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Monday, August 26, 2002 Market WrapUp
Housing Market Still Strong
It was another one of those one-day turn-arounds for the stock market. Financial and energy stocks helped to bring the markets back into the green as investors took heart that the housing market is still running strong. As long as interest rates remain low or are heading lower, and the housing market remains strong, consumers can continue to tap into their home equity, borrowing money to maintain consumption. There are signs this trend is weakening, but for now it is still running strong. The two main pillars of this economy still remain the consumer and the government. Both are borrowing money as if there was no tomorrow. The consumer is still tapping into his home equity while the government taps into the capital market. With the housing market still running strong the consumer is able to monetize that equity through the refinancing of his mortgage. With stock prices taking investors on a roller coaster ride, the appetite for government bonds has grown even stronger with investors.
Gov’t Debt
The deflation of one bubble and the creation of another in housing to take its place have been good for both consumers and the government. The deflating of the stock market bubble has forced money into bonds out of equities. This has helped the US government finance its budget deficits. Mainly, institutional clients have financed the deficits. Financial entities such as banks and insurance companies have a large appetite for fixed income securities to match their lending liabilities. Foreign purchases of US Treasuries have tapered off dramatically. Institutions have stepped into their place. This has been good for government, which has gone on a spending and borrowing spree. In June the debt ceiling was raised by $450 billion from $5.95 trillion to $6.40 trillion. In just a short time the government has already used $250 billion of the $450 billion increase. As of last week, current government debt stood at $6.2045 trillion. Last year at this time outstanding US debt stood at $5.8075 trillion, an increase of $397 billion in less than a year. The government’s fiscal year ends in September, so we still have plenty of time to spend even more money. At this rate we will have to raise the annual debt ceiling once a year.
The sum of it all is that the US is borrowing between $450-500 billion annually to fund our trade and current account deficit, and another $400-450 billion to fund its budget deficits. With a possible war with Iraq on the horizon, that number could go even higher. In order to keep the economy moving it is now necessary for the US to borrow between $800-900 billion a year. That is big money by anyone’s standard. The question is where will this money come from? The exodus out of stocks has been instrumental in funding the government’s deficit. But how long will foreigners continue to fund our trade and current account deficits? With US foreign liabilities now running over $9 trillion, $4.3 trillion net, foreign appetite for US securities is waning. At some point in the near future they may simply say no.
The Consumer
The other pillar of the US economy, the American consumer, continues to echo the behavior of the government. The consumer has found a new friend in his mortgage broker. The boom in real estate, which is being driven by lower interest rates, continues to entice consumers with cheap available credit in the form of refinanced mortgages. Without the refinancing boom, the consumer borrowing and spending binge would have ended long ago. If the Fed can get the ECB (European Central Bank) to lower interest rates, the Fed will have the green light to lower interest rates even lower, and perhaps generate another refinancing boom. As it stands, according to the Mortgage Bankers Association, the refi index is up over 200% from a year ago. Within the last week the refi index is up almost 14% while applications for mortgages are up 11%.
The Private Corporate Sector
It appears at the moment that the twin pillars of government and consumer spending are still holding up based on abundant credit. The whole American economy is one vast and expanding credit machine that shows no sign of stoppage. While these twin pillars of debt and consumption continue unabated, the other pillar of the US economy, the private corporate sector, continues to contract. Companies still don’t have any pricing power. Without the ability to raise prices companies are slashing the only costs they can control, which is labor. The vicious cost cutting now occurring at the corporate level has broader macro economic implications. Companies can’t continue to slash their labor force without a dampening effect on the economy. If one company slashed its labor, it would be one thing, but when all companies within a given sector are doing it, the effect is economic contraction. As one company does it, other companies within a sector are forced to respond. Eventually you have a whole sector within the economy contracting with revenues declining along with costs. The result when carried out across different industries is another recession.
The standard response by most economists and analysts is that fiscal and monetary stimulus will offset this weakness in the corporate sector. The economic models used in Washington and on Wall Street are based on a continuous stream of new debt to keep the economy going. The consumer continues to borrow and spend, extracting more equity out of rising housing prices. The government continues to borrow and spend, with institutions now financing the government deficits.
What happens when the money runs out? The next step at this stage is for the Fed to start monetizing debt. This will allow the government to inflate even further. It hasn’t gotten to that stage yet, but it won’t be long. With the budget deficit now back over $400 billion a year and growing, the deficits will only get larger. At some point not even institutional money will be able to fund them, and when that point arrives, the next step will be debt monetization.
