, then, is equivalent to a 12% increase in the federal tax take from the economy. Add the following fact: Corporations view “cost of capital” as a risk premium above the cost of debt. Hence companies contemplating whether to make an investment will face a hurdle rate that has risen by that same 1% and so will almost certainly decide to take advantage of fewer opportunities. Similarly, families will face higher mortgage, car and credit card interest bills, and so will buy less. There will be slower growth in the real economy and a prolongation of high levels of unemployment.

Redistribution of Wealth

All such changes also entail the potential for enormous wealth redistribution. The Federal Reserve’s current “zero interest” policy transfers real purchasing power from savers (who are earning yields below the rate of inflation on their savings) and transfers it to borrowers (including, especially, our big federal borrower). A jump in the yield curve will shift the transfer of money the other way. Savers will earn more on investments with a floating yield or a fixed yield set after (but not before!) the jump in rates.

Anyone unfortunate enough to own a long maturity bond today will take a large capital loss when interest rates rise. Insurance companies and pension funds are particularly vulnerable. And, if the rate that investments must earn to repay the cost of capital rises, stock prices will fall until their returns (on this now lower base) meet the new target. Because the stock market anticipates changes, we expect that a lot of this reasoning is already priced into stocks.

In this environment, much of the baby-boom generation will find that it is even further from having sufficient assets on which to retire comfortably.

Send a thank-you card to your congressman, your senator and the president.

George Feiger, CEO of Contango Capital Advisors and the author of the preceding article, has recently been quoted by media outlets including BBC NewsHour, Bloomberg News, Bloomberg TV, Chicago Tribune, CNNMoney.com and The Globe & Mail. Mr. Feiger’s past positions include Global Head of Onshore Private Banking for UBS, Global Head of Investment Banking at SBC Warburg and senior partner at McKinsey & Co. Formerly an associate professor of finance at Stanford University’s Graduate School of Business, he holds a PhD in economics from Harvard University.

Contango Capital Advisors is the wealth management arm of Zions Bancorporation (www.contangoadvisors.com). Contango Capital Advisors is an affiliate of Zions Direct.

The US economy has slowed significantly in recent months compared to late 2010 and early 2011. We’re not forecasting a recession … yet. But we are talking about a marked deceleration in the growth rate of our gross domestic product (GDP) – from about 3% in the second half of 2010 to about 2% at best this year.

However, if the huge cuts in government spending now being contemplated in Washington do occur, we could see a recession emerge either late this year or in early 2012. The course of events is likely to be similar to that of the late 1930s, when the government cut spending dramatically after years of fiscal stimulus and thus drove the economy into recession. In 1937, the Dow fell from 180 to 120 – a one-third drop.

US Markets Continue to Fare Well

Despite the economic slowdown and all of the “macro” uncertainty surrounding the economy as a whole, US markets remain reasonably well supported. As of July 25, the Dow was up about 9% for the year, while both the small-cap Russell 2000 and the Nasdaq were up about 7% – certainly decent market returns. We’ve been calling the recent schism between the micro economy – focusing on individuals, households and businesses – and the macro economy “the decoupling of the micro from the macro.” Simply put, although the economy stinks, corporations have, generally speaking, been doing rather well.

Here are reasons for their relative success in an otherwise soggy economy:

—Very low interest rates reduce costs, make more projects profitable, and provide positive operating leverage for a lot of public companies.

—Exposures to fast-growing economies outside the US have helped boost earnings for many companies.

—The weak-dollar policies of the Federal Reserve Board and the Treasury have aided US corporations that operate globally.

—Productivity gains continue to be reasonably strong and corporations have generally been able to grow sales without significant upgrades to plant, equipment and labor.

We’ve already received about half the earnings reports for the second quarter. A lot of big reports came in last week, including earnings from Apple, which once again beat forecasts handily, with earnings 16% above expectations. The key metrics for the second quarter so far are pretty impressive: 18% growth in year-over-year earnings per share (EPS), 13% top-line growth and 0.10% of margin expansion to 8.8%. Some 55% of firms have beat revenue projections so far, which is well above the long-term average of 35%.

Market Risks

We’ve been saying that the biggest risks to the markets, at least through the first half of the year, were related to policy rather than earnings – and that hasn’t changed. So if a major fiscal austerity plan is enacted, it could 1) give a boost to the dollar, which would not be good for the stock market and 2) cause a contraction in the government component of GDP so great that it could drive us into recession.

This means that the best short-term scenario for the markets in our view would actually be relatively modest efforts to curb the deficit this year and next, combined with major long-term structural reforms to the tax code, Social Security and Medicare.

How important has the weak dollar been to US stocks? Well, look at the numbers. Although the Dow is up about 9% on the year, other world markets have been lackluster in 2011. The German DAX is up 6%, the Japanese Nikkei is down about 2%, the UK exchange is flat, and Canada is flat as well. China and Brazil? Down 4% and 13%, respectively. And Germany is probably doing as well as it because of the euro’s global weakness. Certainly, there is no doubt that the weak dollar has bolstered US companies.

