Signs of a Hurricane
The U.S. ‘recovery’ continues…but tensions are billowing beneath its surface. How long before they unleash the winds of fury – causing the consumer to retrench, inflation and interest rates to surge, and the dollar to fall precipitously?
The present "strong" recovery phase in the U.S. economy won’t last for long, as it is totally artificial. There are simply too many imbalances in the system – as reflected by a record low national saving rate, record household debts, and record trade and current account deficits – for this recovery to lead to sustainable strong growth that would justify the present stock valuations.
According to economic theorist Joseph Schumpeter, economic recoveries that are purely a consequence of fiscal and monetary stimulus must ultimately fail. Schumpeter writes: "Our analysis leads us to believe that recovery is sound only if it does come from itself. For any revival which is merely due to artificial stimulus leaves part of the work of depression undone and adds, to an undigested remnant of maladjustments, new maladjustments of its own."
My colleague Peter Bernstein correctly points out the complexity of the issues involved: "Private sector saving, private sector investment, household consumption, government spending, government revenues, capital flows, and trade balance all react upon one another – often in surprising fashion. We live in a complex system: each piece tends to function as both symptom and cause." And while I cannot discuss here Bernstein’s entire analysis of economic data, which he himself admits is "confusing," I would like to point out that he also is "certain" that "current trends are not sustainable."
Economic Imbalances: The Breeze Will Not Be Gentle
Bernstein writes: "The imbalances are now enormous, far more glaring than at any point in the past. Furthermore, the linkage of the parts are so tightly knit into the whole that reducing any one imbalance to zero, or even compressing them all to a more manageable level, appears to be impossible without a major upheaval. A hitch here or a tuck there has little chance of success. When it hits, and whichever sector takes the first blows, the restoration of balance will be a compelling force roaring through the entire economy – globally in all likelihood. The breeze will not be gentle. Hurricane may be the more appropriate metaphor."
Part of the problem the United States is facing is the long-term decline in the U.S. national saving rate (including household saving, corporate cash flows, and the government’s budget surplus or deficit). As a percentage of GDP, there was an improvement in the national saving rate between 1993 and 2000 due to higher taxes and a swing in the federal budget toward surplus…but thereafter, the national saving rate plunged. Over the same time period, real personal consumption expenditures as a percentage of GDP declined modestly between 1988 and 1998, but soared between 2000 and 2003 to a record.
Economic Imbalances: Little Room to Boost Expenditures
Now, in past recessionary periods (1973-74, 1981-82, and 1990), the tendency has been for real personal consumption expenditures as a percentage of GDP to decline modestly and, in the process, create "pent-up" demand – which then leads to sustainable growth. But at present, given the low national saving rate and record real personal consumption expenditures as a percentage of real GDP, there seems little room for consumers to boost their expenditures significantly…unless households increase their indebtedness much more, or households’ net worth or income rises substantially. U.S. consumers have increased their spending for an unprecedented 47 quarters in a row. (The last downturn was in the fourth quarter of 1991.)
More recently, consumer spending rose largely as a result of higher borrowings. U.S. household sector debt to net worth is at an all-time high, having expanded very rapidly since 2000, when the economic expansion started to stall. And while it is true that the cost of servicing the debt isn’t excessive, this is only due to the sharp decline in interest rates we have had since the early 1980s and especially after 2001.
Meanwhile, household income has declined significantly. Hourly earnings increases have been declining sharply since late 2002 – most likely because of the accelerating trend to manufacture in low-cost countries and outsource services to countries such as India. In fact, real wages have actually been in decline since 2001; in the 12 months ended September 2003, they fell 0.2%. Some recovery in real wages is possible…but given the low level of hourly earnings increases, the fading impact of the tax cuts after January 2004, and lower refinancing activity, consumption is unlikely to receive much of a boost from the households’ income.
Then again, actual figures for real wages and salaries are far lower than those reported, as the U.S. government has been purposely understating inflation figures by a wide margin. Moreover, overseas competition for manufacturing and services is here to stay, and inflation may actually pick up. These factors lead me to believe that real wages could actually decline further.
