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 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.
- Massive National Debt ($8 Trillion equals $25,000 per citizen, old and young)
- 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)
- Politicians that can't say "no" or "budget cut" = massive ongoing budget deficits.
- Energy Inflation ($60 oil from $13 in 1998-9) will cut disposable income.
- Real Estate post bubble uncertainty re price valuations (will slow home equity extraction and subsequent spending, and squeeze speculative home investors)
- Interest-rate-dependent economic expansion: What happens when rates rise above these historic below average lows? (Low rates encourage expansion, tightening rates encourage recessions.)
- Adjustable and interest only mortgages: what will rising rates do to hit disposable income when the teaser rates end?
- 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.
- China Boom vs. Slowdown - excess capacity could lead to even more deflationary pressure for U.S. business.
- 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")
- Rule 101 for wealth: Don't spend more than you earn indefinitely. We've seem to think that no longer applies.
- 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.
- 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?
- Major U.S. industries have pre-sold their future, ala automotive industry special discounts and financing…
- 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.
- The Petro-Dollar Recycling paradigm started in the 1970s could be sharply reduced, causing a decline in the dollar's parity.
- 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.
- Consumer spending contraction: recessions reverberate more dramatically the worse the consumer's balance sheet is as consumers restore themselves to fiscal health.
- 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!)
- 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.
- 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.
- 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.
- 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 the economy 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 OK 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.
Article comments
1 - Ruvy in Jerusalem
JC,
Are those your ONLY concerns? Man, are you the optimist.
You havent't mentioned a couple of minor points that I'll add.
1. Every investment house is carefully watching the progress of the avian bird flu. They are scared. They know there is NO cure, in spite of what the bullshit artists hustling Tamiflu say. They know it can kill their bottom lines and are trying to outline areas of "opportunity" if a real plague breaks out in the near future.
2. Reinsurance firms have taken a real hit this year from the various hurricanes that hit New Orleans, Florida and Texas. And meteorologists are saying it will get worse. That means higher insurance premiums for all kind of property insurance.
Seriously, JC, I think you've done an excellent job of analysing the sore spots in the US (and therefore the Israeli) economy. But I would suggest one solution that might help your readers some. Buy some gold COINS and put them in a safe place (NOT A BANK) BEFRORE the rich folk make the Krugerrands too pricey. Also buy a jewellers' scale.
If (I'm more tempted to say "when," but we'll stick with "if" for the time being) the disaster strikes, those gold coins will be the only thing you will be able to rely on.
2 - Dave Nalle
Every good economy has its downside. It's inevitable.
Energy Inflation ($60 oil from $13 in 1998-9) will cut disposable income.
This one is extremely misleading, since at the time you pick for comparison oil was artificially undervalued by as much as 70-75%, a situation which could not possibly last.
Real Estate post bubble uncertainty re price valuations (will slow home equity extraction and subsequent spending, and squeeze speculative home investors)
The Real Estate 'bubble' really only exists in a few isolated areas in the country as has been discussed at length on other threads here on BC. They are areas which are prone to a much more volatile real estate market in general and are also more resilient when contractions happen because they have a great deal of turnover. Florida is the classic example of this.
Interest-rate-dependent economic expansion: What happens when rates rise above these historic below average lows? (Low rates encourage expansion, tightening rates encourage recessions.)
Since the rates are artificially controlled there's no reason for them to rise above a moderate level and no expectation that they will be raised to what anyone would consider high.
Adjustable and interest only mortgages: what will rising rates do to hit disposable income when the teaser rates end?
With so many people refinancing at the lower rates this should be less of a problem that it has been at any previous time. These mortgages have been around for quite a while, but they ought to have less impact than usual now than in the past because more people have gone out of that type of loan and into a low rate conventional loan.
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.
Nothing more reliable to depend on that US consumption. But I do question your figure about the US accounting for 70% of the world's external deficit. That doesn't seem mathematically possible given the massive debtor status of European nations. I haven't researched it, but color me skeptical.
China Boom vs. Slowdown - excess capacity could lead to even more deflationary pressure for U.S. business.
Even China can't sell goods below cost for any extended period of time. All excess production will do is hurt their economy.
American Consumer in a weak state, and likely to back off discretionary spending:
Most analysts would suggest that they already did that and that the trend is likely to reverse itself.
Lacking income growth support (Stagnant wages -- -wages increasing slower than inflation over past few years).
