2nd Quarter 2004 - Who is rational - Consumers or Businesses?

Axel Merk, July 1st 2004
This article was written by Merk Investments before the Merk Hard Currency Fund was launched.

If we look at the economy, we see diverging trends between how consumers and businesses behave:

US Consumer

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US consumer spending comprises over 70% of US GDP. The entire world wants the US consumer to continue spending. While businesses collapsed during the bursting of the dot-com bubble, the US consumer kept on spending because of a total of over $1,000 billion in stimulus provided.

US consumers have increased their already high debt burden sharply in recent years, but have kept their debt service payments orderly because of lower interest rates and because of a shortening of the duration of debt held.

Consumers are desperate to find ways to finance retirement. To do so, money is poured into mutual funds and real estate. Mutual fund managers have little choice but put the money to work. This is nothing new, but investment decisions are more likely driven by greed and fear in such an environment.

Washington Mutual, a large player in the mortgage business, had 53% of its new mortgages issued as ARMs (adjustable rate mortgages) during the first quarter; a few days ago, they said that they have been unable to hedge fully against rising interest rates and reported much lower profits than expected.

Consumer sentiment is up.

US Government

US government debt has risen sharply in light of various efforts to keep the consumer and US economy going; in addition, the military engagements worldwide are very costly. However, government debt service payments have remained in check because the government, too, has shortened the duration of its debt.

We have extensively discussed the current account deficit and the danger it poses to the US dollar and economy; nothing new here, except that we are now close to an annual run rate of $600 billion, a record.

The Bush administration believes that economic pickup will yield higher tax revenue. Should Kerry win the election in November, he has promised that fiscal responsibility would come back. While Kerry would cut back military spending, it is difficult to believe that Democrats would not introduce costly welfare programs.

US Business

US business is different. Greenspan has complained that businesses continue to have net debt retirements; at this stage in the economic cycle, he would like to see businesses invest more than their cash flow. Corporations replace high interest debt with lower interest debt while extending the duration. Businesses are in a defensive mode.

Wal-Mart and Target just gave warnings that their sales growth is no higher than the rate of inflation, lower than what analysts had expected. Cisco, one of the few companies that continue to give ever optimistic forecasts, recently said their gross margins are increasing; on closer look, it was nothing but an accounting gimmick as rising inventories led to lower costs of goods sold.

What do we do with all this information? The hope is that sufficient stimulus has been given to the economy that it will feed on itself. Even jobs are created now. Consumers feel better, there’s a general sense that business has improved, but overall, investments are still lackluster.

The reason may be found in the increased sensitivity the consumer (and government) has to rising interest rates. Businesses work in an extremely tough environment with competition from Asia through manipulated exchange rates, causing global overproduction with low consumer prices, but also high commodities prices. Companies react by keeping employment low. The cautious behavior is likely to lead to higher profitability, but as we have seen, corporations are in no hurry to invest; if they do invest, they disproportionately do it abroad to take advantage of the more competitive labor and currency environments there.

In the meantime, inflation is spreading rapidly everywhere, except for government statistics. The Producer Price Index is so ill-behaved that its release had to be delayed a few times this year. The only prices that are in check are those of finished consumer goods, courtesy of imports at manipulated exchange rates.

US policy makers decided to ignite this economy through stimulus as they saw what happened in Japan when asset bubbles burst. However, there are major structural differences between Japan and the United States. Where Japanese business has been slow to reform, US business is very quick at adapting to new challenges; where the Japanese consumer has always been big on saving, the US consumer has always been deeply in debt. Whereas the decade long recession in Japan was dubbed the “managers’ recession”, the US is going to face a “consumer recession”. With the entire world counting on the US consumer, this is going to be a very painful medicine.

One reason why long-term interest rates have not moved up more is that the market is skeptical about the economic growth prophesied by politicians. However, prices of bonds (and hence interest rates) are ultimately determined by supply and demand. We do not see government spending decrease anytime soon, even should Kerry supersede Bush. Needless to say, the government will try to pre-empt the consumer from getting their personal balance sheets in order by injecting ever more money into the economy. On the demand side, foreign governments have to reduce their purchases of US debt sooner rather than later; US government debt is also becoming less attractive as the extreme imbalances created in recent years are becoming more apparent. When the dollar finally yields under the weight of the current account deficit, consumer goods prices will increase, a perfect recipe for stagflation.

We continue to be on the cautious side as far as the stock market is concerned. The innovators are succeeding, and corporate balance sheets look much healthier; but valuations are high. As consumers tackle their debt, they will have to raise cash, and the easiest way to achieve this is to liquidate investment portfolios. Consumers are unlikely to significantly rein in their spending until their over-leveraged real estate investments lose in value. Greenspan is getting ever more vocal about the fact that the government sponsored mortgage entities GNMA and FNMA hold more debt through mortgages than the total debt of the US government, and that they have no restrictions as to how much debt they can take on. Greenspan wants to have a reform that takes the concentration of this risk away from these entities, and spreads it to the general public.

There’s a saying that the market always does what it is supposed to do, but never when. We believe the real estate bubble is about to burst. As investors rather than speculators, we must not be followers of the market, but put our money where we believe the market should ultimately be heading to. This requires patience, but when it comes to investing, we must be patient, otherwise we are doomed to fail chasing the latest frenzy.

Back in Europe, the population is growing increasingly frustrated with the inability of governments to carry through reforms. While a lot has happened in recent years and corporations are much better positioned, much more could be done to provide a friendlier investment environment. Many Europeans that have traditionally been pro-American are distancing themselves from the Bush administration’s conduct. The long- term damage to international relations und subsequently business cannot be underestimated. When the US consumer decides to reduce his spending, international trade agreements will be revisited (Kerry has already promised this) – it is in everybody’s interest that such negotiations are conducted in good faith by all sides.

Democracy is built on checks and balances. Much of the US legislative, executive and judicial system is based on very broad rules. These rules allow, rightfully so, for society to change. However, if checks and balances have broken down, change is imposed without due process through public debate. If we don’t speak up for our values and rights, we will lose them. The US Supreme Court may ultimately push some things in the right direction again, and the media tries to police the politicians. Ultimately, democracy is not about outsourcing government to politicians or the media, but standing up for the values one believes in. Some feel that it doesn’t matter “what the rest of the world thinks” –, in some ways it doesn’t – the loss for not speaking up happens right at home.