The big picture (part I) – focus on the United States – by A.D

recession



On my weekly reports I mostly comment on recent data / economic events, therofore focusing on short term views. In that series of notes “The big picture”, I will focus on the “big picture”, see where we are today, why we are there, and what we are heading to. I am starting this serie with a focus on the #1 economy, the United States.

1. The US did have a good ride

The US have been the #1 economy since at least 1890. WW II helped the country to increase its power accross the world as US products flooded most countries that had been destroyed by the War. I am not going to go through the whole history of the US since WWII though. In one sentence, the US had a good ride, with strong economic growth, positive trade balance and high consumption up until the 21st century. You can see below the GDP growth per year (in red), and the average GDP (10 year rolling) in blue. You can notice that the 10 year rolling average growth has been declining steadily for the last decades.

USD GDP

Source: Bloomberg

During the last decades the US GDP growth was largely driven by consumers. Indeed, household consumption has contributed to about 2/3rd of GDP growth during the last decades. American households bought 1 TV, 2 TVs, then a TV in every room. They bought cars (2.26 cars per household in 2008), house(s), they spent a lot of money on entertainments etc. Those were the good years. American households were borrowing money that they used to consume. That made everybody happy: the people, the banks, businesses etc.

See below the evolution of US GDP since 1990 and credit debt. We clearly see that up until the 2008-2009 crisis, GDP growth was driven by consumer credit.

credit debt

Source: Bloomberg

Just after the 2008-2009 crisis though, households started to cut debt  (some didn’t have much choice had they went bankrupt / lost they home etc.). But lately they have been spending again and their saving rate is close to the lowest level ever. See below:

saving rate

Source: Bloomberg

2. And then came 2008-2009: the Great Financial Crisis

The Great Financial Crisis occured for several reasons:

  • Central Banks (mainly the Fed) kept interest rates too low for too long following the burst of the dotcom bubble, which contributed to the formation of an housing bubble
  • Deregulation of the financial industry enabled banks to create high risk / toxic products called MBS, CMBS etc. that Rating Agencies granted top ratings
  • Banks didn’t have to care about the credit worthiness of mortgage holders anymore because they were selling those mortgages to investment banks who were then selling them to customers. So they were selling as many mortgages as possible because it meant commissions to them and barely any risk
  • The housing starting to turn, the bubble bursted, American consumers got wacked and banks that had plenty of those toxic products in their balance sheets as well

Following a complete meltdown of the US economy the government tried to stimulate the economy by launching several programms such as “cash for clunkers”. But stimulating the economy as a cost and the government had to do this by increasing its budget deficit. Running a budget deficit in order to spur growth wasn’t new to the US as it had been the case since the burst of the dotcom bubble, but this trend gathered pace following the Great Financial Crisis  (see below).

 

budget deficit

And as a result of this massive budget deficit, lower tax entries (due to higher incomes, lower consumption etc.) etc. the debt to GDP ratio of the US surged from about 60% to more than 100% (see below)!

debt gdp ratio us

 Source: google

This chart is quite scary: it goes back to 1900 and we can clearly see that the debt level that the US currently have is close to their record high that they reached during WW II. Not only the level is scary but the trend is even more.

3. The US since the Great Financial Crisis

This crisis was a big shock for the US. Not only did unemployment reach very high levels but many people lost their home following the crisis (because of foreclosures etc.). Also, it showed the risk of their model based on growth fueled by credit.

Growth has been coming at an increasingly high price for the last decades, and this trend has accelerated in the last few years. See below the evolution of the US government debt (in red) and the GDP growth (blue line). We have less and less growth and more and more growth.

debt gdp us

 

Source: Bloomberg

The graph below is even more telling. Since 2009 the debt has increased by 45% while GDP has only posted a 7.1% increase. During those years, it took about USD 5 of debt to create USD 1 of GDP!

debt gdp

Source: streettalklive.com

The US is clearly in bad shape and this path (more and more debt to create less and less growth is clearly unsustainable.

Further proof of this decline are shown in the industrual production that has been steadily declining during the last few years (see below).

industrial production

 

Source: Bloomberg

Their trade deficit has also been widening (see below).

trade deficit

Source: Bloomberg

What about American people? Well, they are not in a great shape either and have been struggling since the Great Financial crisis.