Of course, as Americans, it’s unnerving to think that we need a weak dollar to support our markets. However, a weak economy needs pressure-release valves, and currency depreciation is one of those right now. A weak dollar makes our products and services more competitive in the global marketplace. That increased competitiveness is reflected in the great earnings numbers posted by US multinationals so far this year.

We remain mostly fully invested in the majority of client accounts, but we are keeping a finger on the sell button should we see a policy action or mistake that we think would end the party prematurely.

This article was prepared by Contango Capital Advisor’s Investment Strategy Group. Contango Capital Advisors is an affiliate of Zions Direct.

IMPACT ON CONSUMER SPENDING AND GDP |

Housing, poses enormous risk to the U.S. economy through its impact on financial markets, financial institution solvency and consumer confidence and spending. Key will be what happens to housing prices and the extent to which falling prices affect expected losses on mortgages and other linked financial instruments and the extent to which declining wealth affects consumer spending. Prospects are decidedly negative on all fronts as housing price declines continue unabated.

The linkages between housing wealth, price changes and consumer spending are imprecise and have been hotly debated. As the evidence comes in the debate is being resolved. Unfortunately, it appears increasingly that the resolution is in the direction of those who believe that housing had a substantial impact in stimulating consumer spending during the bubble phase and will have a commensurate negative impact now that the bubble is unwinding.

Part of the difficulty in tracing cause and effect is tied to transmission lags between changes in household wealth and consumer spending. These lags are long. My modeling indicates that falling housing prices will place considerable downward pressure on GDP growth during 2009 and 2010. Table 2 shows the timing and size of impacts of housing on GDP growth, which captures consumer spending, residential construction and other linked effects. Note that my Severe Recession scenario projects a -12.1% additional cumulative decline in nominal housing prices over the next two years (from 2008 Q3 through 2010 Q3), while the S&P Case-Shiller CME 10-city futures project a -14.7% decline over the same time period.

The Severe Recession GDP scenario indicates that non-housing GDP growth has been weak for several quarters. It turns negative during the fourth quarter of 2008 as recession deepens.

During 2009, the lagged impacts of cumulative declines in home prices have a very negative effect on GDP, which is offset by recovery in the rest of the economy beginning in 2010. The risk is that the recovery in the rest of the economy will be less than forecast because of negative feedbacks from housing (see Chart 1).

Table 3 includes the effect of $700 billion in additional stimulus in 2009 and 2010 on quarterly GDP forecasts. While stimulus has no effect on the housing component of GDP, it has a very favorable effect on non-housing GDP, beginning in late 2009 and gaining momentum during 2010. But, what is also clear from Table 3 is that it will take a very long time to overcome the drag on GDP of negative housing wealth effects and this will keep GDP on a slower growth trajectory for years to come.

GDP Growth Prospects Post Recession

You should note in Chart 1 that GDP growth post recession does not recover to the pre-recession level. Both of the last two recessions have been followed by prolonged periods of sub-potential GDP growth. Not only is this likely to be repeated in 2010 and 2011 but there is cause to expect sub-potential growth to be worse and extend for a longer period of time. Even the massive $700 billion in fiscal stimulus assumed in the Fiscal Stimulus scenario only manages to boost GDP growth to about 2%. I calculate that real GDP non-inflationary growth potential is currently between 2.50% and 2.75%. This is lower than in recent years due to slowing labor force growth and lower productivity gains. GDP growth is likely to remain below potential and that will add to an output gap that is already headed toward -6% to -8% by 2010 according to various estimates. Large output gaps are highly deflationary.

In past cycles aggressive monetary and fiscal policy eventually stimulated recovery, primarily through consumer spending. But there was a consequence. The saving rate resumed its secular decline and consumer debt to income ratios eventually climbed to new highs. Recovery was also assisted by expansion in household wealth.

The era of steadily rising household leverage is over. We have entered a new trend toward greater saving and less reliance on debt. By definition, a higher saving rate means that consumers will spend less out of current income. This will translate into slower GDP growth until the saving rate stabilizes. Moreover, housing wealth will not be an engine of consumer spending for a very long time. Once the housing price correction has run its course, a return to real rates of growth in housing prices of about 1.2% annually seems likely. How much this eventual return to rising real housing prices translates into consumer spending will depend importantly on the rate of inflation, which I expect to be near zero or negative (deflation) for a considerable period of time.

This is part 4 of our four part series of Bill Longbrake’s review of 2008 and the ongoing credit crisis. Bill Longbrake is the former Deputy to the Chairman and CFO of the Federal Deposit Insurance Corporation and Vice Chairman of Washington Mutual. He is currently on the Board of Directors for First Financial Northwest.

Originally published as Bill Longbrake MEMORANDUM, December 15, 2008, RE: Economic Commentary – Massive Negative Demand Shock Threatens Worst GDP Performance Since the Great Depression; Specter of Pernicious Deflation Lurks.

*Artwork created by Iron Man Records under a Creative Commons license at Flickr.com.

OUTLOOK FOR GDP |

The outlook is extremely bleak. The current recession is in its 13th month. Most recessions over the last 60 years have ended by this time. This one not only has not ended, downward momentum is intensifying.

Q3 GDP

The revised estimate of Q3 GDP growth was -0.5%. This figure will be revised once more. The final number will be reported in the coming week and is expected to be revised down to between -0.6% and -0.9%.

