Dr Marc Faber's views on 2004:
I remain convinced that the present 'strong' recovery phase in the US 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.
I have quoted Joseph Schumpeter in previous reports, but for the benefit of some of our new readers, I quote him here once again regarding the subject of economic recoveries, that are purely a consequence of fiscal and monetary stimulus.
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' (emphasis added).
A few years ago, I met Peter Bernstein, the author of several best-selling books as well as the excellent economic newsletter entitled (Economics and Portfolio Strategy www.peterlbernsteininc.com).
Peter is a deep thinker, an intellectual, and a realist, but is certainly not a gloom-and-doomster. In fact, I shall always remember that, in the course of a discussion that took place in the late 1990s, he noted that I was 'very negative' about the economic outlook.
I am mentioning this because his latest newsletter also sounded 'very negative' for someone who has a relatively balanced and moderate view of the world - certainly compared to myself. Peter analyzed in his recent reports the interrelationship of the twin deficits in detail.
According to him, the attitude among US citizens regarding these deficits is 'a combination of hope, indifference, or even puzzlement'. In his view, 'though there may be moments of passing improvement in the data, the evidence and analysis we offer here demonstrates with overwhelming power that neither of these problems is going to disappear any time soon. There is no basis for being light-hearted about these matters: they will continue to haunt our economic vistas indefinitely, casting a shadow over everything the future holds' (emphasis added).
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 just want to point out that he is 'certain' that 'current trends are not sustainable'.
'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.' (Emphasis added.)
In particular Peter is concerned about the long-term decline in the US national saving rate as a percentage of GDP. (The national saving rate includes household saving, corporate cash flows, and the government's budget surplus or deficit.) There was an improvement in the national saving rate between 1993 and 2000 due to higher taxes and a swing in the federal budget towards 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, to create 'pent-up' demand, which then leads to sustainable growth during the recovery phase.
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.
Noteworthy is that US consumers have increased their spending for an unprecedented 47 quarters in a row (the last downturn was in the fourth quarter of 1991) and more recently, consumer spending rose largely as a result of higher borrowings.
As a result, US 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.
Still, according to Merrill Lynch's chief North American economist, David Rosenberg, 'the amount of leverage relative to the size of the consumer balance sheets has never been as large as it is today. While the asset side has been given a lift from the rebound in equity prices and the continuous strength in house values, the reality is that the aggregate liabilities in the household sector have risen by almost 12% in the past year, outpacing asset growth by a factor of nearly three. The 14% jump in mortgage balances over the past year has also nearly doubled the pace of real estate appreciation as home equity was gutted during the latest refinancing boom and easy credit standard nurtured a wave of high loan/value ratio loans for new entrants to the housing market. So far in this nascent two-year old 'recovery' households have added more than 15% to their outstanding indebtedness and yet net worth has barely budged.'
Before explaining what this all means, let us also take a look at households' income where the trend is worrisome. 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, since 2001, real wages and salaries have declined (they declined by 0.2% in the 12 months ended September 2003), and while some recovery in real wages is possible, 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.
I may add that the decline in real wages and salaries was far worse than official figures would suggest, because the US government has been purposely understating inflation figures by a wide margin.
Moreover, I believe that real wages won't increase, but could actually decline further, as overseas competition for manufacturing and increasingly higher paying service jobs is here to stay and inflation may actually pick up.
So where does all that leave us? Consumption could also be increased, if not through income growth, then through a further decline in the national saving rate (see above) and additional consumer borrowings. But for households' borrowings to keep on expanding at their recent strong pace, 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 been largely the driver of the US recovery. (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 mortgage and provided them with additional spending power.
I hope the reader appreciates the precarious nature of this state of affairs. The entire US 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, which, however, carry far 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 US trade and current account deficit, and hence, as we pointed out in earlier comments, to a weakening dollar?
This highly artificial recovery is, in our opinion, not sustainable for very much longer, although 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 obviously 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 be forced to retrench through a rapid loss of the US dollar's purchasing power, which will lead rising inflation rates and inevitably also to higher interest rates.
Accelerating inflation will most likely also bring about falling real household income, as wage increases would unlikely match the rate of inflation, due to the overseas competition for jobs we referred to above. 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, but I am certain that Peter Bernstein will be proved right when he writes (see above) that the breeze that will accompany the restoration of balance won't be 'gentle' but will likely take the form of a financial and economic hurricane.
In fact, trouble may have already started. All measures of money supply have turned negative, and MZM has declined at an annual rate of 7% in the 13 weeks ended November 10 while M3 is growing at its slowest pace since 1993.
The bulls will, of course, point out that there is nothing to worry about in regards to the decline in money supply, which, they argue, has to do with an increased preference for equities over cash by investors. But the steep deceleration in money supply growth is more likely to be due to the collapse in home refinancing activity and was, incidentally, accompanied by first a deceleration in the growth rate and more recently by a decline in total bank credit.
The recent decline in money supply and bank credit doesn't bode well for either the economy or the stock market. In fact, if we look at the recent performance of consumer-sensitive shares such as airlines and retailers, one has to wonder about the wildly optimistic economic forecasts.
Sears and Best Buy have broken their up-trend; Home Depot and Lowe's look like they have topped out; Southwest Airlines and Jetblue have collapsed, and Delta Airlines is no higher than it was at the beginning of the year.
The price of Wal-Mart is weakening despite all the brouhaha about the strength of the economy and is now barely higher than a year ago. Even the recently super-strong Philadelphia Semiconductor Index (SOX), whose components are very economic-sensitive, is no longer leading the market and is breaking down. In addition, most recently, housing stocks also took a beating, possibly confirming the weakness in the Merrill Lynch Housing Index.
In sum, the stock market seems either to have had second thoughts about the sustainability of the present economic recovery, or it may already have fully discounted the recovery. In fact, in the past a high level of ISM orders, such as we had recently, has always been a reliable sell stock indicator! In short, US equities offer limited up-side potential but entail, in my opinion, high risk and should best be avoided.
With Dr Marc Faber
Saturday, January 03 - 2004 at 09:15 UAE local time (GMT+4) |
