Mauldin October 22

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John Mauldin. You can learn more and get your free subscription by visiting www.mauldineconomics.com
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Hoisington Investment Management Quarterly Review and Outlook,
Third Quarter 2014
JOHN MAULDIN | October 22, 2014
I featured the thinking of Dr. Lacy Hunt on the velocity of money and its relationship to developed-world
overindebtedness and the potential for defation in this weeks Toughts from the Frontline, and I thought
youd like to peruse Lacys entire recent piece on the subject.
Lacy takes the US, Europe, and Japan one by one, examining the velocity of money (V) in each economy
and bolstering the principle, frst proposed by Irving Fisher in 1933, that V is critically infuenced by the
productivity of debt. Ten, turning to the equation of exchange (M*V=Nominal GDP, where M is money
supply), he demonstrates that we shouldnt be the least bit surprised by sluggish global growth and had
better be on the lookout for global defation.
Hoisington Investment Management Company (www.Hoisingtonmgt.com) is a registered investment
advisor specializing in fxed-income portfolios for large institutional clients. Located in Austin, Texas, the
frm has over $5 billion under management and is the sub-adviser of the Wasatch-Hoisington US Treasury
Fund (WHOSX).
I am writing this note in a car going to Athens, Texas, where Ill join Kyle Bass and friends at his Barefoot
Ranch for a huge macro fest. October is one of my favorite times of the year to be in Texas, and the ranch
is a beautiful venue. I am sure I will have some challenging conversations.
Last night in Chicago I was picked up by Austyn Crites, who drove me downtown in rush-hour trafc,
which gave us a lot of time to talk about his current passion, high balloons. I have been fascinated with
them for some time, but there hasnt been a lot of reliable information.
Basically, Google and Facebook are both planning to launch very large helium balloons full of radios and
cameras and foat them up to 60,000+ feet. Te concept is working in several remote locations now. Its a
way to get full wireless internet coverage. With about 40,000 balloons you can blanket the earth. Literally.
Full connectivity. Everywhere. Austyn wants to design a new type of balloon and be the manufacturer. Its
tricky as you need a VERY thin balloon envelope (that does not leak) the size of small house in order to get
enough payload that high.
But he thinks the fnal cost of the balloons will fall dramatically and that you might be able eventually
to pull of the operation for a billion or so a year (since balloons eventually come down and need to be
replaced).
But if you are Google and you get the search revenue from connecting an additional fve billion people?
Chump change. Same for Facebook. But what if Apple or Samsung want to make it so that their phones are
aforded free or very cheap access? A consortium of consumer companies could easily see free wif as a tool
for branding. Current telecoms will have to get in the business to compete.
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I kept coming back to the costs and tech issues. Tere are new things that will have to be invented, but
nothing as complex as some of the problems that have already been overcome. Tey will be rolling out in
parts of the world in a few years. Coming to a region near you in 5-10 years. Total game changers. While a
hundred other game changers are coming down the tunnel.
Austyns companys challenge is to be the little guys who dont know they cant invent a new process that
the big guys are working on as well. Can he pull it of? He has the passion and drive. I love meeting young
people like him doing their part to change the world. Tey are everywhere, too. Its why Im optimistic
about the future of the human experiment, if just a tad bearish on governments. You can follow Austyn at
his website.
Time to hit the send button, as we are getting close and I dont want to miss a minute. I will report back
what I can. Have a great week.
Your dreaming of really, really cheap, ubiquitous connectivity everywhere analyst,

John Mauldin, Editor
Outside the Box
Hoisington Investment Management Quarterly Review and Outlook, Third Quarter
2014
Faltering Momentum
Te U.S. economy continues to lose momentum despite the Federal Reserves use of conventional
techniques and numerous experimental measures to spur growth. In the frst half of the year, real GDP
grew at only a 1.2% annual rate while real per capita GDP increased by a minimal 0.3% annual rate. Such
increases are insufcient to raise the standard of living, which, as measured by real median household
income, stands at the same level as it did seventeen years ago (Chart 1).
