Wednesday, April 21, 2004

Dissonance & Euphoria

Max Fraad Wolff

Max Fraad Wolff is a Doctoral Candidate in Economics at the University of Massachusetts, Amherst.

Bullishness is back, in force and vogue. Soaring earnings and economic rebound are the pillars of a glittering recovery McMansion. There is no disputing that the Fortune 500 had a great run in 2003-especially compared to the terrible years of 2001 and 2002. Their 540% increase in profits on 7% revenue gain is both exhilarating and bracing. The causes of macro glee are far harder to understand and follow. While the March BLS employment report was positive, it was far more a PR and short term trading event than an economic sea change. After all, the ranks and rate of unemployment failed to move as 1 month's good data don't undo three lean years. The present bout of euphoria rests on a very selective focus and more than a little bit of dissonance driven acquisitiveness in the markets.

One has to walk a macro and global economy high wire, refusing to look down, left or right. If you carefully follow this self imposed myopia you too can feel happily assured. If - by chance or training - you look around, timber!

Markets have stubbornly refused to price in or trade any of the recent news out of Iraq. No attention is paid to global attitudes- specifically the Pew Global Attitudes Survey. The alarming situation in Saudi Arabia bears only passing mention. The personal debt explosion is ignored. The trade deficit is ignored. Budget deficits are ignored - even as the IMF offers a second warning of threat to the global economy posed by massive DC red ink projection and numbers. The importance of housing and its exposure to upward rate pressure are off the talking points list. Election year risks don't exist-even as polls predict a close, bitter race. Energy prices are no big deal. Persistent economic weakness, growing rage over outsourcing and weak job prospects are not worthy of mention. However we all know the above really do matter.

About those great corporate numbers…

Duke and University of Washington researchers recently released survey numbers drawn from 401 financial executives. The results suggest that better than half would delay value enhancing activity to beat analyst expectation. Almost 80% would decrease research, advertising and maintenance spending to beat the numbers. These are the numbers that convince everyone that things have changed and the good times are set to role. In 2003 the Fortune 500 booked profits of about $446 billion. This is compared to 2002 negative profits of $70 billion. It is a whopping $2 billion more than the profit booked in 2000-less if adjusted for the decline in the dollar or inflation.

How did we regain-or nearly regain-2000 profits? It would appear that trillions in additional housing debt, hundreds of billions in additional personal debt, trillions in trade and budget deficits, multi-decade low interest rates and a declining dollar did the trick. Wow! This great return to profit was done with no real increase in revenues. Fortune 500 revenue went from $7.2 trillion in 2000 to $7.5 trillion in 2003. Stunning 4% revenue growth may explain why federal, state and local governments are broke and 3 million jobs are missing from the economy. It would appear that firms prosper if they pay no taxes, lower wages, little toward pensions, nearly nothing to borrow and repatriate foreign earnings in a declining dollar environment. Recent CBO estimates suggest that more than half of our larger corporate brethren have paid approximately nothing to Uncle Sam of late. I told you not to look to around.

Macroeconomic Strength…

The present prosperity rests on the above robust and sustainable structural pillars. Let's take a look at those tariff protected steel girders. Median disposable household income fell-even adjusting for falling taxes-according to the most recent Census Bureau data. In 2003 we ran a $489 billions trade deficit in goods and services as our trade balances with China, Japan and the EU deteriorated. As people's income fell they added trillions in new obligations in the form of mortgage and personal debt. Spending continued to outstrip income growth as savings stayed at horrifyingly low rates in the range of 2%. I guess that is why major banks assure shaky investors that they will gain when rates rise as new deposits are drawn from America's legions of savers. You might pause to consider that consumption recently passed 70% of GDP. Do you think housing refinancing and heavy borrowing might be feeding the fire? Who knows, it sure isn't coming from savings or wages.

Credible estimates of debt now total about $24 trillion across the household, federal governmental and business sectors. That breaks down to roughly $7 trillions for Uncle Sam, $9.4 trillions in all consumer debt including housing and $7.4 trillions in business debt. If you assign a very low average carry cost of 5% it will cost $1.2 trillions to service obligations with no amortization. That is about 12% of GDP- more than twice bullish growth forecasts. Recent growth has involved intensification of the mortgaging of our economic future-not a drawing down of obligation. Perhaps this is part of the reason that we now must borrow between $1.5 and $2 billion per day from the rest of the world. The difference must be generated by “credit innovation” that stretches the gap between material and monetary value. I told you not to look around.

The looming prospect of rising interest rates should probably rate a major concern as housing comes under pressure and America staggers under heart attack levels of debt intake. REIT investors and carry traders are not the only ones with something to fear. Firms in the debt and or trading games- financials; those who sell into the inflating government sector- defense contractors and security businesses; those with pricing power in a cost cutting economy- pharmaceuticals, energy and insurance firms; soared in 2003. If the macro environment is set to shift, they will have to adjust or fall off the pinnacle of the profit lists. Of course, macroeconomic conditions are still not definitely forecasting rapid and sustained growth. Unless we double dip, common sense would suggest that the radiant blush may be projected onto the recovery rose by dissonant euphoria. ...Link
IMF World Economic Outlook

No comments: