INVESTMENT IMPLICATIONS OF THE
INEVITABLE REBALANCING OF THE
U.S. ECONOMY
OR
MAKING LEMONADE OUT OF LEMONS
Comments By
PAUL L. KASRIEL
Sr. Vice President & Director of
Economic Research
The Northern Trust Company
1 October 2004
THE U.S. ECONOMY IS FUNDAMENTALLY UNBALANCED
- EXCESSIVE HOUSEHOLD SPENDING & BORROWING
- EXCESSIVE GOVERNMENT SPENDING & BORROWING
- TOO LITTLE BUSINESS CAPITAL SPENDING
- EXCESSIVE FOREIGN CENTRAL BANK FINANCING OF U.S. NET DEFICIT
LLY UNBALANCED
HOUSEHOLDS USUALLY RUN SURPLUSES, BUT THEY
ARE NOW RUNNING BIGGER DEFICITS THAN
THEY DID RIGHT AFTER WWII
Household Surplus* (+) or Deficit* (-) Relative to GDP - %
* Disposable Personal Income minus sum of expenditures
on Consumption and Residential Investment
E= average of Q1 and Q2 in 2004
LESS SURPRISINGLY, THE COMBINED U.S. GOVERNMENT
SECTOR ALSO IS RUNNING A DEFICIT
Total Government Surplus (+) or Deficit (-) Relative to GDP - %
E= average of Q1 and Q2 in 2004
BUT CORPORATIONS, WHICH USUALLY ARE IN DEFICIT,
ARE NOW RUNNING THEIR BIGGEST SURPLUSES
SINCE THE WWII YEARS
Corporate Surplus* (+) or Deficit* (-) Relative to GDP - %
* Cash flow minus sum of nonresidential fixed investment
expenditures and change in business inventories
E= Average of Q1 and Q2 in 2004
BY THE WAY, THE FACT THAT CORPORATIONS ARE
RUNNING SURPLUSES IN THE FACE OF LOW COSTS OF
CAPITAL SUGGESTS THAT THE EXPECTED RETURN ON CAPITAL IS LOW
< Earnings Yield on Nonfinancial Cor por ate Equity % p. a.
Moody's Seasoned Baa Cor por ate Bond Yield > % p. a.
BECAUSE THE COMBINED DEFICITS OF THE HOUSEHOLD
AND GOVERNMENT SECTORS EXCEED THE SURPLUS OF
THE CORPORATE SECTOR, BY IMPLICATION , WE ARE
RUNNING A LARGE DEFICIT WITH THE REST OF
THE WORLD TO THE TUNE OF $665 BILLION
Balance on Current Account as a % of GDP - SAAR, %
HOW LONG WILL THE REST OF THE WORLD KEEP SENDING
US $1.8 BILLION A DAY SO THAT WE CAN KEEP BUYING
SUVs, McMANSIONS AND CRUISE MISSILES?
- IF A CORPORATION USED MOST OF ITS STOCK AND BOND SALES PROCEEDS TO THROW EMPLOYEE PARTIES, WOULD NOT INVESTORS SOUR ON IT?
- BECAUSE ALL OF OUR FOREIGN DEBT IS DENOMINATED IN DOLLARS, MIGHT WE NOT TRY TO "PRINT" OUR WAY OUT OF THIS?
IT APPEARS AS THOUGH PRIVATE FOREIGN INVESTORS
ARE GETTING WARY OF BEING PAID IN DOLLARS
WITH DIMINISHING PURCHASING POWER,
BUT NOT FOREIGN OFFICIAL INVESTORS
< For eign Pur chases of U. S. Assets: For eign Official/Total Foreign - %
Nominal Tr ade-Weighted Exch Value of US$ vs Major Currencies > MAR 73=100
IN THE PAST 12 MONTHS, FOREIGN OFFICIAL "INVESTORS"
HAVE PURCHASED $330 BILLION OF U.S. GOVERNMENT
AND AGENCY SECURITIES - ABOUT 50%
OF OUR CURRENT ACCOUNT DEFICIT
Mktble US Govt & Fed Agcy Sec Held For Fgn Official & Intl Accts
Difference - Year to Year EOP, Mil.$
WHAT MIGHT CURB FOREIGN OFFICIAL INVESTORS' APPETITE FOR DOLLAR ASSETS?
