What's ahead for stocks and the economy in 2007? Setting aside unknown elements like major terrorist attacks or natural disasters, I believe six phenomena are shaping the investment climate this year. The world is awash in financial liquidity mainly due to rising house values, the negative US corporate financing gap and the American balance of payments deficit.
Inflation remains low despite higher energy prices. As a result, investment returns are low. Speculation remains rampant despite the 2000-2002 bear market. So, investors are accepting more risks to achieve expected returns. And then there's the insatiable US consumer, who, thanks to the booming housing market, continues to spend freely.
In this climate, I foresee 12 investment themes, seven of which are likely to unfold in 2007 while four will probably work but maybe not until next
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Advice for investors: housing prices will collapse
The housing bubble is deflating as sales of new and existing homes slide, prices begin to drop and housing starts decline. A bigger price plummet may start soon as many speculators give up on appreciation dreams and throw their properties on the market, triggering a downward spiral. Alternatively, interest rates on the Adjustable Rate Mortgages of many subprime borrowers will adjust up dramatically this year and force them into defaults and house sales.
Cheaper energy costs will not offset losses in house appreciation nor will non-residential construction growth. The Fed is unlikely to slash interest rates soon enough and big enough to save the day. Washington will be politically forced to bail out hapless homeowners, but as with the late 1980s-1990s S&L crisis, will probably arrive too late to prevent major damage.
The boom has largely been driven by investors' zeal for high returns, ample cheap mortgage money and lax lending standards. Unlike earlier US housing booms and busts that were driven by local business cycles-such as the rise and fall of the oil patch along with oil prices in the 1970s and 1980s-this one is national and, indeed, global. And since houses are much more widely owned than stocks, the bubble's likely demise will shake the economy more than the earlier bear market in stocks.
Advice for investors: Fed will ease
Meanwhile, the yield curve will remain inverted. Once the Fed embarks on an interest rate-raising campaign, it almost always keeps going until something big happens, and that something is normally a recession. Such a campaign clearly started in June 2004. This time, we're betting that the bursting of the housing bubble beats the Fed to the punch, but if not, the central bank will, as usual, do the recessionary deed. Once housing is in a shambles, either falling from its own weight as we expect or due to central bank action, the Fed, of course, will patriotically ease as the economy hits the skids.
The yield curve inversion, the only meaningful effect of the Fed's current campaign that we can find, rightfully worry many because they have preceded every recession since 1950 with only two fake signals. Today's rationalizations as to why long Treasury yields are artificially depressed appears no more valid than those in early 2000 as the yield curve neared inversion. The federal surplus at the time resulted in few new Treasury bond issues. That, the optimists believed, was depressing Treasury yields and causing a false recession-forecasting signal. But the 2001 recession followed the inversion, as usual.
Advice for investors: US stock prices will fall
US stock prices will fall, perhaps below the 2002 lows, in the midst of a major recession. A major decline in housing prices and activity will almost surely precipitate a full-blown US recession. That, in turn, will send corporate profits down after a spectacular advance over the last five years. Without this robust growth, stocks are vulnerable.
Advice for investors: a hard landing for China
China will suffer a hard landing due to domestic cooling measures and US recession. China is attempting to cool her white-hot economy, which grew at an estimated 10.5% rate last year, but is having difficulty.
Fundamentally, China is experiencing a capital investment bubble, which is very misleading even in open market economies since is sends the wrong signals to participants. Since it takes capacity to build more capacity, what looks like strains and shortages are really symptoms of mammoth excess capacity problems that are only revealed when the boom subsides.
That's what happened in the US new tech boom in the late 1990s, and now in China in less sophisticated industries. That excess capacity will, of course, drive even bigger exports.
A major US recession will shrink Chinese exports dramatically as US consumers buy less of everything, especially imports. Indeed, as US manufacturing shifts to China, so does its inherent volatility and inventory cycles-and the long shipping time between China and the US enhances those cycles' violence. So between domestic economic cooling measures and a US recession, a Chinese business slump is in the cards for 2007.
That, of course, doesn't mean an actual decline in real GDP in China. A cut from the current 10% growth rates to 4% or 5% would be severe since more than that growth rate is needed to employ the hordes that continue to stream from the hinterland to the coastal cities in search of better jobs and lives.
Advice for investors: weakness will spread
Weakness in US and China will spread globally, dragging down economies and stocks universally. The US economy dominates the world, not only because of its size but also because America is the only major importer. Most other countries are running trade surpluses, and the US is the buyer of first and last resort for their excess products. The Chinese economy is closely linked to America's, as just discussed, and a US recession combined with Chinese domestic economic restraint measures insure a global downturn. Other major economies in Japan and Europe simply can't pick up the slack.
