Many observers expect positive changes for the nation, the economy, and the stock market in the wake of President Elect Obama's historic victory. As much as we, at Comstock Partners, would like to be optimistic, we must continue to call it as we see it. We still have the negative views that we have been expressing in our comments over the past 8 years. We are getting closer to the point in the stock market where we will turn more bullish, but we are not there yet. These areas were touched on in last week's comment, "Ideology", just after the sub-title "How Low Can It Go?" We do believe that President Elect Obama is very qualified and is getting advice from the right economic advisors; however, he has inherited a real mess that is not subject to easy solutions.
We have a budget deficit of about $455 billion this fiscal year and as we have warned in many of our weekly comments, we expect a deficit of $1 trillion or more in the next fiscal year. The incoming administration is also inheriting a $10 trillion government debt that we have to hope and pray is not left to our children and grandchildren to pay back. We don't expect the current global recession to end until the end of 2009 or beginning of 2010. The record U.S. total debt of over $50 trillion on an economy of almost $15 trillion is what we would call very onerous. For a period of about 20 years from the 1960s through 1970s it took $1.50 of increased debt to generate each additional $1 of GDP, but that ratio has trended up consistently in the last 28 years and accelerated from 1997 to present. This year it took $3.50 of increased debt to generate an incremental $1 of GDP and we expect that to be the peak for many years to come (chart created by Comstock and published by The Chart Store is attached). The deleveraging will be very negative for our economy. And now that the deleveraging process of debt unwinding is in full swing worldwide, what do you think is going to happen to global economic conditions?
It now looks as if all of the global economic problems we have been warning our readers about over the past eight years are coming to fruition. The Purchasing Managers Index (PMI) plunged this week to 38.9%. The weakest component of the PMI was order backlogs which fell to 29.5% and the next weakest was the employment component which plunged to 34.6%. However, the most significant to our economy was the drop in export orders to 41.0% from 58.5% just four months ago. This shows that most foreign economies as well as the U.S. are in a recession. Japan manufacturing PMI was 42.2%, China was 45.4%, and the Eurozone was 41.1%. The global manufacturing PMI plunged to 41.0% from 52.0% at the beginning of the year. Most investors aren't aware that over the past year the U.S. generated 75% of our growth in GDP from exports; from where will we be getting our future growth? Today many companies in reporting their earnings complained about the strong U.S. dollar hurting their international sales including News Corp, Wal-Mart, and Costco.
Worldwide Rate Reductions
Our regular viewers hopefully remember our predictions in the September 18 weekly comment, "More Predictions", where we used examples of various countries (e.g. Russia and South Korea) whose central banks were raising interest rates and intervening in the currency markets in order to shore up their currencies. We argued that there would be a screeching halt to these policies and a huge swing from rising rates to a trend toward decreasing rates or "competitive devaluations" in order to help generate growth in domestic economies. We mentioned in the September report that the ECB and Bank of England kept their rates unchanged the prior week at 4.25% and 5% respectively and pointed out the reasons they justified to keep their rates high.
Well, most of you now know that there has been a radical change of heart. There was a coordinated rate reduction from many countries including the Bank of England and ECB when Secretary Paulson and Fed Chairman Bernanke met with the G-8 during the worldwide credit crises. And just recently Australia cut its key interest rate by 75 basis points and Japan by 20 basis points (to 0.30 %). Numerous other nations around the world have also cut rates.
Just today the Swiss National Bank lowered rates by 50 basis points, the Czech Republic National Bank by 75 basis points, and Denmark by 50 basis points. The ECB also lowered rates by 50 basis points to 3.25%. By far the biggest surprise was the Bank of England slashing its key interest rate by one-and-a-half percentage points to 3%. This was its biggest rate cut since March of 1980 and the lowest rate since 1955. It has never been below 2% in its history.
We expect this trend to continue as most central banks can now see the tremendous economic weakness caused mostly by the deleveraging process. In the period ahead we also expect that nations around the globe will attempt to devalue their currencies in order to export more goods to their trading partners. And we don't expect it to stop there. As we show in The Cycle of Deflation, "beggar-thy-neighbor" policies will follow. These are policies to export goods and services to trading partners in order to support their own economies at the expense of others. That would include trade policies of exporting goods below cost in order to keep plants open or imposing tariffs on imports.
Again, we would like to be wrong and sure hope the cycle of deflation (or unwinding of debt) will end before resorting to onerous trade policies. In any event we think that the global economy is in for a period of decline followed by sub-par growth for some time to come. If the slew of governmental efforts works, it will prevent the collapse of the financial and credit system. It cannot, however, stop the deleveraging process that is necessary to clear the air for the next cycle of economic growth. In this sense the severe stock market declines we are seeing everywhere is not based on irrational fear and emotion, but on the recognition of the new reality. If anything, it was the twin bubbles of the past decade (dot-coms and housing) that reflected fantasy and irrationality. We are now going through the deflating of a financial mania, and history shows that such transitions are never easy and usually painful.