Filed under: Major movement, Newsletters, Commodities, Housing, Federal Reserve, Recession
“The markets seemed on the verge of a major sea change,” states economist David Smith. In his Cyclical Investing Quarterly, he offers a fascinating review of his concerns for the dangers that lie ahead.
“Recent economic data provides considerable foundation for Main Street fears and little support for Wall Street hopes.
“Two of the economy’s mainstays, housing and autos, continue to tank and consumers are being squeezed between falling real incomes and rising cost of living - notably in energy and food, the two components eliminated from the ‘core’ inflation indices by those who claim inflation is ‘under control.’
“The consequences of these economic stresses can be seen in falling consumer confidence, weak consumer spending, rising bankruptcies among retailers and defaults among un-creditworthy borrowers.
“The knock-on effects include a global crisis in the financial sector, a pullback in U.S. business spending,
mounting layoffs and an uptrend in unemployment, all of which, in my view, pretty much puts the nail in the coffin of the Goldilocks scenario.
“This view is seconded by chief executive officers in the financial-services industry, who placed the likelihood of a recession at 88%, with one in three putting the odds at 100%.
“Meanwhile, US and European central banks are flooding capital markets with liquidity in an effort to prevent credit markets from seizing up. As I’ve often said, ‘There is no free lunch.
“This flood of new money will eventually come back to haunt us as inflation, about which the ECB and Bank of England show due concern, and, if the current plateau in U.S. money supply is any indication, so too does the Fed.
“For investors, the threat of inflation means bond yields will probably climb (and bond prices fall), overriding the contrary pressures associated with economic weakness. My advice, keep your maturities short.
“Wall Streets hopes of an economic rebound in the second half are predicated on a revival in consumer spending, which in turn would encourage business to invest in new plant and equipment.
“The key drivers reinvigorating consumer spending, the theory goes, are $600 per person rebates from the Treasury and lowered short-term interest rates. It seems unlikely that a $600 per person windfall will make much of an impact.
“When the effects of this ’shot-in-the-arm’ wear off, American consumers will still be facing the grim realities of falling home prices; high food, gas, medical and college expenses, stagnant incomes and record levels of personal debt.
“Lower interest rates are unlikely to persuade households up to their eyeballs in debt to borrow and spend liberally, nor will they inspire shell-shocked banks to liberalize their credit standards.
“The only solution for the predicament in which most American consumers find themselves, is the reduction of record household debt. That’s the ultimate answer to the economic malaise affecting the nation.
“Any policy that fails to contribute to the reduction of household debt is doomed to failure in the long run. Debt reduction can be accomplished only in four ways: earn more, spend less, sell assets or default.
Earning more is improbable, given the competitive pressures on wages from globalization and the disinclination of U.S. corporations to share the bounty of increased productivity with anyone other than top executives and shareholders.
Spending less may be forced upon American consumers, squeezed between stagnant incomes and rising cost of living. However, spending less, so as to pay down debt, will mean a recession, contrary to Wall Street hopes.
Selling assets primarily means selling homes, Americans’ main asset. Many Americans are doing just that, at drastically reduced prices, and in so doing are further depressing the market and dampening the economic outlook. Whether they are then using the proceeds to pay down debt or sustain consumption is open to question. If they sell stocks and bonds, that too will have a detrimental economic effect.
Default is becoming an increasingly necessary solution to excessive household debt burdens. As one might anticipate, default has first become widespread among the least creditworthy borrowers - so-called ’subprime’ borrowers - but the practice seems to be extending up the ladder of creditworthiness. Credit card abusers are next.
As cascading defaults have spread, banks have become more reticent to lend, short-circuiting the borrow-and-spend dynamic that has sustained the economy for many years. To the extent that defaults are resorted to as a means of reducing debt, the economy will suffer.
“Bottom line: The band-aid solutions proposed by Washington, failing to address the underlying malaise associated with excessive personal debt, are unlikely to fulfill Wall Street’s hopes of a return to sustainable, moderate economic expansion. Accordingly, an economic contraction in the near-term seems baked into the cake.
“Whether the contraction will be inflationary or disinflationary, will depend on whether the Fed continues to flood the credit markets with new money, in which case serious stagflation will result, or whether it stands fast against inflation, in which case the economy will contract and inflation will abate.
“My ideal estimate of the situation is this: In attempting to revive the economy with a flood of new money in recent months, the Fed has infected the economy with inflation. Given the lag between monetary action and economic reaction, we’ll probably witness more stagflation.
“The recent monetary plateau might indicate the Fed’s belated attempt to quash inflation. Again, given the lag between monetary action and economic reaction, if the Fed sticks to this course of action, the economy will be starved for fuel. So the outlook is for more stagflation followed by a serious economic contraction.”
Each day, Steven Halpern’s TheStockAdvisors.com offers the latest market commentary and favorite investment ideas from the nation’s leading financial newsletter advisors.
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