SAVINGS SPREE By Gary Shilling

SAVING SPREE
by Gary Shilling

My economic, financial and political outlooks have spawned six investment themes for this year. Three are likely to happen, while the other three are in the "maybe" category-they'll probably unfold at some point, but their timing is less clear.
First, a rally in the dollar is likely, especially vs. the euro
The rationale for the weak dollar is the growing trade and current account deficits. The fear is that foreigners will soon no longer be willing to hold the dollars generated by these deficits and invest them in U.S. assets, so the buck's decline is anticipating its collapse. Indeed, Indian, Russian and some other central banks say they are thinking about reducing their dollar shares in favor of the euro.
Nevertheless, most foreign countries depend on exports that directly or indirectly go to the U.S. Also, keep in mind that foreigners are selling and Americans are buying their goods, and in a world of excess supply, the buyer is king.
There are good fundamental reasons for the dollar to strengthen. The United States is the world's growth leader, which should benefit her currency. In addition, America lacks the language barriers, labor immobility and productivity-robbing socialistic tendencies that hinder Euroland economies. With these forces and consumer malaise, the outlook for economic growth in Euroland in 2005 and beyond is bleak. And with slow growth, interest rates there are lower than in the United States, which should attract money to America.
Longer run, America's commanding lead in new tech should ensure the buck's dominance for at least a decade. Historically, the country with the fastest productivity growth had the strongest currency.
Secondly, consumer deflationary expectations will spread:
When deflation is widely accepted, buyers anticipate it by waiting for lower prices before buying. This creates excess inventories and idle productive capacity, forcing sellers to cut prices in order to move goods and services. These cuts, in turn, confirm buyer suspicions, so they wait even further for even-lower prices and, in the process, generate a self-feeding deflationary cycle.
This is already evident in autos. In Oct. 2001, GM introduced loans with zero down, zero interest rates and zero payments for six months or a year, in response to 9/11. The result was an explosion of vehicle sales during that month, as consumers left their barricaded homes and stampeded into auto showrooms. But they got accustomed to big incentives quickly, so GM and other auto companies have had to keep increasing them in order to move the metal.
This last Christmas season showed that consumer deflationary expectations have spread from autos to general merchandise, especially Christmas gifts, as Wal-Mart saw when it decided not to offer giveaway prices on Black Friday, the all-important shopping day after Thanksgiving. When customers simply trotted over to the competition, leaving Wal-Mart with lousy start-of-the-season sales, the giant retailer had to chop prices to catch up.
Airlines also face consumer deflationary expectations as online ticket sales make it easy for consumers to find the lowest fare, and fares continue to fall. Telecom is another example. Intensifying competition among land-based telephone service, cell phone, cable, satellite, and now wireless is slashing prices and encouraging consumers to sign short contracts in anticipation of lower prices.
One can argue that falling real wages among lower-income households are the mainstay of this ruthless search for low prices. True in part, but as noted in the case of autos, and also valid in airfares and telecom, a pattern of price declines spawns deflationary expectations that spread to almost all income classes.
Another point to make is that the yield curve will probably continue to flatten:
The Treasury yield curve has flattened since the Fed started raising the short-term rates it controls last June. There's not much question that the Fed plans to continue its rate-raising campaign, which started when Federal funds was at 1% and at the current 2.5% target is still considered by the Fed to be below equilibrium.
How far is the flattening yield curve likely to go this time? Will it go all the way to inversion with short rates above long rates? It didn't invert in the low inflation run-ups to the 1953-54, 1957-58, 1960-61 and, in essence, the 1990-91 recessions, but it did invert ahead of recessions in the high inflation days-1969-70, 1973-75, 1980 and 1981-82.
The yield curve also inverted ahead of the 2001 recession, and that was definitely not an era of high and rising inflation. But the federal budget was in surplus then, and that may have convinced bondholders to accept lower yields than during the days of deficits. In any event, that surplus is history, at least for now, and in this era of low and, I believe, declining inflation, I look for a further flattening, but not an inversion of the yield curve in the quarters ahead. If I'm wrong and the yield curve does invert, look for a recession. That's always been the case in the post-World War II years. No exceptions.
Even without an inverted yield curve, the effects of the spread between interest rates on 2- and 10-year Treasuries moving toward zero will be considerable. It certainly would ruin the part of the carry trade that concentrates on borrowing short term and investing in long-dated Treasuries. And it's clear that the Fed is not happy with this carry trade anyway.
A flat yield curve would damage many less speculative investments. Financial stocks have done well in recent years and the earnings of those in the S&P 500 index account for about 40% of the total. This isn't surprising since, at heart, many financial institutions are spread lenders, borrowing short term and lending long term. The steep yield curve in recent years has been their bread and butter. Further flattening in the Treasury yield curve would compress these spreads-and the earnings of financial institutions-considerably.
And to start on the "maybe" section...maybe the housing bubble will break this year:
I've warned about the expanding bubble in housing prices in recent years, and continue to forecast its burst. Prices, which normally rise in step with incomes and the CPI, have run well ahead in recent years. What might trigger a nosedive in American house prices?
I can see four triggers. The first would be a spike in mortgage rates, reversing their long and housing-friendly decline. A second pin that could prick the house bubble is loss of confidence in mortgage-backed securities in addition to faith in the obligations of government-sponsored housing enterprises. This could result from the ongoing investigations of Fannie Mae's accounting. Fannie dominates that market, and the fixed-income instruments it backs have become very important components in the portfolios of many financial institutions. Third, the housing bubble could end if the low-end, first-time homebuyers lost their jobs and consequently were frozen out of the market. Then their plight would ripple up the move-up market, as those planning to buy more expensive houses couldn't sell their existing abodes at their hoped-for prices. Finally, leaping house prices might reach the point that they simply fall of their own weight.
A significant nationwide fall in housing prices, the first since the 1930s, would wipe out the slender equity of many homeowners and cause much more national distress than the big 2000-2002 bear market in stocks. As a result, widespread or chronic house price weakness would almost certainly end the 20-year U.S. consumer borrowing and spending binge and touch off a frantic saving spree.
A residential real estate collapse and a saving spree in this country, combined with its echoes and other negative economic consequences abroad, could create a big enough global financial and economic crisis to convert the good deflation of excess supply I foresee to the bad deflation of deficient demand.
Regards,
Gary Shilling
for The Daily Reckoning (daily avail by email at their site)