So where does all that leave us? Consumption could theoretically be increased, if not through income growth, then through a further decline in the national saving rate and additional consumer borrowings. But for households’ borrowings to keep on expanding, asset prices – including housing and equities – must continue to appreciate, or interest rates will have to decline much further!
In other words, rising asset prices, which supported additional borrowings, have largely been driving the U.S. recovery (though the government also made a small contribution by boosting spending). This is particularly true of the housing sector, where rising home prices allowed households to increase their mortgages and provided them with additional spending power.
Economic Imbalances: Trouble Brewing
I hope you appreciate the precarious nature of this state of affairs. The entire U.S. economy is depending on high "asset inflation" in order to stay afloat! Only if asset prices continue to rise at high rates can consumers maintain their borrowing binge.
But trouble seems to be brewing in the American wonderland. First of all, it would appear that the housing sector is slowing down. The Merrill Lynch Housing Index has declined sharply since August, and the growth rate in real estate loans has slowed to an 11.5% year-over-year growth rate, down from this summer’s 18% growth rate. Refinancing activity is down by 70% from its summer peak, and real estate loans at banks have begun to contract. But why worry? Most recently, the tireless and imaginative American consumer offset slower real estate loan growth with a sharp jump in consumer loans carrying a higher interest rate!
The question that arises is, of course, how sustainable is an economic recovery that is driven by a declining saving rate and strongly rising additional borrowings – which in turn depend on rising home and equity prices, especially since the combination of these factors has led to a sharp deterioration in the U.S. trade and current account deficit and hence to a weakening dollar? Please also note the doubling of the trade deficit with developing countries (especially due to U.S. imports from China).
This highly artificial recovery is, in our opinion, not sustainable for very much longer. Even so, we should all realize that the Fed is fully aware that asset prices must, under no circumstances, be allowed to decline. In fact, the Fed will try to make them appreciate even further through highly expansionary monetary policies, as stagnating home prices alone would endanger the recovery, while declining prices would be altogether unbearable for the highly leveraged household sector, whose debt to net worth would soar in an environment of declining asset prices.
So, we are in a situation where the imbalances are likely to worsen further until something gives. At some point, the American consumer will retrench voluntarily, which might slow down the expansion (but probably not much) of the trade and current account deficit. Or, it is possible that the consumer will be forced to retrench through a rapid loss of the U.S. dollar’s purchasing power. Rising inflation rates would then inevitably lead to higher interest rates, and most likely also to falling real household income, as wage increases would be unlikely to match the rate of inflation.
Therefore, a voluntary or involuntary consumer retrenchment could badly derail the Fed’s inflationary monetary policies. I am not sure exactly how the present imbalances will play themselves out, since, as Mark Twain remarked, "A thing long expected takes the form of the unexpected when at last it comes." But I am certain that Peter Bernstein will be proved right when he writes, above, that the breeze accompanying the restoration of balance will not be "gentle"…but will likely take the form of a financial and economic hurricane.
for The Daily Reckoning
February 18, 2004
Editor’s note: Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report. Headquartered in Hong Kong for 20 years and now based in northern Thailand, Dr. Faber has specialized in Asian markets and advised major clients seeking down-and-out bargains with deep hidden value, unknown to the average investing public.
Dr. Faber also writes a regular column for Strategic Investment, from which this essay was adapted. If you’d like to follow his current analyses and learn how to apply them, subscribe to: Strategic Investment
This essay originally included several graphs illustrating Dr. Faber’s arguments about the national saving rate, consumer spending v. borrowing, household debt and real wage growth, to name a few. If you’d like to see them side-by-side with Dr. Faber’s analyses, send an e-mail to: StrategicInsider@agora-inc.com .
Oh là là, we’re glad we bought gold last week rather than this week. Last week, you could get it for around $400. We worried that it might be the last time we would see the price so low in our lifetimes. Today, we wonder if ever, in anyone’s lifetime, gold sellers will ever again accept 400 paper dollars in exchange for an ounce.
The dollar went down hard again yesterday…It had to resist a hot upswing in practically everything else. Commodities went up. Copper hit an 8-year high. Stocks went into even more delusional territory. But the dollar kept a cool head…with both feet on the ground. And then the ground gave way beneath it.