PERHAPS WHEN THEY TIRE OF IMPORTING OUR INFLATION?
WHERE DO THESE FOREIGN OFFICIAL INVESTORS -
PREDOMINANTLY FOREIGN CENTRAL BANKS - GET THE
FUNDS TO BUY DOLLAR ASSETS? THEY "PRINT" THEM!
Japan: Money Supply: M3
% Change - Year to Year SA, 100 Mil.Yen
BY SUPPORTING THE FUNDAMENTALLY WEAK DOLLAR,
FOREIGNCENTRAL BANKS ARE REFLATING
THEIR OWN ECONOMIES
< Japan: Gross Domestic Product
% Change - Year to Year NSA, Bil.1995.Yen
Japan: Output Pr ice: Manufactur ing >
% Change - Year to Year NSA, 1995=100
WHEN THEIR ECONOMIES START TO OVERHEAT,
FOREIGN CENTRAL BANKS WILL
STOP SUPPORTING THE DOLLAR
- THE FALLING DOLLAR AND STRONG FOREIGN
ECONOMIES WILL STIMULATE U.S. EXPORTS
- AS RELATIVELY MORE U.S. OUTPUT IS DEVOTED TO
EXPORTS, UPWARD PRESSURE ON U.S. INFLATION
WILL RESULT UNLESS DOMESTIC DEMAND IS
CURBED
- THE FED WILL RESPOND TO THE DEVELOPING
INFLATIONARY PRESSURES BY RAISING ITS POLICY
INTEREST RATE
- HIGHER INTEREST RATES WILL PROVIDE THE
MARKET INCENTIVE FOR U.S. HOUSEHOLDS TO CUT
THEIR DEFICIT - THAT IS, INCREASE THEIR SAVING
INVESTMENT IMPLICATIONS OF
A SHARPLY DECLINING DOLLAR
- FOREIGN-CURRENCY DENOMINATEDASSETS WILL HAVE THE "WIND AT THEIR BACK"
- U.S. INTEREST RATES WILL RISE
- U.S. OUTPUT AND CORPORATE PROFITS WILL SHIFT AWAY FROM INDUSTRIES RELATED TO INTEREST-SENSITIVE CONSUMER SPENDING, INCLUDING HOUSING, TOWARD THOSE THAT ARE EXPORT-ORIENTED
- BASIC MATERIALS PRICES WILL RISE
SPENDING ON CONSUMER DURABLES HAS
ACCELERATED IN RECENT YEARS
Real Expenditures on Consumer Dur ables / Real GDP - %
THE ULTRA-LOW INTEREST RATES IN RECENT YEARS
HAVE ENCOURAGED AND ALLOWED HOUSEHOLDS
TO TAP THE EQUITY IN THEIR HOMES IN ORDER
TO PURCHASE DURABLE GOODS
Home Equity Extraction - $ Billion
RECENT ULTRA-LOW INTEREST RATES HAVE KEPT
HOUSES VERY AFFORDABLE DESPITE
THE HIGHEST RATIO OF HOME PRICES
TO AFTER-TAX INCOME
< Mar ket Value of Residential Real Estate / Disposable Personal Income - %
Composite Housing Affor dability Index > Median Inc=Qualifying Inc=100
A FALLING DOLLAR AND CONTINUED RAPID ECONOMIC
DEVELOPMENT IN CHINA AND INDIA SHOULD
BENEFIT BASIC MATERIALS INDUSTRIES
< Nominal Trade-Weighted Exch Value of US$ vs Major Currencies
% Change
- Year to Year Mar -73=100
KR-CRB Spot Commodity Pr ice Index: Raw Industrials [+1] >
% Change - Year to Year 1967=100
SOME SIGNIFICANT U.S. ECONOMIC RISKS
TO A SHARPLY FALLING DOLLAR
- RESULTING HIGHER INTEREST RATES
COULD "SHOCK" THE HIGHLY-INDEBTED
HOUSEHOLD SECTOR
- RESULTING HIGHER INTEREST RATES
COULD "SHOCK" AN EXPENSIVE HOUSING
