What is there to worry about?

Last year we answered this same question by expressing our concern as to whether or not American consumers could keep up the pace of spending needed to support continued economic growth. The American consumer did—somewhat to our surprise.

Yet we still worry that the whole global economy is hanging together primarily on the strength of the U.S. consumer. We have been saying for years that if the American consumer ever slows down, watch out! This is one factor that could lead us back into recession by the end of 2005 or sometime in 2006.

We also raised concerns regarding the falling dollar last year. We quoted the Blue Chip Economic Indicators Newsletter, “Others worry that the decline in the value of the U.S. dollar could become disorderly rattling stock and bond markets.” That hasn’t happened so far. The same newsletter reported, “It is said that the dollar’s decline and faster growth abroad should further boost export growth, and perhaps by the end of this year (2004) begin to reverse the sharp widening trade deficit witnessed over the past several years.” Oops, that didn’t happen either. So we go into 2005 worrying about the same things that worried us in 2004. Including the one item we called “unspeakable” last year—terrorist attacks on the U.S. and Great Britain.

Let’s look more closely at potential problems.

We don’t mean to imply that U.S. consumers fuel the global economy alone. They don’t. But the amount of consumption by Americans is so disproportionate to the size of our population that every producer of goods and services on the planet is likely to benefit from U.S. consumer spending, and to suffer if that spending slows down. The table shown below helps to put our point into perspective.

Renowned investor and money manager Bill Gross, of PIMCO, puts it another way. Here is a recent quote.

“The U.S. spends too much, eats too much, drinks too much; TOO MUCH, (thank you, Dave Matthews). And we pay for it with our debt and 80% of the world’s excess savings. In so doing our creepy-crawly balance of payments deficit has inched its way up to 6% of GDP—a level never seen in the U.S. and reflective of third world nations in financial crisis. The imbalance has been tolerated by those nations on the surplus side of the ledger—read “Asia”—in a strange sort of mercantilistic Faustian bargain that promises China and Japan the benefits of a strengthening economy now for the perfidy of falling-dollar-denominated Treasuries bonds later, an arrangement that once again will prove that there is no free lunch, or that hell often follows heaven on Earth.”

Frankly we are amazed that U.S. consumption has continued to grow at a steady pace for the past few years. We simply do not know how this growth rate will continue. At some point the American consumer is simply going to run out of money, and when that happens the global economic growth rate has to slow down.

One of the key reasons is that personal incomes are growing at slower and slower rates—and they have been for over 20 years now. Look at the “annual rate of change” (ARC) section in the chart below. Notice how the ARC was rising from 1959 through 1982. In those days people were not only making more money every year, but the rate at which their income was growing was actually increasing. They were making more money FASTER AND FASTER. No wonder times felt so good during President Reagan’s second term!

Since 1982 the trend has reversed. The ARC is declining. Sure people are still making more money each year (on average) but it is harder and harder to do so. Most American households now have at least two wage earners who are working unbelievably hard to maintain their standard of living.

“Maintaining their standard of living” is the key phrase. For most American households that means substituting debt for lost increases in wages. And, it is not only American households that are substituting debt for wages. Every level of American government is doing it too.

Look at the chart below, which compares the rise in total credit market debt to the rise in the S&P 500.

A chart likes this makes you wonder what will happen if U.S. households and governments run out of ability to borrow? If you look closely at both tables, you will notice that the rate of borrowing started to accelerate in 1981-82. That is the same time that the rate of growth in incomes started to slow down.

That leads us to another observation about the U.S. and global economy. The U.S. consumer is spending all he or she makes and therefore the U.S. savings rate has been dropping for years. Others will contend that we are wrong about this.

Bullish analysts keep coming up with new statistics to explain why the American consumer is still extraordinarily healthy and that we shouldn’t worry about them running out of purchasing power any time soon.

One such bullish opinion was recently offered by Tony Crescenzi, the chief bond market strategist at Miller Tabak + Co., LLC, and adviser to institutional investors on issues related to the bond market, the economy and other macro-related issues. At the request of the Federal Reserve, Crescenzi is a regular participant in the board’s Livingston Survey of economic forecasters.

Here is a quote from Mr. Crescenzi’s recent column on RealMoney.com, “On the whole, consumer fundamentals are fairly good and recent data on bankruptcies and delinquency rates suggest that concerns about a strapped consumer are bunk. Solid income gains, low interest rates, high lending standards, tax cuts and rising home values have helped to fortify the household’s balance sheet. While it is true that some of these factors are likely to be somewhat less friendly to the consumer in 2005, they do not pose substantial risks to consumer spending. Perhaps the greatest risk to the consumer would be a decline in home prices, but this seems unlikely, and even if one were to occur, it probably would be shallow and short-lived.”

We acknowledge that the U.S. consumer has seemed bullet proof so far.

The rise in home prices has strengthened personal balance sheets. But we observe that even as home prices have been rising, percentage equity has been falling. That is because there has been so much refinancing through which people are taking equity out of their homes and simply spending it. They are wasting their equity to maintain their standard of living!

Just look at these graphs and ask yourself what is wrong with this picture? The top half shows the rise in owner’s equity in household real estate since 1952. That is a pretty impressive change from less than $1 trillion dollars to $10 trillion dollars. There is no arguing that point.

But look at the bottom half. Owner’s equity as a percentage of their household value has fallen from nearly 80 percent equity to just over 55 percent. That is the part we worry about.

