David Rosenberg's Outlook For 2010

To his credit--and, if the bullish consensus is right, his doom--David Rosenberg is sticking by his guns.

Below, from Gluskin Sheff's "Breakfast With Dave", is Dave's outlook for 2010.

OUR THOUGHTS ON THE OUTLOOK

The credit collapse and the accompanying deflation and overcapacity are going to
drive the economy and financial markets in 2010. We have said repeatedly that
this recession is really a depression because the recessions of the post-WWII
experience were merely small backward steps in an inventory cycle but in the
context of expanding credit. Whereas now, we are in a prolonged period of credit
contraction, especially as it relates to households and small businesses (as we
highlighted in our small business sentiment write-up yesterday).

In addition, we have characterized the rally in the economy and global equity
markets appropriately as a bear market rally from the March lows, influenced by
the heavy hand of government intervention and stimulus. But in classic Bob
Farrell form, 2010 may well be seen as the year in which we witness the inevitable
drawn out decline that is typical of secular bear markets. There may be some risk
in industrial commodities if global growth underperforms, but the soft
commodities, such as agriculture, may outperform in the same way that consumer
staple equities should outperform cyclicals in an environment where economic
growth disappoints the consensus view. Gold is operating on its own particular set
of global supply and demand curves and should be an outperformer as well,
especially when the next down-leg in the U.S. dollar occurs. We are not alone in
espousing this view — have a look at Why Consumers Are Likely to Keep on Saving
on page C1 of today’s WSJ.

The defining characteristic of this asset deflation and credit contraction has been
the implosion of the largest balance sheet in the world — the U.S. household
sector. Even with the bear market rally in equities and the tenuous recovery in
housing in 2009, the reality is that household net worth has contracted nearly
20% over the past year-and-a-half, or an epic $12 trillion of lost net worth, a
degree of trauma we have never seen before.

As households begin to assess the shock and what it means for their retirement
needs, the impact of this shocking loss of wealth on consumer spending patterns
in the future is likely going to be very significant. Frugality is the new fashion and
likely to stay that way for years as attitudes toward discretionary spending,
homeownership and credit undergo a secular shift towards prudence and
conservatism.

While hedge funds and short-coverings have been the major sources of buying
power for the equity market this year, what has really impressed me is what the
general public has been doing with their savings, which is to allocate more
towards fixed-income strategies. Looking at the U.S. household balance sheet,
what I see on the asset side is a 25% weighting towards equities, a 30%
weighting towards real estate and there is obviously a lot in cash and deposits,
life insurance reserves and consumer durables, but the weighting in fixed-
income securities is less than 7%. So my contention is that this is the part of the
asset mix that will expand the most in the next five to 10 years and I am
constructive on income strategies.

What also makes this cycle entirely different from all the other ones experienced
in the post-WWII era is that this is the first consumer recession we have
witnessed where the median age of the baby boom population is 52 going on
53. The last time we had a consumer recession in the early 1990s, the boomer
population was in their early 30s and they were still expanding their balance
sheets. The last time we had a bubble burst in 2001 they were in their early
40s. Now they are in their early 50s, the first of the boomers are in their early
60s, and we are talking about a critical mass of 78 million people who have
driven everything in the economy and capital markets over the last five decades.
This cohort realize that they may never fully recoup their lost net worth, and yet
they will probably live another 20 or 30 years.

So, what is happening, which is at the same time fascinating and disturbing, is that
the only part of the population actually seeing any job growth in this recession are
people over the age of 55. Everyone else can’t get a job or are losing jobs — there
is a youth unemployment crisis in the United States of epic proportions and a
record number of Americans have been out of work for longer than six months in
part because the “aging but not aged” crowd is not retiring as early as they used
to. My contention is that many retirees who took themselves out of the workforce
because they believed that their net worth would provide for them sufficiently in
their golden years are redoing their calculations and coming back to the workforce
to make up for their lost wealth. They are seeking income in the labour market,
not because they want to but because they have to in order to satisfy their
retirement lifestyles.

So, instead of being tempted into capital appreciation equity strategies, for every
dollar that the household sector has allocated to these funds since the March
lows, over $10 dollars has flowed into income funds — bonds, hybrids, dividends
and the like; the areas of the investment sphere that we have been recommending
this year. We can understand that there are concerns over inflation, but the
history of post-bubble credit collapses is that even with massive policy reflation,
deflation pressures can dominate for years — this was certainly the case in the
U.S.A. and Canada in the 1930s, and again in Japan from the 1990s until today.
Income strategies in both cases worked well with minimal volatility.

