Thomas Friedman expressed the view that if the Republicans had remained in control of the House and the Senate, the US would have become a banana republic. But a banana republic isn’t characterised only by a rotten political system, ruled by a small, wealthy, and corrupt clique usually put in power or supported by foreign interests (in the 20th century, in the case of several Central and Latin American countries, by the US), but also by huge wealth and income inequities, poor infrastructure, backwardness in many sectors of the economy, low capital spending, a reliance on foreign capital, money printing and budget deficits, and of course a weakening currency.
A banana republic is also characterised by a ruling class that curtails people’s personal freedoms and is moving towards a heavyhanded military dictatorship under the excuse of fighting guerrilla (or terrorist) opposition groups or enemies. Moreover, the fact that the ruling class or the elite comes from different political parties isn’t a relevant factor in classifying a country as a banana republic; what is relevant is the determination of the elite, irrespective of which party its members belong to, to shift wealth from the majority of the people (the masses) to themselves, usually through simply printing money and incurring chronic budget deficits, and frequently also through senseless warfare.
Now, I am not insinuating that the US is already a banana republic, but the trend is undoubtedly there. The physical infrastructure is more often than not totally insufficient. Not a single flight I took in the US was on time, with one arriving 10 hours late, another 12 hours late, while two were cancelled altogether, resulting in delays of more than 4 hours. In Philadelphia, my US Air flight was delayed by three hours. The plane was on the ground in front of us, the pilots were all present, as well as one flight attendant (air hostess). But because a second flight attendant was unavailable in Philadelphia, one had to be flown in from Washington, so delaying my flight. Since there was no service provided on the flight, I wondered what purpose the additional attendant might have served.
I stayed at five different hotels on this trip. In three of them they couldn’t locate the FedEx box that my assistant had sent me from Hong Kong and which had been signed for as having been received by the hotel. As I have written before, the productivity of corporations has risen, but the productivity of the consumer is down as he is constantly waiting in lines and has to suffer from insufficient service and support staff. Also, compared to Asian and European cities, the streets tend to be filthy, except, of course, in the “ghettos” where the super-rich live.
In the meantime, members of the American elite are enjoying the asset inflation, the printing of money, and the trade and current account deficits, because they keep the “lower classes” reasonably happy and content by allowing them to continue to consume and buy “cheap” foreign goods. In turn, this excessive consumption and lack of capital spending boosts corporate earnings and cash flows, which then benefit mostly the elite, through rising stock prices. Moreover, the weakening currency, which is also brought about by capital flight another characteristic of banana republics doesn’t bother the elite much because they have the ability to easily transfer their wealth overseas or to fully hedge their exposure to the declining foreign exchange rate. (The aristocrats of banana republics are usually Swiss banks’ best customers.)
This is particularly true in the case of moneyed elites, which are relatively fixed asset poor and hugely financial asset rich. Let me explain. Compare, say, a farmer who cultivates land that has been in his family for generations with a money shuffler on Wall Street. The farmer is far more tied to his land by tradition, and by his inability to transfer that land and his familiar environment overseas, than is the money shuffler, who will feel equally comfortable whether he lives in New York’s Park Avenue, London’s Belgravia, or Singapore’s Nassim Road. Basically, what I am suggesting here is that the financial sector and there are exceptions really doesn’t care much for the overall long-term health of an economy; it is only interested in asset prices moving up no matter how unsound the economic policies might be that inflate those asset prices.
So, when things really turn bad and to use Senator Webb’s words the “bifurcation of opportunities and advantages” along class lines leads to “a period of political unrest”, the money shufflers like so many former leaders of banana republics have done before them just pack their bags, hop in their private jets, and move to another society where they can start playing the same game all over again! Now, this is not to say that there are no responsible people among the money shufflers, but the immense pressure to perform in order to make money as quickly as possible, and hence to enjoy a “high esteem” among their peers, which is now based solely on how much money an individual makes, has shifted the priorities of the money shufflers and the chief executive officers of companies in a way that is regrettable.