Real consumer spending declined at an annual rate of 3.7% in the third quarter(likely to be revised down to -4.0%), the first negative quarter since 1991 and the worst negative quarter since the second quarter of 1980. Unfortunately, based on the severe decline of 4.7% in nominal retail sales from September through November, consumer spending is likely to fall further in the fourth quarter, which would make the current recession comparable in ugliness to the 1973-75 recession.

Capital spending, which was supposed to be the bright spot because of export strength earlier in the year, fell at a 5.7% annual rate in the third quarter. This was the weakest quarterly performance since 2002 when the tech wreck was still unfolding. The decline was concentrated in old economy industrials and transportation equipment. But even technology capital spending growth shrank from 7.9% in Q2 to 2.5% in Q3.

Residential construction fell at a 17.6% annual rate – the 11th consecutive quarterly decline. Not since the Great Depression has housing been so weak for so long. Growth was positive in nonresidential construction but slowed to 6.6% from 18.5% in the second quarter. Based on anecdotal reports, increased credit stringency and collapsing consumer spending, substantial negative growth in nonresidential construction is now underway and will prove to be very troublesome for lenders who have specialized in this sector.

Net exports, still benefiting from the surge in exports triggered by a weak dollar prior to September, added 1.1% to GDP growth in the third quarter. Government added 1.2% (primarily defense related) and inventory accumulation added 0.6%. Without these favorable factors, GDP would have been reported as -3.2%. With the dollar’s value now rising sharply and global recession in full sway, the addition to GDP from net exports will reverse in the fourth quarter. The same can be said about inventory accumulation, which almost certainly is involuntary right now as sales fall faster than businesses can cut back on production.

GDP Forecast

GDP growth over the next two quarters will be very negative. The two GDP forecast scenarios shown in Chart 1 – severe recession (base case) and depression (what do you call a recession that is worse than severe?) – both indicate that 2009 will be a very difficult year.

In the severe recession scenario – base case – the unemployment rate peaks at 9.6% in the first quarter of 2010 and 2009 real GDP growth is -0.8% fourth quarter to fourth quarter and -1.2% year over year; the worst quarter is the second quarter of 2009 at -1.7% over the previous 12 months. In the depression scenario unemployment peaks at 10.6% in the fourth quarter of 2010 and 2009 GDP growth is -1.1%; the worst quarter is the second quarter of 2009 at -2.0%. Based on forecasts from others, it appears that my unemployment estimates are high and my forecast decline in real GDP is too low.

To put these scenarios into historical perspective, the 12-month rate of real GDP growth fell to 0.3% at the bottom of the 2001 recession, but growth did not contract. In earlier recessions GDP growth bottomed at -1.1% in the first quarter of 1991, -2.7% in the third quarter of 1982, -2.3% in the first quarter of 1975.

Economists have busy revising down 2009 real GDP growth estimates. My econometric model’s estimate is -1.2%, which I believe greatly understates the downside risk. Merrill Lynch expects -2.9%; Goldman Sachs expects -1.6%; and Global Insight expects -1.8%.

Obama Administration Likely To Enact Substantial Fiscal Stimulus

Greatest Negative Demand Shock Since the Great Depression. The economy is currently experiencing the worst negative demand shock since the Great Depression. A massive demand shock causes a precipitous decline in spending in all sectors of the economy – consumer, business, state and local government and net exports. The collapse in spending causes revenues and incomes to fall and reinforces the downward momentum of the demand shock on spending.

Liquidity Trap – Monetary Policy Becomes Ineffective. Traditional policy measures include monetary and fiscal policy. Monetary policy focuses on reducing the cost of credit by lowering interest rates and providing ample liquidity. The intent is to strengthen demand by making credit cheaper and easier to

access. However, in the current cycle monetary stimulus has become ineffective because credit markets, which are the conduits through which monetary policy works, have either disappeared altogether or are barely functioning. The financial sector has fallen into a classic liquidity trap in which risk aversion is so intense that zero interest rates and unlimited liquidity have no effect on spending activity.

Fiscal Policy. The other traditional policy tool to stimulate demand is fiscal policy. This can come either in the form of tax cuts (rebates) or spending. Each dollar of fiscal stimulus can have a decidedly different impact in treating and moderating the current demand shock depending on how it is disbursed. Timing is also an issue. For example, infrastructure spending has a high effective spending multiplier and produces substantial improvements in productivity over time but infrastructure projects take a long time to get up and running and therefore have very limited short-term benefits in offsetting a massive decline in spending.  Tax rebates are relatively immediately but they may go into debt reduction and saving rather than offset lost spending.

TARP (Troubled Assets Relief Program) Is Defensive, Not Stimulative. For example, the $335 billion in TARP out of $700 billion that has been earmarked to date will have almost no immediate impact on stimulating demand. Almost all of this money will be invested in financial institutions and simply replace private sources of capital that have disappeared because of the seize-up in credit markets. That is not to say these investments are unimportant. They are very important because they are preventing the potential total collapse of the private financial system. Such a collapse, were it to occur, would greatly exacerbate the

negative demand shock. Preventing a financial system collapse avoids this outcome but it does not induce financial institutions to extend new credit in the face of greater risks. Once financial markets stabilize and private capital flows loosen up, TARP funds will be returned quickly to the federal government. So,

TARP should be viewed as a preventive and defensive policy measure, not as a stimulus measure.

