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The Reckoning

One of the basic assumptions for the recovery this year is an increase in capital spending on the part of business. Consumer spending is expected to remain strong and an increase in capex spending is supposed to supplement it to give us a recovery. There are only two problems with these assumptions. One of them is debt, which is common to both consumer spending and corporate capital expenditures. The other issue is profitability for corporations and in one sense, it is the same for consumers. Profitability as it relates to consumers means employment. Both assumptions are critical in maintaining the economy. Both seem to be absent. Companies continue to lay off workers, which hurts consumer profitability and makes it difficult for consumers to support spending. On the other hand, a decline in real profits and a balance sheet that is burdened by debt is keeping capex spending from materializing.

The issue of debt seems to get ignored when economists or analysts crank out economic or profit form alive, many homeowners are taking out adjustable rate mortgages in order to minimize payments or make home purchases more affordable. The consumer’s record mortgage and credit card debt only looks good as long as real estate prices continue to rise. When real estate prices fall then these record debt levels will look more ominous. Furthermore, as more consumers lose their jobs their ability to service that debt becomes more problematic for lenders.

On the corporate side, the debt issue still remains a problem. The trillions in debt taken on during the 90’s to fund acquisitions, mergers and stock buybacks has increased corporate interest expense. The one mitigating factor has been lower interest rates, which has helped to alleviate part of the debt burden. However, the record low interest rate has not resurrected the stock market and allowed companies to issue new equity in order to reduce debt on the balance sheet. Today interest expense is almost two-thirds of pre-tax profits. And despite a fluctuating and gyrating stock market the general environment for issuing new stock has not been favorable.

Companies need to clean up their balance sheet from all of the excesses of the 90’s debt binge. The only way to do that is to increase profits and use those profits to retire debt, issue new equity or to sell off assets. Up until now companies have tried to restore profitability through cost savings. The main way that companies are cutting costs is by firing more workers. While this may improve profits in the short-run from a macro perspective, it harms the economy in the end. How are fired workers supposed to maintain consumption or service their debt when they have lost their jobs?

In a larger sense, the U.S. economy has been turned upside down by the overemphasis on consumption. Over the last several decades, and since the Great Depression, the emphasis in government policy has been to encourage debt accumulation and consumption at the expense of savings and investment. A good example of this fallacy is that interest expense is deductible by corporations while dividends are taxed twice. A company can deduct all of the interest it pays while the dividend it declares to shareholders is nondeductible and taxed twice, once at the corporate level and then again and the personal level. The left in this country is fighting hard to maintain this policy and opposes the President’s elimination of the double taxation of dividends. However, given the choice between a deduction or no deduction, it is no wonder that it has paid for most individuals and companies to accumulate more debt. The tax laws favor debt accumulation. At the same time, the tax laws discourage capital accumulation by punishing those who save through higher marginal tax rates.

These kinds of polices have transformed the United States from the largest creditor nation to the world’s largest debtor nation. This becomes obvious from looking at the macro economic numbers over the last five years.

Source: The Richebächer Letter, May 2003

As the above statistics show, it is taking more dollars of debt to get a dollar of growth in GDP. The American consumer spends more on imported goods than he does on American goods. The consumer receives his wages from American companies, then takes those wages and spends it on foreign goods. At the same time companies are firing workers, they are shifting manufacturing, research and development, and service overseas. Is it any wonder that unemployment keeps going up and the economy continues to weaken? Today the Institute for Supply Management (ISM) announced that its April manufacturing Index sank from 46.2 to 45.4, the second month in a row. A reading below 50 indicates that the economy is contracting. This is the first back-to-back decline since early 2002. The ISM report also said that new orders for goods, an indicator of future activity, fell from 46.2 to 45.2 and the employment index declined from 42.1 to 41.4. In addition to the ISM report, the government reported jobless claims were 448,000 in the latest week, the eleventh straight week that they have remained above 400,000. U.S. auto companies also reported that despite increasing incentives sales fell last month. GM reported that its sales dropped 8.7 percent while Ford reported that its sales fell 6.7 percent. If there is to be a second half recovery this year and a boost from the end of hostilities in Iraq, it isn’t evident in any of the economic reports.

Recession Hinges on Two Pillars

The two remaining pillars of the economy, government spending and housing, are all that keeps the economy out of recession. GDP growth in Q1 was only 0.4 percent. The housing sector appears to be cooling off; while government spending at all levels shows no sign of abating. The conflict in Iraq may be over but other conflicts in the region have yet to begin. Military spending in the U.S. will be one of the strongest components in GDP going forward. Since taxes are unpopular and inhibitors of economic growth the U.S. will inflate its way through this war. The Fed is busy monetizing debt, and money velocity is increasing, so expect to see inflation rates increase.

However, as I have laid out in my Perfect Financial Storm series, the U.S. will simultaneously experience both inflation and deflation. The cost of things you don’t need that you pay for with discretionary spending will be going down; while at the same time the things that you need, such as food and energy, will be going up. And even though the President will try to stimulate the economy by reducing overbearing tax burdens, state governments will be taking more of your take home pay. Here in the People’s Republic of California, our clueless governor is planning on increasing income tax rates up to 11 percent and making them permanent. The governor hasn’t been able to reign in spending despite an increase in revenues of 28 percent, so he is increasing taxes of all sorts from sin taxes, to motor vehicle taxes, to gas taxes, and now income taxes. His economic plan is going to send the states economy into deeper recession as high earning individuals and companies flee the state to states with lower tax burdens. The exodus of companies has already begun, triggered by a 25 percent increase in workers comp costs on top of last year’s double-digit increase.

If you are a low tax state with low costs of living, including housing, look for an exodus of Californians coming soon to your state. A California homeowner can sell his inflated home here and go elsewhere and buy a much more affordable home in addition to saving a bundle in taxes. Maybe this is a new plan by the governor to reduce the population of the state by sending high earners and companies that provide employment out of the state. The point here is that any tax savings that may come as a result of the President’s stimulus package will be more than offset by an increase in state taxes. Very few states have the real discipline to reduce real spending; not the fictitious reductions of slowing the rate of increases in spending that are commonly referred to as budget cuts.

The day of reckoning is upon us and until we change our ways from debt and consumption back to savings and investment, the U.S. is headed down the road towards impoverishment.

We are substituting asset bubbles created through credit for the building of real wealth. All that we have done in these last two decades is reduce savings, borrow money, and increase consumption, selling off our productive assets in the process.

In reality, we have actually spent the last two decades consuming our capital, exchanging it for depreciating consumer goods. The proof of this can be seen in our burgeoning trade deficit and the growth in credit and the rise in debt across all levels of society.

The end result will be deflation in all things associated with credit that have become bubbles, most notably stocks, real estate, consumer goods and inflation where credit is directed. Looking forward to the decade ahead the real wealth will be made in precious metals and “things” as investors escape and flee from depreciating paper assets.

Today's Market
In trading today, the blue chips ended on a negative note while speculators drove the NASDAQ from losses to gains for the day based on better-than- expected reports from two tech companies: Adobe and Macromedia. Adobe said that software sales would rise in the second quarter thanks to increased demand coming from Japan. Sales have fallen for the last three years along with profits, so the fact that the company could actually experience an increase in sales was extrapolated to mean that the tech sector was improving. Macromedia also followed up Adobe’s positive news by saying that sales actually rose by 9.6 percent this quarter, making it the second quarterly increase in two years. The company also reported its second quarterly profit after seven consecutive losing quarters. Speculators jumped all over software stocks and Internet companies, which led today’s advance in the NASDAQ.

Meanwhile, blue chips can run into difficulty. After the markets closed, Disney reported earnings for the quarter that fell 12 percent as a result of higher TV costs and lower attendance at theme parks. The only blue chips that are doing well seem to be the energy stocks and the financial stocks. Exxon reported that profits more than tripled to a record $7 billion. Rising profits in the energy sector have failed to help the energy stocks as they remain within a narrow trading range. Speculators and fund managers simply aren’t interested. They ignore the energy sector that is experiencing rising demand and higher prices while they chase speculative tech and Internet stocks whose real earnings have yet to improve. Most investors still believe in the last bull market leaders while they ignore the new leadership that is erupting in commodities and raw materials. What the market and investors have failed to awaken to is the U.S. is now at war, a war that will last beyond this entire decade. To finance this war the U.S. government will inflate to pay for it with printed dollars. As the number of those dollars increases as shown in the money supply, the value of those dollars will decrease in value as shown in the first two charts below. The third chart is gold, which is directly related to the first two charts.

One thing leads to another . . .
M3 Money Supply 1/1/2000 - 4/21/2003 click to enlarge	U S Dollar Index 1/1/2001 - 5/1/2003 click to enlarge	Gold 1/1/2001 - 5/1/2003 click to enlarge

Volume came in at 1.37 billion on the NYSE and 1.45 billion on the Nasdaq. Advancing issues edged out decliners by a narrow margin of 17-15 on the Big Board and by 17-14 on the Nasdaq. The VIX rose by .73 to 24.50 and the VXN continued to decline falling .18 to a very complacent 32.49.

Other sectors doing well today were gold and silver shares, which have been rising as the U.S. dollar continues to hit new lows. The dollar broke down today and hit a new four–year low. The dollar fell on news of economic weakness in the manufacturing sector, which has gone back into recession. Precious metals shares travel in the opposite direction of the dollar. The bulls believe the markets will be range bound until the recovery kicks into gear now that the conflict in Iraq is over. The bears see the market differently. They see signs of weakness as the economic news and real earnings news deteriorates. They also see widespread complacency amongst advisors and investors. No new market leadership has asserted itself outside of precious metals, which remain within a bull market trend. The rest of the market has become similar to a casino with fund managers and speculators jumping from one hot sector to the next with no permanent trend emerging. What is hot one day or one week can quickly go cold the next day or following week as speculators jump from one gambling table to the next.  This is definitely a speculators market versus an investors market.

Copyright © 2003 Jim Puplava
May 1, 2003
Charts courtesy of Bloomberg and www.stockcharts.com 

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