  • Their income has been declining (see below the evolution of the median income)

households

Source: Bloomberg

  • More and more and on foodstamps (see below the number of Americains on foodtamps in black and the monthly change in red)

Americans on Foodstamps Dec_0

Source: Zerohedge

  • And even though the unemployment rate has been declining since the peak in 2009, it is still very high compared to historical levels

UnemployFeb2013

Source: Calculatedrisk Blog

Also, those unemployment numbers need to be treated with care because more and more Americans are excluded from the statistics (the participation rate has droping during the last few years and is not reaching the same level as it used to be in the early 80′s!); the real unemployment rate is much higher than that.

  • Consumer confidence has, however, been holding on pretty well during the last few years, besides the deterioration of their conditions. Having said this, the longer term trend is clearly downward (see blue arrow)

consumer confidence

Source: Bloomberg

4. Can the Fed save the US?

 I will try to answer that question but before doing so I can tell you that at least they would have tried their very best to save the US!!! Indeed, they have done everything they can so far to revive the economy (and save the banks)

  • They have put interest rates at record low levels (see below the evolution of interest rates in the US since 1970) for an unlimited period of time

fed interest rates

Source: Bloomberg

  •  They launched a series of Quantitative Easing (QE1, QE2, QE3, QE4 unlimited) and other similar policies such as Operatin twist etc.

Those operations aimed at providing liquidities to the banks, at inflating asset prices (risky assets mainly, such as stocks), lowering rates in order to boost the housing sector (morgages are then more affordable), prevent deflation and encourage investment. See below the expansion of the Fed’s balance sheet since 1995. +242% since 2008!!!

fed balance sheet

 Source: Bloomberg

Currently the Fed is injecting USD 85bn a month in the economy. This is huge and never seen before. The Fed is running into unknown territories; it has gone all-in. I do not believe that the Fed can save the US economy given all the above (lower GDP growth trend, higher debt, less consumption etc.), I don’t believe in miracles and monetary policies only cannot work. What it can do though is inflating asset classes. Hence the transition …

5. The US market

The  Dow Jones Industrial Average is, as I write, breaking another all time high record. If we believe that the market was only based on fundamentals we could think that it is a sign of a very strong and healthy economy. Sadly this is not the case. See this link that compares the situation in the US between now and the previous record high level in Oct 2007 http://www.admacroviews.com/the-dow-then-oct-2007-and-the-dow-now/ And this is focusing on the US only. We could also add the following:

  • Then the Eurozone was expanding, it is now in recession
  • Then China was expanding at a rate of 11-12%, now it is around 7.5%
  • Then Brazil was expanding at a rate above 6%, now it is less than 1.5%
  • Then the banks hadn’t had to be bailed out
  • Then then then …

The truth is that, as I said above, market movements and fundamentals have completely decorrelated because of the Fed’s intervention. See below the impact of the Fed’s intervention on the markets (both equity and bond markets).

SPX-10-yr-yield-and-fed-intervention

Source: www.advisorperspectives.com

When you put so much money into the economy, where does it go? Well, banks don’t want to lend because they don’t have a positive view on the economy and on its near / medium term future, so they invest those liquidities in risky assets (equities, commodities mainly). Great for the equity market. The bond market doesn’t really exist anymore because there is one seller (the Treasury department) and one buyer only: the Fed!

If you want to take a look at it though, see this (below)! Bond yields are at their lowest since 1870! Is it because investors feel so comfortable investing in US Treasuries? No! Is it because there is no fear of inflation? No! Again, the Fed has been pushing so rates lower.

bond yields

Source: Robert Shiller

When prices are inflated artificially this is called a … bubble! The US market has become like a junkie that needs everytime more drugs to keep going. Obviously that cannot go on for ever and it will end badly.

5. What’s next?

This is obviously the toughest part! Let’s start with the US dollar. The Fed’s interventions led to a devaluation of the USD (see chart below, which shows the USD against a basket of the main world currencies since 1980).

