Financial Physical or the Perilous State of the Union
By James J Puplava CFP, February 19, 2003
Twice each year the Chairman of the Federal Reserve Board appears before Congress to give testimony on Fed policy and the current state of the economy. The last appearance was on February 11th. The report given to Congress is called "Monetary Policy Report to Congress" and is listed on our Fed Watch resource page. Like a doctor reviewing the results of a physical with a patient, the report covers the economic health of the nation and current Fed policy to remedy conditions that don't look as healthy. The gist of the report can be summarized in the Fed's own words, �On net, the economy remained sluggish at the end of 2002 and early this year." The Fed is clearly looking for reasons as to why the economy has not responded and recovered in typical fashion.
Those aggressive rate cuts brought interest rates to the lowest level in half a century. Instead of revitalizing the economy in typical fashion following a recovery, the economy is now facing more imbalances in the consumer and housing sectors. The Fed's report starts out with the general monetary and economic outlook. The report then analyzes the various components of our economy from households and corporations to the economic positions in local, state, and the federal government. The report also covers the current health of our capital markets reflecting conditions in the stock and bond markets.
This year's report begins in the same manner as last year with geopolitical concerns. There was also time spent on last year's big issue, which was corporate malfeasance. Aside from the corporate scandals, which dominated much of last year's news in the financial markets, the report was also filled with concerns over geopolitical issues. These ranged from the uncertainty over war with Iraq, terrorism, and tensions in the Korean peninsula, to the strike in Venezuela, higher oil prices, and general political uncertainty. The Fed had to admit that economic activity has lost much of its earlier momentum. The Fed was unsure whether there was enough evidence that the recovery was gathering enough traction to stand on its own legs without further monetary support.
In typical economic psychobabble, having listed all of the uncertainties, problems and other areas of serious concern, the Fed believes overall things are getting better. "Apart from the geopolitical and other uncertainties, the forces affecting demand this year appear, on balance, conducive to a strengthening of the economic expansion." In the Fed's view, the wealth devastation that resulted from three years of declining stock markets should in all probability end shortly, and geopolitical concerns will eventually go away. Once political uncertainties are cleared up and profitability improves then it will be �back to normal' for the economy and the financial markets.� The report then goes on to analyze each major sector of the economy.
The Household Sector
Household spending last year rose by 2 �%, slightly less than the year before. The average in consumption spending over the last few years has been around 4%. Sales of autos also fell slightly. Auto sales and spending on housing still remain as the last few props still holding up the economy. The Fed attributes the robust sales of autos to aggressive manufacturing promotions. The Fed fails to relate the corresponding effect of this aggressive promotion as one factor in the anemic pace of corporate profitability. However, the Fed cites as proof of monetary effectiveness the high levels of mortgage financing last year. Positive attributes of this record amount of new debt is that equity extraction by homeowners has allowed personal consumption to remain high despite higher unemployment. Lower mortgage and financing rates have allowed homeowners the ability to reduce mortgage payments, pay down credit card and installment debt and take on and support higher debt levels. The Fed cited the fact that the ratio of household net worth to disposable income had reversed nearly all of its run-up since the mid-1990s. In other words, all of the gains of the stock market bubble have evaporated.
The current state of household debt is now at a record level. Households continued to expand their debt levels at an annual rate of 9 1/4%. Last year was the largest year of debt accumulation since 1989. Home mortgage debt increased by 11 �%. Refinancing activity accelerated during the fourth quarter when mortgage rates dipped below 6%. The Fed acknowledges that the record amount of debt and especially mortgage debt should not be alarming. Lower interest rates have given homeowners the ability to service larger debt loads. Household credit quality deteriorated very little last year when viewed as a whole. However, credit stress levels are rising rapidly in the sub prime segment of the market where mortgage delinquency rates and bankruptcies are an emerging trend that is accelerating. In short, the household sector is okay as long as rates remain low. The record debt levels are serviceable as long as unemployment doesn't increase and interest rates remain low.
Experts believe that the current debt levels at the consumer and the corporate level will keep the Fed from raising interest rates. Some on Wall Street are already speculating that if the economy weakens further, another rate cut may be in the cards. Things could deteriorate rather quickly if interest rates took a turn in the opposite direction. There is simply too much debt in the system. If rates were to rise, the whole financial system would be in trouble as a result of record debt levels. The average household in the US owes more in debt than what the breadwinners bring home in an entire year. By comparison, debt levels a decade ago were equal to 85% of income, two decades ago they were at 65% of income. Today they are over 100% percent of income. Interest payments for companies and consumers are at record levels and pose no problem as long as rates don't go up.
