The Coming Economic Slowdown - Recession or Depression?
Since the end of the economic recession in 2001 the American consumer has powered the recovery through debt and consumption. To the amazement of economists and analysts, consumption trends have continued far longer than anyone anticipated. Like the Energizer bunny, the American consumer just keeps on spending, going deeper into debt in order to live the American dream. Perhaps it is one reason why consumer confidence is down and the President’s poll numbers keep dropping. The economy continues to expand, but that expansion is requiring larger amounts of debt to keep the economy aloft.
This expansion may now be resting on its final legs. The economic stimulus that has powered this recovery is running out of steam. The tax rebates are behind us and it now looks like the tax cuts themselves could be in jeopardy. They are due to expire in 2008 and there doesn’t seem to be the political resolve to extend them as government debt hits record levels. Spending discipline in Washington is non-existent. With mid-term elections approaching every Congressman up for election is promising voters more lollipops. Tax rates are more likely to rise rather than come down. Here in California income tax rates were raised to 10.3% last year and another measure is on the ballot to raise tax rates an additional 1.7%. Tax hike fever is on the rise.
If we look at other stimulus variables powering this expansion, they are also waning. Interest rates are rising and the real estate market is in a clear downtrend. Home equity loans are starting to level off as a result of rising mortgage rates and falling home prices. Many credit lines are tied to prime interest rates, which have climbed from 4% to 7.5% over the last three years. The market is anticipating two more rate hikes: one in March and one in May. So consumers may be facing 8% interest rate by this summer. These higher rates are slowing the torrid growth rate in home equity loans from the 30% to 40% annual rate to 5% as of this March. A definite slowdown is in place, which is what the Fed had in mind when it began this rate-raising cycle.
Source: Economagic
One by one all of the economic stimulants are being removed. The economic recovery began with tax cuts and tax rebates. It was followed immediately after 9-11 with dramatic rate cuts that put additional funds into the pockets of consumers as a result of refinancing. As interest rates were being slashed, manufacturers and retailers offered additional economic incentives to consumers to borrow and spend through zero-percent financing, no money down purchases, or delayed payments. Many of these incentives have now been withdrawn as many companies are hemorrhaging in a sea of red ink.
Finally, the last incentive of cash-out home equity is also being withdrawn as rising interest rates start to bite into the housing market. Between 2003-2005 anywhere from 28% to over 40% of all new mortgages were variable rate. Nearly half of these VRMs are tied to the 1-year Constant Maturity Treasury (CMT) Index. The interest rate on these adjustable mortgages is adjusted annually as the CMT changes. Most other VRMs are tied to 3 & 5-year Constant Maturity indexes. The point to recognize is that these interest rates are rising, thereby taking more of the consumer's disposable income. In the next three years - unless something changes dramatically - most owners of VRMs are going to see their monthly mortgage payments rise. This will make the burdens of debt more troublesome.
With the consumer's debt burden and cost of living rising, where will the next stimulus come from in order to keep this economic expansion in place? As the BCA Research charts indicate, the real estate ATM machine is running out of steam with falling home prices and home sales. Real wages and salaries haven’t kept up with inflation, payroll growth is dropping, and the savings rate is now negative. Since the early '90s, the savings rate has fallen from 8% to its current negative rate. The equity bull market of the '90s encouraged consumers to spend and borrow more and save less as stock prices went up double-digits almost every year. In this new century, double-digit real estate appreciation replaced stock growth as the engine of consumption.
While most households are in good financial shape, there is very little margin for more rate hikes or higher energy prices. Marginal households pose the greatest risk to the economy. They are at the outer bounds of their limits. Bankruptcies are on the rise as the tailwind from rising housing wealth is fading. In addition to falling real estate prices, the cost of living is going up far greater than is widely reported. The financial markets are focusing on the “core rate.“ However, households must contend with “headline” rates of inflation, which are also understated. Higher living costs are taking a large chunk out of discretionary spending, which is why confidence is down.
The markets are anticipating that the Fed will raise interest rates at least another two times, taking the federal funds rate to 5%. Some anticipate even higher rates. The economy can’t withstand 5% interest rates much less 5.5%. What seems likely is that the Fed will overshoot. By this fall or early winter the Fed should be in a panic mode, which doesn’t bode well for the economy. Today’s bullish statements harken back to early 2000 when the widespread consensus was that the economy was in great shape despite a series of Fed rate hikes. We all know what happened next: a bear market and a recession. How likely is it that the Fed will get it right this time? For now I’m sticking with my 2006 forecast: first the gain, then the pain. The gain comes from the market's anticipation of the Fed rate hikes coming to an end and a sea of liquidity flooding into the markets. The pain comes later as the reality of an economic slowdown, falling profits, a drop in consumer spending, a falling dollar, rising long-term interest rates and rising inflation takes hold. Enjoy the gain while it lasts.
