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All too often the demarcation between fantasy and reality is blurred by a new vision of utopia that enters the financial psyche, as it did in the euphoria of the late 1990s. During that period, the renewed prospects of a new paradigm (a sustained economic boom characterized by the absence of cyclicality) fueled an era of uberspeculation and sky-high price earning multiples.
This notion of a transforming period of economic prosperity was popularized in July 1997 in Wired Magazine's cover story:
"The Long Boom".
Authors Peter Schwartz and Peter Leyden wrote: "We're facing 25 years of prosperity, freedom and a better environment for the whole world. You got a problem with that?"
Unfortunately, the promise of a long boom proved to be, like Goldilocks, another fairy tale. And equities -- particularly of a
-kind -- fell with a thud that plunged our economy into a recession.
While not as conspicuous as the last cycle, many are extrapolating the economic strength of the past three years to continue for the balance of the decade -- a mini long boom, if you will. In the past I have argued otherwise -- that the economic landing will be
This morning I would like to go beyond my explanation of why the economy will weaken worse than many expect and discuss how difficult it will be for the economy to revive after its initial decline.
As growth now fades, many investors foresee a soft landing and a quick rebound. I do not. I believe that profit growth will continue to fall well below expectations, while the economy faces a long, lumpy road ahead before healthy growth emerges once again. Here are some reasons why.
1. An Absence of Wealth Generators
The wealth effect of rising stock prices in 1996 to 2000 was followed by a near-vertical climb in housing prices in 2001 to 2006. This provided consumers a dramatic and unprecedented rise in net worth. Unfortunately, there is no asset class that is likely to provide a similar degree of direct or indirect stimuli over the next several years.
- Housing is not likely to be a stimulus:
Despite the quantum leap in home prices from 2000 to 2006, refinancing cash-outs have increased the American consumer's leverage to real estate as the ratio of mortgage debt to home values has never been higher. Therefore, opportunities to fund consumption by leveraging the housing stock further are more limited than in past economic cycles.
- Equities are not likely to be a stimulus:
Stocks have provided an unprecedented boost to consumers over the last 25- and 10-year periods. Looking ahead, a repeat performance is unlikely. Instead, I believe a period of lumpy and uneven economic growth is likely. This is especially true given the prospects for modest top-line sales growth and rising cost pressures. In fact, I believe that corporate profit margins remain quite vulnerable. Slow economic growth and shrinking margins are not a recipe for expanding price earnings multiples or rising share prices.
2. Mortgage Lending Isn't Likely to Get More Creative
Unconventional and aggressive mortgages already have stretched the limit of lenders and the patience of policymakers. (Aggressive mortgages include ARMs, unusual teasers, high loan-to-value ratios, interest-only loans, reverse amortizations, etc.) Where can you go when you've gone too far? When mortgage lenders lend at 110%-120% of home value, what uncharted credit territory still awaits exploitation? Other debt markets were also creative and liberal in their extension of credit. The automobile industry, for example, has liberalized terms as far as it probably can. Indeed, manufacturers have helped create a tapped-out consumer by offering teaser loans and creative financing. Yet there is little top-line progress to show for it.
3. Businesses and Households Have Locked In Much Lower Interest Rates
David Rosenberg of Merrill Lynch did an excellent job recently of chronicling this interest rate cycle. In short, rates during 2003-06 were already quite low, so the
has little room to maneuver.
In the last cycle when the prime lending rate was pushed up to 9.5% at the peak, the average of the prior three years (1998-2000) was 8.5%. So when the Fed eased and the prime rate hit its low of 4%, there was very substantial stimulus, because everyone rolled out of high average rates to a very low rate.
But look at the current backdrop: In the past three years, prime has averaged 5.35%. The prime rate now is 8.25%. So say the Fed eases 200 basis points after this tightening cycle is done. Who cares? That would still leave prime at 6.25% or 90 basis points higher than the "average rate" being carried by the household sector (averaging out the past three years). You see -- when the Fed eased 200 basis points from January to April 2001, it had successfully taken rates 100 basis points below what the average was and, hence, provided real stimulus for the consumer.
We can carry the same analogy to mortgage rates, especially adjustables, which averaged 6.2% to ultimately scale into a cost that was almost 300 basis points lower. Now that is called rate stimulus. But the average ARM rate from 2004-06 has been 4.5%, so even if the Fed eases enough to take the yield back down to 3.4%, the amount of stimulus based on the mathematics will fall nearly 200 basis points shy of providing the thrust it did in the last cycle.
4. The Lack of Savings Is an Economic Headwind
A 50-year low in the personal savings rate leaves the consumer exposed and illiquid. Simply put, there is no margin of error for the consumer. The decline in savings has dropped to dangerously low levels, so the stimulus of lower interest rates will have a lessened impact on retail activity than it has had in the past.
5. A Growing Schism Between the Haves and Have Nots
The plight of the economically important lower- and middle-income consumer has worsened considerably over the last five years. This reflects sluggish job growth, nascent inflationary pressures, and limited growth in real wages. In addition, tax policy has favored the well-to-do. This has accelerated the decline in the relative position and the overall economic role for the low- and middle-income strata.
6. The Consumer Is Spent Up, Not Pent Up
Responding to an unprecedented loosening of monetary policy, consumer installment and mortgage debt climbed ever higher during the last recession. This happened for the first time in modern economic history. Durable expenditures as a percentage of GDP have never been higher; for example, housing ownership has never been as broad. As a result, the debt-to-disposable income has risen by almost 50% over the last nine years (to 132%).
7. The Twin Deficits of Destruction Pose Structural Problems
The current account and trade deficits are unprecedented in size, and this limits the ability of our government to engineer a recovery through fiscal means. Ongoing geopolitical instability translates into large and protracted financial demands, and this will reactivate the debate regarding guns and butter.
In summary, monetary and fiscal policy has a limited ability to revive the economy as it has in the past. In addition, there are no asset classes that are likely to produce a new wealth effect for consumers.
This is particularly troubling given the massive twin deficits and overextended U.S. consumer. Over the next several years, aggressive monetary and fiscal actions would be required to catalyze lackluster growth. If these tools were used to the degree that is necessary, inflation forces would begin to percolate and bubble to the surface, leading to a vortex of blahflation -- a period of blah economic growth (slightly above stagnating growth) coupled with rising inflation.
The U.S. is addicted to easy credit, low interest rates, foreign capital and federal deficits. Rising prices for stocks and housing have masked an unhealthy consumer that spends too much and saves too little. The U.S. economy is like a drug addict who needs ever stronger doses to achieve a high and the financial system now needs dangerous does of stimulus just to keep growing. Withdrawal will be unpleasant, and risks either recession or inflation.
Doug Kass is general partner for two investment partnerships, Seabreeze Partners L.P. and Seabreeze Partners Short L.P. Until 1996, he was senior portfolio manager at Omega Advisors, a $4 billion investment partnership. Before that he was executive senior vice president and director of institutional equities of First Albany Corporation and JW Charles/CSG. He also was a General Partner of Glickenhaus & Co., and held various positions with Putnam Management and Kidder, Peabody. Kass received his bachelor's from Alfred University, and received a master's of business administration in finance from the University of Pennsylvania's Wharton School in 1972. He co-authored "Citibank: The Ralph Nader Report" with Nader and the Center for the Study of Responsive Law and currently serves as a guest host on CNBC's "Squawk Box." Kass appreciates your feedback;
to send him an email.