The Great Unwinding

The party is over and the Great Unwinding has come. David Rosenberg, North American Economist at Merrill Lynch, wrote an interesting piece entitled "The Frugal Future." While this is his outlook for 2009, it really paints a picture of changing secular trends. His outlook is rather gloomy, as he tends to consistently have bearish analysis. However, I think this piece makes good points and I agree with many of the points he makes.

Rosenberg believes that the US economy will be in recession throughout 2009 and into early 2010 before recovering. This is a consumer-led recession. The consumer accounts for 70% of US GDP and 20% of the global economy. He backs up and notes that the average of the 10 US recession since WWII has lasted 10 months, but the average of the 32 US recessions since the Civil War has lasted 18 months. The reason that recent recessions were milder by comparison was due to two things: favorable demographics (baby boomers) and an expanding credit cycle. He argues both are done now. He spends most of his time on why credit will not expand going forward.

The current recession started largely due to a speculative bubble in housing prices that came unwound with excessive defaults in subprime mortgages. This recession will be prolonged by falling household assets, long-term consumer debt paydown, and deflation. I believe the real story here is the Great Unwinding - consumers are paying down debt. I think we will see this last for several years, not just several quarters. With consumers directing dollars to paying down debt, instead of increasing consumption, we are in for an economic malaise that will last a long time. During the third quarter, households had a net debt paydown of $29 billion.

Household assets are also declining, which is not surprising given what has happened to real estate values. Remember, homes are the largest source of net worth for the average American. Many economists are looking for a near-term bottoming in housing prices, at which point they believe prices will rebound. This analysis misses the bigger picture. The bigger picture is that there is no pent-up demand for houses and no amount of interest rate easing will create demand. Home ownership is still at a near record level, and well above historical averages. Further, we still have a near record amount of housing inventory, which now stands at 11 months. And the housing inventory is holding steady in spite of the fact that housing starts have dropped 65% from peak levels over the past couple of years. Finally, the marginal new home buyer is not credit worthy. People with foreclosures on their credit history will be unable to purchase a new home. With unemployment trending higher (6.7% now, could be going to double digits!), I do not see a catalyst for demand. While I look for the government to do all it can to stimulate demand, there is simply no pent-up demand. The government will merely be pushing on a string.

Deflation will also weigh down the economy over several years. And I see the economy in a deflationary mode. CPI fell 1.7% y/y in November. OPEC announced its largest cut in production ever today - and the price of oil FELL to a 4-year low. Normally, production cuts induce oil price increases. The price of gas has fallen from $4/gallon to about $1.75/gallon today. This is the equivalent of a $325 billion annual tax cut. Twice as much as the "rebate" checks we received earlier this year. Yet, with all this stimulus, what is GDP expected to do in the fourth quarter? Many economists call for GDP to fall 5-6% this quarter.

Ultimately, we are seeing a secular shift in consumer behavior. We have our cars, we have our HDTV's, we have our computers, our cell phones. We also have the debt to go with it. I believe we, as a collective society, will be paying down debt for awhile. I do not think we will revisit the Great Depression, nor do I see us revisiting a Japanese-style stagnation of the 1990's. But, what we do have is the Great Unwinding. What do I advise doing in this environment? Pay down debt. What if you have already done this? Buy long-term US Treasury bonds and long-term high grade corporate bonds. Buy equities that pay consistent dividends and have a history of raising their dividends.