The case for the abyss is straightforward: the subprime-mortgage disaster has already seriously weakened U.S. and European financial institutions, and plunging home prices in English-speaking countries are increasing the damage. The bears argue that the U.S. economy is now either in or on the verge of a recession, and the Fed is way behind the curve in reacting to it. Leveraged companies, high-yield (junk) debt and commercial real estate are the next to fall in what will be the most serious financial crisis in the banking system since the end of World War II.
The result, they say, will be a leaderless and extremely dangerous world, fraught with political uncertainty and soaring oil prices. The monstrous liquidity and leveraging binge of the past 20 years is over. Stand by for the hangover: debt liquidation, a round of “creative destruction” and a long period of economic stagnation.
This deadly brew will cause risk premiums on everything to rise, and the prices of equities, commodities and low-quality assets of all kinds to fall steeply. After all, stocks in most countries are either at or close to new highs, so it is not unreasonable to think they could easily decline an additional 20 to 30 percent. This is the prospect that terrifies everyone.
What do I think? I concede that the case for the abyss is possible, but I view it as very unlikely. In my investment lifetime there have been plausible scenarios for the abyss in 1970–74, 1982, 1987, 1997–98, and 2001–02. In each episode, I was scared half to death, the gurus were just as passionately gloomy and there were portfolio-rattling declines. But the world adapted and survived. In fact, the scares were buying opportunities. In the long run, I am always inclined to bet against the abyss, but I recognize that just because it hasn’t happened doesn’t mean it won’t this time.
The so-called authorities have powerful weapons to avert an abyss. Central banks can (and are) reducing official interest rates and flooding the banking system with liquidity. Governments can actively employ fiscal policy to stimulate their economies by cutting taxes and increasing spending. But as a 17-year secular bear market in Japan demonstrates, the authorities can misjudge the severity of events and make policy errors that can then be very difficult to remedy later.
A recession beginning right now and lasting through a good part of the year would be very painful. The risk of some form of the abyss, with all its consequences, would increase significantly. Currently, the high-frequency economic data in the United States and some other parts of the world are weakening fast, and the wounds to the banking system are deepening by the day.
But the authorities, God bless them, seem to be alert. Fed chairman Bernanke in a speech on Jan. 10 certainly said all the right things, and even the European Central Bank appears to be on the case now. The Fed will almost certainly cut rates 50 basis points at its late January meeting and do whatever else it takes to revive the banking system. I don’t think it’s too late, and I suspect that what we are looking at is a midcycle slowdown but not a recession. The abyss will be averted just as it was in 2000, but when the dust settles a lot of foolish money will have been lost.
Here are some signs of the health of the U.S. economy that you can monitor. Pay close attention to retail sales. December was bleak. The direction of new unemployment claims, job creation and the unemployment rate are crucial. New unemployment claims, currently at 344,000, would signal recession if they climbed to 375,000 (Bernanke specifically cited this indicator in his speech). The latest reading of the so-called manufacturing ISMs’ was 47.7 percent. If it falls to 45 percent, a recession would be likely. The purchasing managers index is another important indicator. If it drops below 50, it means the economy is probably in a recession. Finally, although home building is a relatively small part of the economy, an upturn would definitely improve the mood, as would a firming up of existing home prices in the United States.
What should you do if the economy does go into recession, the banking system seizes up and the odds of the abyss increase substantially? Buy U.S. Treasury notes, 10- and 20-year Treasury bonds, some Treasury Inflation-Protected Securities or gold. And stay close to shore.
