Recession

One reason for the severity of the financial crisis, and the losses incurred by banks, is that bankers and financial analysts were using linear tools in a non-linear, highly complex environment otherwise known as the financial markets.The models didn’t work. The problem we face now as investors will end up being existential for some banking institutions and sovereigns. Our (uncontentious) core thesis is that throughout the west, more debt has been accumulated over the past four decades than can ever be paid back. The question, effectively to be determined on a case-by-case basis, is whether bondholders are handed outright default (which looks increasingly like the case to come in Greece) or whether the authorities, in their understandable but misguided attempts to keep the show on the road, resort to a policy of inflation that could at some point easily spiral out of control. As Rothbard wrote, “The longer the inflationary boom continues, the more painful and severe will be the necessary adjustment process… the boom cannot continue indefinitely, because eventually the public awakens to the governmental policy of permanent inflation, and flees from money into goods, making its purchases while [the currency] is worth more than it will be in future.” “The result will be a ‘runaway’ or hyperinflation, so familiar to history, and particularly to the modern world. Hyperinflation, on any count, is far worse than any depression: it destroys the currency – the lifeblood of the economy; it ruins and shatters the middle class and all ‘fixed income groups;’ it wreaks havoc unbounded… To avoid such a calamity, then, credit expansion must stop sometime, and this will bring a depression into being.”

Anyone wondering why FSLR just jumped, it is because as was just made known, David Einhorn's Greenlight has decided to close its FSLR position, after bleeding that particular corpse dry. "Our largest winner by far was our short of First Solar (FSLR) which fell from $130.14 to $33.76 paper share and was the worst performing stock in the S&P 500." Einhorn also announces that he was among the "evil" hedge funds who dared to provide market clearing transparency and buy CDS on insolvent European governments: "We also did well investing in various credit default swaps on European sovereign debt." As for losers, Einhorn and Kyle Bass can commiserate: "For the second year in a row, our biggest loss came from positions designed to capitalize on eventual weakening of the Yen." He summarizes the global economic environment as follows: "The global environment is very complicated. On the one hand the Federal Reserve has taken a much-needed break from quantitative easing (at least for the moment). Accordingly, inflation in oil and food has abated, providing relief to the US economy. Bearish forecasts that the US was headed back into recession proved wrong for the third time since the end of the last recession. On the other hand, Asia appears to be in much worse shape than it was at this time last year and could be a drag on the world economy going forward. Very few people trust any of the economic data coming out of China, making it difficult to gauge the situation there. Some of the smartest people we know have very dim views. The Chinese have been a leading growth engine for the last two decades and are largely credit with leading the world out of the recession in 2009. A change in their economic circumstances could really upend things." Yet the best thing is his summary of the current investing climate in our utterly and hopelessly reactionary broken markets.

Tomorrow the BLS will announce that last week's initial claims number was revised to over 400K, the first time this important level has been breached, this time in an adverse fashion, in the past 2 months. But why is 400K important, and why do economists and pundits put impact on this particular number? Here is Bank of America with the explanation in the form of a historical matrix, correlating the historical relationship between these time series, highlighting the notable patterns observed in the past several decade, and what it all means for the big picture.

The world's biggest primary silver miner, Fresnillo, had flat silver production in 2011. Output is only expected to remain stable in 2012.  African Barrick Gold said on Wednesday fourth quarter gold production fell 11% and missed its annual production targets. Despite price rises seen in 2011, gold and silver mining is remaining static contrary to claims by gold bears that higher prices would lead to increased production and therefore increased supply. Geological constraints may be impacting mining companies ability to increase production of the precious metals. Standard Bank has said it lowered its average 2012 gold price forecast by 6 percent to $1,780 an ounce, but continues to expect prices of the precious metal to touch new highs in the latter half of this year.  "We maintain that gold will reach new highs this year but, given our dollar view, we believe that these highs will be reached only in the second half of 2012," the analyst said in a note. Standard Bank expects the U.S. dollar to gain strength, especially against the euro, over the next quarter. A few other banks have recently lowered price forecasts for gold, including ANZ and Credit Suisse – however the majority remain bullish on gold’s outlook for 2012.

