recovery???? maybe not

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    Liquidity trap

    By Thomas Verhaest              

    Aug 18, 2003

    The macro economic numbers that came out over the past couple of weeks more or less met investors’ demands. Retail sales went up, deflation seems to be out of the picture, business spending is improving, and so on. The big question now is: is this sustainable, is there a fundamental platform on which the economy can continue to grow at an above trend pace in order to close the output gap? The answer to this according to me is: NO.

    In order for the economy to grow, consumers need money to spend. You can call me a pessimist, but I can’t see any source of liquidity in the markets large enough to fulfil the giant expectations already built in the markets today. Let’s stop a minute to think about this.

    Where did the average consumer get his liquidity from to keep consuming during the downturn of the markets over the past couple of years? First of all (of course): his job. A second major source of liquidity was the extraction of equity out of his home through refinancing. The third source was simply taking out debt through debit- and credit cards. Lastly, the number of products bought on credit exploded as well over the past few years.

    If you take a closer look at those four sources of liquidity, and think about their possibility to fulfil their duty in the future, my worries should become clear. Goldman Sachs estimates that mortgage equity withdrawal was running at an annualised pace of $550bn in early 2003. About half of this money was spent on consumption and home improvement. Due to the dramatic rise in bond yields over the past month or so, these numbers will be roughly cut in half in the future; or in other words, shave roughly 0.8% off GDP growth. The Bush tax cut, where all bulls and politicians talk about as the main engine for boosting the economy in the coming months, will for some 50% be nullified by the rise in bond yields. This is 50% in cash terms, in consumption terms it will probably be more because the bulk of the tax cut goes to the rich and will not have such a big impact on consumption.

    This brings me to the main source of liquidity: The job income. Although unemployment has dropped in July, this was solely due to the drop in the number of people actively looking for a job. About half a million people gave up looking for work last month, indicating further and strengthening weakness in the labour market. True, the jobless claims have been under 400000 for three weeks straight now, but how much of that is due to seasonality’s. The Challenger jobs report (a more fundamental indication) showed a job loss of about 75000, indicating a further declining of job availability.

    About 750000 jobs have been lost in manufacturing over the past couple of months alone. Although, as said before, this is a time where seasonality’s play a big role, these numbers don’t look very reassuring to me. More and more people are loosing their job, or are stopping looking for one, further tightening the family’s budget for future consumption. Many economists keep on hinting at the fact that unemployment is a lagging indicator. First the economy needs to pick up, and then employment will pick up. Okay, I fully agree with that. Question is however, how long does unemployment lag. It has been said that the US recession officially ended in November 2001. This means we are already 22 months in a recovery phase, and still jobs are being lost instead of being created. 22 months seems like an awful long lag to me.

    On to the third source of liquidity, credit cards. Credit card defaults and personal bankruptcies have skyrocket in the past quarter. As more and more people loose their job, more and more people aren’t able to pay their monthly credit card payments. If they also have a lot of other loans (as the bulk of American citizens do), the only way out is to declare personal bankruptcy. This isn’t happening at a massive scale yet, but the trend is however worrying.

    This trend also ripples through in the fourth source of liquidity: the purchases in instalments. I’m sure all of you have heard about the give away conditions in the auto sector in the US. Go to your car dealer, pick out a car and go out without having paid a penny, and without having to pay a penny for the next couple of years. All these sales go in the books of the car manufacturing companies, but aren’t paid yet. What will happen if more people can’t actually pay their monthly payments, and have to default? For now, the profit numbers of most carmakers were okay to good. These numbers don’t reflect the amount of cars sold without having actually received the money though. With already such small margins, it will not need a huge amount of defaults to cause a couple of carmakers to scratch their heads. This problem is not only the case for carmakers though. TV’s, DVD’s, Furniture, Boats, … are all bought on credit and will all have to be repaid with more and more people being out of a job and having less and less liquidity.

    I am not yet mentioning the pension deficits of most of the big companies. Over 300 of the S&P 500 companies have deficits in their pension funds. However, a lot of them have reported gains in their programs because the yields have risen. Pensions are an obligation in the future. The amount of money companies will have to pay out at some time in the future is discounted to present values at the prevailing interest rate to see what the future obligation of the company is worth in today values (to see the principles of discounting, check the theory of J.B. Williams in the ‘seven base theories of finance’ section on the website). Since the long-term interest rates have risen rather sharply, so has the discount factor, and the obligation in today values has thus decreased. In reality however, the deficits are huge. The GM deficit for instance is more than its market capitalisation. Instead of incorporating these shortages in their books, companies report profits on them because of a rise in interest rates. More and more economists are beginning to question that kind of practises and it’s therefore just a matter of time before legislation in this area will have to change.

    Another fragile aspect I would like to point out is the capacity utilisation. This remains at historically low levels of around 75%. This means ¼ of the American economy is currently idle. Greenspan keeps on blessing the high productivity growth numbers in the US economy. I would however like to see a little bit lower productivity growth. The more productivity rises, the fewer workers a company needs to produce the same amount of goods. With an economy growing at a below trend pace, this means the economy isn’t poised to massively create the amount of jobs necessary to create new liquidity for the consumers. If productivity would grow at a slower pace than the economy, the companies would need to hire workers as soon as the economy shows some signs of pickup. At that time, those workers can resume consumption creating extra demand for the economy, and causing the companies to use the 25% spare capacity. Once that spare capacity is used, companies can resume investing, or productivity can rise.

    Let me give you one last reason (on basis of pure sound economic reasoning) why I remain pessimistic about future consumer spending. Consumers have continuously spent more and more of their income to support the economy in the last couple of years. To that point where, at the moment, higher consumer spending comes from increased consumer debt. Since 1998, total consumer debt, not including home mortgage debt, has increased some $44 billion. That counts for a 33% increase in 5 years. Mortgage debt, from its side, rose with a whopping 60% over the same time frame. Knowing that the average American consumer now spends about 105-110% of his income, it’s pure and simple economics to say that servicing all that debt will eat away the consumers buying power in the foreseeable future. This will the more be the case as interest rates rise and extra debt will be harder to get.

    What’s the conclusion of all of this? It is true that the economic numbers have improved in the past couple of weeks (maybe months). The core prerequisites for a fundamental recovery are however not yet in place. The jobs markets keeps on shrinking, the available liquidity of consumers is nearing its end and the basis for capital expenditures (capacity utilisation) is still at historically low levels. With these fundamentals not yet in place, I remain pessimistic for the longer-term outlook for the economy. This will prove to have been a charade recovery with no real fundamental basis.
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