Tax Rebates. To arrest and reverse the downward momentum of the demand shock fiscal policy must focus on stimulating spending that creates jobs and incomes and that restores sufficient confidence in the future so that risk aversion moderates and businesses and consumers begin spending again. In early 2008 Congress enacted a tax rebate program that returned about $100 billion to consumers, equal to about 1% of disposable income. While there is no definitive study available that explains exactly what happened to these dollars, the subsequent massive deterioration in the economy and flow of funds data, which show that consumers reduced debt during the third quarter, imply that a vast amount of the money went into debt liquidation and saving. That helps consumers repair balance sheets, just as TARP funds have a similar effect for financial institutions, but the dollars don’t get spent and so they don’t help much in arresting the demand shock and they certainly didn’t reverse the shock. Indeed, the shock gained considerable momentum after the tax rebates had run their course.

Transfer Payments – Unemployment Benefits and Food Stamps. There are other kinds of spending, such as extending unemployment benefits and food stamps, that unquestionably lead almost immediately to higher consumer spending, particularly in times of rapidly rising unemployment such as now. So, some of the pending fiscal stimulus will go to such programs.

Reduce Tax Withholding and Payroll Tax Schedules. This would be easy to implement quickly but is not likely to have an impact much different from tax rebates. Also, reducing payroll taxes for social security and medicare would further exacerbate the long-term solvency of those programs.

Targeted Grants to State and Local Governments. Unlike the federal government state and local governments are required to balance spending with revenues. When the economy contracts state and local tax revenues also contract leaving states with little option but to cut spending or raise taxes. Both actions reinforce the negative demand shock.

The National Conference of State Legislatures reported that 30 states face a combined deficit of $30 billion in fiscal 2009 and 25 expect a deficit of $60 billion in 2010. Like the initial estimates of subprime lending losses, these numbers are bound to grow by leaps and bounds as the economy continues its relentless deterioration. California alone faces a 2009 budget deficit of $15 billion.

Federal stimulus can ease the impact at the state and local level by allocating stimulus dollars. Some dollars can be immediately deployed, such as Medicaid benefits. But stimulus dollars for other programs, particularly infrastructure projects. will be dispersed over time.

Federal Spending Programs. There has been much talk about systematic underinvestment in infrastructure over the last several years and the need to reverse that neglect. There is little doubt that investment in infrastructure will benefit long-term growth, but it is difficult to deploy infrastructure investments quickly and thus this kind of stimulus will have limited short-run benefits.

President-elect Obama has already emphasized the importance of infrastructure in the following areas: energy-efficient public buildings, modernize and upgrade school buildings, increase broadband adoption, modernize health care system through technology, light rail and other national infrastructure projects.

Possible Composition of Stimulus Package. The Center for American Progress has suggested $350 billion in one-time programs:

Or, grouped somewhat differently:

About 50% of this proposed list is for infrastructure projects but perhaps as little as 10% of that is ready to go.

Goldman Sachs has suggested a more expansive two-year stimulus package:

Size of Stimulus Package. While the programs suggested above total $350billion, as the economic crisis has deepened, policy discussions increasingly have focused on larger numbers in a range of $500 to $700 billion over two years. Knowledgeable observers suggest that a large stimulus size would have to come from additional tax reductions rather than spending increases, if it is to have much additional impact in the near term.

Merrill Lynch asserts that stopping the recession dead in its tracks and holding the unemployment level at 6.7% would require a budget deficit of 14% of GDP in 2009. This would amount to a deficit of $2.0 trillion, about $1.0 to $1.1 trillion above the projected 2009 fiscal deficit without any further stimulus. Merrill suggests further that a $600 billion stimulus program would be required to merely offset the income projected to be lost by the private sector during 2009.

It will be increasingly difficult to gauge the impact of the reported federal budget deficit on the economy because some of the dollars, like most TARP funds, will be included in the reported deficit, but will have little if any direct impact on spending. For example, the budget deficit for September and October 2008 was nearly $250 billion above the deficit for the same months in 2007. However, this increase included $191 billion in TARP outlays and $14 billion in funds obligated in the Fannie Mae and Freddie Mac conservatorships. Most of this $205 billion increase will have little stimulative impact.

Economic Impacts of Stimulus. All GDP forecasts will be revised once the outlines of the Obama Administration’s fiscal stimulus package become public. I have attempted to show the potential impact of stimulus on GDP growth over the next three years in the Fiscal Stimulus scenario in Chart 1. I assume approximately $700 billion in additional spending split $400 billion between fiscal 2009 and $300 billion in fiscal 2010. This is slightly more aggressive than the Goldman Sachs estimate. This stimulus is added to the Severe Recession scenario.

Stimulus improves real GDP growth from -0.8% in 2009 to -0.3%; from 1.4% in 2010 to 2.0%; and from 1.1% in 2011 to 1.6%. Core PCE inflation, which is falling rapidly and is forecast to turn into -2.2% deflation during 2010, falls a smaller -1.4% and then returns to zero by the end of 2011. The inflationary impact of stimulus in a deflationary environment is an extremely important and positive policy outcome.

