The U.S. economy is growing at an above-average rate of 4 percent. Corporate profits are expected to be up 21 percent this quarter and up double-digits for the whole year. The economy has added over 1 million hypothetical jobs over the last several months. Short and long-term interest rates are at the lowest level in half a century. Tax Freedom Day was celebrated on April 11th this year, the earliest Tax Freedom Day in 37 years. Consumers are out shopping, the malls are bustling with activity, restaurants are full, and movie houses are packed with box office receipts at record levels. This is as good as it gets.
Economists and Wall Street analysts have never been this optimistic. Most economists believe the good times will continue well into next year. The 2001 recession was one of the shortest recessions on record. Despite a recession, the terrorist attacks on 9-11, a stock market crash and a war, the economy has bounced back strongly. The economy has recovered, consumer confidence is high, businesses are building inventories again and housing has replaced the stock market as a wealth generator. What is not to like about this picture? Or put another way, what is wrong with this picture? It is very simple:
“It is the debt, stupid."
In the last five years the U.S. economy has added over trillion in debt bringing total outstanding debt to trillion. According to Kurt Richebächer, “During the 13 quarters from the end-2000 to the first quarter of 2004, private household debt has soared by .52 trillion, or 36%, and financial sector debt by .9 trillion, or 35%. Jumping from 8.1 billion in 1980 to ,280.6 billion in the first quarter of 2004, the debt of the financial sector in the United States has skyrocketed from 21% of GDP to 98.4%.” [1]
The U.S. economy and financial markets run on cheap and abundant credit. The balance sheet of individuals and corporations are weighed down by debt. City, state, and the federal government are overburdened by large deficits. The financial markets are heavily levered.
An economy this leveraged and a financial market that is this highly geared can’t afford to withstand a major rise in interest rates.
Careful, Calculated and Critical
The Fed’s moves will be measured and tempered. They have no other choice. Analysts' predictions of a normalized federal funds rate of 3-4% are a pipedream. Rates that high would break the economy's back and send it back into recession. Interest rates that high would also break the carry trade and bring down the financial markets.
The selloff in bonds in April and May is a prelude of things to come, if rates edge higher. The “carry trade" is far from unwound. Most hedge fund managers are running negative returns this year. As some analysts have commented, this has been an unusual cycle. Since the carry trade has yet to fully unwind, there is the risk of a financial mishap later this year, if the Fed continues to tighten. Most players in the bond and derivative markets are on the same side of the fence. Everyone can’t be perfectly hedged. Someone, somewhere is on the wrong side of a trade. The question is who, how big are they, and who are their counterparties?
Economic Recovery Stimulants Stunted
The risk the markets and the economy now face is that three out of the four stimulants to the economic recovery are in the process of disappearing. The quick bounce-back after the recession, the stock market crash, and the attacks on 9-11 was the result of fiscal and monetary stimulus and lower energy prices. The four pillars of the economic recovery are as follows:
- Government spending
- Tax cuts
- Lower interest rates
- Low energy prices
Government Spending Continues to Rise
Government spending has risen from .788.7 trillion in 2000 to estimates of ,140.4 trillion in 2003. Federal spending has grown at an annual rate of 4.5% from years 2000-2003. This rate is understated when you consider the amount of debt taken on during these years when the federal government’s budget deficits ballooned. The lower spending increases are the result of a decline of 13.4 percent per annum in net interest payments.[2] The true growth rate of federal spending is closer to 7-8%.
As interest rates rise, so will the government’s budget. Government spending is the only area that shows no sign of letting up. In fact, government spending is now accelerating with both presidential candidates vowing to spend even more money. A Kerry presidency would rely mainly on government spending to stimulate the economy and create hypothetical jobs. The point here is that neither party in Congress nor presidential candidate show any signs of fiscal restraint. Government spending can be expected to accelerate as the economy weakens.
Prospect of Higher Taxes
The second form of stimulus, tax cuts, would be reversed with a Kerry presidency. Even if President Bush was reelected, he could be forced to raise taxes if budget deficits became unwieldy. Cutting spending to solve a budget deficit crisis is an anathema in Washington. Nonetheless, raising taxes on the so-called "rich" as Kerry proposes or repealing the Bush tax cuts as many in his party want to do would remove another prop holding up the economy. The so-called "rich" in this country are mainly small businesses that are struggling with higher wages, escalating healthcare costs, higher energy, and raw material costs. Higher taxes would be one more burden that would have to be absorbed by small businesses in addition to the heavy burden they now bear.