Savings short
Last I checked savings and investment were up across the board for several quarters in a row.
Overly-indebted (consumer debt to GDP at record levels)
Record levels being what, a 1 point increase over the average for the last 10 years?
I'll give you points on the unviability of the auto manufacturers and the serious problem with pensions, but most of your later points report conditions which regularly apply in the economy and could be looked at as positives or negatives depending on the context.
Dave
3 - J.C. Ernharth
Nalle:
re
Energy Inflation ($60 oil from $13 in 1998-9) will cut disposable income.
To which you replied:
"This one is extremely misleading, since at the time you pick for comparison oil was artificially undervalued by as much as 70-75%, a situation which could not possibly last."
Misleading?? I'd argue that this is a bit of the pot calling the kettle black. The consumer has less disposable income compared to the late 1990s when his dollar went much further with lower energy costs. Today he has comparitively less disposable income.
Many journalists and analysts miss the point that these sorts of things are relative -- consumers don't care that adjusted for inflation, energy is still not all that expensive relative to the 1970s. They care that their energy bill is triple vs. three years ago.
4 - J.C. Ernharth
re: Interest-rate-dependent economic expansion: What happens when rates rise above these historic below average lows? (Low rates encourage expansion, tightening rates encourage recessions.)
"Since the rates are artificially controlled there's no reason for them to rise above a moderate level and no expectation that they will be raised to what anyone would consider high."
Rates are only partially controlled by central bank and government collusion. The markets determine what market rates will be. For example, if foreign central banks decide to diversify out of the dollar, U.S. bond rates will rise and the dollar will devalue relative to other asset classes -- The Fed can try to stop that through open market policy, but not indefinitely or without creating other problems in the process.
5 - J.C. Ernharth
re: "Nothing more reliable to depend on that US consumption. But I do question your figure about the US accounting for 70% of the world's external deficit. That doesn't seem mathematically possible given the massive debtor status of European nations. I haven't researched it, but color me skeptical.
That figure comes from Morgan Stanley's chief global economist, Stephen Roach. It is astounding and real, reflecting both a massive global trade imbalance, and the recklessness of U.S. consumption.
6 - J.C. Ernharth
Personal savings are negative at the moment, and have been for some time according to Federal Reserve Bank of St. Louis.
7 - Dave Nalle
Regarding savings - I hadn't looked at the figures in a few months, but the trend I remembered is there. Personal savings was up steadily and substantially throughout 2004. But much to my surprise it dipped enormously in the 2nd and 3rd quarters of this year. Really alarmingly, in fact.
But on the upside, investment continues to be up and up strongly. Personal investment is up 25% since the start of 2003, and that's really a better sign than savings is, since savings does less for the economy and less for the consumer as well.
This info is available from the Bureau of Economic Analysis.
Dave
8 - Ruvy in Jerusalem
JC, Dave,
I recall a similar debate going on at Kathy Gill's article "Our Road To Financial Ruin", where she merely concentrated on one of the twenty odd points in this article.
JC, I stayed out of the debate on your previous article because I wanted to see the "bones of the beast," if you will. Aside from my comments on the bird flu, and the rising casualty insurance rates down the road, you did a thorough, if seemingly pessimistic job.
And that is the point, Dave. JR's piece is seemingly pessimistic.
Oil costs $3/bbl to pull out of the ground. How is $13 - $17 per barrel that terribly under-priced? Are you saying that the obscene profits going to the oil and banking establishments are too small?
Early in 1973, a World Bank economist was told by his boss to write a report explaining how a tripling of the world's oil prices would benefit the world's economy. The gentleman, a graduate of the best schools in the States, went to his calculator and crunched the numbers and lo and behold, no matter how he crunched them, he could find NO benefit from tripling the world's prices.
He went back to his boss and said this.
He got the standard line given to subordinates who just don't get it - "look, we're not paying you to think, we're paying you to produce. Now come up with that report and get it done quickly!" We've all heard this in one version or another in our careers.
The economist in question did not do that. Highly disturbed, he went to some friends of his and explained the problem. His friends told him to go to the press and he did. I don't remember if it was the NYT or the WSJ, but the story WAS published and Jon Hulley left his post in a flurry of controversy and recriminations - but in the course of the War of the Day of Judgment some months later, the price of oil DID triple.