Bill Fleckenstein has identified what he calls the "7 small steps to crisis":
* Step 1. Nobody notices or pays attention to the fact that the dollar is falling.
* Step 2. Folks wake up, but they either don’t care or they rationalize dollar weakness as a good thing.
* Step 3. The central banks now know they have a problem, but the bankers think the market will obey them. It will, for a while. (This is the step we have now reached and what emerged at the G7 meeting.)
* Step 4. The dollar now tests everyone’s resolve by resuming its decline. The currency markets will not respond to jawboning by finance ministers.
* Step 5. In this step, the finance ministers are forced to take action. (Think about it. Even if they’d stated that they wanted the dollar to go up, nothing either explicit or implied indicates they’ll do anything about what’s happening. That will come next.) When they do take action, the market will do what they want – but only for a while.
* Step 6. The ministers take some additional action, but it won’t be enough, and the currency markets won’t do what the ministers want.
* Step 7. Finally, we’ll have a full-blown crisis, and that will be the end game.
Americans have come to expect stability from their dollar. Not that it held its value…but that it lost value at a reasonably predictable rate. They didn’t sweat the dollar’s decline; they welcomed it. A steady rate of inflation and full employment made it easier for them to live beyond their means; they could borrow…confident that inflation would make the loans a little easier to carry.
But now the dollar is losing value in a new and different way – while prices at Wal-Mart are going down, too. They don’t know what to make of it. They continue to bet that they won’t really have to pay their debts…while, as in Japan 10 years ago, consumer prices sink and well-paying jobs become scarce.
We don’t know what will happen…but, before it is over, we wager that the poor lumps will wish they had bought gold below $400.
Addison is vacationing in the French countryside, we hear. But here is Dan Denning, our other Paris-based analyst, with more news…
Dan Denning in the City of Light…
– "Why are the lumps buying?" your New York and Nicaraguan editors ask. "Why ask why," your Paris-based pinch-hitting editor replies, "step up and buy!" The market was open for business again yesterday, and fresh from a three-day weekend, investors couldn’t resist the urge to buy.
– I’m only joking about buying, of course. But all the signs are pointing to a new high on the Dow, whether it makes any sense or not. The Dow was up 87 points at 10,714 by yesterday’s close. It’s now within spitting distance of its all-time closing high of 11,287, set way back on May 12, 2000. To put that in perspective, the Dow need only rise 5% to make a new all-time high, or about one month’s solid effort (the Dow was up 5.6% in December).
– How is this possible? Isn’t the financial economy terribly overvalued? Well, yes. The S&P 500 trades at about 30 times earnings. And yet the Fed reported yesterday that foreigners bought another $75.7 billion in U.S. financial assets in December. That was down about 13% from November’s $87.5 billion level. But it still represented net buying.
– In fact, while no one was watching, a handful of financial indexes started trading at new all-time highs. The Philly Banking Index (BKX) is up 50% since March of last year – at 1,008, it’s higher than it was in 2001. The Amex Broker/Dealer Index (XBD) is up 114% over the same period and is also trading at an all-time high.
– As Steve Barrow, a currency trader at Bear Stearns in London, remarks: "Too much liquidity has been created. It has to find a home. And with global growth still sluggish, it will find a home in financial assets."
– All this is happening in spite of the dollar…that miserable excuse for purchasing power. In London this morning, it will cost you $1.91 to buy a pound. And here in Paris, it now costs $1.29 to buy a euro, leaving me with an average nightly bar tab of $13 for two beers at the Australian bar on rue St. Denis. Just think what the euro will get you over in the States now, though. In fact, I’m encouraging other American immigrants in Europe like myself to mail euros to our currency-cursed relatives back home.
– Oddly – in this age of financial oddities – even while the world sells the dollar, it turns around and buys U.S. bonds. The rest of the world bought another $29.8 billion in U.S. government bonds in December. This total is down from $33.5 billion the month before, but not enough of a reduction to worry about a panic selling in the Treasury market (yet).
– This is good news if you own bond calls (as I’ve recommended to readers of my options service.) But it’s not entirely good news. Here’s a curious fact I gleaned from Treasury department data: between 2002 and 2003, Caribbean banking centers added to their ownership of U.S. bonds by almost 40% – from $49.5 billion in 2002 to $69.5 billion in 2003. They are now the fourth-largest owner of U.S. bonds, behind Japan, China, and the U.K.