While his diagnosis of the balance sheet recessionary outbreak that is sweeping global economies (including China now he fears) is a useful framework for understanding ZIRP's (and monetary stimulus broadly) general inability to create a sustainable recovery, his one-size-fits-all government-borrow-and-spend to infinity (fiscal deficits during balance sheet recessions are good deficits) solution is perhaps becoming (just as he said it would) politically impossible to implement. In his latest missive, the Nomura economist does not hold back with the blame-bazooka for the mess we are in and face in 2012. Initially criticizing US and now European bankers and politicians for not recognizing the balance sheet recession, Koo takes to task the ECB and European governments (for implementing LTRO which simply papers over the cracks without solving the underlying problem of the real economy suggesting bank capital injections should be implemented immediately), then unloads on the EBA's 9% Tier 1 capital by June 2012 decision, and ends with a significant dressing-down of the Western ratings agencies (and their 'ignorance of economic realities'). While believing that Greece is the lone profligate nation in Europe, he concludes that Germany should spend-it-or-send-it (to the EFSF) as capital flight flows end up at Berlin's gates. Given he had the holidays to unwind, we sense a growing level of frustration in the thoughtful economist's calm demeanor as he realizes his prescription is being ignored (for better or worse) and what this means for a global economy (facing deflationary deleveraging and debt minimization) - "It appears as though the world economy will remain under the spell of the housing bubble collapse that began in 2007 for some time yet" and it will be a "miracle if Europe does not experience a full-blown credit contraction."

This will hardly be a surprise to anyone with 3 neurons to rub across their frontal lobe, but at least it is now official.

• WORLD BANK CUTS GLOBAL GROWTH OUTLOOK, SEES EURO-AREA RECESSION

And the punchline:

• World Bank urges developing economies to “prepare for the worst” as it sees risk for European turmoil to turn into global financial crisis reminiscent of 2008
• Even achieving much weaker outcomes is very uncertain

Morgan Stanley may want to revise their 37% Muddle Through probability outcome, to something more like 36.745% on this news.

We don't have to run through the maze 5 times before we know what lever to push! 

Wonder why nobody trusts bank numbers, and why US financial institutions trade at some fraction of book value? The chart below should explain a big part of it. As can be quite vividly seen, of the $28 billion in pre-tax net income from continuing operations "generated" over the past two years, exactly half, or $14 billion, has been due from a simply accounting trick, namely the release of loan loss reserves, which have been positive for 8 quarters in a row, and which in the just completed quarter amounted to more than the actual pretax number, confirming EPS would have been negative absent accounting trickery (source). One wonders what happens to Citi Net Income once the world openly re-enters a recession, and releases have to become builds again... And for those who enjoy the myth of reported numbers, and are trying to reconcile the resurgence in bank stocks with abysmal earnings, yet wish to understand why Citi has let go the well known Rohit Bansal, and Chris Yanney, who headed the bank's distressed and HY trading respectively, below is also a chart showing the dramatic collapse in the bank's Securities and Banking revenue which just came at the lowest in the past two years, with Norta American top line in particular being decimated.

With Fed officials a laughing stock (both inside and outside the realm of FOMC minutes), Bank of Japan officials ever-watching eyes, and ECB officials in both self-congratulatory (Draghi) and worryingly concerned on downgrades (Nowotny), the world's central bankers appear, if nothing else, convinced that all can be solved with the printing of some paper (and perhaps a measure of harsh words for those naughty spendaholic politicians). The dramatic rise in central bank balance sheets and just-as-dramatic fall in asset quality constraints for collateral are just two of the items that UBS's economist Larry Hatheway considers as he asks (and answers) the critical question of just how safe are central banks. As he sees bloated balance sheets relative to capital and the impact when 'stuff happens', he discusses why the Eurozone is different (no central fiscal authority backstopping it) and notes it is less the fear of large losses interfering with liquidity provision directly but the more massive (and explicit) intrusion of politics into the 'independent' heart of central banking that creates the most angst. While he worries for the end of central bank independence (most specifically in Europe), we remind ourselves of the light veil that exists currently between the two and that the tooth fairy and santa don't have citizen-suppressing printing presses.