Still, I was very gratified to see that there are still some socially responsible companies in the US, and this is the second good news I have to report about the US. On my trip I stayed twice at Marriott hotels, where I found the staff to be extremely friendly and helpful. In New Orleans, at a private party hosted by David Tice, I spoke at length to two Marriott employees who were attending to the bar. One of them had been with Marriott for over 20 years, the other for eight years, and both of them couldn’t praise the management enough for “caring” for its employees.
So happy were they, they assured me, they wished to work for Marriott until they retired. Not entirely believing what I was hearing, I asked my cleaning lady at the San Francisco Marriott how she enjoyed working for the chain. Again, she had only positive things to say. She smiled and said that she was “very happy” to work for the company, where she cleans 40 rooms a day. And although I don’t agree with some of the Marriott’s policies (no smoking facilities in their US hotels, and in San Francisco patrons are prohibited from bringing their own alcoholic beverages into the hotel), it is encouraging to see that successful and profitable companies can also treat ordinary people well.
The third good news is that although there are ominous signs of the US drifting towards the status of a banana republic, the polarisation of wealth isn’t due only to appreciating asset values, inheritances, and the disproportionate growth of the financial sector compared to the rest of the economy. The five richest Americans all made their money themselves, and while money managers, real estate moguls (including hotel and casino owners), and leverage buyout artists are very predominant on the Forbes list of the 400 richest people in America, there are also a large number of “new economy” entrepreneurs on the list, such as the founders of Yahoo, eBay, Amazon, and Google.
This goes to show that there is still ample social mobility in American society. Still, what is striking about the list of America’s richest people is that most of the wealthy people (inheritances aside) are involved in some form of money management, consumer finance, real estate, oil and gas, or anything that has to do with consumption, such as casinos, hotels, retail, advertising, fast food, media, entertainment, sport, cosmetics, and health care. This gives me the impression of a relatively lopsided economy consisting of asset inflation beneficiaries and entrepreneurs who know how to encourage and capitalise on Americans’ seemingly insatiable appetite for consumption.
Finally, I also have to point out that there are two socially different Americas: there are the money and asset shufflers in the coastal areas; and then there is the conservative, but extremely friendly and hospitable, inland and southern population. Tennessee was an eyeopener for me. Although I had travelled around the South in the past, the contrast between Tennessee’s social fabric and that of New England or of California’s coastal regions could hardly be more striking. And while in earlier reports I have been very critical about the Southern states that supported the Bush administration, I also have to admit that the types of Americans who live outside the coastal regions are also those most likely to retard the process of American society sliding into the state of a banana republic.
These people tend to have high ethical values (although admittedly sometimes misdirected), and they are very concerned about and proud of their small communities. I came away with the impression that people in these communities help and support each other, and are also in a positive sense patriotic and proud to be Americans. I was also pleasantly surprised by Tennessee’s scenic beauty (there are some magnificent homes along the Tennessee River) and its low price level. In a bar in Knoxville, where a band (unfortunately without Dolly Parton) played hillbilly rock, a pint of excellent local draft beer cost just $2. In fact, I found wages for less-skilled workers in the US to be extremely low when compared to wages for similarly skilled workers in Switzerland and most of the EU.
A builder from Baltimore, whom I met on the street in New Orleans, told me that he pays his foreman according to him, a highly qualified worker just $18 per hour, while all his other staff earn between $10 and $12 per hour. (Baltimore, by the way, has the highest murder rate in the US.) A New Orleans waitress told me that her basic wage was $2 an hour, but of course she earned tips on top of that. A taxi driver in Knoxville told me he earns between $300 and $400 a week. Compared to wages in Switzerland, these amounts are extremely low. They are also very low compared to prices of US assets (real estate and equities). Based on the low level of wages compared to both Western European wages and US asset prices, I am inclined to think that either US wages might continue to rise or asset prices could adjust down to the wage level. Also, whereas the US dollar may adjust on the downside against Asian currencies and precious metals, it may be less vulnerable against the Euro.
