Money's Big Picture

Most economists will tell you that America is credit obsessed as we were responsible for both the conception and proliferation of credit cards. The revolution of computers and on-line banking, allowing for our economy to move towards a card based system instead of cash based economy, also paved the way for more consumer debt.

In fact, until 2008 we had an expansion of consumer credit for 20 years in a row. Our debt problem  especially increased in the early and mid 2000s, as from 2000 to 2009 the ratio of aggregate debt compared to consumer income increased from 100% to 150%. This vast amount of debt intensified the negative events of the financial crisis to the average American consumer*.

However, as a result Americans decided it may be time to deleverage and have done so relatively quickly. From a high of 150% debt to income ratio mentioned previously, Americans have now dropped below 130%. Likewise, they have also decreased the number of open credit accounts from an average of 6.5 per person in 2008 to 5.2 now, a 12 year low. Lastly, the number of Americans with no credit cards has increased from 16% to 24%*.

Despite the large consequences of the financial crisis, an overall consumer deleveraging of credit may help benefit the country in the long term. Creating a more financially responsible American consumer could be a silver lining in the middle of the harsh realities of the 2008 crisis we are still dealing with.

*Yuliya Demyanyk and Matthew Koepke, 2012. American Cut Their Debt The Big Picture

There has been a lot talk and political jousting over where the American economy really stands. Conflicting news stories and complicated economic analysis only add to the confusion and frustration amongst investors and retirement savers.

One of the ways to avoid the political spin during an election year and try to feel where we are really going is by looking at economic indicators, many of which had recent updates in the last week. The key is to avoid the manipulated indicators like the unemployment rate, which has so many moving parts that the actual reported rate is almost worthless (many economists consider the U-6 unemployment rate, currently at 15% for July, to be far more accurate than the official and reported unemployment rate of 8.3%)*.

Some of the more concise indicators seem to be pointing toward an improving economy, albeit a slowly improving economy. One of the most encouraging indicators has been the housing sector which has seen almost all indicators improve this year. For every month reported in 2012, housing starts have increased significantly over the corresponding month in 2011. Retail sales also have increased lately, as July 2012 was 4.1% better than the numbers released for July 2011**.

Companies are also producing more as industrial production increased 0.6% in July and the percentage of facilities utilized in production moved up 0.4% to 79.3%***. 

While all these indicators show improvement, it is also important to gain some perspective. Previously, I mentioned housing starts had increased over the last year, but we still have a long way to go to get back to historical levels. For instance in January 2008, single unit housing starts were over 775,000 a month. The numbers for July were only 502,000**.

Likewise, the percentage of facilities utilized in production for July increased to 79.3%, but is still below the levels seen in 2007 and 2008 which hovered between 80 and 81% and far below the 1990s when the number elevated above 85%***.

So in closing, yes our economy seems to be improving in many vital areas, however it is doing so very slowly and we still have a long way to go.

*Seeking Alpha. Aug 2012 What is the Real Unemployment Rate www.seekingalpha.com

**McBride, Bill. Aug 18 2012. Summary for Week Ending August 17^th Calculated Risk www.calculatedrisk.com

***Federal Reserve Aug 2012

A lot of controversy has surrounded the impending inflation that most people feel we are going to see in the United States over the next decade. However, despite the theoretical musings by economists and political pundits, the important aspect to remember when talking about inflation, or its opposite effect deflation, is how will these economic shifts affect me?

First off, inflation is simply the concept that over a period of time goods and resources are going to slowly rise in price and become more expensive. This is exactly what we have seen in our country’s history as well as in other countries’ monetary policy well before the United States was established.

Deflation, is the exact opposite effect and actually only happens on rare occasions in today’s economic environment. The United States has only dealt with a major deflation event 4 times in its history. The 4 periods started in the late 1810s, late 1830s, 1870s, and the 1930s. It is important to note that we have not had a major deflation period in over 80 years. This is largely due to the United States going off of the “gold standard.” ¹

History of Inflation

The gold standard was the policy that all US dollars were backed by physical gold. In fact, up until the 1930s United States citizens could actually exchange their dollars for a fixed amount of gold. In essence, dollars were deposit slips for gold holdings. This remained theoretically true until 1971, at which time the United States dollar became its own value and completely separated the dollar from gold prices.

Getting rid of the gold standard did several things for the general US economy. First of all, it eliminated the likely possibility of deflation. Second, it smoothed out expected inflation. Before, when on the gold standard, inflation would routinely exceed 10% a year and sometimes even exceed 30%. Now inflation has rarely crossed 10% and is typically below 5%. However, despite smoothing out inflation, it actually increased the average inflation we see by 2-3% a year. ²

Understanding the Effects

Now, the slightly more difficult task is understanding how inflation or deflation impacts the US economy and impacts you personally. Just like the previous post about interest rates, inflation typically benefits one group of people, while deflation theoretically benefits the opposite group of people.