Is it a Bull or a Bear?
In its recent March issue, BCA took a look at the current equity market. Is an approaching bear market eminent? They looked at investor sentiment, the Presidential cycle, a flat and inverted yield curve, monetary policy and stock market valuations. Their conclusion is that there is very little statistical support for an approaching bear market. Investor sentiment is not at extremes - and more importantly - traders are bullish, which augurs well for the markets. The second year of the Presidential Cycle is usually bearish close to 50% of the time. However, as Bank Credit Analyst points out, the outcome for the markets is different when it comes to two-term Presidents. The market returns during the second year of a second-term President is favorable the majority of the time. The exception was Richard Nixon whose second term experienced a Middle East War and oil embargo that tripled prices and ended with Nixon resigning in disgrace. The result was the worst bear market since the Great Depression. All other second-term presidencies experienced favorable markets.
Besides these factors, BCA points to favorable monetary conditions. Despite the successive rate hikes, interest rates are still at historically low levels. More importantly the Fed is flooding the financial system with liquidity as shown in the graph of M-3, which disappears next week. M3 increased by close to $90 billion last month, or an annual rate of over 10%. Rates may be rising, but credit is plentiful whether to buy property, expand business, or to speculate.
Finally, when it comes to valuations, markets aren't cheap, but they are no longer expensive as they were in the last bull market. Most valuation levels are neutral or slightly below average. The markets aren’t a great bargain, but they also are no longer selling at extremes. In a financial economy with plenty of liquidity, one of the favorite routes for excess money creation is the financial markets. So what we see is new multi-year gains for the major indexes such as we are now seeing for the Dow Industrials, the Dow Transports, and the S&P 500. Once again... our theme “first the gain, then the pain.”
Looking for Money
In order to avoid hitting the debt limits of $8.2 trillion the Treasury Department has started to draw money out of the civil service pension fund. The government is relying on tapping into government workers Retirement and Disability Fund to avoid the statutory debt limit. The government has been doing this with the Social Security Trust fund for decades. It is one reason why Social Security and Medicare are heading for a crisis by the end of the decade. There is no trust fund. The government has spent the money. Now it is necessary to tap into Civil Service Pensions. Coming soon within the next ten years they’ll be tapping into private pension plans in order to fund the deficit, probably through mandatory zero coupon purchases. Tapping into private pension funds is the next step. They’ve emptied the Social Security Fund, they’re raiding Civil Service Pensions, how long before they start raiding private pensions? No private employer would be allowed to do this to meet cash shortfalls. But then again it's the government. Hold on to your wallets, because they will be picked by higher taxes or mandatory debt financing in the future. This is something to think about when you look at all the promises that are now being made by our politicians.
The Next BIG Thing
In April of 2002 I penned a piece calling for rising commodity prices as The Next Big Thing in the financial markets. Since the time I wrote that Storm Update, commodity prices have been rising relentlessly -- whether it is energy, gold and silver, copper or uranium.
Since reaching a low in October of 2001 the CRB index has risen 144 points for a gain of 79%. Many individual commodities have experienced even higher gains. Oil prices have quintupled, gold and silver have more than doubled and uranium prices are up nearly 400%. This is just the beginning. Higher prices are on their way and should be with us for at least another 10-15 years... if not more.
Another trend is emerging and will shortly move to the forefront as we approach peak oil. The Next Big Thing in this author’s opinion is alternative energy. When we run out of cheap oil we’ll be scrambling for anything that can replace it. That is where alternative energy comes into play. To get a glimpse of things to come look at the chart of the Wilderhill Clean Energy ETF. The fund invests in companies that are engaged in the business of clean energy or conservation.
Peak Oil and the Army's Future
We’re not the only ones who believe peak oil is eminent. According to a recently released US Army report, “The days of inexpensive, convenient, abundant energy sources are quickly drawing to a close.” The report was a result of a study done by the U.S. Army Engineer Research and Development Center. The Army gives credit to the published works of ASPO (Association for the Study of Peak Oil and Gas). The report calls into question the USGS estimates of bountiful oil supplies, which suggest a five-fold increase in discovery and reserve additions without any supporting evidence to back this assertion.
Source: Energy Trends & Implications for US. Army Installations, Energy Bulletin
In order to sustain itself as a fighting force, the Army needs to insulate itself from the upcoming energy shortages. Wars over the last century have been fought and won over the issue of energy. No fighting force can win battles when its supply of energy is limited or cut off. The Army study looked at all forms of renewable and non-renewable energy options. The report looks at establishing a new energy policy with the following objectives:
- Eliminate energy waste in existing facilities
- Increase energy efficiency in new construction and renovations
- Reduce dependence on fossil fuels
- Conserve water resources
- Improve energy security
If the U.S. Army is looking at alternative energy, maybe it's time for investors to do the same.
Until the next time... fair winds and clear skies!
© 2006 James J. Puplava
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