The consumer won’t be as fortunate as the government. Unless housing prices go into a hyper bubble state or if the Fed can successfully expand credit even further to drive down rates, the refi boom may be coming to an end. As corporate cost cutting continues to pick up steam more consumers and households will be losing breadwinners. It is hard to get mortgage financing when one member of the household has lost their job. The job market then becomes an influencing factor on the housing and refi market. You can’t qualify for a mortgage when you’ve just lost your job.
The US now finds itself in a precarious situation. It is dependent on the willingness of foreigners to finance its trade and current account deficits, and financial institutions to finance its budget deficits. The remainder of the economy is dependent on rising housing prices and lower interest rates to maintain consumer spending which is dependent lower interest rates. It hasn’t dawned on anyone yet that this is a prescription for disaster. In my 23 years in this business I have never seen such an absence of understanding of macroeconomics. We now have a recovery scenario that is based solely on a continuous pyramiding of debt. No one seems to contemplate what will happen when that debt spirals out of control.
I have seen many of the deflation arguments about what is in store for us. However, I don’t buy the strict deflation argument. I believe my Perfect Storm thesis is what we are going to see. There will be deflation in credit related and luxury goods while we have severe inflation in key raw materials and in basic goods. The storm that is in front will be no ordinary textbook storm. The US economy today isn’t the same US economy of the 1930’s. We are no longer the world’s largest creditor nation. Instead, we are now the world’s largest debtor with our debt now growing exponentially. We are no longer self-sufficient in manufactured goods. Look at the labels of the consumer goods you buy and see where they were made: the US or overseas? The US is no longer self sufficient in energy. We now import over 60% of our oil and over 15% of our natural gas. In fact, the US is no longer self sufficient in many raw materials and that has broad implications, especially if foreign goods and raw material producers no longer want dollars for the goods they ship us.
I’m afraid we are not living in ordinary times. This has not been a normal recession, nor has this been a normal recovery or a normal bear market. That alone should tell you that we live in different times. The previous shibboleths of previous booms echoed so many times throughout this last bubble and now the current housing bubble that “this time is different” is more appropriate to what comes afterwards. The storms now building in the international monetary system should turn inward and start to retrograde. That is a rare event but so was the Perfect Storm.
Today’s Market
Inside of today’s stock market the major indexes recovered after a positive housing report showed the housing market is still running strong. July existing home sales shot up 4.5% and new home sales rose 6.7%. These numbers will probably be revised lower as happened last month for June housing sales. For the moment, however, housing still looks good. This is helping to raise consumer, finance, and energy stocks. Tomorrow we’ll get to see if the housing market has legs with two key economic reports out on durable goods and consumer confidence. Over the next few weeks the markets will have a busy schedule of economic reports to digest. Then beginning the middle of next month we start getting into the earnings pre-reporting season. Wall Street analysts have already begun to slash pro forma earnings projections faster than the Fed can grow the money supply. Thank goodness no one knows how to read a financial report. If the media and Wall Street were to suddenly talk about GAAP earnings, investors would be frightened out of their mutual funds. The word from Wall Street is to stay invested.
Volume was light in this pre-holiday week. Big board volume came in at less than 1 billion (998 million) while Nasdaq volume was 1.44 billion. Market breadth was positive by 23 to 9 on the NYSE and by 21 to 12 on the Nasdaq.
Overseas Markets
European stocks declined as KarstadtQuelle, Germany's biggest department store owner, said consumer demand in Europe's largest economy may not recover until next year. The Dow Jones Stoxx 50 Index fell for a second day, slipping 1% to 2793.29 points, and taking its two-day drop to 2.6%. All eight major European markets were down during today’s trading.
Japan's Nikkei 225 Stock Average closed above 10,000 for the first time in almost a month on optimism a U.S. homes report will indicate an improved outlook in the world's biggest economy. Exporters such as Toyota Motor Corp. gained. The Nikkei rallied 2% to 10,067.74.
Treasury Markets
Government bonds lost the bulk of earlier gains as stocks found their footing late in the trading day. The 10-year Treasury note was up 1/8 to yield 4.225% while the 30-year government bond edged up 3/32 to yield 5.015%.
© Copyright Jim Puplava, August 26, 2002 |
