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Weren’t You Bearish And Wrong? or The Hindenburg Debate (abridged)

A friend who works on Wall Street (W. S.) recently sent me an email in which he pointed out some areas of strength in the US economy. His intention was to imply that I have been way too bearish. He’s a smart guy and asks some valid questions. I thought you would be interested in reading our exchange. I have copied it below.

Richard,

I would love to know your thoughts on the following analysis.

1. The S&P is close to an all time high.
2. Job growth continues to grow, see ADP National Employment rate.
3. US PMI just hit a 5-year high. Industrial production continues to trend up.
4. US federal deficit is quickly evaporating: $600bn this year, $300bn next year.
5. Current account deficit shrinking as well on account of oil/gasoline import substitution.
6. US cities are being allowed to bankrupt. (Adios Detroit Unions)
7. The US is developing an “unassailable lead” not in Solar, but in fracking technology. Oil & gas Production.
8. QE will soon be tapered, and eventually ended.

Best,

W. S.

My reply:

Hi W. S.,

Great to hear from you.

You will recall my view has long been that the US economy is on “government life support”, in the form of unprecedented fiscal and monetary stimulus. My position has been that the economy is fundamentally (even structurally) very weak, but that the government would have no trouble keeping it afloat for the next 5 to 10 years.

When we last met in August last year, I expected that the Fed would soon have to launch QE 3 and that when it did that stock prices would rise. My advice to equity investors was straightforward: expect stocks to rise when the Fed is printing money and expect them to fall when the Fed stops printing money. I believe this view regarding the outlook for stocks was considerably more optimistic than many others during 2012.

In September, QE 3 was launched. In January it was doubled to $85 billion a month (the equivalent to $1,020 billion or 6% of GDP a year). This extraordinary and unprecedented government intervention has produced the anticipated stock market boom. The Dow is up nearly 25% since November. Even more impressively it has also produced a new property market boom, with home prices now up 12% year on year. Combined, these new booms have pushed household net worth to $70 trillion, a new all time high, thus creating a Wealth Effect that has fueled consumption and economic growth.

Despite this Fed-induced wealth creation, the economy remains very weak. The GDP expanded by only 1.8% in the first quarter and is expected to be weaker still (approximately 1.3% growth) in the second quarter.

Disposable personal income is up only 0.8% (year on year) during the first five months of this year. Personal consumption expenditure (which makes up about 70% of GDP) is a little stronger, up just under 2% during the same period. It has only been possible for consumption to increase more than income because the consumers have once again begun to save much less. The personal savings rate is back down to 3%, near the all time low. It can’t go much lower.

Much of this weakness is due to the sharp reduction in the US budget deficit this year, resulting from higher taxes and sequestration. As you mentioned, the budget deficit is expected to fall from $1.1 trillion last year to $650 billion this year. That is creating serious headwinds for the economy – and these should become worse as the year progresses.

Because the US economy is so weak, US imports are not growing. US imports are THE driver of global growth. Consequently, the growth in world trade is slowing to a standstill. US exports are not growing. And China’s export growth is very weak. More importantly, China’s imports have contracted year on year for the last two months. That means that China is now adding nothing to the growth of the rest of the world.

Given the above, it is frightening to think how severe the recession would be without QE.

Nevertheless, so long as QE persists, it will continue to create a very favorable liquidity environment that should continue to push asset prices higher. At its current pace of $1,020 billion a year, QE 3 is 57% larger than the government’s expected budget deficit this year. That means after monetizing the entire budget deficit this year, there is a surplus of another $370 billion available from the Fed’s printing presses to drive up the price of stocks and property.

Should QE stop, the picture would be altogether different. Interest rates would rise (perhaps sharply). And stock prices, property prices, net worth and consumption would fall. Then the US would go back into severe recession. So the assertion that QE will end by the middle of next year, combined with the suggestion that all will still be fine, is wildly optimistic.

Images of The Hindenburg come to mind. The airship traveled smoothly from Germany all the way to New Jersey. The difficulty was in the landing. That did not go so well. I doubt if QE will end by mid-2014. But, if it does, I expect there will be severe global repercussions, both in the financial markets and in the real economy.

So, my views haven’t changed. Our economy remains on government life support. Of course, while QE is staving off a severe recession (or worse) it is doing so by creating an artificial stock market and property market boom, similar to those leading up the crisis of 2007-08. These are likely to be unsustainable over the long term. Furthermore, the artificially depressed interest rates are causing widespread mal-investment and excess capacity that will not be profitable if interest rates ever return to normal levels. Thus we are storing up new problems for the future.

On the more positive side, I had expected QE 3 to lead to another surge in commodity and food prices. Luckily, that has not happened. Higher prices have resulted in more supply, which (combined with weak demand from China) has pushed most commodity prices lower.

Also, as you point out, the shale oil revolution is a very positive development for the US economy. Over the next five years, it has the potential to sharply reduce the US trade deficit. That would boost US economic growth and should cause the dollar to strengthen. (If so, a stronger dollar should cause commodity prices to weaken further.) Outside the US, the lower US trade deficit would reduce global liquidity and lead to somewhat weaker economic growth, certainly in the oil exporting nations. This unforeseeable development (shale oil) makes me believe that perhaps God really does love America more than other countries (as I heard Senator Phil Gramm once say in a very strong Texas drawl).

With best regards,

Richard

My friend and I exchanged three more rounds of emails on this subject. If you are interested in reading the “unabridged” version of the debate, I have posted it on my website for your convenience:

http://www.richardduncaneconomics.com