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Over the latest fve years ending June 30, 2014, real GDP expanded at a paltry 2.2% annual rate. In
comparison, from 1791 through 1999, the growth in real GDP was 3.9% per annum. Similarly, real per
capita GDP recorded a dismal 1.4% annual growth rate over the past fve years, 26% less than the long-
term growth rate. A large contributor to this remarkable downshif in economic growth was that in 1999
the combined public and private debt reached a critical range of 250%-275% of GDP. Econometric studies
have shown that a countrys growth rate will lose about 25% of its normal experience growth rate when
this occurs. Further, as debt relative to GDP moves above critical threshold levels, some researchers have
found the negative consequences of debt on economic activity actually worsens at a greater rate, thus
becoming non-linear. Te post-1999 record is consistent with these fndings as the U.S. debt-to-GDP levels
swelled to a peak as high as 360%, well above the critical level noted in various economic studies.
In terms of growth, it looks as if the second half of 2014 will continue to follow this slow growth pattern.
Although all of the data has not yet been reported, it appears that the year-over-year growth in real GDP
for the just ended third quarter period is unlikely to exceed the 2.2% pace of the past fve years. Economic
vigor is absent, and the fnal quarter of the year looks to be weaker than the third quarter.
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Poor domestic business conditions in the U.S. are echoed in Europe and Japan. Te issue for Europe is
whether the economy triple dips into recession or manages to merely stagnate. For Japan, the question
is the degree of the erosion in economic activity. Tis is for an economy where nominal GDP has been
unchanged for almost 22 years. U.S. growth is outpacing that of Europe and Japan primarily because those
economies carry much higher debt-to-GDP ratios. Based on the latest available data, aggregate debt in
the U.S. stands at 334%, compared with 460% in the 17 economies in the euro-currency zone and 655%
in Japan. Economic research has suggested that the more advanced the debt level, the worse the economic
performance, and this theory is in fact validated by the real world data.
Falling World Wide Infation
In this debt-constrained environment, it is not surprising that infation is receding sharply in almost every
major economy, including China. Te drop in price pressures in the U.S. and Europe is signifcant, and the
fall in Chinese infation to 2%, from a peak of nearly 9% in 2008, is notable.
In the latest twelve months, the CPI in the euro currency zone rose a scant 0.3% (Chart 2), the lowest since
2009, while the core CPI increased by 0.7%, near the all time lows for the series. Te yearly gain in the
U.S. for both core and overall CPI was 1.7%. Since 1958 when the core CPI came into existence, it and the
overall CPI have increased at an average annual rate of 3.8% and 3.9%, respectively, over 200 basis points
greater than the current rates. Both the overall and core personal consumption expenditures U.S. price
indices rose by 1.5% in the twelve months ending August of 2014. Both of these are near the all time lows
for their respective series.
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Te risk of outright defation in Europe with infation at such low levels, and the danger of similar
developments in the U.S., should not be minimized as infation has fallen in almost every previous U.S.
and European economic contraction. Lower infation is, in fact, almost as much of a hallmark of recessions
as is decreasing real GDP. From peak-to-trough the rate of CPI infation fell by an average of slightly more
than 300 basis points in and around the mild U.S. recessions of 1990-91 and 2000-01. Starting from a
much lower point, the CPI in Europe at those same times dropped by an average of 150 basis points. Given
that infation is already so minimal in both the U.S. and Europe, even the mildest recession could put both
economies in defation.
Japans recent quantitative easing has helped devalue its currency by 44% versus the dollar, since the 2011
lows. Tis import- dependent country has therefore seen its costs rise dramatically. Tis, along with higher
consumption taxes, has created a current year- over-year infation rate of 3.3%. Tese higher prices are an
enormous drag on economic growth as incomes fail to rise commensurately. Tus negative GDP growth
will result in a continuing pattern of defation. Japans CPI has been zero or negative on a year-over-year
basis in 16 of the last 23 quarters.
Declining Money Velocity A Global Event
One factor that connects poor growth with the low infation and low bond yields evident in the U.S.,
Europe and Japan is that the velocity of money (V) is falling in all three areas.
Functionally, many things infuence V. Te factors that could theoretically infuence V in at least some
minimal fashion are too numerous to count. A key variable, however, appears to be the productivity of
debt. Money and debt are created simultaneously. If the debt produces a sustaining income stream to repay
principal and interest, then V will rise since GDP will rise by more than the initial borrowing. If the debt is
unproductive or counterproductive, meaning that a sustaining income stream is absent, or worse the debt
subtracts from future income, then V will fall. Debt utilized for the purpose of consumption or paying of
interest, or debt that is defaulted on will be either unproductive or counterproductive, leading to a decline
in V.
