The Last Analysis

Mr. Greenspan has been hailing the wonderment of the U.S. economy’s new resilience, both to the bursting of the stock market bubble and to the various shocks from terrorists and the Iraq war.

But the cause is obvious. What, for the time being, has prevented a deeper and longer recession in the United States is more and more of the very same consumer- borrowing-and-spending bubble, which has been propelling U.S. economic growth over the past several years.

Yet two things have changed. The first one is the collateral behind the consumer borrowing and spending binge. Rising stock prices have been replaced by rising house prices. The second is that it needs more and more rampant credit and debt creation to master just marginal GDP growth.

Our highly critical assessment of the U.S. economy’s performance during the past two to three years, in fact, finds its major justification in the atrocious discrepancy that has developed between extremely promiscuous monetary and fiscal stimuli and their extremely poor economic effects.

Weak Consumer Spending: Credit and Debt Deluge

Between 2000 and 2002, the federal budget has swung from a surplus of $295 billion into a deficit of $257 billion, heading for a $400-500 billion deficit in 2003. During the same two years, total nonfinancial credit zoomed $2,520 billion and financial credit by another $1,879 billion, both adding up to $4.4 trillion.

What was the effect of this credit and debt deluge on the economy? GDP during these two years grew in real terms by $248 billion and in nominal terms by $621 billion. To us, this is an outright policy disaster.

Yet, American consensus economists are definitely consistent in their approach. Undeterred by data that overwhelmingly point to the enduring weakness of the economy, they stick to the same forecast of the U.S. economy’s imminent, strong recovery. Though there is no trace of the generally predicted postwar snapback, optimism about the U.S. economy and its imminent, strong recovery remain the order of the day.

Betting on the government’s third tax cut, further Federal Reserve easing, a weaker currency, and still more mortgage refinancing, the consensus expects economic growth to accelerate to 3-4% in the second half of this year, compared to the dismal sub-2% in the first half.

Credit and Debt Deluge: Not a Dramatic Effect

In striking contrast, Mr. Greenspan and the Fed have become distinctly more cautious in their utterances about the economy’s prospects. The Fed’s latest Beige Book admits that economic activity remains sluggish. Although “the unwinding of war-related concerns appears to have provided some lift to business and consumer confidence,” the report said, “the effect has not been dramatic.”

Consumer spending was said to have “remained lackluster.” Labor markets were described as “weak” and manufacturing activity as “mixed.” In particular, one remark concerning consumer spending shocked us: “Overall consumer spending was soft in April and May. Retail sales picked up some after subdued sales in March, but most reports indicated that sales remained below the level of a year ago.”

This weakness in consumer spending is ominous, considering that new borrowing and mortgage refinancing are setting ever- new records. Both new and existing home sales rose to record highs last year, with mortgage origination totaling $2.5 trillion. According to estimates by the Mortgage Bankers Association, mortgage origination this year is set to reach even $3 trillion, with over $1.7 trillion of refinancings.

This mortgage-refinancing binge has had two effects. One is the change in net new borrowing by the consumer, which rose by a record amount of $768 billion during 2002. The other effect is the amount ‘saved’ by private households through the refinancing of existing mortgages on their interest payments. Considering that 30-year fixed rates for mortgages have plunged by more than two percentage points over the past 12 months, from well over 7% to almost 5%, these savings have played an important role in bolstering disposable consumer incomes.

Pondering where all this money went, we took a look at the pattern of consumer spending from 2002’s first quarter to 2003’s first quarter. What we found greatly surprised us.

Weak Consumer Spending: Flat Consumer Durables Spending

Apart from a temporary, minor surge in the sale of motor vehicles, expenditures on consumer durables were flat over the year. Among nondurable goods, the major increases in spending were on food, gasoline and fuel. Actually, 63% of the higher consumer spending was on services, and mainly on housing and medical care.

It was a discovery that has shocked us – because we learned that the American consumer’s heavy borrowing is largely financing expenditures on essentials.

The other, equally important conclusion to be drawn from these facts is that consumer spending, despite ever-new records in borrowing, is not able to lead a sustained recovery. So far, it has prevented a deepening recession, but it is much too weak for more than that. The obvious indispensable further condition for sustained, stronger economic growth is higher business fixed investment. Mr. Greenspan has certainly realized this, having said in a recent speech, “the central question about the outlook remains whether business firms will quicken the pace of investment.”

Scrutinizing the GDP numbers and also the necessary conditions for a broad recovery in business fixed investment, we see no chance for it to happen. But first a clarification of facts:

Over the 12 months to the first quarter of 2003, nonresidential fixed investment has declined in nominal terms by $21.7 billion and in real terms by $17.6 billion. The decline occurred across the board, but it was centered in structures, that is, in nonresidential buildings.

Weak Consumer Spending: A Broad Recovery

Business investment on equipment and software, measured in current dollars, increased slightly, by $10 billion, or 1.2%, implying virtual stagnation. Measured in real terms, however, one item – computers and peripheral equipment – showed a sharp increase by $56 billion, or 21%. For many bulls, this is one ray of hope in the economy’s overall dismal picture. But we see nothing but hedonic pricing. In current dollars, business spending on computers rose by just $4.4 billion.

Pondering the possibility of a broad recovery in business capital investment, we can only repeat what we have stressed many times before. Profit prospects are the key question in this respect. But scrutinizing the various macroeconomic components that ultimately determine aggregate profits, we note a preponderance of negative influences. The greatest potential threat to profits is a return of private households to higher savings, which is sure to happen when the mortgage refinancing frenzy abates and long-term interest rates stop falling.

