Saturday, August 2, 2008

catching up

I have been neglecting this blog horribly. one reason is I feel I have been largely right on many trends such as oil prices and the squeeze on corporate profits. both of these scenarios as playing out as I expected.

I am not sure if these ideas will play out as much, but they're worth thinking about:

who will provide the american consumer with goods over the next 20 years? for the last 20-40, asian producers have taken over large parts of our supply chains. now their currencies are destined to appreciate and our trade gap is narrowing. the trend of using the global economy to cut procurement costs is nearing its end -- especially because of fuel costs. consider this in today's NYT:

When Tesla Motors, a pioneer in electric-powered cars, set out to make a luxury roadster for the American market, it had the global supply chain in mind. Tesla planned to manufacture 1,000-pound battery packs in Thailand, ship them to Britain for installation, then bring the mostly assembled cars back to the United States.
But when it began production this spring, the company decided to make the batteries and assemble the cars near its home base in California, cutting more than 5,000 miles from the shipping bill for each vehicle.

link

basically, we need to rebuild the productive capacity in the USA. we need to build electronics, machinery, etc.

I have at least three major concerns:

1- the causes of off-shoring and out-sourcing remain. production has been leaving the USA since the 1960s because of problems with taxes and regulation.

2-the US financial system is now under distress, discouraging investment in new factories and companies.

3-the trend in CFO-land has been away from investment and in favor of shareholder returns. given the bubble in capex in the late 1990s, management has generally preferred to buy back stock than to invest in the USA. this prejudice has to be unlearned. (in the long run, it's bad for stocks because lets capital to leave the equity market in general.)

these trends seem to be playing out right now. and, of course, there is the CREDIT CRUNCH as well. when people can't borrow, it reduces the earnings power (and thus value) of normal equity investments. this creates a perverse incentive to hoard capital... which is why money market accounts now have near-record balances.

DEFLATION is another worrry. first, let me say I am not worried about deflation. our declining currency and negative real interest rates will prevent us from facing a real deflationary problem.

but people are right to worry about the possibility of deflation. when banks are impaired, they lend less, meaning that less new money comes into existence. this has a broadly deflationary and depressionary effect.

Mastercard's second-quarter earnings illustrate what may be going on. this is the change in the gross dollar volume (GDV) of transactions:
Q4, 2007: +10.6%
Q1, 2008: +8.9%
Q2 2008: +6.2%

the slowing pace of growth reflects less money moving through the economy, one of the key elements of deflation.

(management cited the continuing shift away from consumer discretionary to non-discretionary items. given that many people and assets (stores, etc) are linked to non-discretionary activities, this means other problems lay down the road for the US economy.)

to sum it up... we have the:

DEFLATIONARY pressures of a damaged banking system

combined with the

INFLATIONARY pressures of low interest rates and a declining currency

this seems to be a similar situation as was found in latin america in the 1980s, but I still need more data on that. I am not sure how distrssed the banks were. it's very different from the case of japan in the 1990s... their deflation problem resulted largely from the doubling of the yen in the 1980s.

I think it's a bearish situation. because we have deflation, people don't want to invest in new businesses.

hopefully, capital will flow into the areas where products are the most inflated: fuel and food.

right now, there are so many inefficiencies to overcome -- it's actually quite exciting to think about. for example, why in NYC must we consume carbon to ship large amounts of heavy organic food waste to landfills 100s of miles away? why don't we have restaurants put their food waste separately and charge them per pound of other waste. why don't we have a municipal swine yard someone on staten island? the city could turn waste into real revenue (by selling meat).
I see a world where suburbanites grow things like potatoes in their yards rather than rely as much on trucks and companies to deliver them from far away.

but in the next few years, I think the trend will be toward contraction and problems before they start to be solved.

in sum, we're only now starting to feel the real economic effects of the problems in the financial market. the truth is, this isn't just about financial markets. it's a question of the assets in our country. many were built with certain assumptions in place (such as "we can always refinance when the loan resets" .. or "gasoline will be under $3 a gallon" or "the consumer will always have money to spend" ) ..

those assets were largely debt financed. as they lose value, banks will lose money. (which is happening right now.)

when banks have losses, they need to TAKE money from the economy in the form of new investments. note that this is a 180 degree turn from their normal function, which is to GIVE money to the economy.

I think one more irony is emerging in this credit crunch. we are now finding that debts secured by a certain asset, such as a home mortgage or car, are falling apart. yet credit card defaults have not risen as much. I believe that once assets fall out of favor, debtors will be less willing to honor liabilities tied to them.

if you know houses are falling in value, you don't want to own one... that means you don't see any reason to need a mortgage, and you don't have to worry about your credit score... so, why not walk away? people may link the debt to the collateral.

on the other hand, a credit card is tied to their personal spending, and thus lifestyle. cash is a giant hassle -- especially with more and more commerce moving online.

essentially, it's more important to keep a functioning credit card then a functioining mortgage. it's also much cheaper for most people. as a result, they will continue making at least their minimum payments.

it's just another intesting irony that the collateral itself, intended to reduce the risk, might actually be the source of the risk.

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