Friday, December 31, 2010

The Economy: Karl Denninger, "The 2011 Predictions"

 "The 2011 Predictions"
by Karl Denninger

"We're not going to get away with spending another $450 billion in deficits on top of the $1.6 trillion we blew last year. $2 trillion in deficits? Not a prayer. Coburn (who voted for TARP, incidentally) said we had "four or five years" to get this under control. Nope. The time is now and this will be the year where the strain shows up in very uncomfortable ways. Since we put in place hundreds of billions in tax incentives and changes for the next two years, and The Republicans won't back off on that, we're going to see some sort of spending issue. This should get interesting given the Senate and Obama in the White House. What The Democrats seem to forget is that not spending is in fact something The Republicans can do whether the Democrats like it or not as they can refuse to pass and send up appropriations bills or continuing resolutions! The only question remaining on the table is whether The Republicans will come to town and do this or whether the market will force them to do it. Pick one, either way "entitlement nation" is about to get a surprise. Incidentally, I see this as emergent in 2011 but really getting ugly into the elections in 2012 - which sets up a number of interesting scenarios for that year.

Europe will not get their debt situation under control. I give us a 50/50 chance that Ireland repudiates it's "deal" immediately following their elections, and the cancer there will spread. I won't call a breakup of the Euro - yet - but the possibility exists that one or more nations will leave the common currency next year. I only see the odds as something around 50% though, so it doesn't go on the "prediction" board for this year.

The Dollar remains the hooker with crabs while many other currencies have AIDS. The wildcard is the Pound. Britain may actually have their act under reasonable control. We'll see. For the Euro, no such luck. I expect a wide trading range with lots of both euphoria and tears, perhaps as much as 40% or more. That means we'll get plenty of whipsaws in the /DX as well. Nonetheless, the doomers call of a dollar collapse and gold at $3,000+/oz will be wrong.

Oil is going to $100, and maybe considerably higher - but not on demand, rather on a "safe haven" and speculative play. Go look at 07/08 for how this plays out. And get ready for the bad effect on your wallet from higher gas prices. I expect the $4 line to be breached in high-cost areas by the summer, and we may see $5 gas this year. But - by the end of the year oil will be on the decline. Again. And again, it will be because the economy is in fact going down the crapper.

Commodities will continue to ramp right up until oil tops as the economic reality that "charge it" can't fix what's broken sinks in. Recognition will come hard and fast, and metals will not be exempt.  When oil starts to roll over beware. Everyone loves commodities. When everyone's on the same side of the boat it usually tips over and there are sharks in the water below.

Fannie and Freddie will get some sort of "resolution" path - and it won't be positive for them.  There's wide agreement that they were part of the problem. The republicans will blame the CRA as has been their refrain for years, but in the end it won't really matter. Expect an intermediate-term solution that prices Fannie and Freddie out of the mortgage market over the next 5-10 years but my best guess is that the government doesn't have the stones to force the bad paper back where it belongs - not entirely anyway. The government will also not be willing (or able) to keep its paws off the market, and this may well lead to a new crisis - in another 5 years or so. In other words they'll "fix" it by breaking it worse. Best bet is that we have Fannie and Freddie get "merged" and they'll try to hide the bad paper.  That may work for the Fannie and Freddie MBS, but.....

"Someone" will pry open the REMICs in MBS-land for at least private-label deals and fun will ensue. Don't be long big banks when it happens. The wheels of justice turn slowly, but they do turn and I believe 2011 will be the year when the logjam breaks. This, incidentally, is the one prediction that in my opinion is the highest-risk - the banks know this bomb is ticking and will try to defuse it through some sort of backdoor deal. I don't think they'll get it done - the lawyers smell blood and there's too much money to be made taking bites out of some very fat cats. If I'm right there will be at least one burnt offering made - probably BAC - and, if it comes at the wrong time, it won't stop there. If this gets going in the middle of a broad market sell-off Lehman will look like a cake walk.

China will roll over as their attempts to tighten policy have come too small and too late. They too have too many plates in the air.  Anyone who thinks that you can build cities full of apartments with nobody living in them and not have it blow up in your face is ridiculously naive.  Is China a good bet down the road?  Sure, once that speculation comes out and the pricing adjusts.  But this isn't in the here and now.

Housing is and will "double-dip."  There's no bottom. Those who bought the gamed reflex bounce on the tax credits and faux "stabilization" are in big trouble. My projection is for a mid-single-digit to 1x% decline in prices nationally in 2011, and even then it won't be over.

States will try to tax their way out of pension trouble, and fail. The Whitney call will be wrong but only because of how she phrased it.  States and municipal governments will be increasingly recognized as insolvent but they will continue to play games to try to stretch cash flow rather than defaulting outright. The States will not get bailed out (again) by The Feds - the money isn't there.  Beware the municipal bond market - IQI, for example, looks damn enticing right now in the $11s, down from $14 and yielding 7.3% tax free. That sort of spread over Treasuries is beyond insane, especially with the tax preference, and is pricing municipal debt as trash. If you like gambling and want to bet that The States will pull it off it's damn hard to beat a current 7+% tax free coupon and a potential 20% or more price appreciation potential on top of it. The problem with such appearances of a free lunch is that the sandwich offered to you is almost always laced with arsenic.

Between forced State austerity and semi-forced Federal austerity the rug will get pulled of the master "credit card spending" support. The disruption that will become evident, especially in the back half of the year, will be material. But the worst of it won't be in 2011 - it will be in 2012 and beyond.

Fed Index price paid/received divergences along with inventory build say we're going to double-dip in the general economy. I believe it. The Fed has of course tried to stop this with their QE games but they're not getting the effect they claimed they were after. The Hopium runs out in 2011 and the addict will go through withdrawal.

