Wednesday, June 17, 2009

The (New) Case for Economic Trouble

My regular readers know that I have been pretty optimistic about the near to mid term prospects for the economy, for the past few months. See for example this article I wrote in February before the stock market rally began, and this article I wrote in late April. However, over the past few weeks, I have begun to get nervous again. It's not that I think we are headed for a "great depression" style economic calamity as was a distinct possibility late year, but I think that significant headwinds are once again gathering for the economy. Here are a few indicators that I find disconcerting:

10 Year Bond Yields - with the government issuing prodigious amounts of debt, the yield on the 10 year treasury note has moved up from a low of about 2% late last year to about 4% currently (see chart). People are nervous that the government is selling so much debt that it will have to offer very generous interest rates to make people buy that debt. Why should you care? If treasury yields continue to go up, interest rates will go up in the rest of the economy as well. This will make borrowing money more expensive, and could potentially stifle the recovery before it has a chance to take hold. A concrete example: over the past few weeks, mortgage rates have shot up. This is bound to put new pressure on home sales and prices. This will also prevent some homeowners from refinancing their mortgages, which in turn will mean that they have less money to spend or invest.

Dollar Weakness - the government's massive spending and bailout programs (which probably saved us from complete economic collapse) are leading foreign governments to doubt our currency's role as the world's premier reserve currency. Countries like China and Russia are talking about selling some of their dollar denominated assets, or at least slowing down purchases of such assets. This increases the chance for a further dramatic decline in the value of the dollar. In the short term, a decline in the value of the dollar will make our exports more competitive and may actually improve the odds of recovery, however this same decline also decreases our purchasing power and lowers our standard of living. In addition...

Commodity Price Increases - commodities are often traded in dollars and a decline in the value of the dollar often leads to an increase in commodity prices. Oil is the example which is easiest for most of us to notice. As of my writing these lines, oil trades at $72 per barrel, up from a low of about $37 early this year (see chart). The US uses about 7.5 billion barrels of oil per year, meaning that the $45 per barrel increase from this year's lows will cost us an extra $337 billion this year alone (assuming prices for the year average about $72 per barrel). This is like a massive tax increase, money out of our pockets that we cannot spend or invest. This amount is equal to approximately HALF of the federal government stimulus plan...

Surge in the Stock Markets - I have now stopped putting new money into the stock market. I have been putting more money into stocks ever since this crisis began, but no more. With the Dow up about 37% from its lows in March (as of Friday), I just feel that we have come too far, too fast. Yes, things are looking better, and I don't think depression is in the cards anymore, but I also don't think that the economy is a picture of health. If stocks return to a downward trend, consumer confidence may tank again too.

Consumer Frugality - there has been much talk about the new found American consumer frugality. Certainly Americans have been reducing their debt load, however according to this article and chart, when measured as a percentage of net worth, consumer debt is at incredibly high levels. In fact, when measured in this context, Americans' debt load has gotten worse, not better. Can overextended consumers pull the economy out of recession? Good question.

Still - many metrics continue to improve, including the TED spread, LIBOR rates, international shipping rates and international trade. Signals continue to be mixed, and this is clearly still a very challenging time for the economy. I don't think we are quite out of the woods yet, but it's better to be in the woods than to be falling off a cliff... :-)

Here are some other posts about the economy which you might enjoy:

All financial matters also asks whether we can really have a recovery when people have so much debt. Yup. That's my question too.

The Weakonomist has a detailed post looking at the pros and cons of universal health care in the US. For me, that's not even a question. I think market based health care is an idea that has been thoroughly discredited.

Bad Money Advice takes on another favorite topic of mine: the government taking over the car industry. What a nightmare...

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Joe said...

I have just put a big chunk into the market. Not trying to time the ups and downs. My main reasoning is that the massive debt and printing of new money will continue the devaluation of the dollar, maybe 20% or more.

I am putting half my "new" money in commodity related stocks and the other in a total market index. Hopefully, this will be a bit of an anti-inflation hedge.

Rob Bennett said...

I think that the Depression possibility remains a real threat.

My view is that huge stock crashes happen in stages. It is investor emotion that sets stock prices in the short term. So we have to think about how humans process information in thinking through what is likely to happen with stocks over the next few years.

We were shocked by last year's crash. But humans do not take in the reality of a shock all at once. We go into denial of the full reality, we engage in bargaining, this sort of thing. It takes a few years for us to work up the courage to bear the full reality of the bad news.

I believe that the full reality is that Passive Investing (investing without regard to price) can never work. When that hits, we may see another huge price drop.

Then we'll be in great shape on a going-forward basis. If we are able to pull through the damage done to our economy by having the middle-class lose another 50 percent of their retirement savings.


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