MARKET
- A "SHOCKED" HOUSING MARKET COULD
SEVERELY DAMAGE THE BANKING SYSTEM
HOUSEHOLD RELATIVE INDEBTEDNESS
IS JUST OFF A POSTWAR HIGH
Households: Total Debt / Total Assets
% 4-qtr MovingAverage
DESPITE THE LOWEST INTEREST RATES IN 40 YEARS,
HOUSEHOLDS' REQUIRED MONTHLY PAYMENTS
ARE HIGH RELATIVE TO THEIR INCOMES
< Household Financial Obligation Ratio - SA, %
Contract Rates on Commitments: Conventional 30-Yr Mor tgages, FHLMC > - %
DESPITE THE LOWEST INTEREST RATES
IN 40 YEARS, PERSONAL BANKRUPTCY FILINGS
ARE AT A RECORD HIGH
< Nonbusiness Bankr uptcy Filings, U.S. - Units
10-Year Tr easury Note Yield at Constant Matur ity > - % p.a.
WOULD A SIGNIFICANT RISE IN INTEREST RATES DO GRAVE HARM TO AN "EXPENSIVE" HOUSING MARKET?
THE "P/E" RATIO FOR HOUSING IS THE HIGHEST IN HISTORY
< 10-Year Tr easur y Note Yield at Constant Maturity - % p.a.
Mkt. Value of Res. Real Estate / Imputed Rental Ser vices on Res. Real Estate >
THE RECENT RELATIVELY MINOR RISE IN MORTGAGE
RATES HAS LED TO A RELATIVELY LARGE DECLINE IN
HOUSING AFFORDABILITY
< Composite Housing Affor dability Index Median Inc=Qualifying Inc=100
Contract Rates on Commitments: Conventional 30-Yr Mor tgages, FHLMC > - %
AT A TIME WHEN THE LOAN-TO-VALUE OF RESIDENTIAL
REAL ESTATE IS AT A RECORD HIGH, BANKS'
EXPOSURE TO THE HOUSING MARKET
ALSO IS AT A RECORD HIGH
Households: Mortgage Debt / Mar ket Value of Residential Real Estate - % 4-qtr MovingAverage
U.S. Chartered Comm. Banks: Mortg.-Related Assets*/Bank Credit - %
* includes mortgage pool and collateralized mortgage obligations,
direct mortgages, and liabilities of gov't.-sponsored agencies.
WHAT MIGHT HAPPEN IF A SEVERE DECLINE IN THE
HOUSING MARKET CAUSED REAL ESTATE VALUES TO FALL
FOR THE FIRST TIME SINCE THE GREAT DEPRESSION?
- HOUSEHOLD WEALTH WOULD DECLINE, PUTTING
A CRIMP IN CONSUMER SPENDING
- THE RIPPLE EFFECT OF WEAKER CONSUMER
SPENDING WOULD INCREASE UNEMPLOYMENT
- INCREASED UNEMPLOYMENT WOULD LEAD TO
MORTGAGE DEFAULTS
- MORTGAGE DEFAULTS WOULD LEAD TO FURTHER
DOWNWARD PRESSURE ON REAL ESTATE VALUES
- MORTGAGE LENDERS, INCLUDING BANKS, COULD
SUFFER SIGNIFICANT LOSSES
BUT DON'T WORRY ABOUT THIS RISK CASE
BECAUSE ALAN GREENSPAN HAS ASSURED US
THAT THERE IS NO HOUSING MARKET BUBBLE
HAVE A NICE DAY
1 October 2004
Paul L. Kasriel, Director of Economic Research (plk1@ntrs.com)
Asha G. Bangalore, Economist (agb3@ntrs.com)
The information herein is based on sources which The Northern Trust Company believes to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.