At the expense of being called anti-American, I found that, with the exception of the areas where the wealthy people live, as I mentioned above, the streets are filthy. The French Quarter in New Orleans, which escaped being flooded during Hurricane Katrina, may not be entirely representative of inner-city areas in the US, but on an early morning walk, Bourbon Street looked as if hordes of Vandals had just ridden through! The streets around the Marriott hotel in San Francisco (located on 4th Street adjacent to Market Street, and a block from Bloomingdale’s and thus not exactly a slum area) weren’t much better. (Compared to, say, Japan, the streets, clothing, and food in the US are, to put it bluntly, schmuddelig tacky or filthy.) I have also never seen anywhere in the world as many police cars as I saw patrolling the streets of New Orleans. (The more police cars required to patrol the streets, the closer a region or a country is to being a banana republic.)
Above, I referred to the insufficient physical infrastructure in the US. Not only are airlines late, but the types of old aircraft that are frequently in service wouldn’t be used by even budget Asian air carriers. Airports are mostly inefficient (there are long lines and long waiting times for luggage delivery) certainly compared to Asia; and there are no transit facilities at US airports for foreign visitors en route to another country. So, if a passenger from Asia transits in Los Angeles on the way to Mexico, he or she needs to clear US immigration and customs in LA. This increases the workload of immigration and customs officers for no purpose whatsoever.
Late, unreliable, and uncomfortable flights, as well as poor airport facilities, then motivate wealthy people, corporate executives and, of course, politicians to travel by private plane. This increases the amount of airline traffic and clogs air space. In turn, this causes even more flight delays. In addition, and this should be understood very clearly, if the wealthy, corporate executives, and especially politicians increasingly live a life of their own (private jets, private schools, private clubs, personal drivers, and high-end living compounds), they frequently fail to notice the poor state of affairs in, and also begin to care less and less about, the rest of the country and its physical, security, and educational infrastructure, which then creates a huge gap between social classes (another characteristic of a banana republic).
I am not suggesting that we don’t have huge wealth and income inequities in Asia, but whereas in Asia people are accustomed to these conditions, in the US this growing two-class system will lead to disappointed expectations and, at some point, in all likelihood, to social strife.
As I have explained above, however, not all is rotten and bad in the US. There are many pockets of incredible inventiveness, innovation, technology, research and development, education, knowledge, and high moral and ethical values. But the trend I am observing, after having been a regular visitor to the US since 1970, is certainly not very encouraging. It will take very strong determination and sacrifices by all classes of the American nation to reverse this relative social and economic decline when measured against the newly emerging economies of the world.
IS THE US ECONOMY ROLLING OVER?
There is growing evidence that US consumption is slowing down, based on the weakness in the housing industry and slower credit growth. In fact, the August 8, 2006 GBD report, entitled “Increased Recession Risks!”, alerted our readers to the possibility of the US economy entering a recession in late 2006 or early 2007. However, there are a few issues we need to address. First, it is far from certain that the US consumer will cave in; and second, we will need to address the investment implications of a slowdown or decline in US consumption. I mention this because it is one thing to forecast economic trends, and another to draw the correct investment conclusions.
Most strategists and economists correctly forecasted the global economic expansion, especially the strength in Asia, following 2001, but they totally failed even to mention industrial commodities as the preferred asset class for capitalising on such a global economic recovery. Others were misled into believing that strong corporate profit growth in the US would lead to a strong US stock market performance, when in fact the increase in US equities in the last four years significantly lagged the performance of emerging market and European equities and was flat in Euro terms, as rising US financial asset prices were offset by a weak dollar not to mention the continuous decline of US asset prices in gold and silver terms. So, to conclude that a weakening US consumer will inevitably lead to a lower stock market is tenuous at best.
