More Consumption or More Production - What is the Solution?
02/28/09
"For the past two years, Asians and Europeans have tended to view their own financial and economic problems as largely imported from the United States. The impacts on their own economies, they reasoned smugly, would be modest and short-lived. Turns out they were wrong." Thus starts the insightful article from Steven Pearlstein in the Washington Post. Read it while the newspaper business is still functioning. (Denver's oldest newspaper meanwhile had to close its doors forever this Friday. 130 years of excellent reporting became history.) Europe is facing a financial crisis that is even worse than ours. Most big European banks are more leveraged than ours. Their loans went largely to eastern European borrowers (prime and sub-prime alike) who are struggling now more than ever. Aggravating is the fact that most loans were made in Euros. Eastern European families and corporations are now faced with the double-whammy of declining revenues and rising debt service, since their currencies have all declined against the Euro. The Hungarian Forint for example declined by 40% since July 2008. Europeans therefore are facing the same problems that they had thought were only the just deserts for some decadent Americans. Hubris may prove dangerous to your financial health.
The world as we knew it is changing rapidly. Economic activity continues to decline and unemployment continues to rise. Real Gross Domestic Product was revised downward from minus 3.8% to minus 6.2% for the 4th quarter 2008. The decline was worse than the consensus forecast of 5.4% and the worst since 1982. One ray of hope is that retail sales for January showed the first stabilization since May of 2008. Seasonally adjusted retail sales climbed from $161.2 Million to $162.4 Million. The overall retail sales level (first chart above) has now reached the level of 2000 - 2002, before the home equity loan frenzy began. So why does this retail environment feel so much worse than 2002? The per capita consumption in the second chart above (I divided sales from the fist chart by the population estimate of the Bureau of Economic Analysis) has declined already way below the 2002 levels. That's why! How is it possible that gross sales are less down than the per capita number? Population growth is making up the difference. In 2000 $160 Million of retail sales was generated by a population of 288 Million. In 2009 the same volume is generated by a population of 306 Million inhabitants. Without immigration (are you listening Lou Dobbs?) the numbers would have been far worse. The reason for this dramatic decline in retail sales is the lack of financing. Consumers are visiting showrooms, we have anecdotal evidence of that, but they can not get the financing for their purchases. Financing had been provided by the shadow banking system mostly, which consisted of private investment pools and unregulated financing companies who in turn relied on the securitization of those loans to free up their capital to be able to finance further loans. Securitization, however, has ground to a halt since the demise of Lehman in September 2008 and so Washington and Wall Street are struggling to find alternate means to provide financing to the consumer. TALF is in my opinion the most important program at this time to get the economy lubricated again. The term asset-backed securities loan facility, or TALF program, has yet to be launched. The plan is that the Fed will loan money to institutions that are willing to buy asset-backed paper. The assets will be auto loans, student loans, credit card receivables and small business loans. Potential participants are indicating that transferability of the loans and/or the collateral may not be as easy as it should be which may become an impediment to universal acceptance. Nevertheless, I believe that it will start to thaw the securitizations of loans. A further sign that we may be approaching the depth of this deflationary bout may be the fall in excess reserves at the Federal Reserve. Excess reserves at the Federal Reserve are a barometer for the amount of cash hoarding by banks. When banks hoard cash they increase their deposits at the Federal Reserve and "excess reserves" are created. On January 13th Ben Bernanke gave a speech where he said that when banks start lending again excess reserves will decline.
Excess reserves (first chart above) peaked in early January at approximately $878 billion and have been steadily declining so that as of February 11th excess reserves were down to $611 billion. While the current level of excess reserves at $692 Billion does not mean that the economy is healthy (prior to the crisis excess reserves were around $2 or $3 billion), the direction of excess reserves is down which is a good sign. The other good sign is that average weekly earnings (of those who still have jobs) are continuing to climb. Data on average weekly earnings are collected from the payroll reports of private nonfarm establishments. Earnings of both full-time and part-time workers holding production or no supervisory jobs are included. This series bears watching. If households are ever going to be able to repair their balance sheets, then higher wages and falling energy costs are going to accelerate the process. This may frighten some hard core supply side minded conservatives, but it has many benefits for the economy. I will refer to Marc Chandler (again) to make the arguments for me. His recent article "Cutting Consumption Is Not The Answer" is required reading. He closes his well formulated and concisely argued article with the statement: "The solution is not to cut consumption. The solution is not to boost productive capacity. Rather, the solution will lie with putting the consumption on better fiscal footing, which means boosting incomes instead of credit scores. The solution will also lie with the government consuming or financing a greater share of GDP." I knew that would wet your appetite. Supply sider or not this is heresy in many investors' eyes. However, I agree with his argument that consumption on sound fiscal footing rather than on sound credit must be the solution. Credit is important for the functioning of our modern society but the mania of credit has put us close to the brink. I think we all understand the lesson. No danger of moral hazard for the next generation, so much seems clear. The rebuilding of a new world with new priorities can begin under new risk parameters.
For this reason, I am not nearly as worried about inflation as many others. M2 growth has accelerated to 10.5% as a result of Bernanke operating the printing press. Velocity of money, in contrast, declined dramatically and thus is keeping inflation in check. Rapid M2 growth however serves to increase the amount of cash on the sidelines. In 2002 two months of M2 growth above 10% were enough to initiate a one year long stock market rally. It should work again in the very near future!
Hermann Vohs
"The distance between insanity and genius is measured only by success."
Bruce Feirstein
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