One could easily make the argument that this hardly matters. It would stand to reason that since interest rates are low, most people are refinancing and locking in a good low rate, and therefore protecting themselves from future rate increases and higher debt service payments. But that is not the case. More and more people are refinancing by using Adjustable Rate Mortgages (ARMS).

As housing prices have been increasing, so has the share of ARMS. We suspect that people are opting for the ARMS because they can’t afford the payments on fixed rate loans. What is going to happen if these same people suddenly find themselves facing the higher rates they were trying to avoid?

Mr. Crescenzi and other bulls say “the greatest risk to the consumer would be a decline in home prices”. No, that is not the greatest risk. The greater risk is that homeowner’s are squeezed by rising interest rates on their ARMS at the same time the price of their house is falling.

Our next worry is the falling dollar that was supposed to reduce the current account deficit

The dollar has fallen approximately 35 percent against the Euro and 24 percent against the Yen over the past three years, yet the deficit continues to increase. The plan (if there is one) is clearly not working, and it can’t. Calamos Investments points out, “The U.S. is not going to gain a competitive advantage over India or China by having is currency depreciate 30 or 40 percent when they have a 20 to 30 to 1 cost advantage over us in labor. We would have to depreciate our currency by 95 percent to pick up some advantage there.”

So far the falling dollar has appeared to be good for U.S. stocks and many American based multi-national corporations. But we are in the camp that fears that a continuing fall in the dollar can really turn around to hurt U.S. interests.

There are lots of pundits arguing that our current account deficit and the fall in the dollar don’t matter. In fact Calamos Investments is pretty sanguine about the falling dollar. We beg to differ. We borrow generously from a recent article in the Economist to explain:

“The current-account deficit is now being financed by foreign central banks and short-term money. In the year to mid-2004, foreign central banks financed as much as three-fifths of America’s deficit. The recent purchase of reserves by central banks is unprecedented. Global foreign-exchange reserves (65%, remember, are denominated in dollars) have risen by $1 trillion in just 18 months. The previous addition of $1 trillion to official reserves took a decade. These purchases of dollars have nothing to do with the prospective returns in America, but are aimed at holding down the currencies of the purchasing countries.

Worse, in recent years capital inflows into America have been financing not productive investment (which would boost future income) but a consumer-spending binge and a growing budget deficit. A current-account deficit that reflects a lack of saving is hardly a sign of strength.”

This ties right back to our worries about the American consumer running out of money. Right now the U.S. is borrowing from whoever will lend us money and we are going further and further into debt. That is true of the individuals and government entities alike.

The shear size of the debt and the amount of capital that is required to fund it make us incredibly nervous. Right now it takes approximately 80 percent of the entire world’s surplus of savings to buy U.S. Treasury Notes and Bonds EVERY SINGLE DAY to continue financing the U.S. deficits. If the debt continues to grow at present pace it will require 100 PERCENT OF THE WORLD’S SURPLUS SAVINGS WITHIN JUST A FEW YEARS! That CAN’T be done! Something has to change.

The chart to the left shows the trend line of the current account deficit. As Bill Gross pointed out, we are fast approaching levels that have broken “banana republics.”

The Economist also reports , “For almost two decades, economists have worried about America’s current-account deficit and predicted a plunge in the dollar and a hard landing for the economy. The dollar did indeed fall sharply in the late 1980s, but with few ill effects on the economy. So why worry more now? One good reason is that the current-account deficit, currently running at close to 6% of GDP, is almost twice as big as at its peak in the late 1980s, and on current policies it will keep widening. Second, in the 1980s America was still a net foreign creditor. Today it has net foreign liabilities and these are expected to reach $3.3 trillion, or 28% of GDP, by the end of 2004 (see chart 2).”

We owe that money to foreign governments! Get it? We owe them. They don’t owe us! They own that debt in U.S dollars, which they have been buying in droves. The Economist also concludes, and we concur, that if we let the dollar fall another 30 percent—that is in effect the largest foreign debt default in the history of the planet. We are very worried about the possible consequences of that ‘default’.

The foreign governments who are buying this debt are not stupid. They know what is going on and they are already starting to take steps to diversify their holdings away from the U.S. dollar. What happens if their purchases of the dollar slow too much to continue financing our insatiable appetite for their imported capital? Interest rates in this country will have to RISE dramatically to continue attracting their purchases of our government bonds. We are like addicts to their money and we will have NO CHOICE but to pay them what they demand to keep the juice flowing.

Now assume our fears about an economic slowdown in the second half of next year turn out to be correct. Couple that slowdown with rising interest rates and what do you get? STAGFLATION. Welcome back to the 1970’s. We just hope we don’t go back to those fashions! Saturday Night Fever anyone?

We think a lot about how small a world we live in nowadays, and how interdependent we have all become. There is a precarious economic balance in place right now. The continued health of the American economy is a key to that balance. Therefore the policies of the U.S. Federal Reserve Bank and the U.S. government are also keys to that balance. We certainly hope that they know what they are doing with their “de facto” weak dollar policy—but we aren’t exactly betting on it.

They should be focusing on reducing the deficit, not monetizing it. The Fed and the current administration are risking creating long term inflation at much higher rates than are currently desirable. They are also risking a “de facto” default that could end the reign of the U.S. dollar as the world’s reserve currency. That will inevitably lead to higher borrowing costs for the U.S. and contribute to a long, slow DECLINE in the standard of living for many Americans.

Interestingly many American companies have been strengthening their balance sheets during the past several years, and avoiding the debt pitfalls that face many consumers and government entities. Corporate America’s balance sheets have probably not been this healthy in years.

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