This Recession Will Be Anything but Deep

by: Bo Peng October 16, 2008 | about stocks: DIA / FXE / IVV / SPY / UDN / UUP    

Bo Peng

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In Aladdin, Iago, Jaffar's sidekick parrot, has one of my favorite cartoon slapstick bits: Why am I not surprised? I think I'll have a heart attack from not being surprised!

News came out yesterday that Bernanke thinks there'll be a recession. And it's supported by retail sales numbers. The market had a heart attack from not being surprised.

I mean, is it news to anyone that we'll have a recession? We've been in one for a year. And we surely haven't seen its end yet.

But all this talk of a deep, wide recession is nonsense. Human intuition is based on linear extrapolation. Gloom and panic are always at the height just before the bottom. But in the height of panic people have forgotten one key difference: the government finally got it this time.

Bloomberg had an interview saying "Bailout Is Big, Bad, Ugly, the Only Answer: Jane Bryant Quinn." I agree with Jane on everything except the "only" part. None of the government rescue efforts since last August were the only choice, especially the massive liquidity injection of the past few weeks, the $700B bailout and the latest comedy of banks being forced to accept government money for peanuts in return. But, be that as it may, this latest mafia drama will break the logjam because it finally stumbled on one of the root problems. It will take some time for the massive liquidity and capital to flow down the money supply chain. But it will. It must. Banks need to make money, even if they're not allowed to fail.

The other root problem, housing prices, has been helped by several pieces of give-away legislation, and will no doubt continue being helped by the new president and congress. These bailouts are equally morally suspicious and objectionable as are the bank bailouts. But, again, they will work. As a result, housing prices may still go down somewhat, but much slower than without the help.

Government supported housing prices plus government supported banks:  Wow, everybody is risk-free! It's a risk-free world! How can banks not lend and buy risky assets as long as there's no chain reaction on 10/21? In a few months, as the money flows down the pipe and with banks begging everybody to borrow (they would do a Paulson if they could), how can companies not hire and expand?

And, remember the $400B write-downs by US banks and $300B by European banks? They're write-downs, paper loss. As soon as housing prices stabilize and CDO market volume recovers, $350B of it will become write-ups. Bank quarterly numbers will go up so fast and furious, it'll feel like the good ol' times again.

This recession will be anything but deep.

So will we get out of this mess without paying any price? Of course there's a price. The price is prolonged inflation and massive debt for future generations.

Inflation will be mostly driven by the commodities bubble, credit bubble, and housing bubble. Yes, we may very well have yet another housing bubble in front of us.

But what's the problem if we can keep the bubble going in perpetuity?

The only problem is we can't. At some point people will stop buying our debt and stop using our currency to settle trades. Sure, Saddam threatened to settle his oil in Euro and look where he is now. But unfortunately we got in so much trouble in Iraq, the lesson we intended to teach others has turned into encouragement, for Chavez at least.

Yes, people have no viable alternative since the Euro is in even worse shape now. But desperate people find desperate solutions. Just as we've been doing unimaginable, desperate things to avoid the current crisis from deepening, the world will find unimaginable, desperate alternatives if necessary. You can only count on others being suckers for so long.

The fantastically flawed and effective bailouts we've seen in the last few weeks have hastened the day of reckoning, or at least made it much harder to avoid or delay.

But that's our children's problems. For now, enjoy the new, risk-free world. Be bubbly.

Disclosure: None

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This article has 28 comments:

  •  
    Oct 16 09:54 AM
    Who's afraid of the big bad (INTC)? Not I! I see this down turn in the market a chance to capitalize and to buy (AMD) at a reduced price and be into the the awaiting of competition factor for (AMD) both R&D and new innovations coming from the design staff for the long haul. So take off the gloves and come out designing the next series of smart processors.
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  •  
    Oct 16 09:56 AM
    Thank you for reminding everyone that the sky is not falling despite what an omnipresent sensationalized media would have us believe.

    Living in the age of instant information, we are able to witness every important event. Modern day Americans have come to expect events and history in fast motion. We no longer know or accept patience.

