Is the US Economy Shock-Resistant?
How well equipped is the U.S. economy to weather shocks, such as the catastrophic hurricane Katrina? How does the economic stimulus of rebuilding the area weigh against the effects the high cost of energy has on the consumer? Why is the dollar down and gold up since the catastrophe hit? In our view, we need to look for the answers by looking at the big picture.
For starters, we should wind back to the days before Katrina devastated Louisiana. Before significant parts of US energy supply, as well as an important transit route (the Mississippi) for food and raw materials were taken offline. Before the hurricane, commodity prices ranging from oil and gas, from steel to copper, from coffee to grain were near or at historic highs. These high prices are a reflection of elevated global demand; part of this high demand is due to a US economy that has enjoyed and continues to enjoy accommodating monetary and fiscal policies (low interest rates and low taxes); Asia's drive to sell cheap consumer goods to the US and Asia's growing internal consumption have also contributed to high commodity prices.
To understand how shock-resistant the US economy is, let us look at its most important and vulnerable part. A key driver behind economic growth in recent years has been consumer spending which comprises about 70% of Gross Domestic Product (GDP). Declining interest rates and lower taxes have contributed to consumer spending growing faster than overall GDP for more than a decade. When the technology bubble burst in 2000, consumer spending never declined. At the same time, the savings rate has been declining in the US. While Chinese consumers save more than 30% of their income, the US savings rate recently turned negative to an unsustainable -0.6% for the first time since records began in 1959. Negative savings rates are possible if consumers spend by selling assets, dipping into savings or borrowing against future income. The savings rate is also lowered by homeowners that refinance and take more money out of their home; in recent years, many consumers have treated their homes like ATMs (cash machines). The rise in housing prices has far exceeded the rise in income leading us to believe that current housing prices are not sustainable, and that we are in a housing bubble induced by an extended period of very low interest rates. Talking to real estate agents around the country in some of the hottest areas, we believe we have passed the peak in the housing market. In summary, the US consumer is the key to understanding what will happen to the US economy. Not only does the US consumer have record amounts of debt, but the drivers that have allowed this debt to accumulate have shifted into reverse: interest rates are rising and housing prices are at risk of declining.
Another important factor influencing consumer spending is real income. If incomes were to rise, then the effects of higher interest rates could be mitigated. We have long argued that real incomes have a very difficult time rising in an environment where US corporations are squeezed by both high commodity prices on the production side and low consumer prices because of a flood of cheap imports from Asia. In such an environment, US corporations attempt to keep up their profit margins by accelerating their outsourcing. In a best-case scenario, we believe income growth will lag GDP growth.
Taken together, US consumer spending is most vulnerable; the question in our view is when, not whether consumer spending will falter. Unlike the government, consumers cannot print money to pay off their debt. As housing prices decline and incomes don't rise, consumers will have to spend less and liquidate other assets (such as their stock portfolio) to serve their debt.
The massive US trade and current account deficits are another threat to the economy. Every day, foreigners need to purchase almost 2 billion worth of US dollars just to keep the dollar from declining. If the US economy slows, foreigners may be less inclined to invest their assets in the US economy. The aforementioned squeeze on US corporations through high commodity and low consumer goods prices has resulted in an erosion of the manufacturing base; to illustrate this point, Germany just surpassed the United States as the world's largest exporter. Even a declining dollar will not bring that manufacturing base back anytime soon. However, a declining dollar would further increase inflationary pressures. Unless policies are instituted that foster savings and investment, we believe the pressures on the dollar may remain firmly in place for years to come.
Higher fuel prices at the gas pump already have an impact on weaker consumers and this winter, heating costs most likely will be substantially higher. In the building frenzy over the past couple of years, lots of larger homes were built requiring higher maintenance costs.
Note that all of this was in place BEFORE the hurricane hit the Gulf Coast. You may start to understand why lawmakers have already approved over $60 billion in aid to help the region recover. This is an unprecedented amount - a reflection of the ever greater stimulus needed to keep an economy going that is dependent on a consumer living on borrowed money.
When evaluating the net economic impact of hurricane Katrina, it is not sufficient to try to consolidate the economic output lost with the spending package approved. While terrible for the region, the loss of tax revenue in Louisiana and the other Gulf states will not derail the national economy; thousands that are likely walking away from their mortgages can also be absorbed by the financial sector. We would like to point out that many creditors have provided a payment moratorium. This "generosity" discourages people from declaring bankruptcy in which case the creditors would go empty-handed. Importantly, it discourages filing bankruptcy before October 17, 2005, when much tougher bankruptcy laws come into effect.