Higher Property Taxes
In addition to the prospects of higher taxes under a Kerry presidency, there are also higher taxes being levied by local and state governments. Strapped local governments are imposing big increases in property tax rates as well as increasing assessments as a result of housing inflation. Faced with huge budget shortfalls, local governments have turned to property and sales taxes as a last hope of balancing their budgets. From California to New Jersey property taxes have been rising between 20-50%. In the Washington suburb of Alexandria, Va., property taxes have skyrocketed 53.1% since 2000. In Danville, California outside San Francisco property taxes have risen 56.9% since 2000. In Yorba Linda, California they are up 48.7%. In Kendall, Florida and in Roswell, Georgia they have gone up 46.5% and 36.7% respectively. [3]
In other areas of the country experiencing rapid population growth such as Las Vegas, land prices are rising so fast that without a cap on property tax bills, property taxes could rise as much as 20%-50% next year.
Taxpayers are starting to revolt and local governments are getting the message. Yet, the housing bubble continues to inflate. Here in my own city of San Diego, the housing affordability index continues to plummet. According to the California Association of Realtors, a median-price home in San Diego now goes for 5,030. Assuming a 5.77% fixed rate mortgage, a prospective buyer would need 1,740 of annual income to qualify for a loan. San Diego’s median income is ,543.[4] Property taxes and additional fees are also high. Combined property tax rates can get as high as 2%. In our new development, tax assessments have gone up three times over the last 18 months.
Marginal Debtors and Buyers Dilemma
While interest rates have pulled back recently [thanks to a rally in the bond market], consumers are getting very little relief from the pullback. The Mortgage Bankers Association reports that its adjusted market index, a measure of mortgage activity, fell by 6.3% to 643.9 from 687 the previous week. The Association’s purchase index, a gauge of new loan requests for home purchases, fell by 6.4% to 468.8 from 500.9 the previous week. Although fixed and adjustable rates are still higher from where they were a year ago, housing activity remains strong. Marginal buyers have switched to adjustable rate mortgages, currently 3.93% versus a thirty-year fixed rate of 5.95%. While new buyers have switched to adjustable rate mortgages, existing homeowners have moved over to home equity loans, which are tied to the prime rate.
The problem for the credit markets is the marginal buyer. This buyer is the most susceptible to the risks of higher interest rates or a downturn in the economy. Most homeowners are now sheltered from the risks of rising interest rates. The proportion of mortgages locked in at a fixed rate has increased from about 60% in 1990 to over 75% today.[5] As the following table from BCA Research's The International Bank Credit Analyst shows, most consumer debt is now fixed.
The risk to the consumer is not so much a rise in rates, but a sharp deterioration in employment. This is the good news. It is also why Fed officials aren’t concerned about rising rates. The Fed believes that only a quarter of total household debt is exposed to rising interest rates.
This is where the problem lies. It is the marginal debtor and the marginal homebuyer that create the greatest risk for the credit markets. These are the people that are least able to weather even a small rise in interest rates or a major increase in living expenses as in food and energy. They are the borrowers who rely on credit card debt to meet shortfalls in living expenses—people like Ms. Quenneville at Krispy Kreme who now has a 0 unpaid balance on her gas card as a result of rising gasoline prices.
The problem for marginal debtors using credit cards is that banks are attempting to squeeze more revenues from struggling consumers. Banks are allowing borrowers to exceed their credit limits. Once borrowers go over those limits, the banks immediately hit them with higher interest rates and large penalties. The penalty fees aren’t new, but they now represent over 33% of total credit-card revenue. Last year the credit-card industry took in .7 billion in revenues from penalties, up 9% from the previous year.[6]
In any credit crisis, it is always the marginal debtors who are least able to weather a storm. Those who are most leveraged are least prepared when the economy turns. Small incremental increases in the cost of food, energy, a increase in a cable bill or “over limit” fee from a bank can push the overextended borrower over the edge. These borrowers are the least able to withstand a rise in inflation. Denise Quenneville can’t go to her boss at Krispy Kreme and get a weekly raise to cover the weekly increase in her gas bill. It is the increase to fill a tank of gas, the - weekly increase in filling a grocery basket that is starting to show up in the weekly retail reports. It is why retailers such as Wal-Mart, Target, Best Buy, and Circuit City are seeing inventories build and weekly sales fall short of expectations. It may also be what the charts are telling us about major retailers.