    In a few months we will have a new administration and the spend spigot will continue wide open. A year from now we will be dealing not with recession but a different subject, inflation. By then the media will need a new event to shove in our face.
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  •  
    Oct 16 10:13 AM
    Here is a different scenario:

    Much of the government equity being infused into financial institutions around the world does not get into circulation. Instead it disappears into a black hole as the pyramid of debt is unwound (default write-offs) and money is added to reserves to keep these banks in business. With only a limited amount of all this "new" money actually being available to support new credit, there is little inflationary pressure. With credit remaining tight, house prices continue to decline, production continues to flat line (or even drop) and deflation is a much bigger risk than inflation.

    Is Bo Peng looking at the correct picture or am I? Stay tuned. I believe the world is teetering on a fence and could go either way.
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  •  
    Oct 16 10:34 AM
    I agree with jlounsbury59 that we could have either deflation due to the continued unwinding of debt or inflation as a result of all the newly-printed money governments are shoving out into the system.
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  •  
    Oct 16 10:50 AM
    Name one time where the US has had a 'deflationary' solution to anything. You'll see that we have an 'inflationary' campaign in both the past and especially in this current 'crisis'.

    Bailouts, handouts, liquidity, injections, yada yada. It all spells inflation with a capital I. The deflationary theorists will be proven wrong again. Our government's going to inflate our way out of this, and it's already in motion to do just that.
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  •  
    Oct 16 11:05 AM
    I totally agree with the inflationary period ahead of us...however I keep wondering when that cycle is going to start since the dollar seems to be holding. Certainly it's up due to the fact that it's the "best looking" ugly currency in the basket - but with the US printing presses winding up and a rising tide of dollars being pushed into the economy...I'm expecting an inflationary process to begin almost any day...
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  •  
    Oct 16 11:15 AM
    I disagree with the fundamental premise here. While government intervention is indeed finally becoming effective the recesionary effects of the restoration of sustainable credit standards and general common sense in the pricing of risk will still mean significant housing and commodity price declines. These declines will lead to a deep recession and an equally sharp recovery. We are however at least 12 months from the end of the recession and at least 6 months from its bottom. It will be time to buy stocks again once more reasonable earnings are priced in for FY 09 which will likely happen some time between Q1 and Q2 earnings reports. Bond yields also need to come back towards reasonable levels. Banks do indeed need to make money, and in order to do so they need to take risk. It is extremely difficult to make money by taking risk if the price of the risk is artificially deflated.
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  •  
    Oct 16 12:16 PM
    Deflation in the short term is expected, as banks and hedge funds deleverage and/or unwind. I was talking about inflation in the longer term, starting from at least a few months out, when money flows down the pipe and reaches Main St and takes effect in consumer credit, hiring, etc.
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  •  
    Oct 16 12:43 PM
    Even if the money going into the banks is used to retire debt, that money flows into the pockets of lenders. The only debtor who is piling up debt, is govt and everyone else, who receives the funds from debt repayment will have to buy something with the funds. ONly govt can retire debt and vaporize money, people-sovereign funds-hedge funds or any one else getting money from debt retirement gets cash. Will they put that cash in a cave for a rainy day?? Not likely, they will create the next bubble, only I don't know what bubble will be created next, since all assets have now been deflated.
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  •  
    Oct 16 12:50 PM
    You just let me know when I can wallpaper my house with Benjamin Franklin's green face on those hundred dollar bills because it will be cheaper to do that than to go out and buy real wallpaper.
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  •  
    Oct 16 02:53 PM
    If you think inflation is an answer it is actually a major contributor to the original problem -The consumer is maxed out already -if you take him from deflation to inflation he will be even more broke - this is starting to look like a dog chasing his tail -
    you must make the consumer whole again - do you think higher- interest rates -credit card bills -food costs -energy and gasoline bills are going to do that you are delusional
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  •  
    Oct 16 05:05 PM
    mr. g - your comment is a good one, but it should be directed at our own government. They're going to inflate us out of this current state, no question. The only thing we can do is prepare for that coming inflation. Cash in savings accounts will crumble in value.
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  •  
    Oct 16 08:45 PM
    Well if you believe that there could be either inflation or deflation then I guess you are most certainly going to be both right and wrong aren't you?
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  •  
    Oct 16 08:50 PM
    When the credit crisis recedes - and the signs are that it is beginning to do so - China and India will resume their industrialization and middle class growth and the entire developed world will be absolutely awash with new money chasing a relatively fixed number of assets, creating inflation.
    Inflation is "always and everywhere a monetary phenomenon".
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  •  
    Oct 16 09:03 PM
    i am a little confused here. a recession is not a discussion of the market or bank write downs. we have a real recession with loss of consumption.
    Reply | Link to Comment
  •  
    Oct 16 09:42 PM
    I enjoyed and had a good laugh... be bubbly. Peng is a genius... it is true; today real estate firms in Spain were finalizing debt restructurings. No more debt problems... be bubbly. We will choke in these exhilarating moments.