Advice for investors: Treasury bonds will rally
Yields rose a bit over the last year, but surprisingly little in view of continued economic growth and further Fed tightening. This tells me that global deflationary forces are robust.
Downward pressure on Treasury yields will result when the Fed reverses gears and eases once housing is clearly in retreat and a recession is evident. I expect the current 4.7% yield on the 30-year bond to decline in
2007 and ultimately reach my long-held target of 3% when deflation becomes irrefutably established.
Advice for investors: Dollar will rally
The dollar will rally, but only after the recession becomes global. The greenback last year remained string against the yen but not against the euro. Of course, the global recession that will make the buck a safe haven is yet to unfold. Meanwhile, with the US likely to be the first major economy to slump and the Fed the first major central bank to cut rates, the dollar may be weak early this year. Strength would come later in the year as US consumers curtail spending, imports fall and, as a result, foreign economies become weaker than the US
Later this year, the dollar should gain against the euro and yen and also against the commodity currencies-the Canadian, Australian and New Zealand dollars-which will suffer as global recession slashes commodity demand and prices. Emerging countries' currencies will also suffer in global recession.
Advice for investors: commodity prices will nosedive
Commodity prices have shown unusual strength in recent years. And the robustness has not just been in the energy sector, but spread broadly. Industrial metals prices have skyrocketed. So has livestock and grains of late. Even precious metals have reached prices not seen since inflation was raging in the late 1970s.
In the long run, we don't see any constraints that will prevent the normal reaction to high commodity prices- increased supply that will depress prices. In energy, the Hubbert's Peak devotees believe the world is running out of crude oil so prices will skyrocket in the years ahead. But we're convinced that human ingenuity will, as in the past, prevent a Malthusian outcome. The ongoing fall in US home sales and likely collapse in prices will have very negative effects on the prices of building materials such as gypsum and copper. Lumber prices have already nosedived. And copper prices are already at a nine-month low.
Advice for investors: global and chronic deflation
Maybe global and chronic deflation will commence in 2007. With a global recession collapsing commodity prices and the robust deflationary forces already at work, major goods and services price indices here and abroad, such as the CPI, will fall this year if a global recession unfolds. But that doesn't guarantee chronic deflation. Inflation usually recedes in recessions, so it's the action in the following recovery in 2008 that will tell the tale. If price indices continue to fall then, true deflation will have arrived.
10. Maybe US consumers will start a saving spree, replacing their 25-year borrowing and spending binge. The money extracted from, first, stocks, and more recently, from houses are behind the drop in the US consumer saving rate. Just like the falling saving rate, the rising debt and debt service rates can't continue forever. With stocks likely to again fall significantly, a significant fall in house prices seems almost certain to precipitate the monumental shift from a quarter century borrowing-and-spending binge to a saving spree- unless another source of money can bridge the gap between consumer incomes and outlays. But no other sources such as inheritances or pension fund withdrawals are likely to fill that gap.
With no remaining alternatives, and with baby boomers needing to save for retirement, American consumers will be forced to embark on a long-run saving spree, although clear evidence of a chronic saving binge may be postponed until after the forthcoming recession.
Advice for investors: deflationary expectations
Maybe deflationary expectations will become widespread and robust. Deflationary expectations spread and intensified in 2006 as consumers waited for lower prices for cars, airline tickets and telecom fees before buying. Christmas 2006 sales depended heavily on slashed electronic gear prices.
When consumers wait to buy, producers are left with excess capacity and inventories that force them to cut prices. Those cuts only fulfill consumer expectations and encourage them to wait for even lower prices.
'Maybe' those expectations will leap this year because 'maybe' widespread and chronic deflation will be recognized. If so, then buyers will wait for lower prices, and vigorously so in many more product areas.
Advice for investors: suffering will extend beyond housing market
Housing is not the only area of heavy risk-taking. It just appears to be the most vulnerable. A Great Disconnect between the real economy and the speculative financial world has existed since the late 1990s. It's been fed by mountains of liquidity sloshing around the world, expectations of and demands for oversized investment returns, and low volatility, all of which have encouraged risk taking. Anticipated stock volatility remains at rock bottom. Spreads between yields on junk bonds and Treasuries are tiny as ample financing and loose lending keep corporate defaults at record lows.
The huge gap between speculative financial markets and economic reality has persisted for a decade. It will probably be closed with many tears in the next recession, only adding to its depth.
By Gary Shilling for The Daily Reckoning. You can read more from Gary and many others at www.dailyreckoning.co.uk
Editor's note: A regular columnist for Forbes magazine, Gary Shilling appears frequently on radio and television business shows and has written six books, including Is Inflation Ending? Are You Ready? In 1983 and, more recently, two books detailing his forecast for the new world order and its consequences for your wallet.