An important lesson from the 1970s is that when there is a supply shock (energy shortage), providing an economic stimulus is highly inflationary. The reason is obvious: if you have too little energy, attempting to boost economic output will leave you with an even greater energy shortage. At the same time, it would be political suicide to suggest after the hurricane that an economic stimulus package is out of place.
The administration tries to pre-empt the inflationary spiral that could be triggered by an economic stimulus package with an international call for help. Everything from crude oil, to refined gasoline to food has been offered to the US, and the US has gladly accepted the offers. Note that natural gas cannot be easily imported (PG&E, California's main utility company, announced that residential gas bills will rise by 40% in the coming weeks). The US has a reserve of crude oil, the "Strategic Petroleum Reserve" but does not have significant inventories of refined products. It is already expected that refineries will want to purchase less crude oil from the reserves as there is plenty of supply coming. The administration has also issued a plea to refineries to postpone non-essential maintenance, and to boost output. In addition, refineries are requested to produce regular diesel instead of higher grades, such as low-sulfur diesel. This shows how concerned the administration is about squeezing the maximum out of US refining capacity (to which no significant additions have taken place since the 1970s). Rumors have been spreading that the administration will try to artificially lower the cost of energy. At the very least, we believe the administration will work very hard to try to minimize the inflationary pressures caused by the stimulus package just passed.
Eyes will be on the Federal Reserve to see whether they will continue to raise interest rates in light of the plight caused to so many by the hurricane. Federal Reserve Chairman Greenspan has in the past always come to the rescue of the markets when there was a crisis; oddly, Greenspan recently complained that there was not enough of a risk premium in the markets - a risk premium that may have eroded because investors believe Greenspan will rescue us. Monetary policy continues to be stimulative to the economy, and a pause would further increase inflationary pressures.
We are now adding tens of billions of unplanned expenses to the national debt to get through this winter. Even with all the policies instituted, we can expect much higher heating costs than last year. Now add to this that it is impossible to permanently increase refining capacity within months (it takes years), and that foreign aid will abate in the coming months. What we are left with is an economy that will have received a substantial stimulus that is working itself through the system, on top of a very tight supply situation before the hurricane hit.
The only way to think of what we are about to experience as non-inflationary is if we exclude energy from our inflation measures. Conveniently, there is a government statistic called "core inflation" that excludes food and energy. It turns out that even the core numbers have been inching upwards. On the other end of the spectrum, we have an economy that is conducting a cliff-walk, dependent on ever stronger government stimuli holding up consumer spending. The Fed may not be able to raise rates far enough to contain inflation. At the same time, the housing market will, in our analysis, switch from being a positive force on economic growth to being a weight on the economy. Whereas a stock market may correct in days or weeks, the housing market is likely to be a drag on the economy for a very long time. Given the tremendous leverage in the housing market (home buyers often pay down 20% of less of the purchase price), we are in for an extended period of belt tightening.
Good intentions have brought us here in that we wanted to keep America rolling after 9/11. Money was made easily available and taxes were lowered. At the same time, though, globalization has allowed Asia to contribute more actively to the US economy. To allow for job growth, Asia provided an environment that has fostered an over-supply of goods; the massive flood of goods into the United States has kept consumer prices down. That in turn has made it more difficult for US manufacturers. There is certainly a new breed of US corporations that are able to thrive in this environment, but labor intensive, "old-economy" style companies, notably in the automotive sector, cannot adjust fast enough to this environment. The US economy is growing briskly; yet, "employee discounts" have to be awarded by the auto industry to empty inventories. This is one of many warnings signs that the US consumer is not in good shape.
There is a saying that if the United States sneezes, the rest of the world catches a cold. Much of the world has oriented itself to sell to the US consumer. The question is where you can hide or seek to profit from a situation where decreased consumption in the US will be a drag on the economy; where consumers will have to pay down their debt; where inflationary pressures will continue to build and be a threat to the bond market; where the dollar is at risk because of an enormous current account deficit and the risk of lower investments into the US should the US economy slow; and the risk to numerous international companies and countries that are highly dependent on selling to the US consumer. There will always be select opportunities, both domestically and internationally. Personally, we are biased and favor a basket of hard currencies with a gold component as part of a diversified portfolio.
On a personal note, I will be in China the week of September 12, 2005, where I will attend the Shenyang Summit, an international economic forum where I moderate an interactive panel session on "Liberalization of Banking Systems and Development of Effective Capital Markets." I very much look forward to meeting both business and political leaders in a region that will play an increasingly important economic role in the years to come. I will share my impressions in an upcoming report.