There is no doubt that, as David Rosenberg pointed out, US retail sales growth has slowed. An especially sharp slowdown in sales growth occurred in housing-related retail sales. Whereas last March housing retail sales were growing at an annual rate of over 17%, in the three months ending October they rose year-on-year by only 4.5%. But, considering the weak housing environment, I find the current growth rate in this sector to be quite remarkable. Moreover, the slowdown in housing retail sales doesn’t tell us anything about whether we should be long or short Home Depot.
Moreover, as David Rosenberg also pointed out, many strategists have expressed the view that, based on slower bank consumer and mortgage credit growth, the economy will weaken further. This may be the case, but the fact is that while consumer loan growth (ex auto leases) has slowed, it is still positive. Moreover, even if consumer loan growth turned negative, as it did in 1997, it wouldn’t mean that a recession is just around the corner. After all, the 2001 recession occurred almost four years after consumer loans turned down, and actually at a time when consumer loan growth had recovered. Obviously Mr. Greenspan’s money printing, post the 1998 LTCM and Russian crises, and ahead of Y2K, had a positive impact on equities and consumption.
I am not trying to downplay the significance of slower consumer credit growth; I wish only to point out that easy money and rising equity prices can postpone a consumer downturn. Furthermore, banks’ real estate loans, as well as commercial and industrial loans, still seem to be growing rapidly. I concede that banks’ real estate loans could be increasing because of still-strong non-residential construction activity, including construction for commercial buildings, hotels and amusement parks. (Amusement park construction leading to more consumption is, of course, exactly what the US needs at present!) But also home mortgage borrowings are still rising, although obviously at a far slower rate than a year ago.
One factor that needs to be considered when making predictions based on a decline or slowdown in bank credit growth is, of course, that bank lending is only part of credit growth, as consumers and businesses can increasingly borrow money outside the banking sector through bond issuance and all kinds of other asset-backed and collateralised debt securities. According to Doug Noland of PrudentBear.com, total commercial paper issuance is up, year-to-date, by 20%, and while asset-backed security issuance is running 6% below the 2005 record pace (home equity loans are down 5% y-o-y), collateralised debt obligations issuance is running 80% ahead of 2005. Moreover, international reserves (ex gold) a reliable indicator of international liquidity are up year-to-date by 18% annualised!
I am aware that bank loan officers are reporting that households and corporations are slowing down their borrowings. In fact, Albert Edwards of Dresdner Kleinwort recently published a report entitled “Almost unnoticed, one key part of the liquidity cycle turns downward”, in which he makes the case that,
…both corporate and household appetite for debt is deteriorating at the same time, in contrast to say, 1994 and 2001, where weakness in credit demand in one sector was counterbalanced by strength in demand by the other sector. What does it mean if the credit cycle is turning down when, at the same time, the US private sector has been borrowing heavily to finance its yawning funding gap (the excess of spending over income)? Any cessation of borrowing appetite can only mean one thing a sharp retrenchment in spending must now be underway and with it comes the risk of a hard landing. There is no way around it as we are working within National Income Account identities.
According to Edwards, “the liquidity lake is drying up at the same time as the fundamentals are deteriorating…. When prices swing in the other direction and investors begin to feel the pain, ‘liquidity’ will suddenly evaporate as either investors end speculative excesses or alternatively banks pull the plug.”