It should be pointed out that while interest rates remain low presently, municipal, state and Federal deficits are now growing at alarming rates. This means that governments at all levels will have to tap the capital markets in order to finance these growing deficits. Increased demand for debt without a corresponding supply of new savings will eventually raise the cost of money. Money is a commodity like anything else. When there is greater demand for more of something than there is supply, the price rises. In the case of money, higher costs mean higher interest rates. The Fed has put the markets on notice that it stands ready to intervene and buy (monetize) debt in order to keep the price of money (interest rates) low. This is something the Fed can't do indefinitely without creating inflation. There is a limit to the Fed's ability to create money out of nothing.
The Business Sector
The chief characteristic of the business sector is that investment spending went down last year. The good news is that the rate of decrease was less than the year before. Outlays for computers and software went up, but these numbers are fudged through hedonic indexing which creates artificial numbers in technology sales due to the higher computing power of computers. The trouble is nobody received these artificial sales. They are make-believe numbers. The US is unique in the way it computes, massages, and seasonally adjusts its economic numbers to arrive at GDP. Let us just say there is tremendous statistical leeway in computing the numbers. This is most clearly evident in the way government statisticians treat investments in computers.
In 2000 actual spending on computers rose from $90.4 billion in the prior year to $93.3 billion. By the time the numbers were hedonically adjusted, that same $93.3 billion turned into $246.4 billion, up from a hedonic $207.4 billion the year before. The only trouble is nobody received the difference between $246.4 billion and the actual number of $93.4 billion. The difference of $153 billion was all an illusion. Furthermore, the actual increase of only $2.9 billion was translated into a hedonic increase of $39 billion. In addition to hedonic indexing, another improvement in GDP came when software spending went from the business expense column to being capitalized. If you understand this fiction, then you understand why high tech executives see no improvement to their businesses, why they continue to fire workers, and why capex spending is still dormant. Businesses can't plan, budget and spend around fictional numbers. They must deal with real numbers, real profits and cash flow.
In addition to a lack of spending by business, profit growth remains anemic as well. As shown by the chart to the left, nonfinancial companies rebounded slightly in late 2001, remained dormant, and in fact declined in the latter part of last year. Sluggish aggregate demand, lack of pricing power and intense competitive pressures continue to affect the bottom line. As long as the outlook for profits remains uncertain, capex spending will remain on hold. It is profits that drive capex spending. You can't spend pro forma profits. It takes real profits and cash flow to pay for new investments -- something Wall Street and the Fed have forgotten in this new world of pro forma economic and financial reports.
In the corporate sector, thanks to rising credit spreads, companies took on less debt last year. Debt expanded at less than 2%. Instead, companies relied on liquid assets, which were liquidated rather than take on expensively priced debt. Credit spreads improved last year in Q4 as the Fed flooded the financial markets with liquidity in an effort to bring down spreads as shown in the chart to the left. In addition to relying on internal cash to finance operations cash financed mergers, stock buybacks were at the lowest rate since 1994 as companies struggled to conserve cash. Last year companies issued bonds, cut back on investments, and instead, companies chose to repair debt-laden balance sheets. The only sectors taking on new levels of debt were the government and the consumer.
Debt defaults last year are still at record levels as shown in the accompanying chart. The rate of corporate debt downgraded last year was fourteen times the amount of debt that received an upgrade. The recovery rate of defaulted bonds remained below 25%, which put last year at the low end of recoveries out of a recession. Delinquency rates on business loans at banks rose substantially along with loan writedowns. Banks have noticeably cut back on business lending; while opening the spigots on mortgage and home equity refinancing.
In addition to debt levels and lower levels of profit, the Fed made mention to this year's possible profit killer, which is underfunded pension plans. Besides having to make up for pension losses with new contributions, companies still need to clean up worthless goodwill remaining on their balance sheet. It is estimated that $200 billion will be written off this year. That figure could get even larger if the stock market continues to fall further as it has this year. It is a Catch-22 situation. The more stocks fall, the more goodwill will have to be written off this year.
In summary although companies continue to take steps to repair balance sheets, there is nothing on the horizon that would indicate another capex boom driven by rising profits is about too begin. The outlook for profits is uncertain at best.
The Government Sector
The best way to explain what is going on with government is through a review of selected charts, which tell the whole story. To summarize:
1) Surpluses are gone. Deficits are growing and will get even larger in the years ahead. Deficits are growing and will get even larger in the years ahead.
2) Government receipts are declining; while expenditures are rising; while expenditures are rising. This is why we have deficits.
3) The trade and current accounts are now at dangerous levels raising the specter of a dollar crisis.s are now at dangerous levels raising the specter of a dollar crisis.
In short, this is an economy that is in trouble with or without a war.
Back at the casino, all the major averages fell as renewed concerns over a coming war with Iraq overshadowed the markets. The on again-off again war with Iraq has hung over equity markets here in the US and overseas. The markets fell after Secretary Powell accused countries that want UN inspections in Iraq of being afraid. The UK, which is backing the US, has advised its citizens to leave Iraq immediately. Syrian troops have also been given orders to move out of Lebanon. Their destination could be the Golan Heights or possibly Beirut.