Threat of Pernicious Deflation and a Perpetuating Negative Feedback Loop. Falling aggregate demand and price deflation are a deadly combination for the financial system. Debts are denominated in nominal dollars but in a deflationary episode incomes decline not only because unemployment rises but because wage and salary rates are first frozen and then cut outright. This means that in a deflationary environment it becomes increasingly difficult for employed people to service their debts. This will inevitably result in increases in defaults and bankruptcies. Such an outcome must be avoided at all costs because if it takes hold, the current collapse in aggregate demand will extend, deepen and lock into a perpetuating negative feedback loop. This is what economists refer to as pernicious deflation – or as Irving Fisher called it, “the debt-deflation cycle”. It is a very real and serious threat. It is one that precious little attention has been paid to as many economists continue to obsess about the risks of inflation. This is hardly the time to worry about future inflation. The consequences of pernicious deflation to our economy and social stability are much greater and the threat is much more imminent than the possibility and consequences of runaway inflation.

This is part 3 of our four part series of Bill Longbrake’s review of 2008 and the ongoing credit crisis. Bill Longbrake is the former Deputy to the Chairman and CFO of the Federal Deposit Insurance Corporation and Vice Chairman of Washington Mutual. He is currently on the Board of Directors for First Financial Northwest.

Originally published as Bill Longbrake MEMORANDUM, December 15, 2008, RE: Economic Commentary – Massive Negative Demand Shock Threatens Worst GDP Performance Since the Great Depression; Specter of Pernicious Deflation Lurks.

*Artwork from Iron Man Records under a Creative Commons license at Flickr.com.

2008 FORECASTS –RESULTS YEAR TO DATE |

Overview

Table 1 shows the range of opinion that prevailed at the beginning of 2008 and the year-to-date results. Actual results through the October-November timeframe reflect a severe and troublesome deterioration in the performance of the U.S. and global economies coincident with the violent upheaval that swept over global financial markets beginning in mid-September. Indeed, virtually all optimism has evaporated and fears of the potential consequences of the rapidly escalating global recession abound.

The pessimistic view presented in Table 1 at the beginning of 2008 was actually not the worst view at the beginning of the year but one that reflected a mild recession scenario.

At the outset of the year I mentioned that the risks of a more severe recession developing during the year were higher than normal. I stated that factors that could lead to that outcome included a progressively worsening credit crunch, a more rapid decline in housing prices and further erosion in consumer confidence which collectively would lead to substantial pull back in consumer spending. Unfortunately, not only have all of these risks now become reality, the situation appears to be worsening by the day. Evidence is emerging that the U.S. and global economies may have fallen into a “Liquidity Trap”, an economic condition in which credit markets break down and monetary policy becomes ineffective. The last time this occurred was during the Great Depression of the 1930’s.

As I have expected since the beginning of the year, the National Bureau of Economic Research finally dated the onset of recession in the U.S. as December 2007. Initially, deterioration was gradual during the spring and early summer which emboldened the optimists.

We can now, with the benefit of knowing what has happened, say without doubt that this optimism was illusion, wishful thinking and based on precious limited critical thinking. This kind of herd mentality and bias for “feel-good” talk seems to be a natural collective human tendency. Because of this tendency we rarely attempt to study with any degree of rigor how today’s policies and decisions could lead to problems and consequences in the future. We want to believe that markets work … in recent years this belief has bordered on being religious dogma. Because we believe, we become lazy critical thinkers and collectively become blind to imbalances that are developing and may potentially induce negative outcomes. Also, because we believe, we don’t engage in any kind of contingency planning. Then, when the deluge comes, the tsunami engulfs us, we don’t have a clear understanding of why it is happening and therefore policy responses are late and often are only partially effective or ineffective because they do not target the right problems. When the history of the last few months is written there will be much to say about the failures of policy making leading up to the crisis and also how some of the ad hoc solutions in the early stages of the unraveling process were ineffective and may even have contributed, in some instances, to deepening and accelerating the process of collapse.

But, let me start, as I customarily do, with a recap of what has happened in the U.S. economy so far during 2008 by reviewing key economic indicators listed in Table 1. These data, since they are averages for all of 2008, no longer paint a very accurate picture of the severe recession we are now in. Third quarter GDP growth was revised to -0.5%, which brought the annual rate of growth over the first nine months of 2008 to 1.0%. Q4 is shaping up to be an extraordinarily negative growth quarter. Current estimates range between -4 and – 7%, which would be the worst quarterly contraction since the second quarter of 1980 when the Carter Administration’s ill-fated experiment with credit controls decimated the economy. This would reduce GDP growth to 1.0%, as conventionally measured, and to -0.8% when measured from the fourth quarter of 2007 through the fourth quarter of 2008. If that is what occurs, then my view at the beginning of 2008, while seemingly quite pessimistic, at the time will prove to optimistic. (Note: 2008 GDP forecasts in Table 1 are not measured in the conventional fashion of year over year but rather from the fourth quarter to fourth quarter, which is the method I use in my econometric model [see Table 2 below] to derive a 2008 GDP growth estimate of -0.3%., considerably worse than my forecast in Table 1 of 0.0 to 0.5% growth. On a year over year basis my model’s real GDP growth estimate converts to +1.0%. However, my model’s estimate for Q4 while pessimistic, as it projects -3.9% growth, now appears to be at the optimistic end of the emerging forecast range.)