Te Nobel laureate Milton Friedman, as well as economist Irving Fisher, commented on the causal
determinants of V. Friedman thought V was stable while Fisher believed it was variable. Presently, the
evidence suggests that Fishers view has prevailed. Fisher would not be at all surprised by the current
impact of excessive debt since he argued in his famous 1933 paper Te Debt-Defation Teory of Great
Depressions, that falling money velocity is a symptom of extreme over-indebtedness.
Tracking that theory, it is interesting to note that velocity is below historical norms in all three major
economic areas with existing over indebtedness. Te U.S. V is higher than European V, which in turn is
higher than Japanese V. Tis pattern is entirely consistent since Japan is more highly indebted than Europe,
which is more highly indebted than the U.S. Unfortunately, broad monetary conditions (M2 money
growth and velocity) are deteriorating, with 2014 displaying conditions worse than at the end of last year.
Te poor trend in the velocity for all three areas indicates that monetary policy for these countries is not a
factor in infuencing economic activity in any meaningful way.
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United States. Te U.S. year-over-year M2 growth has remained at about 6%, an annual growth level that
has been consistent since 2008 (Chart 3), and the velocity of money has trended downward by about 3%.
In the frst half of 2014, V declined at a rate of 3.6%, but it is still too early to tell if this represents a new V
deceleration to the downside (Chart 4).
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According to the equation of exchange (M*V=Nominal GDP), the expected growth of nominal GDP is
constrained to no more than a 3% increase with velocity declining by 3% and money supply expanding by
6%. However, when assessing the type of debt currently being employed (unproductive, at best) the risks
are for lower growth levels. 2014 has witnessed a resurgence of consumer auto and mortgage lending that
was achieved by a lowering of credit standards. Te percentage of subprime consumer auto loans (31%)
returned to the peak levels reached prior to 2008. Such lending has historically turned counterproductive.
If this were to occur again, velocity would accelerate to the downside, resulting in a sub 3% path for
nominal GDP.
Europe. V has only been available in Europe since 1995 as that is the starting date for GDP in the euro-
currency zone. During the span from 1995 through 2013, V averaged 1.4, dropping from a peak of about
1.7 in 1995 to 1.03 in 2013 (Chart 5). Over that span, therefore, euro V has been trending lower at about
a 2.6% per annum rate. On the money side, euro M2 increased by 2.4% in 2013, which is weaker than
the average growth in the last four years (Chart 6). If the trend rate of decline in V remains intact, then
nominal GDP in the euro zone could be fat. Infation of any magnitude would result in a negative real
GDP outcome.
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Japan. From the start of the comparable M2 and nominal GDP statistics in 1969 in Japan, V in Japan
has averaged 1.0, dropping from 1.54 in 1968 to a record low of 0.57 in the latest year (Chart 7). Tus,
over this period V was falling at an average rate of 2.2% per annum. M2 in Japan increased 3.6% in 2013,
which is slightly higher than the growth rate of recent years (Chart 8). If Vs downward trend remains
intact, nominal GDP would be estimated to grow by 1.2%. However, infation is currently running at 3.3%,
suggesting real GDP could decline by over 2% in the next twelve months. Tis circumstance illustrates the
double-edged sword caused by a sharply depreciating currency. Te weaker yen boosts exports but raises
domestic infation. Japanese infation is already exceeding the rise in wages and household spending. Tese
events are consistent with a contraction in economic activity and are the expectation derived from the
analysis of money growth and its velocity.
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Debt Research
Important new research by four distinguished economists (three in Europe and one in the U.S.) is
contained in a report titled Deleveraging? What Deleveraging? (Luigi Buttiglione, Philip R. Lane,
Lucrezia Reichlin and Vincent Reinhart, Geneva Reports on the World Economy 16, September 2014). It
provides additional evidence on the role of debt dynamics and the state of the global debt overhang. Tey
write, Contrary to widely held beliefs, the world has not yet begun to delever and the global debt-to-GDP
is still growing, breaking new highs. Further, it is a poisonous combination when world growth and
infation are lower than expected and debt is rising. Deleveraging and slower nominal growth are in many
cases interacting in a vicious loop, with the latter making the deleveraging process harder and the former
exacerbating the economic slowdown.