USD index

Source: Bloomberg

It makes sense: you increase supply of USD (by printing via the Fed), which brings its value down because the demand hasn’t quite increased. This devaluation of the USD has been intentional, in order to boost its exports. While the US economy did benefit from this devaluation, it also created issues (higher inflation in other countries such as China. I won’t go into too much details as China will be the topic of my big picture part II!). The devaluation of the USD also angers foreign holders of US debt (they own a security in a currency that is weakening). Look at China’s holdings of US Treasuries below, it hasn’t increased its holdings since mid 2010. And they have good reasons not to trust the US and not to want to hold US debt considering the irresponsible fiscal policy of President Obama (regarding the very high level of debt and budget deficit) and the Fed (massive expansion of its balance sheet)!

China Treasuries

Source: Bloomberg

I think that in the years to come the USD will be challenged as world currencies for the following reasons:

  • A good reason for holding USD was because commodities were priced in USD only, which is not the case anymore. For example, Iran is now selling its oil in other than USD currencies. The influence of the US in the Middle-East and amongst OPEC countries has been declining during the last few years. It is not just the US anymore but also China and other emerging countries
  • Trust in the USD has deteriorated for the reasons mentioned above (very loose fiscal and monetary policies, increasing debt to GDP ratio etc.)
  • The influence of the US in the world has been declining during the last few years with the emergence of China and other emerging countries

As for the US economy, I think that the years to come will be tough. Obama has been “kicking the can down the road” since he became president. The debt? we don’t care, the priority is the economy, so let’s keep spending as if there was no tomorrow! This policy is obviously not sustainable and not very responsible either.

Many talk about this great housing recovery but:

  • Yes it is recovering but coming from a very low level and nowhere yet at the level it was before the bubble burst (if we look at housing prices, new home sales etc.). See below the evolution of new home sales since 1964!

housing

Source: Bloomberg

  • It is not such a significant part of the US economy
  • The trend is unlikely to continue as the extremely favourable conditions that it currently benefits from (ultra low interest rates level etc.) will not be there for ever

 At some point (soon), the US government will need to reduce its budget deficit and it will impact consumer spending and the government’s contribution to GDP growth. It has actually started already with the fiscal cliff and sequester sagas. Even though US consumers have been extremely resilient so far, they will get hit at some point.

External demand is weak and likely to remain as such with the main trading partners of the US in recession (Eurozone) or slowing down (China).

 As a conclusion I believe that the US is reaching the end of a strong period of growth based on consumption fueled by credit (internally), on strong external demand (Eurozone, China and other emerging countries), on the king USD, on a very dominant influence on foreign affairs etc. It won’t lose his #1 status overnight but will do overtime.

As for the impact on the markets, it will of course have strong consequences. We could experience a collapse of the equity market (once markets start losing confidence in the Fed’s actions or see the Fed running out of amunitions) and of the bond market as well (if Treasury holders start believing thet the US will not be able to pay them back, or pay them back with a highly devalued currency. The trigger could be a worsening of the situation in the Eurozone, a hard landing of China, a war (North Korea, Israel Vs Iran), a drop of US consumer confidence, the burst of the student loan bubble etc.

But until then, let’s keep dancing until the music stops!

A.D

 

 

 

 

 

 

6 Responses to The big picture (part I) – focus on the United States – by A.D

  1. Dorothy says:

    I like your Big Picture series, very dynamic illustration! Looking forward to reading part 2.

  2. RR says:

    Good article A.D. – Don’t you think USD is still considered the best of the worst when compared to Euro? So even if the fundamentals are not good investors would still prefer USD rather than Euro?

    • A.D says:

      ThanksRR! That’s a good point. Currently it is rather the least ugly and not the most beautiful currency that wins. For now USD is still perceived as the least ugly but at some point there should be a lack of faith in the USD (because of the Fed and US government policies, massive debt etc.) and that should push the USD lower.

  3. ASN says:

    Enlighting ! thanks AD.
    Scary FED’s balance sheet; how much more can it take?

    • A.D says:

      Very good question! In theory they can grow their balance sheet with no limit, but at some point there would / will be a lack of confidence / faith in the USD that might lead to its collapse.

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