Inflation

Core PCE inflation for 2008 should average about 1.8%, only slightly above my beginning of the year forecast. For a while it appeared that my forecast that core inflation would fall during the year was far too optimistic because I did not anticipate the short-lived but powerful commodity price bubble which totally overwhelmed gathering disinflationary forces during the first half of the year. Over the first nine months of 2008 core PCE inflation increased at an annual rate of 2.4%. However, the crash in commodity prices since mid-summer and the swoon in consumer spending since mid-September seem poised to drive core inflation to zero during the fourth quarter and annual inflation for all of 2008 to 1.8%.

Total PCE inflation peaked in July at 4.5% and declined to 3.2% in October. Because of the collapse in commodity prices and the dramatic decline in consumer spending, the descent in total PCE inflation will accelerate over the remainder of 2008 and could end the year as low as 0.0%.

Employment

Payroll employment during the first eleven months of 2008 declined an average of 178,000 per month. This far exceeds the pessimistic view, and is worse than my even more negative view of -100,000 per month. November’s payroll loss was a staggering 533,000 on top of revised losses of 403,000 to September and 320,000 in October, bringing total job losses since the onset of recession in December 2007 to 1.9 million. The continuing and enormous escalation in initial unemployment claims in recent weeks makes negative revisions to October’s and November’s payroll data highly likely and implies a loss of 300,000 or more jobs in December.

Real Consumer Income and Spending

Consumer income and spending data were distorted earlier in the year by the fiscal stimulus program. While hopes were high that the stimulus would serve to prevent recession or keep one very mild, based on subsequent events, the fiscal stimulus either had very little lasting impact or its benefits were entirely swamped by high energy and food prices followed by the stock market crash after Labor Day. Through October, real consumer income rose just 0.5% (annual rate of 0.6%) and real consumer spending actually fell 1.5% (annual rate of -1.8%). Both results are considerably worse than my forecast and the pessimistic forecast.

In November retail sales fell 1.8% from the October level and are down 6.7% from a year ago. Both of these data points are in nominal terms. This means that the collapse in retail sales is far worse when adjusted for inflation.

Given what is happening in labor markets and the extreme loss of real estate and financial asset wealth, growth in real consumer spending for all of 2008 will be extremely negative. Growth in real consumer income will be near zero and could even be slightly negative.

Saving

The saving rate averaged 1.4% during the first ten months of 2008. It averaged 0.6% during 2007. The saving rate always rises during recessions and it is following this traditional progression in the current recession. I expect the saving rate will average 1.5 to 1.6% for all of 2008, slightly lower than my forecast of 1.8%. The saving rate was 2.4% in October, so there is a reasonable chance that my end of year forecast of 2.3% could be close to the mark.

Housing prices

Based on January-September data from Case-Shiller’s 20-city housing price index, housing prices fell -12.7%, or at an annualized rate of -16.5%. The 12- month rate of decline has worsened steadily throughout the year from -10.7% in January to -17.4% in September. Prices are now down -21.8% from the July 2006 peak. The monthly Federal Housing Finance Agency (FHFA) housing purchaseonly price index has declined 7.0% over the 12 months through September 2008. The FHFA index covers only homes with prime mortgages less than $417,000. Regardless of index, the rate of housing price decline accelerated from October 2007 through September 2008. For the second year running, all forecasts of home price declines are likely to end up being too optimistic. Most analysts expect prices to fall an additional 10 to 15%.

Housing Starts

Starts fell to 791,000 in October, bringing the year-to-date average to .97 million. Starts are now down 65.2% from the January 2006 peak and are near levels that marked bottoms in previous housing recessions. However, a variety of housing data implies that starts will need to fall further before the housing market can stabilize.

Dollar

The trade-weighted value of the dollar rose 12.3% over the first ten months of 2008, or 13.4% at an annual rate. None of the beginning of the year forecasts is on the mark. The optimistic scenario with a forecast for no change in the value of the dollar is closest, but for the wrong reasons. Through the first seven months of the year the value of the dollar declined, as forecast. The reversal over the last three months has been a direct consequence of the global financial markets crisis. Until the enormous U.S. trade deficit shrinks substantially the value of the U.S. dollar will be under relentless downward pressure. This fundamental force is still very much in play but has been overwhelmed temporarily by the global financial crisis. As global deleveraging has accelerated there are only two currencies investors wish to hold – the dollar and the yen. Both currencies have appreciated against all other currencies over the last three months. Given the severity of the crisis and the fact that deleveraging still has a long way to go, it seems likely that the U.S. dollar will remain a preferred currency for the foreseeable future. This is a very unhealthy development for U.S. businesses and for U.S. exports. Since peaking in July, through October U.S. exports of goods were down 13.3%. During the same timeframe, imports of goods were down 11.3%.

