*** Marc Faber - Signs Of A Hurricane ***
SIGNS OF A HURRICANE
by Marc Faber
Wednesday 18 February 2004
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."
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.
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.
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.
Regards,
Marc Faber
for The Daily Reckoning
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