Tis research also identifes two other highly signifcant trends. First, global debt accumulation was led by
developed economies until 2008. Second, the debt build-up since 2008 has been paced by the emerging
economies. Te authors write that the rise in Chinese debt is especially stunning. Tey describe China as
between a rock (rising and high debt) and a hard place (lower growth). In addition to China they identify
India, Turkey, Brazil, Chile, Argentina, Indonesia, Russia and South Africa as belonging to the fragile
eight group of countries that could fnd themselves in the unwanted role of host to the next leg of the
global leverage crisis.
We interpret this research to mean that the monetary policy may begin to become inefective at emerging
market central banks, just as has happened in the U.S., Europe and Japan. Weaker growth conditions
in the emerging markets are thus likely to accentuate, rather than ameliorate, poor business conditions
in the major economies. Indeed, this years downturn in global commodity prices is consistent with the
beginning of such a phase. Te huge jump in emerging market debt is also signifcant because research has
found the severity of economic contractions is directly related to the leverage in the prior expansion.
Asset Bubbles
Historically, in our judgment, the most important authority on the subject of asset bubbles was the late
MIT professor Charles Kindleberger, author of 20 books including the one of the greatest books on
capital markets Manias, Panics and Crashes (1978). He found that asset price bubbles depend on the
growth of credit. Atif Mian (Princeton) and Amir Suf (University of Chicago) provided confrmation for
Kindlebergers pioneering work and expanded on it in their 2014 book House of Debt. Chapter 8, entitled
Debt and Bubbles, contains the heart of their insights. Mian and Suf demonstrate that increasing the
fow of credit is extremely counterproductive when the fundamental problem is too much debt, and
excessive debt can fuel asset bubbles.
Based on our reading of these two books we would defne an asset bubble as a rise in prices that is caused
by excess central bank liquidity rather than economic fundamentals. As Kindleberger clearly stated,
the process of excess liquidity fueling higher prices in the face of faltering fundamentals can run for a
long time, a phase Kindleberger called overtrading. But eventually, this gives way to discredit, when
the discerning few see the discrepancy between prices and fundamentals. Eventually, discredit yields to
revulsion, when the crowd understands the imbalance, and markets correct.
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Economists have commented on the high correlation between the S&P 500 and the Feds balance sheet
since 2009. From 2009 to the latest available month, the monetary base (MB) surged from $1.7 trillion to
$4.1 trillion. We ran the MB increase against the S&P 500 and found a very high correlation of 0.69. While
correlation does not prove causality, the high correlation is certainly not inconsistent with the idea that
the Fed liquidity played a major role in boosting stock prices. However, even as the MB has exploded since
2009 and stock prices have soared, the U.S. economy has experienced the worst economic expansion on
record. In spite of a further large rise in the base this year, the GDP growth has subsided noticeably and
corporate profts afer taxes and adjusted for inventory gains/losses (IVA) and over/under depreciation
(CCA) has declined 10% in the latest four quarters. Such discrepancy between the liquidity implied
by the base and measures of economic performance could indicate the process of bubble formation.
Kindlebergers axiom that asset price bubbles depend on excess liquidity may yet face another test.
Still Bullish on Treasury Bonds
With the nominal growth trajectory extremely sof, U.S. Treasury bond yields are likely to continue
working lower as similar circumstances have created declines in government bond yields in Europe and
Japan. Viewing the yields overseas, it is evident that ample downside still exists for long U.S. Treasury
bond yields, as the higher U.S. yields ofer global investors an incentive to continue to move funds into the
United States.
Another factor suggesting lower long- term U.S. Treasury yields is the strength of the U.S. dollar. In many
industries, the price leader for certain goods in the U.S. is a foreign producer. A rising dollar leads to
what economists sometimes call the collapsing umbrella. As the dollar lifs, the foreign producer cuts
U.S. selling prices, forcing domestic producers to match the lower prices. Tis reinforces the prospect for
lower infation as nominal GDP wanes. Tis creates a favorable environment for falling U.S. Treasury bond
yields.
Van R. Hoisington
Lacy H. Hunt, Ph.D.
Copyright 2014 John Mauldin. All Rights Reserved.
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