Of course, all the talk right now is about reflation and all the efforts from the
central banks to create inflation, but the facts on the ground show that the
inflation rate for both consumers and producers has turned negative for the first
time in six decades. Perhaps inflation is a consensus forecast but deflation is the
present day reality and often lingers for years following a busted asset and credit
bubble of the magnitude we have endured over the past two years. So, to protect
the portfolio in this deflationary landscape, a pervasive focus on capital
preservation and income orientation, whether that be in bonds, hybrids, or a focus
on consistent dividend growth and dividend yield would seem to be in order.

Be that as it may, what has also become crystal clear is the attitude that the U.S.
government has taken over the beleaguered U.S. dollar, which can only be
described as benign neglect. After all, 2010 is a mid-term election year in the U.S.
and the Administration will do everything it can to squeeze every last possible
basis point out of GDP growth and to prevent the unemployment rate, the most
emotionally-charged statistic of them all, from reaching new highs.
The decisions to give 57 million social security recipients another $250 and to
not only extend the first-time homebuyer tax credit but to expand the subsidy to
higher-income trade-up buyers smacks of populist economic policies that will
stop at nothing to generate growth, even with the budget deficit-to-GDP ratio is
already at a record of over 10%. While I still believe that a sustainable return to
inflation is a long ways away, there is little doubt that we will see continuous
efforts at policy reflation, which means that the U.S. money supply is going to
continue to expand rapidly, which in turn is positive for commodities, which are
after all priced in U.S. dollars.

On top of all that, it does appear from a volume demand perspective, that the
secular growth dynamics in Asia, China and India in particular, have reasserted
themselves and this part of the world is the marginal buyer of commodities. This is
the key reason why the Canadian stock market, given its resource exposure, has
continued to do very well in comparison to the United States, especially when the
positive trend in the Canadian dollar
enters the equation, and I expect this
outperformance to continue.

Typical of a post-bubble credit collapse, I see the range of outcomes in the
financial markets and the economy to be extremely wide. But one conclusion I
think we can agree on in this light is the need to maintain defensive strategies and
minimize volatility and downside risks as well as to focus on where the secular
fundamentals are positive such as in fixed-income and in equity sectors that lever
off the commodity sector, under the proviso that the “experts” are correct on this
particular forecast — that China and India remain the global growth leaders.

With that in mind, we were encouraged to see this on page B1 of today’s NYT —
Cutting Back? Not in China: Rising Incomes Make it Easier to Splurge. As Dennis
Gartman pointed out yesterday, there was a time (1820) when the U.S.A. was 2%
of global GDP and Asia was 33%. That is tough for a lot of folks to swallow but
maybe we will see in our lifetime a period when the Chinese economy does
surpass the size of the U.S.A. (with 1.3 billion people, four times the U.S.
population that actually seems quite likely).

After all, for the first time ever, China is going to be buying more vehicles than
Americans will this year (then again, 20% of the Chinese aren’t exactly three-car
families either) — 12.8 million units in China compared to 10.3 million in the U.S.
And it’s not even fair to compare appliances any more either with consumption in
China now up to 185 million (we are talking about washers, dryers, refrigerators,
etc) versus an expected 137 million in the American market.

In Q3, Chinese consumers bought more computers (7.2 million) than the U.S.A.
too (6.6 million). So while China is indeed still export-dependant and relies
heavily on government infrastructure projects, there may be something to be
said, at the margin, that consumer demand is also becoming an important
contributor to its economic growth. Now keep in mind that most of this stuff is
made in China and not in the U.S.A., so this is more of a commodity-input story
than it is a U.S. export story.

China’s strategy of deploying its surpluses in assets around the world is quite a
bit different than what Japan did with its surpluses in the 1980s. China is not
into golf courses or movie studios as much as in gaining ownership of global
resources in the ground. At last count, the country has signed trade deals with
Africa to the tune of $60 billion (heck, that’s only 8% of the size of TARP, which
is now going to be diverted towards a government-led job creation program in
the U.S.A.). Have a look at the nifty article on the topic on page 11 of the FT —
Africa Builds as Beijing Scrambles to Invest.