Consumption Declining, and Along With It, Possibly the Economy
The weakness seen in retail stocks could be a major sign signaling an impending slowdown in consumer spending is dead ahead. The slow down in spending by the American consumer, the lynchpin of the global economic recovery, may be pointing to an aborted U.S. recovery. Any sign of economic weakness would put the U.S. dollar at risk.
Fund flows into the dollar are weakening and are barely enough to finance the current account deficit. The U.S. needs to take in billion a month to finance the current account deficit. Foreign investors purchased a net .4 billion in U.S. securities in May, down from a revised billion in April. The May figures are the lowest seen since last October when foreign purchases dwindled to only .2 billion.
Rising property taxes, sales taxes, and state income taxes are just one more added burden that homeowners and families will have to shoulder in the months ahead. Higher taxes and inflation are the main reasons families and households are struggling today. Both show no sign of letup and are beginning to manifest themselves through a decline in retail sales.
The Commerce Department on Wednesday reported retail sales fell last month by 1.1%, the biggest decline in the last 16 months. The largest component of that decline was due to a sharp drop in auto demand. Besides a decline in auto sales, other categories of discretionary spending also fell such as clothing and restaurant sales. The only strong components were furniture sales, up 1.1%, and building and garden store sales up 0.1%. The last spending categories are all associated with housing.
While homeowners face the threat of rising interest rates and higher property tax burdens, they are also facing higher food and energy costs. What worries economists are the marginal income earners who can least afford higher energy and food costs. And yet, they routinely dismiss these costs from monthly inflation reports.
The Wall Street Journal featured a story this week of suburban workers making the commute to work in the city. For Tampa, Florida Krispy Kreme cashier Denise Quenneville, who earns an hour, her gas bill has gone from to in the last year. She needs to fill her tank every couple of days. To keep her car on the road and still pay her bills, she has resorted to credit. Her gas company credit card currently has an unpaid balance of 0.[7]
Assuming an average of 15,000 miles driven per year, higher gas costs can add up to an additional 0 a year. For families with 2-3 cars, that could add up to an additional ,000 a year. It may be unnoticed by economists and analysts, but - more per week for gas and additional - per week more for food, with an additional - per week for property taxes all adds up. It is one reason Wal-Mart Stores has expressed concern over higher energy prices. Those - increments in weekly living costs eat into the discretionary spending of its customers.[8]
Lower Energy Prices a Mirage
Wall Street is still predicting lower energy prices. They have been predicting those lower energy prices for the last two years. They have yet to materialize. The closing price for crude oil today was .03. Natural gas prices are at .89 and not at as forecast for this summer. I recently read a report by a prestigious financial firm calling for lower oil prices. Their reason for lower prices was that OPEC was ramping up production, large spec positions in oil that will have to be unwound, and rising inventories. This firm was predicting oil. They felt that weakening economic growth in Asia, especially China and in the U.S. would reduce demand for oil and bring supply and demand back into balance. Left out of this analysis were geopolitical factors, which are becoming increasingly unstable.
The International Energy Agency (IEA) estimates that oil demand has grown by 2.3 million barrels a day, or 2.9 %, to 81.1 bpd this year. That is the steepest increase since 1980. Moreover, the world’s spare production capacity has fallen to less than 2% of demand.[9] This isn’t much of a spare margin. According to the IEA, OPEC has only 800,000 barrels of spare capacity left. That figure was reduced to only 600,000 barrels after OPEC increased production last month. In a market that consumes over 80 million barrels a day, that isn’t much comfort. A supply disruption, a major strike in Nigeria, Venezuela or Norway is enough to send prices soaring. The world’s largest producer, Saudi Arabia, is becoming increasingly unstable with recent terrorist attacks. Iraqi production is too erratic. The terrorists blow up the pipelines almost as quickly as they can be repaired.
Oil prices are over a barrel and that is without a serious supply disruption. What is clear is that terrorist groups are now focusing their efforts on Middle Eastern oil. From blowing up pipelines and attacking oil terminals to beheading and killing oil workers, the oil infrastructure of the Middle East has become a 
clear target for terrorist. On the day this was written, Iraqi police found drill holes in a pipeline near Basra. On the same day, they set a pipeline running from Kirkuk to Ceyhan on fire, stopping exports. Events like this are becoming a weekly occurrence.