Margin compression will become realized. I'm just about the only one who's been talking about it in the back half of 2010 based on the PPI/CPI reports and regional Fed indices, but that won't last. We'll start to see it in the Q4 earnings and by Q1 people will be talking about it. This will put a cork into the "multiple expansion" crap that a whole lot of "pundits" have been running over the last year.

The inventory build we've experienced will prove to have been unwise. Expect a cycle of write-downs which will further damage earnings. Unsold inventory is a millstone around your neck. I've been talking about the warnings evident in the data on this for six months or so - the bet the market has made is that this will be sold through. Nope.

The Fed will get neutered, but it won't be due to Ron Paul.  He'll huff and he'll puff but won't blow down their house. It won't matter. Bernanke's credibility will be severely trashed by the end of the second quarter as his monetization will be increasingly seen by The Republicans as nothing more than a way to pander to the profligacy of Congress (which they'll try to pin in the Democrats, despite their fully-complicit role in it.) The end result (albeit through the typical partisan BS) will be that QE2 is the last time that happens, period. I expect an all-on attempt to change The Fed mandate to remove "employment" and possibly define "stable prices." These two things, incidentally, would be tremendously positive, and the first might actually succeed. The second?  Don't hold your breath.  Dennis Kucinich's bill would be even better, and it will be reintroduced - and fail to gain any material sponsorship including from the Pauls. Somewhere around the middle of the year this entire dynamic starts to become interesting in the 2012 Presidential sense.

The TNX will hit 4%, likely in the first quarter. The bad news is that spreads are likely to widen against everything else. Paradoxically, if we do get forced austerity - even a hint of it - on the federal spending side (and I believe we will) we'll see rates on the long end remain in control post-QE2 - they won't collapse as they did post QE1 but they also won't go bananas on the upside.  Scratch that latter half prediction if the 'Pubs roll over on spending or worse, try to ram through more tax cuts (and they might) - if so you better buckle up and the trade of the year will be to short the long end of the curve.

We won't get bond auction "fails" per-se (that's impossible given the Primary Dealer setup) but there will be plenty of "D"s and "F"s in terms of grades, with lots of tail showing.  Again, I expect this mostly in the first half of the year - unless the Republicans do something stupid (see the above item.)  This of course won't do good things for mortgage rates and stability in the mortgage market (which feeds into the housing projection above.)

The market will roll over this year.  And not in a small way either.  We may finish the year over 1,000 on the SPX, but we're going Helium-style diving at some point first.  Since timing is everything in this game I'll stick my neck out - there will be a sucker sell-down early this year, the market will bounce, and then Hell will rain on earth later in the year and into 2012.  If you want an analogue for it look at 2000 and before you buy into the end of the year note that buying the 2000 Christmas rally into January 2001 was one of the worst mistakes you could have ever made.  Momos will crack first - this has probably already started.  When you look at the above if even half of the above predictions play out the odds of an outright crash are quite high as the market has priced in an actual recovery.  I don't see it - what I see is unemployment remaining high and we're trying to hide it with the government credit card.  There are too many plates in the air on too many sticks and someone's gonna drop one.

Expect extreme volatility.  Anyone thinking the VIX in the teens makes sense is going to be proved nuts. There will be insane money-making opportunities for short-term speculative traders in both directions - bull and bear - in 2011. If you're short volatility in 2011 you're going to get trashed. The corporate leverage index will become realized risk in 2011.  I expect more than one extreme "crash-like" move during the year - the bad news is that not all of them will retrace. "Buy the dips" has been good for 18 months. Do it at the wrong time in 2011 and you're dead, especially if you're levered (and from the margin stats at present, a lot of people are. Hint: Take that risk down NOW!)

The potential for a regional war to break out is extremely high. I won't score this one, because I only give it a 50/50 chance.  But 50/50 is so far beyond the usual boundary of risk for these events that it deserves mention.  The most-likely and obvious place it happens?  North Korea - but that's not the only flashpoint.  I'm very concerned about a number of other areas across the globe including some that are off most people's radar at the moment.

• Civil unrest will spread beyond a few demonstrators in Europe. This includes the possibility of unrest in the United States. The Federal Government knows that as long as the Food Stamps and other general handouts continue they can keep a lid on things, but the fraying around the edges is apparent even now. It only takes one bad court decision or one person who is the wrong color and gets beaten in the wrong place by an overly-militarized police department to set off generalized unrest. The Federal Government's utter refusal to deal with the outrageous actions in Foreclosuregate along with bad acts by various parties, private and public (e.g. police departments) is stoking the firebox with dry tinder and spraying gasoline all over the place. All we need is a match to get lit and things will get out of control very quickly. While the Federal government should preempt state and local laws and make unfettered ownership of defensive arms available to all everywhere, the clowns in DC are too stupid to understand that when defensive force is needed in seconds to stop an arson, assault, or murder 911 will be there in 10 minutes - if the local copshop's cars aren't out of gas.

In 2007 I called upon Congress to set aside a hundred billion or two for "three hots and a cot" - literally - for up to 25% of the population for a year or more. I wasn't kidding, but now it's too late as we don't have the money, and there's zero evidence that at least in the big cities and other "liberal bastions" law enforcement understands that they cannot win against armed thugs - there are and will be too many of them. The only way peace can be maintained in such a circumstance is if the people are willing and able to help the police and that means unfettered ownership and carry of defensive arms. The radical left is beyond ridiculously wrong on this one, and we can only hope that this prediction turns out to be in error, especially if you live in a city of more than 500,000. The wise will figure out right now what they're going to do (and "shelter in place" is not one of the valid choices) if this prediction turns out to be correct.

As is always the case I reserve the right to make edits up until 1/1/2011 @ 11:59 PM - although I don't think anything's going to change in the next 48 hours in terms of my outlook."

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