Jim Chanos shorting China

The conventional wisdom in Washington and in most of the rest of the world is that the roaring Chinese economy is going to pull the global economy out of recession and back into growth. It’s China’s turn, the theory goes, as American consumers — who propelled the last global boom with their borrowing and spending ways — have begun to tighten their belts and increase savings rates.

The Chinese, with their unbridled capitalistic expansion propelled by a system they still refer to as “socialism with Chinese characteristics,” are still thriving, though, with annual gross domestic product growth of 8.9 percent in the third quarter and a domestic consumer market just starting to flex its enormous muscles.

That’s prompted some cheerleading from U.S. officials, who want to see those Chinese consumers begin to pick up the slack in the global economy — a theme President Barack Obama and his delegation are certain to bring up during next week’s visit to China.

“Purchases of U.S. consumers cannot be as dominant a driver of growth as they have been in the past,” Treasury Secretary Timothy Geithner said during a trip to Beijing this spring. “In China, ... growth that is sustainable will require a very substantial shift from external to domestic demand, from an investment and export-intensive growth to growth led by consumption.”

That’s one vision of the future.

But there’s a growing group of market professionals who see a different picture altogether. These self-styled China bears take the less popular view: that the much-vaunted Chinese economic miracle is nothing but a paper dragon. In fact, they argue that the Chinese have dangerously overheated their economy, building malls, luxury stores and infrastructure for which there is almost no demand, and that the entire system is teetering toward collapse.

A Chinese collapse, of course, would have profound effects on the United States, limiting China’s ability to buy U.S. debt and provoking unknown political changes inside the Chinese regime.

The China bears could be dismissed as a bunch of cranks and grumps except for one member of the group: hedge fund investor Jim Chanos.

Chanos, a billionaire, is the founder of the investment firm Kynikos Associates and a famous short seller — an investor who scrutinizes companies looking for hidden flaws and then bets against those firms in the market.

His most famous call came in 2001, when Chanos was one of the first to figure out that the accounting numbers presented to the public by Enron were pure fiction. Chanos began contacting Wall Street investment houses that were touting Enron’s stock. “We were struck by how many of them conceded that there was no way to analyze Enron but that investing in Enron was, instead, a ‘trust me’ story,” Chanos told a congressional committee in 2002.

Now, Chanos says he has found another “trust me” story: China. And he is moving to short the entire nation’s economy. Washington policymakers would do well to understand his argument, because if he’s right, the consequences will be felt here.

Chanos and the other bears point to several key pieces of evidence that China is heading for a crash.

First, they point to the enormous Chinese economic stimulus effort — with the government spending $900 billion to prop up a $4.3 trillion economy. “Yet China’s economy, for all the stimulus it has received in 11 months, is underperforming,” Gordon Chang, author of “The Coming Collapse of China,” wrote in Forbes at the end of October. “More important, it is unlikely that [third-quarter] expansion was anywhere near the claimed 8.9 percent.”

Chang argues that inconsistencies in Chinese official statistics — like the surging numbers for car sales but flat statistics for gasoline consumption — indicate that the Chinese are simply cooking their books. He speculates that Chinese state-run companies are buying fleets of cars and simply storing them in giant parking lots in order to generate apparent growth.

Another data point cited by the bears: overcapacity. For example, the Chinese already consume more cement than the rest of the world combined, at 1.4 billion tons per year. But they have dramatically ramped up their ability to produce even more in recent years, leading to an estimated spare capacity of about 340 million tons, which, according to a report prepared earlier this year by Pivot Capital Management, is more than the consumption in the U.S., India and Japan combined.

This, Chanos and others argue, is happening in sector after sector in the Chinese economy. And that means the Chinese are in danger of producing huge quantities of goods and products that they will be unable to sell.

The Pivot Capital report was extremely popular in Chanos’s office and concluded, “We believe the coming slowdown in China has the potential to be a similar watershed event for world markets as the reversal of the U.S. subprime and housing boom.”

And the bears also keep a close eye on anecdotal reports from the ground level in China, like a recent posting on a blog called The Peking Duck about shopping at Beijing’s “stunningly dysfunctional, catastrophic mall, called The Place.”

“I was shocked at what I saw,” the blogger wrote. “Fifty percent of the eateries in the basement were boarded up. The cheap food court, too, was gone, covered up with ugly blue boarding, making the basement especially grim and dreary. ... There is simply too much stuff, too many stores and no buyers.”

(from politico.com, November 10, 2009)