In summary, governments and consumers are unlikely to get much energy relief at the gas pump. The world has become far too dependent on Middle Eastern oil, a dependence that will grow each year as oil production in the west declines as a result of peak oil. In a world of rising demand—where economic growth is dependent on increasing supplies of cheap energy—there are no margins for error. The oil markets aren’t priced fully for supply disruptions and inventory levels remain far below normal. Supply disruptions due to terrorism and discord in the oil sector are two reasons why western and eastern countries are building up their strategic stockpiles of oil.
Terrorism alone doesn’t fully explain high oil prices or the increase in price volatility. The simple fact is that demand is high, especially from Asia and China, and supplies are tight. Western oil production is now in decline and we have very few alternatives in the short-run to replace our dependence on oil. The world is dependent on Middle East oil and that dependence will grow each year. Here in the U.S. we haven’t built a refinery since 1984. We haven’t built a nuclear power plant in over two decades. We aren’t building coal-fired plants. The power plants we are building run on natural gas, an energy source we must import from Canada and in the future from the Middle East where the world’s largest supply of natural gas lie. In addition to supply and demand imbalances, high energy prices remain hostage to not only geopolitical concerns, but domestic political concerns as well. Prices haven’t gone high enough to get the attention of politicians. Energy is simply on the sidelines in this year’s political debate. Perhaps when oil prices rise to a barrel, when gas prices exceed a gallon, or when consumers are subject to power-outages and gas lines will we have a serious debate on energy. It is the lifeblood of our economy and very few analysts, economists, or politicians seem to understand this.
Corporate Earnings Picture Depends on Sectors and Cycles
Finally, the last bastion of optimism for higher stock prices and a growing economy rests on higher corporate earnings. However, when it comes to the earnings picture, this is as good as it gets. The easy year-over-year comparisons will get tougher in the second-half of the year. Last year quarterly earnings comparisons were easy. In 2002 companies were still dealing with earnings scandals and goodwill write downs from costly mergers in the 90’s. The economy was also slowly emerging from the 2001 recession and the terrorist attacks of 9-11. Last year's second-half economic performance was explosive due to a refinancing boom and tax rebates. The economy grew at an 8% annual rate in the third quarter and by almost 5% in Q4. This will make it tougher for companies to beat in the second-half of this year. The consumer shows every sign of slowing down as evidenced by recent retail sales reports coming from the Commerce Department and major chain stores such as Target and Wal-Mart.
A recent spate of earnings warnings this quarter, especially from the tech sector, indicates the recovery in earnings may be further along than expected. Company profit warnings have risen this quarter and the margin by which earnings are expected to beat forecast has narrowed considerably. Analysts have been trimming earnings forecasts in recognition that expectations may be too high. Fifty-four companies issued earnings warnings last week and only 21 companies said they expect to beat estimates. Last week was the highest weekly negative-to-positive preannouncement ratio in more than two years.
The quarterly earnings game is now upon us and it isn’t going as smoothly as forecast. More companies are issuing warnings and business inventories are starting to build especially in the tech sector. The picture in technology is mixed. IBM’s earnings rose 17% and the company issued an upbeat assessment of the future after the markets closed on Thursday. Nokia’s profits rose 14%, but reported that sales had weakened. Bank of America had solid second quarter, while Citigroup’s profits fell 73% as a result of a .95 billion litigation charge. Wachovia and Fifth Third posted higher profits, but both experienced a slowdown in corporate borrowing. Consumer borrowing increased for both companies.
The picture that is starting to emerge is a mixed one. Some companies are doing well, while others are starting to struggle. A few technology analysts believe that technology profits have peaked in the first quarter or possibly the second quarter. The Commerce Department reported last month that business inventories rose for the eighth consecutive month. As Fred Hickey opines in his latest newsletter, investors have been ignoring all of the signs from a slowdown in retail sales and softening IT spending to large buildups in inventory. Techtel CEO Michael Kelly in an interview with IBD reports that “The bulk of the replacement cycle has already gone by already.”[10] As Hickey points out, the technology industry is a huge industry that is now closely linked to the fate of the economy. According to Hickey, “Just like other mature industries, the big computer tech sector has become cyclical…This is a far different tech world from the 1980s and even early 1990s. It was recently announced that the computer industry’s big tech conference, Comdex, has been cancelled this year. It used to be a show that everyone in the industry had to attend. In 2000 there were 200,000 attendees. Last year attendance was 45,000. This year it will be zero. Do you think Comdex would have cancelled if the industry was about to experience a big replacement up-cycle?”[11]
It isn’t just Hickey who is seeing the tech slowdown, others from Merrill Lynch to technology fund managers see a global tech slowdown ahead. This becomes important when you consider that most tech stocks are selling at P/E multiples that hover between 50-60. There is not a lot of margin for error given the high price multiples that investors are paying in the belief that another upswing in technology earnings is on the way.
