Posted At : June 11, 2009 9:48 AM
Economic Update – Hope for the recovery, prepare for its failure
The market is digesting a trifecta of bad news, and holding up quite well. The Census Bureau reported the April Trade Deficit is at -$29.2 billion. This follows a revised March deficit of -$28.5 billion. Today’s figure was in-line with the consensus estimate. Unfortunately for the US economy, it does not appear that trade will contribute much to a recovery. Exports fell to the lowest level in 3 years. This lack of exports this fare in 2009 suggests overseas demand for US goods remains weak that US exporting industries have not been able to take advantage of the sagging dollar. We just had a 10 year treasury auction that was just dismal, almost 4%. That’s up from about 2% just a few months ago. The world clearly doesn’t like our spending and the financing of it. The fact is that people — not least the Chinese government — are already distinctly dubious. They understand that US fiscal policy implies big purchases of government bonds by the Fed this year, since neither foreign nor private domestic purchases will suffice to fund the deficit. This policy is known as printing money and it is what many governments tried in the 1970s, with inflationary consequences you do not need to be a historian to recall.
To round out the triple play, throw in rising oil prices, which crossed $70 per barrel this morning, and this at a time when the economy is still in recession. I’d hate to see what it will be at when the world economies fully recover. Unfortunately for the consumer, higher per-barrel oil prices act as a very effective tax thereby reducing consumption. As energy prices rise and demand picks up, inflation is an inevitable by product. Rising inflation acts as a drag on real economic growth and puts pressure on the Fed to raise rates to offset inflation. Although, if the inflation is being imported into the US via higher oil prices, the effectiveness of monetary policy is diminished.
No doubt there are powerful deflationary headwinds blowing in the other direction today. As I have said, assets are being destroyed faster than the government can inflate…today. There is still surplus capacity in world manufacturing. But the price of key commodities has surged since February. Monetary expansion in the US, where M2 is growing at an annual rate of 9 per cent, well above its post-1960 average, seems likely to lead to inflation most likely not this year but almost certainly next.
Can the markets go higher? Absolutely…but for how long? There are serious obstacles that still exist that will likely push us back to retest and possibly break the lows. The demographic challenge of an aging population is turning spenders into savers. The personal savings rate in the USA at the end of April 2009 was 5.7%. Just over a year earlier ago the nation’s personal savings rate was 0.2%! And that trend is going to continue. With 70% of our nations GDP coming from consumer spending, this is devastating. Private sector deleveraging, reregulation and reduced consumption all argue for a real growth rate in the U.S. that requires a government checkbook for years to come just to keep its head above the 1% required to stabilize unemployment. Five more years of those 10% of GDP deficits will quickly raise America’s debt to GDP level to over 100%, a level that the rating services – and more importantly the markets – recognize as a point of no return. At 100% debt to GDP, the interest on the debt might amount to 5% or 6% of annual output alone, and it quickly compounds as the interest upon interest becomes unsustainable.
In addition, housing is nowhere near a recovery, as we will start to see increasing commercial and prime loan defaults. This could become massive. For most of the past 50 years, the loss rate on all bank loans has stayed well under 2 percent. The Fed estimates that over the next two years the loss rate could reach 9.1 percent. You know all those historical comparisons that end with “the worst since the Great Depression”? Well, 9.1 percent would be EVEN WORSE than during the 1930s. Still looking forward to a soft landing or a quick recovery? The Fed projects that the median loss rate could hit 8 percent on mortgages, 10.6 percent on commercial real estate loans, and 22.3 percent on credit card loans. A number of banks that made riskier loans face loss rates that are much higher. Banks can’t just absorb losses of that magnitude and briskly bounce back. To survive, they’ll have to sell assets, hoard cash, curtail lending, and simply wait it out. None of that generates economic growth. Oh, let’s not forget about the unemployment rate, which was pegged for 2009 at 8.9 percent—which happens to be lower than where it is now. With unemployment forecasted to rise for the rest of the year, we can expect higher default rates and even deeper bank losses than the Fed predicted.
Regards – Keith Springer