Interest Rates – Short-Term Rates – Federal Funds Rate

After much talk during the middle of the year that the Fed was done cutting interest rates and would soon need to raise them to stanch the threat of inflation, the meltdown in financial markets in September forced the Fed to lower the Fed Funds rate target to 1.0%. This is the level I forecast at the beginning of the year. Increasingly, it appears that the Fed will cut this rate to 0.50% or even 0.25% at the FOMC meeting on December 17th. Already the evidence indicates that the Fed has shifted to quantitative easing. The effective Fed Funds rate has considerably below the target of 1.0% for weeks.

Interest Rates – Long-Term Rates – 10-Year Treasury Rate

Long-term Treasury rates finally dropped precipitously in the last month in one of the greatest rallies of all time. I expected the rate to average 3.4% for the year and then end the month of December at approximately 3.0%. Through November this rate averaged 3.78% and looks likely to average about 3.7% for the year. However, the December average rate should be close to 2.7%.

The commodity price bubble and inflation scare during the first half of the year delayed the decline I and others expected in long-term rates that usually occurs in the early stages of a recession. After falling below 3.5% in March during the Bear Stearn’s crisis, long-term rates rose above 4.0% during the inflation scare. Now that the inflation scare is history and the severity of the global economic downturn has been recognized, the 10-year Treasury rate has fallen precipitously. As of December 12th, the rate was 2.57%, which is 95 basis points below the November average and 125 basis points below the October average of 3.82%.

This is part 2 of our four part series of Bill Longbrake’s review of 2008 and the ongoing credit crisis. Bill Longbrake is the former Deputy to the Chairman and CFO of the Federal Deposit Insurance Corporation and Vice Chairman of Washington Mutual. He is currently on the Board of Directors for First Financial Northwest.

Originally published as Bill Longbrake MEMORANDUM, December 15, 2008, RE: Economic Commentary – Massive Negative Demand Shock Threatens Worst GDP Performance Since the Great Depression; Specter of Pernicious Deflation Lurks.

*Artwork created by Iron Man Records under a Creative Commons license at Flickr.com.

GLOBAL CREDIT CRISIS: SYNOPSIS |

The month of September marked a stunning collapse in global credit and financial markets. Unlike the financial turmoil of 1987 and 1998 when economic activity was relatively unaffected, incoming data reports indicate unambiguously that global economic activity is weakening sharply and rapidly in every country of consequence in tandem with the deterioration in global credit and financial markets.

The triggering event was the decision by U.S. authorities to let Lehman Brothers fail, which with the benefit of hindsight was a grievous error. However, I do not wish to leave the impression that the crisis we are now deeply enmeshed in could have been averted had the authorities bailed out Lehman Brothers as they did with Bear Stearns earlier in the year. It still would have occurred, perhaps a little later, and perhaps a little less violently, but it still would have occurred. Why? … because it is now abundantly apparent that we are at the end of a decades-long debt leveraging super-cycle.

While it is indisputable fact that increases in debt leverage increase risk, we deluded ourselves into believing that financial innovations and greatly increased financial modeling and policy sophistication enabled us to manage the increased risk brought about by ever increasing leverage and made it possible to tame the business cycle. We shall see in due course what the economics profession has to say about the much-lauded “Great Moderation” in the economy we experienced over the last 30 years. It now appears that the “Great Moderation” might have been artificially induced by steadily escalating amounts of debt leverage and that reduced volatility was simply an artifact of financial engineering at the transactional level and aggressive use of monetary and fiscal policies at the macro-economic level. What is abundantly clear is that imbalances built in every country and in every economic sector to the point where the systemic aggregate risks had become so great that in the end the system’s collapse became inevitable.

I have remarked in past commentaries about the risk of ever increasing leverage and how aggressive policy intervention to limit the consequences of recession was preventing a full cleansing of the previous cycle’s excesses so that the level of risk built progressively from cycle to cycle. I also commented that ultimately the extent of leverage would become so great that policy would no longer be able to limit or control the adjustment process.

Two things are now clear. First, there is no longer any doubt that the spectacular collapse in global financial and credit markets, the inevitable consequence of an overextended system that permitted aggregate risk to accumulate way beyond institutions’ and governments’ ability to manage and contain it, has been followed by a precipitous and massive collapse in aggregate demand globally. Prior to the events of September the unraveling process was already underway, but the slow pace fortified the optimists’ belief in the efficacy of aggressive policy intervention to foster the healing process, both in financial markets and in macro economic activity. Policy failed, not so much because of specific mistaken actions but because the problems that had built up over decades were so much greater than traditional policy was capable of handling. That is not to say, however, that policy does not matter, which leads me to my second point.

Second, the power of negative feedbacks stemming from the burst housing bubble, balance sheet deleveraging and the unwinding of other unprecedented global economic imbalances, such as the huge U.S. trade deficit and the rapid and unbalanced growth in China, continue to be underestimated. In my opinion, the ability of policy intervention to contain negative feedbacks continues to be overestimated. For policy intervention to be effective, it must be structured in ways that permit excesses to be purged and reasonable balances to be reestablished. But, it also must be structured to avert the very real potential for violent negative feedbacks to become perpetuating in ways that fuel the negative global aggregate demand shock and drive global economic activity down to levels that foster intense human suffering and create unwelcome social and political upheaval. Thus, policy needs to focus on interdicting the negative feedbacks and in restoring enough confidence and optimism that dilutes the excessive risk-averse behaviors that are currently compounding the downward spiral.