– There may be an obvious reason for this. Offshore hedge fund buying, for example. But we don’t really know who is now the fourth-largest owner of U.S. bonds. It could be a hodge-podge of wealthy individuals. Then again, it could be narco traffickers…political terrorists like Osama bin Laden…or George Soros (who was once called a financial terrorist), building up a huge position in Treasuries to spring an October surprise on George Bush and crash the dollar by selling.
– As Stephen Jin, a currency economist, said in a recent Wall Street Journal article, it probably isn’t desirable for the U.S. that "a small number of countries control its Treasury market." Then again, that’s what you get when you spend more than you earn (or tax away). It’s probably not desirable that the U.S. has twin current account and fiscal deficits of half a trillion dollars a piece. But it’s a fact anyway.
– The silver lining? Gold. April gold traded up to $416/oz yesterday. I’d say a lot more about gold, deflation, inflation, bonds, and the dollar…but these are just notes, folks. If you’re interested, though, I do write daily on the markets in more detail in Strategic Insider, for paying subscribers of Strategic Investment. If you’re interested in a free trial, send an e-mail to StrategicInsider@agora-inc.com.
Bill Bonner, back in Nicaragua…
*** Japan’s economy is growing at a 7% rate – faster than at any time since its slump began in 1990. Is its recovery for real? Maybe.
*** The financial economy is "terribly overvalued," Dan Denning notes above.
Dan Ferris agrees: "After 11 months of a rallying market, bargains are scarce."
Even Warren Buffett, the king of value investing, can’t find anything worth investing in inside the U.S. stock market. On only one other occasion did he reach a similar conclusion:
"In 1968," writes Dan Ferris, "Buffett’s partnership gained $40 million, or 59%. Assets ballooned to $104 million. After a year like that, a modern-day mutual fund manager would take out a full-page ad in the Wall Street Journal. He’d brag about his one-year, five-year, and ten-year track records, trying to garner more capital…and more fees.
"Not Buffett. He let it be known that such a performance ‘should be treated as a freak [event],’ akin to a 100-year flood.
"That’s the difference between value investors and everybody else. Everybody else loves it when stocks go up. They buy more and suddenly feel like financial geniuses. Value investors just collect their profits and wait for stocks to get cheap again.
"That’s exactly what the great value investors of our time are doing right now."
*** Surprise, surprise. We all know, of course, that Americans are getting rich by borrowing money. Now, USA Today tells us the average car buyer puts down only a third as much as he did 10 years ago…and stretches out his payments over 63 months rather than the 48 that were common in the 1990s. What’s more, he typically finances 101% of the purchase price.
*** What a treat. After months in cold, gray Northern Europe…we lay beside the pool last night and admired the stars.
"I didn’t know there were so many stars," said Henry. There were blue stars and red ones. Small, faint little twinkles and great shining stars that looked like parking lot lights. We didn’t even need our reading glasses to see them.
But why are we telling you, dear reader? You have seen the stars yourself. Still, as we looked up the heavens last night, we felt as if we had forgotten them. They must have been there all along…but we hadn’t noticed. Instead, we filled our days and our heads with Dow price points, deadlines, homework, and trips to the bakery. We forgot that we lived among stars.
"Is that Orion’s Belt? Is that the Big Dipper? I think that must be Mars…or is it Venus?" The boys had questions your editor couldn’t answer. So he changed the subject:
"Look, that big dusty cluster that stretches across the sky…that’s the Milky Way," he said confidently. "And some of these stars are dead. The stars are so far away it can take millions of years for the light to reach us. So, what we see is the way the star looked millions of years ago."
"That was before I was even born," said Edward, 10.
"Wait a minute, Dad," said Henry, spotting the flaw. "If you had looked out millions of years ago, you wouldn’t have seen what you see now. You would have seen what the star looked like millions of years before that…maybe you would have seen nothing, because it hadn’t been born yet. You can only see what you see now right here and right now. So what we see is what the star looks like right here and right now…not the way it looked millions of years ago. Right?"
"Henry, don’t you have a book to read?"