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  •  
    Oct 16 09:46 PM
    Inflate or die.
    Reply | Link to Comment
  •  
    Oct 16 10:23 PM
    Talin, what we're witnessing is nothing less than the tragic failure of private capitalism AND democracy. This is a sad chapter in human history.
    Reply | Link to Comment
  •  
    Oct 17 12:31 AM
    Finally a sane discussion. You remember Y2K? Planes were going to fall out of the sky, the electrical grid was going to shut down, gravity would reverse, and anarchy would ensue. All because computers couldn't handle an extra byte or two. Teams were formed, code was written, arguments were held over whether 2K was the year 2000 or 2001. People bought generators, bought guns and ammo, loaded up on freeze dried food, hoarded cash because ATM's would not work, and vendors of this stuff, loved it. The media LOVED it too. They saw the potential and milked it for all it was worth. Magazines wrote articles on every angle, radio shows talk-talk-talked up the panic, and TV scared everyone with teasers so they'd get "the inside story". The big day came, and if memory serves me correctly, one water treatment plant in Wisconsin had an issue.

    Now everyone is freaking out about the market (and they should this time because they have retirements and pensions at stake), but the alarmists are siting hedge fund sell-offs, related to margin calls resulting from Lehman swaps, as if this is the end of capitalism. We are deleveraging. We are deflated. We'll flood the world with capital and get back to inflated so that debts can be settled. Let's hope everyone learned a lesson for twenty years, invests more conservatively, understands their financial limits, and repeat the whole thing over again in 2025.
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  •  
    Oct 17 01:31 AM
    I tend to be more pessimist considering that i) How many times have we seen 3 out of 5 of the biggest investment banks and the biggest insurance in US fail or falter together. ii) The derivatives mess has been estimated at 2-3 Trillion dollars (making the 700 billion looks small). Personally, the bailout may not be sufficient and only time can tell. Also S&P 500 has only fallen 40% since Oct 2007, this is still short of the 50% drop in the Dot Com bubble and I am sure that the bubble today is bigger and more widespread than 2001.
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  •  
    Oct 17 02:42 AM
    There are a few things missing here in the inflation/deflation argument:

    1) We are destroying credit, which is deflationary. Much of the money supply is credit and/or leverage. It is imaginary, not "real" money supply. As a result, money is being destroyed faster than it is being created.

    2) We already HAD the rabid inflation people were predicting years ago. In case you missed it: oil was trading around $150 bbl, gold was north of $1000/oz., etc., ad infinitum.

    3) We have never had inflation during a falling housing market.

    4) We have passed a psychological threshold where banks, people, and businesses no longer view "easy credit" as desirable. Gov't can't reinflate that balloon right now, there are too many holes in it.

    My personal opinion is that we get strong deflation for a while as the deleveraging and credit destruction continues. Once that unwinds fully, we will finally see inflation again.

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  •  
    Oct 17 06:29 AM
    Thanks, Mr. Peng. Sorry I was misunderstood... what you say is what I mean. Too tragic what we are witnessing.
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  •  
    Oct 17 11:43 AM
    Pretzel Logic, I agree with most of what you said. But I also say the destruction of credit is close to an end -- some hedge funds, perhaps even another regional bank or two.

    In addition, it's hard to argue what the gov has done to Fannie and Freddie, no matter how flawed, is not helping the housing market. And there'll be more and more such "help homeowner" legislation and policies going forward. Politicians will feel obliged to dish out handouts until the deflation is over. So housing market will be help by two sides: easy credit and homeowner support.

    As to the psychological aversion to "easy credit", I don' think it'll last. We may have learned a lesson now. But we also forget. Instant gratification and greed triumphs over long-term discipline every time.
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  •  
    Oct 17 01:00 PM
    I tend to agree with pretzel logic. I don't know of any significant occurrences of asset price deflation that didn't also have product price deflation succeed it.

    As for Peng's idea that the financial losses are not as bad as they appear because the prices of the debt instruments may go up, I would point out that US financial firms are understating their losses, because as the price of their debt drops below par, they record that price drop as profit. The accounting principle is that they can buy the debt back cheaper than they sold it for.