The current situation with the three U.S. automakers – General Motors, Ford and Chrysler – is illustrative. Nominal retail auto sales have fallen 26% over the last year. The impact has been far greater on the U.S. manufacturers than foreign manufacturers domiciled in the United States. Now these three manufacturers are in desperate straits with only enough cash to survive a few more months. We know that if we let these companies fail there will be enormous negative consequences for the U.S. economy. Yet, we also know that a return to business as usual, once the crisis passes, will leave us with weak companies ill-equipped to be successful in a restructured economy that will focus increasingly on energy efficiency and environmental issues.

The tough love of bankruptcy will surely reinforce the downward spiral in aggregate demand and greatly compound our economic troubles. But based on the experiences of other countries that shored up and protected broken companies, such as Japan during the 1990’s, we know that such responses not only delay essential rejuvenation but also weaken the economic strength of the nation as a whole.

The U.S. automakers are victims of two things – one based on longstanding U.S. policies and the other of their own making. The policy failure is a decades-long commitment to cheap energy. This policy has been intertwined with other policies such as those promoting ownership of single family detached dwellings. As any land use economist would tell you, this has led to inefficient and extremely costly development and provision of social services. We are now at a point where energy is no longer abundant in the traditional forms and certainly isn’t cheap.

The question now is whether we will have the determination and willingness to fundamentally alter these policies or whether we will band aide them and continue to stagger from crisis to crisis. The automakers are already authorized to borrow from the federal government to retool their factories and design cars that are more energy efficient and environmentally compatible. However, the collapse in auto demand has presented an immediate operating crisis.

The second failure is that American automakers do not seem to know how to make cars that Americans will buy. When wages are reduced and health and pension plans are right-sized to meet intense global competition, the automakers will still not be able to compete effectively until they make the right kinds of cars. This is a matter of corporate culture that appears unique to the American manufacturers. The task of saving the companies and simultaneously guiding them in directions that will result in long-term successful viability without enormous and on-going subsidization seems daunting. But, it is a task that must be accomplished both to avert worsening the economic downturn in the near term but also to ensure that the companies emerge as a vibrant part of a revitalized and balanced economy.

While the automakers are a graphic and perhaps extreme example of what has gone wrong in the U.S. economy, they are illustrative of the need to revamp policies across the board in ways that deemphasize Americans’ obsession with consumption and overreliance on debt and in ways that recognize that systemic risks can grow to unmanageable levels without appropriate and effective governance and regulatory processes.

In the commentary that follow I discuss eleven key economic variables and comment on what has happened since various 2008 forecasts, including my own, were made at the beginning of the year.

In the remainder of this economic commentary I focus on U.S. GDP, which is poised to fall at a rate not experienced since the ill-conceived Carter Administration’s experiment with credit controls decimated the U.S. economy in the second quarter of 1980. Most unfortunately, the current crisis and collapse in aggregate demand is much more fundamental. In 1980 we were faced with runaway double-digit inflation and high interest rates, but we did not have excessive levels of debt, we did not have a trade deficit with the rest of the world equal to 5% of GDP and we did not have the plethora of financial risks that have now reached systemic proportions courtesy of financial engineering and ineffective governance. What this means is that it will not be easy to slow the negative momentum of falling demand, let alone reverse it.

The U.S. and global economies are on the razor’s edge. This is no ordinary recession. All of the global excesses brought about by unprecedented use of leverage and misunderstanding of systemic risks are unwinding furiously and simultaneously.

We have been living in a world fraught with excess supply, which in and of itself is highly deflationary. That fact was hidden from view by the powerful global economic cycle, now ended, that produced a series of bubbles in real assets, such as houses and commodities, which made it appear for a time that inflation was the problem. Inflation can never be a problem in a world of excess supply and reasonably disciplined monetary policies. But deflation can be an enormous and potentially deadly problem leading to extreme financial system distress and even to social and political upheavals. We are now on the razor’s edge of falling into a pernicious deflation which surely will occur if aggregate demand continues to collapse.

Policy must focus on shoring up and eventually restoring aggregate demand. In this regard, I am hopeful and optimistic that the incoming Obama Administration understands the gravity of the situation and the risks and understands the urgent need to respond quickly, decisively and in size. Let us all hope that the new administration will be successful and also that longer run it addresses and revamps the policies that led us into this quagmire.

This is part 1 of our four part series of Bill Longbrake’s review of 2008 and the ongoing credit crisis. Bill Longbrake is the former Deputy to the Chairman and CFO of the Federal Deposit Insurance Corporation and Vice Chairman of Washington Mutual. He is currently on the Board of Directors for First Financial Northwest.

Originally published as Bill Longbrake MEMORANDUM, December 15, 2008, RE: Economic Commentary – Massive Negative Demand Shock Threatens Worst GDP Performance Since the Great Depression; Specter of Pernicious Deflation Lurks.

*Artwork created by Iron Man Records under a Creative Commons license at Flickr.com.