Thursday, December 11, 2008

Which Economy is Hurting the Most?

The EURO rallied mightily against the US Dollar from 2000 to 2008. From July of 2008 until October, the US Dollar turned with a vengeance. Since October, there has been a cat and mouse game of which area is the weakest. The US economy lead the way into the recession. Then it seemed like the wheels were falling off the cart in England and in most of Euroland. For the past few weeks, Euroland has bounced back. One can earn about half a percent more on ten year Euro paper than on US paper. The 10 year notes are now projecting very slow growth in Euroland but extra slow growth in the USA. So what?

The fact of the matter is that both areas are benefiting from the decline (turn) in input costs. Consuming nations, including Japan, are enjoying the turn and producing nations such as Saudi Arabia and Russia are taking the big hit. Countries such as China and India are the hybrids which are receiving inputs at lower prices but which are being slammed by the slow down in consumption of goods.

As the largest beneficiary of lower input prices (like the alarmist note, we consume 25% of the worlds energy supplies), the USA will lead the world out of recession. Japan and Euroland will take the hike with us. China and India will walk behind us at a distance. but once they start catching up, they will gather speed and run right past us, again (in terms of growth rate). It will take the resource providers, such as Russia, much longer to recover. The price of oil is not going to rebound as much as the economy.

The price of gasoline is likely to hit a US average of $1.50 pretty soon. By Memorial day, it might be back up to $2, but the glide path is down. According to reports from Brazil, the marginal production cost of their multi billion barrels discoveries is under $40 per barrel. My estimate of margin production cost on the last barrel of around 80 million per day is $35. The implication is that gasoline will get down to the $1.15 range within a few years. The big swings are fading and the price will be relatively stable for a number of years. Hybrid autos will show dramatic gains in market share when the 2010 cafe standards kick-in.


Holding the HYG bond funds is making the wait more fun. This junk bond fund has moved up just a little in the past 3 weeks, but when you hold bonds that have a current yield of 12+% and a yield to maturity of 21+%, there is no hurry. Was November 20 the Turn Date for junk bonds? I don't know, but all sorts of spreads have been settling down. The wild swings are mostly gone. The thirty year home mortgage is still high relative to 30 year treasury bonds but last week a credit union temporarily offered a come-on rate of 5.08%! When the words of Bernanke caused mortgage rates to drop two or three weeks ago, there was an historic surge in refinancing applications. Despite the fear in the market by many savers, there are still those ready to borrow on good terms. There is pent up home buying demand.

The narrowing of spreads is the return of "health" to the credit markets. Problems that built up over decades, such as the extremely high cost structure at GM, will not be solved easily but it is no longer true to say that "as GM goes, so goes the nation". GM is a very tiny portion of our GNP relative to what it was 50 years ago. Fifty years ago, there were hardly any fast food places to drive to. Today there are probably more people working in genetics labs than there are at GM.

Like other manufacturers, GM is seeing massive declines in input costs. Thousands of jobs have been replaced by robots that do not care about health insurance. Unfortunately, the company owes 68 billion dollars! It will take a lot of profitable sales to pay off its built-up debts, which are trading as low as 13 cents on the dollar. The bill to lend the auto companies 14 Billion Dollars is likely to pass. By March, these companies will need to have put together a "packaged settlement". The current idea is to appoint an Auto Czar to work out the details. The attempt will be made to do the packaged deal without doing a "packaged Chapter 11 deal".

The important fact is that we are drawing very near to the jumping off point in the cycle for consumer cyclical goods. A couple of hundred million US consumers are in the best financial position they been in for many years. Credit card debt as a percentage of disposable income peaked in 2005 for most consumers. The affordability of the average home for the average income was negative in 2005 but it is at an all time high now! The swing in real estate has been a much more significant economic event than the 70% drop in the price of oil. Real estate is the big daddy of asset classes.

The Russian economy has probably fallen the hardest. The US economy fell first but it is already seeing signs of recovery. The massive turn of the "Real Estate Battleship" is well underway. Now is the time to leverage real estate. Investors will make high returns on stocks and junk bonds over the next couple of years but the aggressive will make a fortune by taking over ownership of real estate with $1 down and the assumption of debt. Even properties that are currently worth less than the mortgage balance will be highly profitable to those who have the resources to make the monthly payments. The rents on many underwater properties are sufficient to make 90% or more of the payments.


The poorest of people are enjoying great relief as a result of the decline in the price of food (those who live off of corn meal see the price decline long before those who buy corn chips and cokes). Many of those who live off the equivalent of $1 per day are in much better condition today than they were last summer. It is interesting to note that one of the reasons that food is in greater supply is because when consumers cut back on their purchases of clothing, cotton farmers converted to corn or soybeans. Also, the bankruptcy of several ethanol plants did not hurt.

The poorest of the poor own cell phones. Suddenly there is a glut of cheap cell phones and the cost to provide service is falling rapidly. In the US, AT&T bought a WiFi provider because the more AT&T customers use WiFi, the less they use expensive cell towers. If an iPhone user is connected by WiFi most of the time, then AT&T collects the same revenue at a fraction of the costs. Today, one who has a WiFi enabled lap top can drive across the country and stop to make free connections at 10's of thousands of locations. Drive into the parking lot of a Holiday Inn and you are in business. Hot spots in places such as McDonald's and Starbucks are a low cost method of attracting customers. The fellow who buys a second cup of coffee at a Panera Bread Restaraunt pays the covers the cost of hours of WiFi service. A $100 per month connection at a store opened 12 hours per day cost the store 27 cents per hour.

While easy communication access is providing a major boom to productivity in the US, it is the poor who are benefiting the most. A very short text message might save an African a two day walk; that is called a productivity gain!

The bottom line is that the economies that were enjoying the rise in commodity prices are now hurting and the people who buy commodities are now being blessed. The self correcting hand is at work. The slower the economies the lower the prices fall and the more profitable certain businesses become.

By the way, over the next few weeks, I plan to add a lot of investment pictures to my FaceBook page. You are invited to check them out. I am finding that FaceBook is not all "fluff". It is a very powerful communications tool.