I have no doubt that Albert Edwards will be right at some point. The question, however, is whether reduced appetite for debt by the household sector can be offset by an increased appetite by investors (including foreigners) and whether the corporate sector has indeed less appetite for debt. After all, commercial and industrial loans growth is still well and alive (also confirmed by the credit growth figures provided by Doug Noland). Reduced demand for funds by the corporate sector could also be the consequence of corporations being flushed with cash. Moreover, as long as the US current account deficit doesn’t contract, foreign net financial investments into the US won’t contract. As Bridgewater Associates pointed out recently in a piece entitled “What To Do With All of the Money?”, the resilience of the US economy can largely be explained by foreigners loading up on US government bonds and the diminished demand by the government and by cash-rich businesses that don’t need to borrow at all. According to Bridgewater’s Bob Prince and Jason Rotenberg,
…over the past year, foreigners plowed 6.4% of GDP into US financial assets (entirely debt), business provided another 0.6%, saver households provided 4% and the government only needed 2.8% to finance the deficit. The total financing was 8.2% of GDP. This financing was essentially thrust upon the remaining households, who were then forced to borrow it, which means that they were forced to spend it, which required output and employment.
I have to say that I am not entirely in agreement with the analysis by Bridgewater. I could argue that ultra-expansionary US monetary policies after 2001 led to excessive US consumption. In turn, excessive consumption led to a growing trade and current account deficit, which then forced foreigners to plough back funds into the US equivalent to the current account deficit. Last month’s GBD was entitled “No Chain is Stronger than its Weakest Link”. I’m not sure what the weakest link is in the equation: consumption in the US, or the appetite of foreign central banks for continuing to finance this consumption through enormous net financial investment flows.
I have to confess that I am at a loss to see exactly what event will act as the catalyst to unravel this admittedly unstable and, in the long run unsustainable, equilibrium. It could be accelerating inflation, a total loss of confidence in the US dollar, or, as Albert Edwards suggests, a sharp retrenchment in consumption. It could also be an exogenous event such as war, the interruption of oil supplies, a major terrorist attack (it is only a matter of time before terrorists will be in possession of nuclear or biological weapons) or a pandemic that derails the Goldilocks scenario. Something is bound to happen, but then we also have to take into account that Mr. Bernanke and Mr. Paulson will be standing by with their money printing machines and “extraordinary monetary policy measures” to bail out their bodies on Wall Street and in government.
There is one last point I wish to make and this concerns the recent improvement in the still-negative saving rate and, as David Rosenberg puts it, the net paydown of consumer credit. From the figures provided by Bridgewater, we can see that although the average household isn’t saving, there are still a huge number of US saver households that are lending money through the financial system. These household savers provided 4% of GDP to balance the financial gap (see above). Now, in an economy where wealth is shifted from the masses or the median household to the Wall Street bonus recipients and other asset shufflers, the saving rate does increase: the average household may not save out of current income, but people earning in excess of US$50 million a year may have a 90% to 95% saving rate.
As a result, the overall increase in the saving rate for the economy as a whole may be due not to the typical household’s willingness to increase its savings and rebuild its balance sheet, but to his complete inability to spend. In this instance, the growing income and wealth inequities lead to some form of “forced saving” and can contribute, as some economists maintain, to an economic slump. (The Great Depression of 19291932 is explained partly by rising income inequity: the masses want to spend but cannot afford it, while the rich can spend but already have everything and therefore don’t spend enough.)
From our remarks about the polarisation of wealth in the US, one could construe that the typical household in the US is vulnerable, whereas the type of people who make the Forbes list of the 400 wealthiest Americans will continue to thrive. (I could also be labelled as a socialist.) This would imply avoiding stocks such as Wal-Mart and Home Depot, and buying any company that has to do with the economy of the superrich, such as auction houses, brokerage stocks, publicly traded hedge and LBO funds, luxury goods retailers, and high-end hotel chains, or investing in top-end properties around the world. Indeed, if we compare the performance of luxury department stores to the performance of low-end stores, it is evident that the economy of the super-rich has done far better than that of the median household.
However, when payback time comes, it is likely that the economy of the super-rich could be hurt rather badly. This would certainly be the case if Albert Edwards is correct and the “credit cycle is turning down”. In the mid-1990s, Stephen Roach frequently wrote about a “workers’ backlash”. His view was that, in time, wages would rise, lifting the rate of inflation and depressing corporate profits. While this view was premature then, I wouldn’t be surprised to see wage inflation accelerating and shifting some income back from Wall Street and corporations to the labour force. Such a shift would lead to higher inflation and have a negative impact on corporate profit margins, and on the valuation of bonds and equities.