Conclusion
Whatever your economic views are, it is getting harder to ignore evidence of an economy that is slowing down. Moreover, the massive stimulus of the last three years appears to be coming to an end. It is highly unlikely we’ll get another tax cut this year. So no rebate checks will be sent out to taxpayers this summer. In fact tax cuts may be replaced by tax increases depending on the outcome of this year’s election. In addition to no further tax cuts, the interest rate stimulus is also being removed. The Fed is raising interest rates instead of lowering them. What is more important than what the Fed thinks is what bond investors such as Bill Gross think. Bond investors are getting restless and are demanding higher interest rates to compensate for growing debt imbalances in the U.S. and higher inflation rates. In a recent letter to shareholders, Gross emphasizes “The debate I helped foster over a balanced vs. imbalanced global economy revolves around the fundamental proposition that bad things can happen in a levered economy.”[12]
Source: Bill Gross, "Back To The Garden," Investment Outlook, July 2004
Gross centers his arguments on the graph above. When debt levels get this high, a sudden jump in interest rates due to geopolitical concerns, a sharp rise in inflation, an imbalance of debt distribution in a portfolio, or a change of view of America’s foreign debt holders (foreigners own over 50% of outstanding Federal debt), bad things can happen to financial markets.
Gross is not alone in his view. Even Bank Credit Analyst acknowledges that a financial crisis breaking out later this year is a distinct possibility. BCA risk models for the market leave no room for bad news. Liquidity conditions are drying up, which can only mean bad news for the market. BCA’s Fed Monitor is peaking out with only a 25 basis point rate hike. Interest rate expectations have already fallen by 60 basis points from peak levels reached less than a month ago.
It has long been my point of view that the Fed would not get very far with its rate hikes. (See my last Storm Update "The Unraveling") One, two, no more than three quarter point hikes would be the maximum. Tough talk of more aggressive rate hikes is just talk. The Fed is trapped and the markets are beginning to realize that.
For now, this is as good as it gets.
Investors need to start thinking more defensively. Start taking profits where you can and start hedging your portfolio against a simultaneous deflationary/inflationary storm. To quote Gross once again:
“The economic and investment consequences appear to be as follows: real short-term rates kept too low will create asset bubbles and accelerating inflation. Real yields raised too high will pop existing asset bubbles and lead to economic recession…If bond investors are accepting of this thesis, they must acknowledge the uncertainty of their own portfolio structures. Accelerating inflation speaks to defensive durations and a healthy dose of TIPS. But potential recession at some point speaks to extended durations and a reemphasize deflationary preventative interest rate policies similar to the past 24 months." [13]
My only difference with Gross is that I believe both forces can exist simultaneously.
Chart Courtesy: StockCharts.com, Pimco.com, Grandfather Economic Report, BCA Research
References
[1] Richebächer, Kurt, The Richebächer Letter, July 2004, p. 9.
[2] Hutchinson, Martin, "The Bear's Lair: The Fiscal Crisis of 2005," United Press InternationaI.
[3] Smith, Ray A., "Property Tax Rise Triggers Backlash in some Areas," WSJ, July 13, 2004.
[4] Weisberg, Lori, "Fewer Can Afford to Buy Homes Here," San Diego Union, July 9, 2004.
[5] The International Bank Credit Analyst, July 2004, Vol. 42-No. 10, p.28.
[6] Pacelle, Mitchell, "Growing Profit Source for Banks: Fees from Riskiest Card Holders," WSJ, July 6, 2004.
[7] Ball, Jeffrey, "For Many Low-Income Workers, High Gasoline Prices Takes a Toll," WSJ, July 12, 2004.
[8] Ibid.
[9] Bahree, Bhushan, "World Oil Supply Faces Stress in Months Ahead," WSJ, July 14, 2004.
[10] High Tech Strategist, July 2004, p. 3.
[11] Ibid, p 4.
[12] Bill Gross, "Back To The Garden," Investment Outlook, July 2004.
[13] Ibid.