Positive influences from the macro perspective during 2002 were the sharply widening federal budget deficit and rising residential building. Major negative influences were the continuous rise in the trade deficit and declining net investment, mainly due to the continuous rise in depreciations.

The fact is, there are no reasonable signs of an imminent pickup in U.S. economic growth in general and of business fixed investment in particular. In the last analysis, all the prevailing optimistic forecasts are based on the conviction that the Fed and government have the infallible means to generate a recovery under any circumstances. The chorus calling for the Fed to open its money spigots further has become deafening.

Best regards,

Kurt Richebächer
for the Daily Reckoning
July 10, 2003


How do you make money in this market?

“Well, for the past few months,” explained colleague Dan Denning, “you buy the worst stuff on the market. In our trading portfolio, for example, we’ve been buying tech stocks…goofy tech stocks…and we’ve been making a lot of money.”

Yesterday, the Dow fell 66 points. But the tech stocks have been leading this rally; the Nasdaq ended yesterday’s session in the black.

The smart money, and the insiders who have it, have been taking advantage of the situation; they’ve been getting out. Of course, for every seller there has to be a buyer. Who are these buyers? Whom should the insiders thank for taking the world’s trashiest stocks off their hands?

The lumpeninvestoriat! The moms and pops in mutual funds…the little guys…investors without a clue or a prayer.

Bless their hearts…

Addison and his wife, Jennifer, are enjoying their new 2nd son this morning. Though born in July, they have named him August. Eric is still enjoying the beach with his children.

And your editor is enjoying the spectacle around him. Yesterday evening, he went to his second Tango lesson. Entering the room, he found women in various stages of deshabille, including one who was nearly stark naked. But this is Paris, and what a wonderful place to spend the summer.

Besides, his wife has gone to the country for the summer, leaving him alone in the city…like Jack Lemmon in “The Seven Year Itch,” waiting for a flowerpot to fall on his head.

And what is more entertaining than watching investment markets in the Late Dollar Standard period? Did not the U.S. pump in trillions of dollars worth of new ‘money’ into the world’s money system? Didn’t this new cash and credit bulge out the Japanese stock market until it looked like a sumo wrestler…and then bubble up the U.S. stock market too? And hasn’t it ballooned America’s trade deficit…and brought a industrial boom to China…and caused the average American to go a little light-headed, loading himself up with more debt than at any time in history?

Despite the highest unemployment numbers in 9 years, consumers added another $7.34 billion of debt in May – not including mortgage debt. This comes after an increase of $7.83 billion in April, bringing the total to $1.76 trillion.

We gawk at the whole spectacle and wonder what will happen next. Further evidence for what kind of rally this is comes from a little Reuters dispatch:

“Bonds with the weakest credit ratings are making up a bigger part of new junk issuance this year…companies with the lowest ratings, CCC or below, have sold more than $5 billion of bonds, up from just $463 million in the first half of 2002.”

“Your best predictor of how something performed this year,” Reuters quotes a high-yield specialist, “would have been basically how risky it was. The higher the expected default rate, the better a bond has done.”

Bless their hearts again. Not only do the lumps bail rich investors out of their bad stocks, they also provide financing for their scammy, hopeless companies.

And the poor schmucks have no idea. The Harris pollsters discovered that while 57% of investors think interest rates will rise in the next two years, 65% were “unaware that rising rates generally have a negative impact on the value of bond investments.”

“It is amazing how stupid people are,” said my friend Michel at lunch.

We had just told him about another little spectacle that took place in the street outside our office. A group calling itself the “Grasshoppers” set up a cozy demonstration on the sidewalk. They rolled out green carpets…and set up tables, parasols and lounge chairs. On the tables was laid out a collation, served to whomever came up to ask for it.

In the middle of this pleasant scene, a young woman in a black t-shirt stood up to a microphone and began a harangue worthy of a sweaty Bolshevik or a cool Bush.

“We, the Grasshoppers, are ready for the fight. We will take on the ants. We will battle against them…we will beat them…we will vanquish them…”

She did not say that they would rape the ants’ horses and ride off on their women, but she was thinking it.

Who were these strange people? What were they up to?

“Probably some group with a government grant…some kind of street theatre,” offered Michel. “Wasting taxpayers’ money…

“But if you ask people where the money comes from for this sort of thing, they say it comes ‘from the government.’ They have no idea that it comes out of their own pockets. I have to explain to my employees that the money we pay to the government in ‘social charges’ – 40% of the salary in France – is really a cost to them. It could otherwise go to them. But they think it comes from the employer…or the government…or from the rich…like manna from heaven.”

Readers who have stuck with us this far are probably wondering where we’re headed. This does not sound like the Daily Reckoning market commentary you’re used to, does it?

But it’s summertime. Addison and Eric are not looking over our shoulder. And we’re warming up to something…exactly what, we don’t know yet…but watch this space, tomorrow.

In the meantime, we note that refinancing activity fell off – down 21% – last week. The Fed is caught in its own oxymoronic lie. On the one hand, it assures the nation that inflation is as sure as California sun. And on the other, it seems to take offense when investors put on a little sunscreen. Long rates are rising, despite the Fed’s latest cut in short rates. Higher long rates mean more expensive mortgages. More expensive mortgages mean fewer refinancings…and less consumer spending…and, unless business spending suddenly springs to life, more slump…which means the Fed becomes even more frantic in its effort to avoid deflation!

“The steep fall in global bond markets in recent weeks is threatening to slow global economic recovery through higher mortgage and corporate lending rates,” the Financial Times clarifies.

Spot gold dropped 70 cents yesterday, while gold for August delivery lost 5. Why would gold go down if inflation were really guaranteed by the Fed? Perhaps it is warning us; deflation won’t be so easy to beat, after all.

The Daily Reckoning