Storm Watch Update
LET'S
FACE FACTS
by Jim Puplava
www.financialsense.com
October
12, 2001
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Storm Watch Update |
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There is no question that even before the September 11 attacks, the economy was headed towards recession. Having peaked in the 4th quarter of 1999, it began its descent in the third quarter of 2000. While the manufacturing sector of our economy was the first to be hit, the downward slope was hidden by the strength in consumer spending and in housing. A boom in real estate replaced the boom in stock prices. Lower interest rates ushered in a wave of refinancing that helped to bolster consumer spending. So while manufacturing and technology spending began to falter, and stock prices began to crumble, the economy was buoyed by rising real estate prices and strong retail sales. This served to mask the general weakness in the economy. Where We've Been...
By the first quarter of this year, it became obvious that all was not well in the economy and in the financial markets. Stocks were in negative territory, companies began to report a slowdown in earnings, job layoffs began to make front-page headlines again and economic growth rates began to falter. This was explained by most as a simple inventory build due to a slowdown in sales. Once the inventory was worked off, the economy and profits would begin to pickup again. This theory became known as the second-half recovery scenario. Economic growth and earnings estimates were simply postponed until the second half. Everyone was still bullish on stocks and the economy. Everyone, that is, with the exception of the President. The President's advisors had warned him that he had inherited an economy and weakened financial market that was headed towards recession. Once sworn in, the President made an economic stimulus package a priority. Unfortunately, the full package was watered down. Tax rate reductions were strung out over a decade. All Americans got was a measly rebate. The debate in Congress was over the size of the surplus. Even up until the attacks on the Trade Center, the Left was still arguing over the size of the surplus numbers. The debate over missile defense the week before the attacks was portrayed as unnecessary. Our cities were in no danger. Who would even dare attack the U.S.? The President was criticized for even considering such a plan. There was even talk of repealing the tax cuts because of a shrinking deficit. House Minority Leader, Dick Gephardt, vowed to make tax increases a priority if his party regained the House in 2002. The missing argument in the debates was the fact that the shrinking deficit was due to an economy that was already heading towards recession. Much of the huge surplus of the preceding years was due to the stock market boom and the resulting tax on capital gains and personal income tax on stock options granted to employees of public corporations. Attention
Shift Priorities
Changed Four
Weeks Later...
However, the attacks dealt the final blow to consumer confidence. Collapsing stock prices, layoffs, the cuts in overtime and hours worked and now security have zapped what once was the one strong remaining sector of the economy. The drop in confidence has impacted not only consumer spending, but along with it, the related strength in the housing market. The greatest evidence of this is the shift in consumer priorities. As the graphs below indicate, personal income went up by 1.7% during July, but spending only rose 0.1%. Instead of spending the tax rebates, consumers chose to save the money. The Saving Rate has jumped dramatically to the current rate of 2.5%. Personal savings had been gradually rising since the beginning of the year as uncertainty in the economy and the stock market increased. The consumer could no longer count on the 20% annual returns from the stock market to replace the need for savings. Another
Day Older and Deeper in Debt
What drove this market was aggressive lending by government-sponsored lenders known as GSEs. Fannie Mae and Freddie Mac expanded their balance sheets through the securities markets and allowed down payments as low as 3%. Other lenders were advancing as much as 125% on a house’s value. Low mortgage rates also mushroomed as homeowners took out equity out of their homes to finance spending. The result has been a downward trend in equity as shown in the graph below.
Housing has now started to soften. Housing starts fell 7% in August even before the terrorist attacks. Vacancies for commercial buildings are rising to levels approaching the last recession. The Conference Board, which tracks consumer confidence, reported that intentions to buy homes within the next six months fell in September. The luxury home market has been hit the hardest. With the dot.coms turning into dot.gones the McMansion prices are starting to come down. As the equity base in homes evaporates, individual bankruptcies are scaring away lenders. Given the sharp drop in consumer confidence, and the mounting job losses following the Trade Center attack, the drop in housing prices could turn into self-feeding liquidation cycle bringing leading to lower prices and foreclosures. The fall in housing, combined with the plunge in consumer confidence, and the concomitant drop in spending, will remove the last legs supporting the economy.