There is another point I should like to make about the economy of the super-rich. In the late 1980s, the super-rich did very well in Japan. In the mid-1990s, the super-rich creamed off all the money in Southeast Asia. Both periods were characterised by asset accumulators becoming rich and being highly leveraged. In both cases, subsequent events the bear market in asset prices in Japan, and the Asian crisis hurt the asset shufflers the most; ordinary people, especially those living in the countryside, were hardly affected. I suppose that if you have nothing, you have little to lose! Therefore, as a contrarian bet, I would look at shorting at some point companies that have benefited the most from the shift in wealth from the masses to the asset shufflers. Such a list would obviously include luxury retailers, the brokerage industry, asset management companies, and custody banks, all of which either arranged or benefited from this transfer of wealth and the asset inflation.
The last few weeks have been characterised by a weak dollar and rising equity, bond, and commodity prices. As we move into 2007, the pattern will be the same. Either the Fed will finally decide to implement tight monetary policies, which would strengthen the US dollar and weaken all asset prices except bonds, or it will continue with its expansionary bias. In that case, asset prices will continue to rise and the dollar will continue to weaken. However, it should be understood that under easy monetary policies, dollar assets (US equities, bonds, and real estate) will, as has been the case for the last few years, underperform foreign assets and commodities. Since Mr. Bernanke was appointed Fed chairman, the S&P 500 is up by 14.6% in dollars, but only by 7.5% in Euro terms. Over the same time frame (November 1, 2005 to November 27, 2006), gold is up 40%, silver 80%, and copper 68%. Year-to-date, the S&P is up 11% in dollars but only up 0.2% in Euros and, of course, it is down against gold and silver. The worst investments were US dollar cash and bonds, both of which declined in value in both Euro and gold terms. Therefore, I advise investors who wish to have an equity exposure to overweight foreign markets, especially the Asian stock markets, and to significantly underweight US assets.
Near term, asset markets are mostly over-extended and the contrarian play is to reduce exposure to all asset markets. Moreover, after its recent weakness, the dollar could stabilise, but a strong rally shouldn’t be expected. Euro-area monetary and debt growth has been strong over the last 12 months and may force the European Central Bank to increase interest rates, which should support or even strengthen the Euro. Also, given the record short positions that exist in the Japanese Yen, I would consider buying Yen against the US dollar.
As of late November, asset markets became extremely overbought. I recommend deferring any buying and to await the shape and the severity of the expected correction.
I wish my readers a Merry Christmas and a Happy New Year. I would like all my readers to travel often to new places to see the world, to learn about other cultures, and to take an interest in other people’s lives. I also hope that my more affluent readers know that giving money away isn’t the only way to help those who are less fortunate. As the author Han Suyin (A Many Splendored Thing) observed, “There is nothing stronger in the world than gentleness.” And as Abigail Van Buren remarked, “The best index to a person’s character is how he treats people who can’t do him any good, and how he treats people who can’t fight back.” At the same time, I hope that my readers enjoy their lives and have some fun and laughs. The famous and extremely popular golfer Chi Chi Rodriguez once said: “I was born broke, so I want to live like a millionaire and die poor; I don’t want to live poor and die a millionaire.” Mark Twain believed that, “Twenty years from now you will be more disappointed by the things that you didn’t do than by the ones you did do. So throw off the bowlines. Sail away from the safe harbor. Catch the trade winds in your sails. Explore. Dream. Discover.”
At the same time, on a more sobering note, don’t forget the words of Mahatma Mohandas K. Gandhi: “The things that will destroy us are: politics without principle; pleasure without conscience; wealth without work; knowledge without character; business without morality; science without humanity; and worship without sacrifice.”
December 23, 2006