    There are also a lot of companies with defined benefit pension plans, who assume an annual profit on those plans, even in a year like this, which are in their earning statements. And finally, the companies that are losing money, get to record future tax credits as profit now, even though they have to make a profit to collect that tax savings. Remember GM? They finally had to write those imaginary profits off, because they weren't going to make a real profit in time to collect the tax credit.

    My point - the reported losses are actually much bigger than reported.
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  •  
    Oct 17 02:15 PM
    Don't Worry, Be Happy.

    Opaque "Shadow Banking" still in effect causing banks to be tight.

    "Financial Engineering" that no one seems to be able to value adding to the constriction.

    Adjustable rate mortgages still reseting in tidal wave proportions until 2010.

    The Fear based metrics still at all time highs and having a reinforcing effect.

    Think I will just look away from the storm and ignore the peals of thunder until it gets here.
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  •  
    Oct 17 09:11 PM
    The writer is wrong. My father used to say, about the Great Depression: "Steak was a quarter ($.25) a pound. That was a great price, but almost no one had a quarter." In our current era this country had so much money in play when it lost its financial footing that it will require a long, slow slide to produce the final losses, which are going to be almost incomprehensible. But those losses are coming, by degrees, as we are able to afford only less and less expensive things. In the meantime, put all your quarters in a jar, at the end of each day. In time, you'll still be able to eat steak when most people cannot.
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  •  
    Oct 19 03:33 AM
    Bo Peng - I totally disagree with the often mis-stated notion that this was a failure of democracy and private capitalism. Perhaps a failure of democracy (because the unaware masses have allowed the politicians the power to do this to us) but certainly not a failure of true free market capitolism. Prices are moving which means its still working. Grocery stores are still full of food. On time supply chains are adjusting to our demands. The failure is in Fascist controlled fiat money supplies that destablize prices causing inflation which pushes a moral people into immoral speculation just to be good savers or worse pushes people not to worry about the future at all and spend everything they have. If you look at all the problem areas (government overspending, too much military spending, the federal reserve and its politician friendly loose money supply, susidized airlines, subsidized this and that, ethanol subsidies or high corn prices, sugar import tarrifs, an unaccountable education system, government backed monopolies,....I could go on and on. Almost all the problems with the exception of very short term issues are in areas that are highly regulated, fascist, socialist, etc... Its not a free market failure its a failure of socialism and fascism as it pretty much has been throughout the history of the world. Free markets have always worked when void of socialism, fascism, and monopolies. Government will do to healthcare what they have done to everything else they've touched. Think customer service at your post office or local DMV. Think about how much they will pay for office supplies when they can be bought cheaper at office depot. Think of that new computer governments by for people every two years who only do word processing.


    I think the dollar is holding value because people are selling stocks and getting back into dollars. Dollars are replacing bad debt. Even if its a perfect offset to deflation right now eventually things will normalize and we will have more dollars in circulation. Since we buy every thing in dollars the price of everything will go up. Especially if the banks leverage off of the larger dollar supply again. There are so many factors that play into the supply demand picture of the dollar and just about anything else that it is really hard to tell what will happen.

    Diversify.
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  •  
    Oct 22 07:49 PM
    Today's market has been somewhat puzzling. No reports of damage from Lehman settlement, which may mean the daily hedge and collateral adjustment may have worked better than many (me included) had expected or feared. Or it could mean just a delay -- the public won't see it until the next quarterly report.

    The Fed's decision yesterday to inject $630B into money market funds was also puzzling, after reports showing a sizable inflow into them. Why did they decide it was necessary, ineptitude of the Fed or factors unseen by the public?

    Synthetic CDOs are definitely affected by this settlement. But I don't understand why the big fuzz all of a sudden as if it's a huge surprise. Synthetic CDOs based on ABS certainly have taken their losses a long time (months) ago. Those involving Lehman may have their equity or mezzanine tranches wiped out or severely damaged. But these tranches are very narrow. And CDO issuers (big banks) usually hedge them, though may not perfectly. The ultimate losers in synthetic CDOs are the CDO investors in equity and mezzanine tranches, of which there aren't that many.

    Regardless, I think we can say by now that the government bailouts have worked. Chain reaction has been stopped, at least for now. I expect Libor to continue dropping and the money pipes to continue opening up.
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