The
Trauma to Americans is Personal
The attacks occurred on American soil -- not somewhere in Asia or in the Middle East. The attacks came against American symbols of commerce and financial strength. Past crises like Pearl Harbor, Korea, the Cuban Missile Crisis took place offshore. In 1941 we didn't have television to broadcast the visible images of the attack. This war will be much more like Vietnam. The battle won’t be easily defined, nor will the conflict's resolution come speedily. This creates more uncertainty -- something that makes the human psyche and the stock market uncomfortable. This war's battles will be fought around the globe and on our shores. The
Unseen Conflict In this war, our personal freedoms will suffer and government power and intrusion into the economy and into our lives will grow. Government’s power always increases in a time of war. Its influence will increase as it begins to repair the damage from the attacks. Airport security and air marshals aboard planes will expand government’s role in the economy. Home security issues will also expand the government powers. The budget caps will be busted to pay for increased security, an expanded military and the effort to fight the war against terrorism. The deficit will widen, as the economy contracts. That will provide some stimulus to help offset weakness in the private sector. Efforts have been made to prop up the financial markets and suppress the price of gold. In the end, they will prove to be in vain. The government is running against a tide. The
Keynesian Threat What led us to this financial crisis was an expansive monetary policy over the last decade that has created malinvestments in the economy and excesses in the stock market. Fiscal spending during the last two years of the Clinton Administration grew at an annual rate of 8%. The cheap and abundant credit led to companies and consumers leveraging their balance sheet; while the government sucked money out of the economy through massive tax hikes in 1991 and again in 1993. It was this return to Keynesian economics in the 1990’s that created the artificial boom in our economy. Monetary ease and the abundance of cheap credit over stimulated the economy. It produced malinvestments in technology; while ignoring the building and repair of our nation's infrastructure. It was behind the parabolic rise in our stock market. It was behind the housing boom. What we experienced during the last decade was uncontrolled and unchecked monetary expansion. It produced the largest credit bubble in history. We will now have to live through working off those excesses. Like an unwanted hangover we must suffer through it. The kind of medicine that Tyson and fellow Keynesians propose is akin to giving an alcoholic another bottle when an aspirin is what is needed. The President’s tax cuts is the boost we need. It was what Reagan used to move us out of the economic malaise of the Carter years. Let us hope that the President prevails. He may not be able to stop the pain of the bust that is upon us, but at least he can lighten the burden and hasten the recovery. The Gephardt, Daschle, and Tyson solution will lead us into depression. Let us pray that wiser heads prevail. The
Jig is Up
Gold prices are being kept suppressed at a time of fear and uncertainty and supply deficits. Many of the mines around the globe are being shut down because of artificially low induced prices. At below $350 an ounce, most mines are unprofitable to operate. They are shut down, consolidated or merged. Last year the industry wrote off $5 billion in assets. Even the bigger, more profitable mines are slowing down production. At today’s low artificial price, it doesn’t make business sense to mine the metal. Before its takeover by Barrick, Homestake Mining was getting ready to shut down its century-old South Dakota mine. The mine couldn’t survive the low prices of the last four years. As mines cut back exploration or the development of new projects, the reserve base is falling. This will only make the annual deficits even larger.
As a result of continued low prices, Gold Fields Mineral Services Ltd., a London-based precious metals research firm, estimates that world production will begin to fall next year. The deficits are only going to get larger. This is before there is any significant investment demand. The intelligent investor should be asking why prices have remained so low when demand has outstripped supply for nearly a decade. The answer to that question is the opportunity that avails itself to those who appreciate value. As this graph of the Dow/Gold indicates, we are now close to an inflection point when the pendulum will swing in the opposite direction. When prices are kept below production costs, the result is scarcity. From an economic perspective, scarcity eventually brings back prices to a point of equilibrium again. This is basic economics -- not rocket science. No manipulation or intervention can change an irrefutable law of economics. Financial alchemy has been tried in the past by pharaohs, emperors, prime ministers, and presidents. In the end, it has always failed. Fiat money systems have a history of failure. Unfortunately, we keep fooling ourselves into thinking that we have found the alchemist's stone. It is a sad lesson of history that seems to be repeated with unintended consequences. ~ JP
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James J. Puplava
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The
rise in home values helped to offset the loss in the stock market, so consumers
still felt wealthy enough to continue spending. Spending habits were
supplemented by adding additional debt from credit cards to refinancing
mortgages. This allowed homeowners to pull out additional equity out of their
homes to pay for cars, big screen TVs, DVDs and vacations. The economy was still
growing,
Source:
Barron's
Source:
