"You look mahhhvellous!!" - Billy Crystal's character, Fernando Lamas, on SNL.
Originally published February 21, 2005 (updated April 15).
We've read it countless times in the past months - America's economy is doing fine ... looking "mahhhvellous!!"
Economic growth will remain strongly positive in the plus 3.0% range according to most of the major forecasting agencies - from the OECD to the IMF. Compared to the sick men of the European Union and Japan (which has recently again succumbed to the fourth recession in a decade) the US juggernaut should be seen as the envy of the world. According to the popular view, if it weren't for America's huge appetite for foreign capital, where would the growth-retarding savers of the world find such an attractive destination for their savings? With its highly efficient capital markets, the USA is creating wealth like no other nation.
What are our views? Well, it is absolutely true that the American economy has outperformed other major economies over the past several years. There is no contesting that fact. However, as for the rest of the views expressed, we can hardly agree.
The major questions we pose are these: At what price was the last economic recovery won? And, what will it take to win the next one? These are timely questions as they reflect on economic growth prospects this year and next. Given the high cost of past growth - in other words, the enormous amount of propulsion fuel that was used to propel the US economy these past few years - we must conclude that it has been the worst economic performance since the 1930s. If so, what next?
Here, the facts can speak for themselves. We anticipate disappointing economic growth. Actually, we think that there is at least a 50% chance of a hard-landing over the next 18 months or so.
Finding Sustainable Fuel
Says Business Week, "US Policymakers have properly stayed focused on what really matters: fostering strong economic growth to increase prosperity." To that we say, "mahhhvellous", but at what price?
In assessing financial prospects, we like to differentiate between factors that have a one-time influence and those that are sustainable. One time reactants act like rocket boosters. Once the fuel is spent, the cylinder is empty and falls away. Unless another fuel stage kicks in right away, the rocket quickly decelerates and begins to hurtle back to earth. Sustainable factors, on the other hand, are self-replenishing and balanced. They are sustainable in the sense that they generate ongoing momentum - income, profits, investment and employment. Invest in a lemonade stand and it can produce income for a long time; buy a consumable item like an automobile, and it will produce little more than depreciation ... even if it isn't a lemon. Important to consider is that a consumer asset will not produce any income that can liquidate a loan.
So it is with economies. In the model of classical capitalism, sustainable growth factors cause selfreinforcing growth. High investment spending, savings and labor force growth are examples. This type of growth can go on indefinitely - for centuries and centuries - without causing financial imbalances.
Other growth influences are more temporal. They make the job of investing much tougher. Why? Because they can cause enormous distortions that lead to economic busts and confusing, deceptive financial trends.
It is exactly these types of non-sustainable influences that have been driving US economic growth and asset markets over the past few years.
The table on the next page illustrates our point. Quite a few one-time fuels - from macro-economic to financial - have boosted growth unsustainably in the US.
Consider 2002. Total GDP growth in nominal terms amounted to a small 3.5% for the year. However, it took a lot of fuel to get even this small amount of lift. Total new debt rose 6.6% relative to GDP that year (a pace, by the way, that would lead to a doubling of total debt versus GDP in 15 years.) The current account deficit (representing foreign borrowing) gapped a further 0.8% of GDP. Not to be forgotten is the stimulatory effect of government spending. Total government deficit spending increased by an equivalent of 3.2% of GDP that year. Was the meager result worth the high price - much higher debt both domestic and abroad? Time will tell. What about the results in 2003? GDP growth boomed 4.9% in nominal terms that year ... the envy of the world. But again, at what price?
Total debt again grew much faster than GDP, arcing up a further 6.4% as a percentage of GDP, thereby transferring the cost of recovery to future workers. Government spending and foreign borrowing also contributed temporary fuel to economic growth. Taken all together, there was likely hardly any natural, self-sustaining growth at all - even though the economy apparently was soaring. But that's not all. So far, we have only considered macro-economic effects that can directly generate spending. There has been another type of influence that has boosted economic growth by stimulating consumer spending - the "wealth effects" through excessively lax monetary policies. It's a new mainstay of today's type of economic growth.
In 2003, the wealth effect finally kicked in big, thanks to low interest rates and a surging stock and real estate market. The increase in real estate value jumped 11.9% relative to disposable personal income (DPI). Last year, real estate values jumped even higher ... probably amounting to well over 20% of DPI. (At this pace, people will soon start to accumulate more net worth sitting at home than by working! That reminds us of the day-traders back in 1999.) The value of stocks and mutual funds has also been boosted over the past two years contributing a further wealth effect equivalent to another 38% of DPI. Of course, as appreciated as such wealth gains might be, they really represent an increase in the cost of living of present and future generations. Not only does residential housing cost more relative to current income levels, so do future claims upon financial income for tomorrow's retirees.
We long ago dubbed this wealth-driven model the "KNOW economy" - the knowledge and wealth economy. It has very little to do with the sustainable wealth creation dynamics of classical capitalism. In this perspective, it doesn't matter what kind of developments produce the dancing apparition of financial wealth creation. We see very little attention given to the sustainability of the drivers behind booming financial values. Worst of all, there is no regard given to underlying income growth, long-term productive capacity, and the accumulative effects and risks of growing debt levels. It's the Fernando Lamas economy. The important thing is to "look mahhhvellous!!" What's underneath the cosmetics is seemingly of small concern to Wall Street and policymakers as long there's hope that any long-run problem doesn't become a short-run issue.
Sustainability: Running on Empty?
We worry about sustainability. Why? That's what solid, stable investment returns are based upon.
In the meantime, the rocket fuel is showing signs of beginning to run out. Government spending last year produced zero stimulative effects in the US. Chances are that this will become a negative factor this year ... unless government deficits rise to even greater unprecedented highs. Also, it may only be a matter of time until rising interest rates staunch the "wealth effects" of rising real estate and stock markets.
Given the massive savings imbalances globally, it is not unfounded to worry about a continuing US dollar crisis.
Failing a further plunge into debt (assuming willing international creditors), we see little sustainable growth factors on the horizon. The traditional drivers of balanced economic recoveries are still restrained. Job growth remains tepid and business investment spending has yet to recover to new cycle highs despite strong cash flows.
Having documented the enormous amount of rocket fuel that has been spent on producing economic lift since 2001, it is a fact that the amount of US growth produced has been alarmingly inconsequential. According to our calculations, over the past five years (to the end of the 3rd quarter 2004), it has required $4.63 of new debt for each incremental dollar of nominal GDP growth. Yet, the past recovery has been the weakest of the post-war period. Considering the unprecedented cost, contrary to the fawning reviews from Wall Street and mainstream media, the US economic situation could hardly be more worrisome. Should the economy turn down again, what can be done for an encore? Even higher deficits ... higher real estate values relative to consumer incomes ... even higher foreign borrowing? If so, this time the rest of the world may not be as compliant as has been the case to this point.
The US economy is running out of fuel and out of policy options. As always, the timing of short-run economic and markets trends is problematic. After all, financial markets are driven by the collective of humanity - a force that rarely complies with the predictions of neat economic or financial models.
We think that there is at least a 50% chance of a hard economy landing occurring some time over the next 18 months. GDP growth of under 2.50% (in nominal terms) for a quarter or more would, meet our definition of a "hard landing." That would put current-dollar economic growth well below average interest rate levels. As such, we are maintaining above average cash levels, reduced equity positions and continue to emphasize overseas income assets.