Comstock Partners, Inc.January 24, 2013
The Consumer, the Debt, and Competitive Devaluations
The Consumer, the Debt, and Competitive Devaluations
The stock market is continuing to rally and test the two major resistance levels of 2000 and 2007 (1555 and 1575 on the S&P 500). We do not believe the market will be able to break through those levels in any significant way since they were established after two major financial bubbles (dot-com and housing) and peaked after multi-year gains followed by collapses in the market. The current move up over the past 4 years is being driven by the Fed's loose monetary policies (just as other global markets have been driven by their Central Banks). Most bulls believe the loose polices will stimulate enough consumer demand to lead to a significant U.S. economic recovery. We, however, continue to believe the debt- laden consumer, along with the still other unresolved debt burdens, will be a major drag on the U.S. economy, and that will have negative affects on the global economy.
The consumer is the main driver of the U.S. economy, and there are many pundits who believe the consumer will significantly help the U.S. recovery. They believe that consumer spending has quite a few tail-winds that should help the recovery starting this year. They cite the turnaround in the automobile market ( up 19% in 2012) as well as the housing market (prices up 6% in 2012), . They also cite the 4 year rally in the stock market which is up over 100% in all the major indices, and the recent decline in gasoline prices at the pump.
On the other hand, we believe the headwinds of the real wage decline of about 8% over the past 12 years, the enormous consumer debt that is in the process of being deleveraged, and the overall U.S. debt will offset all of these consumer tail-winds. The government debt of $16 trillion (tn) is just the beginning of our debt problems. The private debt of about $40 tn has to be added to the government debt to put a better perspective on the total debt. But the total debt of $56 tn still understates the true debt of our country since we have promised so much to so many of our citizens. These promises have left us with unfunded liabilities from Medicare, Medicaid, Social Security, and government employee pensions which range from $70 tn to $122 tn depending upon the discount rate used and how far out we can assume that they won't be addressed. Therefore, total debt is at least over $125 tn, and that has got to put a damper on this latest bull market that started in 2009. We are convinced that the market will turn down and make a triple top at levels below the peaks made in 2000 and 2007 while we resume the secular bear market that started in 2000.
How will our country resolve the enormous amount of debt we've built up over the past 30 years? The obvious answer is to drastically cut the spending and raise taxes enough to balance the budget or at least bring the deficit down to about 3% of GDP vs. the present 7-8%. However, the problem with raising taxes and cutting spending too drastically is that this will lead our country into a severe recession or even a depression. The U.S. economy is made up of just 4 categories: 1. Consumer Spending--> 71% 2. Business Investment-->13% 3. Government Spending--> 22% and 4. A negative in our Trade Balance.
So what is the answer to this dilemma? There doesn't seem to be a clear answer but a letter signed by many CEOs (a group dubbed "Fix the Debt") was just sent to the lawmakers to push a plan forward to gradually raise the eligibility age to 70 years for both Social Security and Medicare. Other potential remedies would be to means test both Social Security and Medicare and phase this in over the next few decades. The demographics have changed so much since these plans were established in 1965 (Social Security Act adjustment and start of Medicare). Forty seven years ago the life expectancy was 67 for males and 74 for females , and now the life expectancy for men is close to 80 years of age while women's life expectancy is over 80. It is clear that even more adjustments have to be made to the cost of Medicare since the government outlays were $565 bn in 2011 and are projected to be over $1 tn in 2022 (if you add Medicaid and Social Security these entitlements will absorb much more than the projected revenue). The problem with relying on spending cuts and revenue generated from taxes raised are the unintended consequences of much lower growth, which could possibly drive us into a recession or even a depression.
If we are correct in our assessment of the U.S. entering a recession in 2013, we expect the U.S. downturn to spread globally and probably lead to a global recession. It will drive the countries that will be most affected by the downturn to be forced to lower their currencies in order to export more goods and services to their trading partners. As many of our long-term followers have seen over the past dozen years, we have shown a chart we named the "Cycle of Deflation" (and is again attached here) showing what results from too much global debt-"Competitive Devaluations". We have been in this segment of the "Cycle of Deflation" now for the past decade, but it will be most apparent next year if we enter the global recession we expect.
We have witnessed a tremendous central bank easing over the past few years, with virtually every country attempting to devalue its currency with a total of 335 central bank easings. Well, we also witnessed this when our Fed brought rates down to 1% in mid 2003 and started the wild housing bubble that almost brought us to our knees. And just recently the new prime minister in Japan made a clear move to "competitive devaluation." The yen has been fluctuating during Japan's deflation since 1989, but the trend has been up, and the new Prime Minister Sinzo Abe believes that the only way Japan will be able to extricate themselves from 23 years of deflation will be to get the yen down relative to their trading partners like China, the U.S. and Europe. Their goal is to stimulate now, but aggressively starting in 2014, until the inflation rate rises to their goal of 2%, from a slight deflation presently. However, the U.S. and Europe will do whatever they can to not allow this to take place-and that is why we call this "competitive devaluation"! And if we continue along this path the next step is "beggar-thy-neighbor", which is the next stage of the Cycle of Deflation. It is similar to competitive devaluation, but is just more severe since it essentially means that in order to keep plants and businesses from closing down, exports are sold below cost to their trading partners.
The Fed's balance sheet expansion has resulted in the U.S. dollar declining about 11% against a basket of world currencies since Quantitative Easing (QE) started in 2009. Stocks, bonds, and commodities have also risen, but the recovery has been very sluggish and inflation has remained tame. The Japanese stimulus may get the yen down relative to their trading partners, but with their heavy debt load (even more than the U.S.) and aging demographics, getting to their goal of 2% inflation will not be as easy to achieve as they hope.
Japan has been in the same "liquidity trap" as the U.S. They can print money and drive interest rates down (and boost stocks, bonds, and commodities), but real inflation only comes about by borrowing and spending. Neither the U.S. nor Japan can lower rates enough to encourage its citizens to borrow and spend. As the saying goes, "You can lead a horse to water, but you can't make it drink." Japan has been using different forms of QE for many years, and in fact, they even bought Japanese stocks to reverse the deflation to no avail. We believe the new Prime Minister , Shinzo Abe's present significant stimulus plan will fail again.
In summary, because the U.S. consumer is over burdened with debt we don't believe there will be enough consumer demand to spark business spending or hiring. The consumer had increased household (H/H) debt every single quarter since World War II (including the severe recessions of the early 1970s and 1980s). H/H debt averaged around 65% of Personal Disposable Income (PDI) and 50% of GDP for decades (50s, 60s, 70s and 80s) before taking off in the 1990s to double this average by 2008 (130% and 100%). However, in 2008 when the Great Recession hit the U.S. and because H/H debt rose so much, H/H debt declined for 15 out of the last 17 quarters. Some would think this deleveraging would be a positive for the U.S. economy and stock market, but because the H/H debt to PDI is still 110% and 100% of GDP, the total H/H debt is still close to $13 tn and would have to drop by another $3 tn or so to get back to the normal relationships to PDI and GDP (Ned Davis Charts are attached). This continued deleveraging will dampen consumer borrowing and spending which, in turn, will effect business spending and hiring not only in the U.S. but globally. If we are correct, the U.S. and global economies will contract and there will be a race to the bottom with "competitive devaluations" rampant. All the countries that need exports for economic growth will be very aggressive in the race to the bottom, as the global economy struggles, and drives these same countries into the next stage of the "Cycle of Deflation" ---"Beggar-thy-Neighbor."