For most economists, the main question is whether we will have a new recession.
For Gary Shilling, the only questions are when and how big.
Unlike many gloom and doomsters, Shilling is a genial sort who likes cracking jokes and keeps bees as a hobby. But when it comes to economics he’s dead serious: He’s been consistently gloomier than the economic fraternity and consistently right over the past few years.
Now, he parts ways with his peers again by declaring that a new global recession already has begun in Europe and that it will touch our shores soon.
That, of course, would be a nightmare for the few bulls left on Wall Street and for President Obama’s re-election team, who are crossing their fingers and toes that Europe doesn’t implode before November.
Shilling thinks Europe fell into recession last quarter—not every country, perhaps, but enough of them to drag the continent down into the muck.
Here’s the really bad news: He thinks Europe will experience a recession as deep as ours was from 2007 to 2009—enough to tip the US’s relatively better economy into recession, too, during the first quarter of 2012.
And he’s looking for a hard landing in China, as consumers in contracting developed economies tighten their belts.
Shilling starts from the proposition spelled out in his book, The Age of Deleveraging, that the world (and especially the United States) had a credit bubble that lasted for decades until 2007, when the debt-ridden US housing market collapsed. The bursting of that bubble was like an economic Big Bang whose effects will be felt for years as households deleverage.
He agrees with the research of Carmen Reinhart and Kenneth Rogoff, who studied financial crises over several centuries and found that major crises of the kind we experienced start with too much debt in the private sector.
Then, governments step in to “save” the financial system by taking on the liabilities of financial institutions and sometimes individuals. But as public debt grows too large, it curtails economic growth, Reinhart and Rogoff found, prolonging the agony and making it harder for countries to recover.
That’s exactly what’s happening in Europe now, and to some extent the United States. Note the recent downgrading by Standard & Poor’s of several European countries’ sovereign debt ratings—including France, which lost its AAA rating less than six months after the US did.
European countries are finding it harder to keep Greece, Portugal, even Italy and Spain from defaulting, as their own economies struggle.
“Europe is in what I think will be a deep recession,” says Shilling, “because they will have a financial crisis and an economic crisis” just like 2008, he believes.
And the eurozone’s lack of a unified fiscal policy makes it harder for them to deal with that crisis. “They’re dithering over fiscal policy,” he says.
“It’s pretty hard for any of them to avoid” recession, he says, as the trade links that were supposed to bind them in prosperity drag them down.
The World Bank has just slashed its global growth forecasts and projected GDP decline of 0.3% this year in the 17-nation eurozone, a mild recession by some definitions.
Even mighty Germany had negative GDP growth in last year’s fourth quarter, so it might not be immune. Chancellor Angela Merkel’s government just slashed its forecast for economic growth in 2012, although it insisted the country won’t go into recession. Does the lady protest too much?
Shilling isn’t too sanguine about the UK, either. The spillover from trading partners in Europe and the Conservative government’s austerity program are combining to bring recession to the UK, he says. Prime Minister David Cameron’s plan, which included three pounds of spending cuts to every pound of tax increases, cuts nearly 20% out of many ministries’ budgets, Shilling says.
“I think it’s a noble experiment, but the timing is awful,” he concludes.
And he doesn’t think the European recession will be mild. “If you look at the US in 2007-09, real GDP fell 5.4%,” he says. He expects “something in that order” in the eurozone. Greece, for instance, had a GDP decline of 5% to 6% last year.
Omnipotent China won’t escape, either. GDP growth slowed to 8.9% in the fourth quarter as the Chinese government tried to squeeze inflation out of the system.
GDP growth of 5% to 6% “would constitute a hard landing in China,” Shilling says. There are signs Chinese exports are weakening, while consumption still hasn’t gone beyond 34% of GDP—half of what it is in the US.
And speaking of the US, Shilling does expect a recession here, but not as deep as what Europe will go through. “We’ve got a…decline of 2.1%…, ranking in the lower half of postwar recessions,” he says.
Should we all celebrate now? The reason we’ll get off relatively easy is because we don’t have that much exposure to Europe: Exports comprise 13% of GDP and the eurozone represents only 15% of that, so it’s only about 2% of GDP.
“That’s relatively minor,” said Shilling. “The big hit is the spillover in the financial sector.” On the surface, US banks aren’t as exposed to Europe as, say, French or German banks are, but “you don’t know what the counterparty risk is” with derivatives and the like, so it’s an open question.
Last year’s stock returns may back up Shilling’s prognostications. According to MSCI, equity markets of countries in the European Monetary Union lost 18.4% of their value in 2011 while the US broke even, suggesting at worst a milder recession here.
Meanwhile, Shilling returns to familiar ground with his prediction that US housing prices will fall 20% more in 2012. (They’ve already lost a third of their value from their peak.)
The reason? “Foreclosures have been minimal the last two years because they were held off” by government loan-modification programs and the scandal over robo-signing. But now “foreclosures are likely to come back, and that’s the next leg down,” he says. Thanks for reminding us, Gary.
So, what should investors do? For three decades, Shilling has recommended 30-year Treasury bonds, ever since their yields topped 15% in 1981. He sold a bunch of them in 2008 when yields hit 2.5%, he bought more when yields rose to 4.5% (and great investors like Bill Gross were selling).
Now, with yields under 3%, he says, “we’re getting near the end of the bond rally of a lifetime.” During those 30 years, long US Treasuries vastly outperformed stocks.
I don’t think the risk-reward tradeoff on long- and intermediate-term Treasury securities looks attractive, so I’d stick with investment-grade corporate bonds and high-quality dividend-paying stocks.
Shilling isn’t always right, of course. As a permabear, his predictions do well in bad years…but he missed the 2009-2010 rally, and I think he’s being a bit too pessimistic here. Unless Europe falls apart—which I don’t expect—I think the US will avoid recession until much later in the year, at least.
But ignore his warnings at your peril. His track record says that unfortunately, attention must be paid.