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Dec

7

There are Good Reasons for Rethinking the Economy

December 7, 2005 |

(the following was originally published by Ernharth Perspective)

At about this time of year, most Wall Street firms are releasing their economic outlook for 2006 and beyond and doing the usual mea-culpa for where they missed targets. At any given time you’ll find pros and cons for what the future holds for the economy, and by inference, for the domestic and global investment markets. Hence, any assessment worth a grain of salt will focus on not just the general predictions of GDP, inflation and so forth, but also on the possible downside risks to that prediction.

Rather than address one analyst or another and nitpick their prognostications, I thought a more valuable contribution would be to point out that few analysts are taking what I would call a sober look at the potential risks we face today. Moreover, those who are covering some of the concerns are not doing so as comprehensively as they might. Perhaps they don’t want to appear as gloom and doomers, but just the same, being from the same industry I often find that the tendency is to downplay risks in order to encourage participation. In other words, more than a few year-end bonuses depend on your confidence pushing the market up as high as possible.

That said, here is my list of situations you should be soberly monitoring, even if some “experts” might suggest otherwise. Any few of them would be a something to note, but generally nothing to be worried about given the history of the U.S. and global economy to accommodate some pretty extreme shocks and dislocations. But its just that sort of belief that may have lead to too much complacency. “That’s the way its always been” is not a long-term sure-bet.

As well, more than a few analysts will tell you that if some of my concerns really mattered, the markets would have already suffered the fall out.

Not necessarily; To paraphrase Charles Munger of Berkshire Hathaway fame, If you jump from the 42nd story building, your still doing fine when you pass the 27th floor. But that does not mean you don’t have a serious problem.

So, without further ado, here is my outline list of concerns for 2006 and beyond.

  1. Massive National Debt ($8 Trillion equals $25,000 per citizen, old and young)
  2. Off balance-sheet unfunded Federal obligations (Takes the obligation figure above to $100,000 per citizen, according to the Comptroller General of the United States)
  3. Politicians that can’t say “no” or “budget cut” = massive ongoing budget deficits.
  4. Energy Inflation ($60 oil from $13 in 1998-9) will cut disposable income.
  5. Real Estate post bubble uncertainty re price valuations (will slow home equity extraction and subsequent spending, and squeeze speculative home investors)
  6. Interest-rate-dependent economic expansion: What happens when rates rise above these historic below average lows? (Low rates encourage expansion, tightening rates encourage recessions.)
  7. Adjustable and interest only mortgages: what will rising rates do to hit disposable income when the teaser rates end?
  8. Global trade imbalance: US accounts for 70% of world’s external deficits, requiring massive lending from foreigners - overly dependent on the U.S. consumption miracle.
  9. China Boom vs. Slowdown - excess capacity could lead to even more deflationary pressure for U.S. business.
  10. American Consumer in a weak state, and likely to back off discretionary spending:
    • Lacking income growth support (Stagnant wages — -wages increasing slower than inflation over past few years).
    • Savings short
    • Overly-indebted (consumer debt to GDP at record levels)
    • Asset growth dependent (the $600 billion “home equity ATM”)
  11. Rule 101 for wealth: Don’t spend more than you earn indefinitely. We’ve seem to think that no longer applies.
  12. Rule 102 for wealth: With debt you have three choices:
    • Pay it down (at the expense of consumption/ economic growth);
    • Default on it;
    • Pay it off with cheaper dollars by printing money / inflation.
  13. Money Supply Expansion - While talking tough on inflation via rates, the Fed continues to bloat money supply (13% alone in the three months ending October 2005). Why else are energy, commodity and asset prices rising so much?
  14. Major U.S. industries have pre-sold their future, ala automotive industry special discounts and financing…
  15. The looming pension default crisis: Many large pensions are underfunded by well over $450 billion dollars. Pensions are insured by the PBGC - already $23 billion in the red, and facing potential defaults from giants like Delphi and GM.
  16. The Petro-Dollar Recycling paradigm started in the 1970s could be sharply reduced, causing a decline in the dollar’s parity.
  17. P/E ratios in the equity markets richly valued on 2004 earnings that may not be sustainable because of an economy heavily dependent on asset inflation and debt.
  18. Consumer spending contraction: recessions reverberate more dramatically the worse the consumer’s balance sheet is as consumers restore themselves to fiscal health.
  19. Dependence on the kindness of strangers: Foreigners finance massive amounts of our debt, and by inference, hold our bond markets in their hands. What happens if they diversify? (Central Bank diversification away from the dollar may explain the most recent run-up in gold!)
  20. The Derivatives Market: Warren Buffet refers to derivatives as “Financial Weapons of Mass Destruction” due to their complexity and capacity to shake the foundations of the system in domino fashion, ala Long Term Capital Management in 1999.
  21. Global Labor Arbitrage (to quote Stephen Roach of Morgan Stanley), where U.S. labor cannot compete with the ultra-cheap infrastructure-enabled emerging markets. This pressure is moving from manufacturing jobs into the once thought impervious service sector jobs.
  22. Global Efficiency Arbitrage: Adding to Roaches premise above, the complexity of doing business in the U.S., with our hyper-overregulated environment, gives many steps up to foreign competition at the expense of U.S. business and workers.
  23. Gravitation towards trade barriers: Many issues noted above could involve politician-pimped populist quick-fixes that protect a few people’s jobs by blaming external factors vs. addressing needed internal reform. This places extra pressures this places on cash-strapped consumers and their ability to sustain our consumption driven economy.

I know that’s a big list. But in an environment where many folks tell you is ready to take off, or that a concern here or there is nothing to worry about, I disagree firmly. Indeed, while superficially we may see some O.K. GDP or inflation numbers, we can’t ignore core structural problems lurking just below the surface. If more than a few of these problems mature, it becomes ever more likely that more from the list will come into play in a sort of geometric fashion.

Am I a “gloom and doomer”? Call me whatever you want. But one thing I am not is an ostrich or a Rah! Rah! Wall Streeter.

I recommend readers to follow these issues - not just for a week or two, but for at least the next year — in order to avoid being blindsided if they should mature. If they don’t cause problems, at a bare minimum you’ve come away understanding more about how the economy can affect not just your investments, but your life.


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