On the diplomatic front Stratfor.com has revealed that France and Germany may have much to hide. France has been instrumental in helping Iraq build its nuclear power program. According to Stratfor.com, France sold Iraq two reactors. Chirac has had a relationship with Saddam that goes back to 1974. Back then Chirac was instrumental in negotiating the sale of nuclear reactors as well as uranium-enriched plutonium. France sold Saddam enough weapons-grade uranium to produce three to four nuclear weapons. Baghdad also purchased a one-megawatt research reactor and France has agreed to train 600 Iraqi nuclear technicians. Essential, according to Strator, France has been instrumental in developing Iraq�s nuclear program. According to The New York Times, Chirac has maintained a close business and personal relationship with Hussein going back to the 70's.
Another Stratfor story details a German newspaper Frankfurter Allgemeine Zeitung that reports on how the German government for months intentionally suppressed evidence that Iraq possessed supplies of smallpox. If the story proves true, it would indicate that the German government has actively denied the UN and its allies information about the existence of an Iraqi WMD program; while helping to lead a global anti-war crusade. If proven true as alleged in the German newspaper, such a development could hasten the end of the political career of Chancellor Gerhard Schroeder and trigger early elections in Germany.
It appears that French and German reluctance to war had other motivations behind them. If these allegations are all prove true, then the anti-war tilt in Europe could shift directions towards war. It appears that war is now imminent. The clock is running out for negotiations. The US finds itself in a position that it can no longer wait and avoid war. Experts now believe that military operations could begin at the end of this month or non later than early March. The outcome and the subsequent events that have followed 9-11 have changed the world considerably. The possibilities for a negotiated settlement have now declined. According to Stratfor, "The United States is in a situation in which it cannot avoid war, in which diplomatic complexity remains substantial, and which the enemy, Iraq, is fully alerted and prepared." The US and British intelligence services have been monitoring the movement of three Iraqi mystery ships which are suspected of carrying weapons of mass destruction. These three ships have been seen circling around the globe for the last three months; while maintaining absolute radio silence in complete violation of international maritime law. The ships fly the flags of three different nations.
With so much geopolitical news on the front page, it has been no wonder that stocks have been gyrating. There are too many crosscurrents for the markets to handle--much less understand. On top of the political news, there was a blizzard of bad news coming out of retailers from CEC Entertainment Inc. to disappointed investors saying that Monday's storm has hurt earnings. Retail sales fell by half during the President's Day weekend. Copart Inc., the seller of damaged and recovered stolen cars, said profits and sales this year would be below forecast.
There was nothing to report today that was encouraging. We are now in a two-week period or no man's land between the next earnings reporting season. Earnings confessions should start in about three weeks, along with war. This isn't the kind of news that would make investors run out and buy stocks. Given all of load of inventory that is backing up in the distribution channel, the reports coming out this next quarter appear to be damaging to assumptions made at the beginning of the year. It now looks as if earnings assumptions will be heading much lower and the profit recovery pushed back much further. In summary, it looks like another second-half recovery scenario.
Technical analysts see another possible test of last year's October lows unless stocks bounce higher during the next few days. The possibility of war and the upcoming earnings confessions will probably take a good deal of wind out of the markets. Volume has been steadily declining since last summer. Today we barely made it over 1 billion with 1.07 billion shares exchanging hands on the NYSE. Only 1.16 billion shares traded on the Nasdaq. Market breath was negative by 3-1 on the NYSE and by almost 2-1 on the Nasdaq. The VIX fell to 35.22 and the VXN dropped to 47.63.
European stocks slid as Deutsche Telekom AG put on sale 2.3 billion euros ($2.47 billion) of bonds that must be converted into shares, prompting concern more companies will raise money by selling securities. Insurers including Prudential Plc dropped amid concern companies in the industry may sell shares to current investors. Reckitt Benckiser Plc fell after the company's main stockholder put some of its stake up for sale. The Dow Jones Stoxx 50 Index declined for the first day in four, shedding 3 percent to 2209.76. The Stoxx 600 Index slid 2.3 percent to 186.07, with telecommunications and insurance shares accounting for almost a quarter of the loss.
Japanese stocks fell as Sumitomo Mitsui Financial Group Inc. led other banks lower on concern its offer to cover potential losses from a sale of preferred shares will disadvantage holders of common stock. The Nikkei 225 Stock Average fell 0.2 percent to 8678.44. The Topix index shed 0.4 percent to 853.59, with banks the biggest contributors to its drop.
Charts courtesy of Federal Reserve Monetary Policy Report to Congress, February 11, 2003
© 2003 James Puplava