First Glimmers: New Dollar Era?
Recently, we have been approaching our strategy deliberations with more trepidation than usual. And not because our assessments have faced any major revisions, but simply because our analysis seems ever more misaligned with the apparent consensus.
Quite frankly, optimism in financial markets has shown itself to be incredibly resilient in recent weeks and months. Though bond markets have virtually collapsed recently, no great sense of fear has emerged. Risk spreads have not widened substantially, nor have the "carry trade" currencies strengthened sharply. Financial markets show themselves eager to recover ... rebounding rapidly from any setbacks. Even though colossal, epic shifts and imbalances are occurring across the globe, none of these are widely thought to present sufficient risks to the current global financial party. At least, such popular thinking holds true for the majority. However, as long-time market observers know, the majority always will tend to be caught unaware at major inflection points. Are we approaching any inflection points?
We definitely see major developments. We have identified no less than 3 Significant Events (SE) in recent quarters (one of which remains pending) which in more normal times would portend reason for caution. But, apparently such monumental shifts are taking place invisible to most market observers ... at least to this point. While the general investment consensus -- virtually around the globe, no less -- is more brazenly complacent and optimistic than ever, we see ever-heightening risks and deteriorating investment values.
As always, we focus upon opportunities, but not without first understanding risks. And, it is this latter concept, that has been mortifying us. Risks are high and without adequate or reasonable promise of compensation. When we say high risk, we do not mean to imply that we can forecast any short-term development nor, of course, any financial accidents. It simply means that an above-normal level of vulnerability exists. Let's next review the new Significant Event that we perceive -- the retrenchment of the legendary North American consumer. In time, it may hold implications for the US dollar.
New Significant Event-Consumer Retrenchment. It is a significant development that has been long and often anticipated .. though, mostly wrongly. However, this behavioral change in the North American consumer has unfolded somewhat differently and much later than we had originally expected. All the same, this SE, in our minds, is absolutely pivotal. Quite a number of strategy perspectives hinge upon this one change. Included among these are such core issues as the direction of the USD and the world economy growth rate. In turn, several more factors hinge on these outcomes.
Why is this consumer SE so pivotal? Quite simply, the biggest core contributor to the current world boom and its imbalances has been the willingness of the US household sector to run towards a deficit. In short, the US household has been willing or forced to maintain spending well in excess of income growth. Related to this seminal impulse for global financial markets, was the US housing boom and the associated "mortgage" bubble. Not only have US household savings rates collapsed over these past decades, they are at negative levels. Given the widening wealth skew in America -- fast approaching Latin Americantype Gini scores -- one shudders how negative the savings rate may actually be for the "median" household. It goes without saying that this savings collapse is simply unprecedented and has been identified as such for some years by numerous analysts.
Remarkably, despite a rise of 70-80% in US residential home prices over the past 6 years or so, the average homeowner's net equity ratio has declined over this period. It is important to gain a sense of the potential impact that this statistic unveils. As housing values soared, home equity ratio should have increased as much as 16-17 percentage points to perhaps 70% of home value (assuming debt growth in line with nominal GDP growth). Instead, it decreased by approximately 5 percentage points, slumping to a new low of 52.7% at the end of 1Q this year (Fed Flow of Funds Z1 report.)
It is obvious that an enormous amount of extra housingrelated leverage -- possibly amounting to $3 trillion and more over the period between 2000 and 1Q 2007 -- has inflated consumption. The flipside is that debt-service and debtleverage for households has since increased sharply ... certainly far faster than underlying incomes. Some time in the future, historians may look back on the chart shown in Figure #1 and refer to it as the "smoking gun" and the main emblem of financial recklessness of our current era. Time will tell.
What should happen were the above-mentioned savings trends and behaviors ever to reverse? It would certainly exert significant pressure on US economic growth (as is already occurring). It could also mean an eventual turning point in the US dollar, given certain attendant conditions.
Crucially, we think that consumer behavior has begun to change. The US consumer is gradually and belatedly beginning to conserve cash and lower consumption. There is both anecdotal and theoretical indicators of this shift. We list a number of these:
• Credit card debt increased 9.2% in May 2007, a sharp increase in growth. We consider this a sign of consumer duress, particularly as housing Refi has fallen substantially.
• The US household sector has not acquired net financial assets for the past year. We interpret this as a symptom of insufficient cash flow.
• Consumer spending (despite a strong May statistic) has been steadily declining. The current growth rate has usually coincided with the onset of a recession in the past.
• Interest rates costs are rising. Mortgage resets are currently accelerating as previous "teaser loan" features are coming to an end. Also, in recent weeks, long-term interest rates have soared to the highest levels since 2003.
• Employment gains remain sub-par for any past economic recovery in the past 60 years. Recent corporate HR surveys, indicate that many companies anticipate higher lay-offs and outsourcing activities in the next year.
• Oil and gasoline prices are not declining. In recent weeks, prices have in fact risen.
• Household debt growth has slowed sharply. According to the Federal Reserve Z1 report, household debt growth registered 6.0% growth (annualized) in Q1 of this year, versus 9.3% the same quarter a year ago.
• On balance, consumer spending surveys show marked spending slowdowns as of late February this year. Even the mighty Wal-Mart has experienced negative sales growth during some periods.
• US import growth has slowed sharply in recent months.
In conclusion, these developments, further catalyzed by recent interest rate increases and slowing Refi (mortgage equity withdrawal is declining), signal that the retrenchment of the US household balance sheet has begun. It stands to have global implications ... in time.
Significantly, we expect US imports to begin declining, in fact, possibly even faster than the (ex ante) capital account. This argues that the major world imbalance represented by the large trade and current account deficits of the US, could begin to contract ... albeit slowly. For now. the major pressure on the US trade deficit is high energy volumes and prices.
It is important to grasp the significant leverage of such a shift. Currently, the US external savings deficit approximates 6.5% of US GDP, which in turn represents 26-27% of world GDP. As such, US excess demand is stimulating Rest of World GDP by 2-3% per year, not to mention the sizable impact upon currency reserve accumulation in surplus countries. Therefore, should the US deficit contract (and also, considering all of the multiplier effects that are involved) the slowing effect upon world growth is potentially significant. Even China would be impacted at the margin.
Assuming a US dollar funding crisis does not occur first, it is possible that such a consumption shift will again boost the US dollar. However, for the time-being, even though the larger trends are beginning to shift for the US dollar, it nevertheless remains in a vulnerable position.
To again re-emphasize, we consider this SE -- Consumer Retrenchment -- the most pivotal in many years. Several other SEs hang on its expected outworkings -- a world economic slowdown (and therefore a reversal in the attendant effects upon commodity prices ... etc). We will comment on these potential issues more fully in future strategy updates.