Just like back in the first half of 2011, when GDP experienced a premature climax to coincide with the end of QE2, only to tumble promptly afterwards, so just as two thirds of the S&P by market cap prepare to announce earnings starting tomorrow, Q4 EPS forecasts have hit the lowest they have been at in the past 12 months. While the general economy has been lagging the contraction of Europe and Asia, yet finally hit a downward inflection following the disappointing data of the past week (more on that shortly, as we explain why with the Fed set to begin an easing bias in 10 days, all economic indicators are about to take a dive), it has been corporate results that have so far managed to keep the market afloat. This may be coming to an end, courtesy of a perfect storm of negative earnings preannouncements (which have soared to a ratio of 3.5x compared to positive ones; the highest since Q1 2008) together with outright coincident misses. Because as the chart below shows, at $24.09 and pointed decidedly downward, Q4 EPS and its transition to Q1 2012 does not portend anything good for the world economy or markets. In fact, with the EUR plunging, while the news is welcomed by German exports, the adverse impact to US companies, via FX losses and otherwise, is about to be unveiled.

It would appear that the German public (and political class to some extent) are beginning to see the European project in the same manner as we described back in July. As the increasing burden of saving the eurozone from its own excess falls on the shoulders of every Tobias, Dirk, and Heike taxpayer in Germany, even industry leaders, such as Wolfgang Rietzle, the CEO of Linde, this weekend according to Reuters, are suggesting a line in the sand has to be drawn and that "if we do not succeed in disciplining countries then Germany needs to exit." This has been very much a view we have held for months, that instead of the periphery limping away one-by-one, the very core of the foundation will simply decide enough is enough or as Reitzle notes (among many other critically insightful comments) "the willingness of countries to reform themselves is abating if, in the end, the European Central Bank steps in." This morning Germany's FinMin Schaeuble added to the potential separation rhetoric with his comments, via Bloomberg:

• *SCHAUEBLE SAYS ECB AS LENDER OF LAST RESORT WOULDN'T CALM MKTS
• *SCHAEUBLE SAYS JOINT EURO REGION BOND SALES NOT A SOLUTION

Hardly reassuring given the dreams of every GGB owner and BTP-exposed insurance company are banking on the ECB cranking the presses to 'secure' nominal returns in the real world. Friday's mass downgrade (and S&P's more interesting Q&A) have perhaps left Germany on the hook for up to 56% of its GDP via the EFSF support mechanisms and as we noted six months ago, the moment for Atlas to shrug draws closer with every downgrade and SMP action.

When these two agree, look out!

For anyone convinced that yesterday's S&P two notch downgrade of Spain to A is the last one for a while, we have some bad news: in Q4 Spanish unemployment soared by the most since the Lehman collapse, hitting what new PM Mariano Rajoy called an "astronomical" 5.4 million. This compares to 4.978 million people unemployed at the end of Q3 2011. Since the official number is not yet public and will be released on January 27 we will take his word for it. In which case it becomes clear that in Q4 the Spanish economy experienced a Lehman-like collapse, losing more than 400K people, or the most since the bankruptcy of Lehman brothers. In percentage terms this means that Spanish unemployment rose by a ridiculous 2%, or from 21.5% to 23.3%, in one quarter! And since Spain is a country of the Keynesian persuasion, we can only assume the number includes a whole bunch of meaningless birth/death and seasonal adjustments, but we'll leave it at that. Incidentally, it means that by the time the mean reversion exercise, with cost-cutting and what not is complete, Spanish unemployment will be well north of 30%, and 2 out of 3 people aged between 16 and 25 will be out of a job, if ot more. It also begs the question just what the real unemployment picture in the US, which lately has put the Chinese Department of Truth to shame, would be if reported on a realistic, unadjusted, and not "workforce contracted" basis. The chart below shows you everything you need to know.

Pres. Barack Obama has launched new international diplomatic poker with “a trailing hand”. It is impossible to exaggerate the forces at play, economic as well as political, foreign and domestic, and their interplay.

All your questions about the historic European downgrade should be answered after reading the following FAQ. Or so S&P believes. Ironically, it does an admirable job, because the following presentation successfully manages to negate years of endless lies and propaganda by Europe's incompetent and corrupt klepocrarts, and lays out the true terrifying perspective currently splayed out before the eurozone better than most analyses we have seen to date. Namely that the failed experiment is coming to an end. And since the Eurozone's idiotic foundation was laid out by the same breed of central planning academic wizards who thought that Keynesianism was a great idea (and continue to determine the fate of the world out of their small corner office in the Marriner Eccles building), the imminent downfall of Europe will only precipitate the final unraveling of the shaman "economic" religion that has taken the world to the brink of utter financial collapse and, gradually, world war.