When you and I, just average joes with the average joe's understanding of the economy, have to deal with players like this, we are at a serious disadvantage. The power of the rich man is the fatness of his wallet, his staying power in a tough situation, while you and I, with our relatively thin wallets, have to go out and ask for help.
That is why JC's analysis is only seemingly pessimistic. It's not the numbers you throw around, and the two of you have thrown some pretty hefty ones at each other. It's the approach.
When you have a relatively thin wallet, and you're playing in a field with economic gangsters, you really have to watch your ass.
Now let me get back to the tripling of the world's oil prices way back when I had hair on my head and the energy (if not the money) to play cards for 30 hours straight.
That has been sucking the American economy dry. That is the reason, over thirty years, for the shitty savings rates. People don't have money to put away because they're paying at the pump, in plastics prices and loads of other ways for the overpriced petroleum enriching the oil and banking establishments.
In addition, the price of labor has plummeted. That means that both spouses have to work to put food on the table for a family, these days. This wasn't so, back in 1973.
You appear to be in marketing and you are good at what you do - I've seen your work on "The Other Iraq." But reality is not a marketer's world. It's a lot rougher than the smooth package the marketer tends to show you.
Try looking at the picture with that in mind, and you'll see that JC's list is a reasonable one for a man who has to watch his ass in a sea full of sharks.
Shavua Tov, (Have a Good Week)
9 - Dave Nalle
Ruvy, the price of oil in the US has not tripled. At its highest point it had barely doubled, and right now it's only up 50% from a couple of years ago. And there are at least some benefits to higher oil prices. It encourages people to use public transportation and to demand more fuel efficient vehicles or alternative fuel vehicles, which will ultimately benefit everyone.
Briefly this summer regular diesel actually became more expensive than biodiesel. I'd personally like to keep the price up there in the $3 range and do it with a whopping big gas tax.
That has been sucking the American economy dry.
Except that even when gas prices were at thier highest the overall rate of inflation remained low, which suggests that without the increase in gas and transportation costs our consumer prices would probably be going down.
That is the reason, over thirty years, for the shitty savings rates. People don't have money to put away because they're paying at the pump, in plastics prices and loads of other ways for the overpriced petroleum enriching the oil and banking establishments.
That would explain the nasty drop in savings earlier this year which coincides with the higher gas prices. But I have to point out that investment is still up, and it's essentially just a more sophisticated form of savings.
In addition, the price of labor has plummeted. That means that both spouses have to work to put food on the table for a family, these days. This wasn't so, back in 1973.
It hasn't exactly plummeted. If you compare current wages to wages 20 years ago and adjust for the change in value of the dollar wages are still up, just not very much. However the median income over that period is up really substantially - about 40%. An awful lot of people have moved up the salary scale even if overall salaries have had only a moderate increase.
You appear to be in marketing and you are good at what you do - I've seen your work on "The Other Iraq." But reality is not a marketer's world. It's a lot rougher than the smooth package the marketer tends to show you.
Maybe I ought to be in marketing, but I'm not - except to the degree that every entrepreneur has to do some marketing of product. As for what kind of world it is, the world is very much what we make it. If we approach it with a positive attitude then good things will result.
Dave
10 - J.C. Ernharth
Nalle -- No, he's right --oil has tripled since 2002 when it was at about $20 a barrel.
Regarding inflation, CPI core is not a terribly reliable number -- even Greenspan admitted that it smoothes out more than it ought to by various methods of tweaking. Core also lacks energy and food components, which both have been going up. If you look at PPI, that's been really up as of late. Moreover, while talking tough on inflation, the Fed has been inflating the money supply something like 13% in the 3 months ending October 31. We might be able to export a lot of that (e.g. by those dollars being spent abroad via our trade deficit...)... but then we have two problems as a result: 1) our bond market is in a bubble created by those dollars getting recycled back into the U.S., and 2) foreigners are chasing some of these same resources we have been -- oil being a primary one, well -- prices triple.
re savings vs. investment -- i think that investment has more of a speculative element to it. Folks today consider housing an investment -- and even savings. We'll see how the old home as an ATM plays out over the next few years, or how excited bankers are to provide cheap equity loans.
On labor, I think all of the West will continue to feel pressure from global labor arbitrage. Western labor carries with it a ton of baggage, including social benefit costs. In the past few years, U.S. wages have stagnated and we're seeing those out priced jobs being off-shored, now even with service sector jobs. Consumers have not constricted their spending, though: they've tapped into savings and debt.