Generally speaking, inflation encourages people to spend more money. After all, if something costs less today than it will tomorrow, it makes sense to purchase now. This spending cycle is believed to encourage our economy upward. Also, inflation effectively lowers the value of debt outstanding. Picture this, if I took a loan out today for $100,000 and only paid the interest on it for 10 years, my loan balance would still read $100,000. However, with inflation at 3% that $100,000 of 2012 money would only be worth around $74,410 in 2022 money, making the weight of my loan much lighter. Effectively, inflation benefits people who are in debt or are taking out loans (ie. Our Federal Government).

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A major financial topic over the last two years has been the incredibly low interest rates that we have seen in our economy. What many people do not realize is the effect these interest rates have on just about everyone. However, the effects end up splitting our population into people who benefit and those who suffer. 

Despite the news coverage that tends to look upon low interest rates as a favorable economic condition, it is distinctly hurting a sector of our population at a time when they need it the most.

First, lets understand why the Federal Reserve wants to keep interest rates low. All economists agree that individual business expansion and growth is what drives an economy forward, and one of the ways that most businesses in the US expand is by financing (taking loans) the expansion. When interest rates are low, it makes lending more favorable to individual businesses and makes them much more likely to expand. With commercial loan rates for A-rated businesses at or below 4%, business expansion has become an easy decision for most business owners or CEOs. Also, businesses that were already planning on expanding can possibly now expand even more than planned because the loan will “cost” less.

This business expansion and investment helps drive the economy forward and helps stimulate an economy coming out of a recession like we saw in 2008 and 2009.

The other reason why the Federal Reserve has kept such a emphasis on low interest rates is due to the real estate collapse that started around 2007. Low interest rates in the mortgage market have encouraged many first time home buyers to go out and look at purchasing a home. It has also helped many current homeowners refinance their house instead of turning it over to the bank after foreclosure. Added on top of these benefits is that just like businesses who were already looking to expand, home buyers who were already looking to purchase can now spend more because interest rates are so low. 

Consider the case of a couple who has decided that on top of their down payment, they will be able to comfortably afford a $1,000 house payment (for simplicity we will forget about taxes, insurance, PMI, etc). If they were looking for a house back in January of 2000 when a 30 year fixed rate loan according to Freddie Mac was about 8.21%, they would have been able to qualify for a loan amount of around $133,608.00. However, in March of 2012 when rates were at an almost 40 year low of 3.95%, the new house loan they could obtain was around $210,731.00. This new loan amount is over 57% more than what they could afford 10 years ago. 

Despite these positives for the general economy, current retirees and people nearing retirement are suffering because of low interest rates. 

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What might this mean for the economy & the markets? 

Congress punts on third down. Unable to reach consensus, the Congressional super committee of 12 offered America a disappointing result Monday. Panel co-chairs Rep. Jeb Hensarling (R-TX) and Sen. Patty Murray (D-WA) announced that “it will not be possible to make any bipartisan agreement available to the public before the committee’s deadline” on November 23, throwing in the towel with two days to go.¹

The big divide was over the Bush-era tax cuts. While Sen. John Kerry (D-MA) reminded the public and his fellow legislators that “we are not a tax-cutting committee, we’re a deficit-reduction committee,” there was stiff opposition to rolling back the EGTRRA and JGTRRA cuts of the 2000s. The super committee paired some strange bedfellows among Capitol Hill legislators, so this head-butting was not unexpected.² 

What happens now? As the super committee failed to create a plan to trim $1.2 trillion or more from the federal deficit, that sets things up for an automatic $1.2 trillion in cuts effective over a 10-year stretch beginning January 2, 2013. According to the Budget Control Act passed in summer 2011, that $1.2 trillion will be slashed almost 50/50 from the defense budget and government services programs. Social Security and Medicaid payments, military pay and veteran’s benefits will be exempt from cuts; current Medicare recipients will not be directly affected. This default deficit reduction could mean as much as a 9.3% cut to some federal programs, by the estimate of the left-leaning Center for Budget and Policy Priorities.^3,4 

This is what the super committee’s apparent failure means politically. Economically, it could result in pain for American investors given the probable impact on our credit rating, stock market, tax laws and economic growth.

Is another downgrade ahead? Standard and Poor’s cut the U.S. credit rating a notch to ‘AA+’ on July 14, and it warned that another cut to ‘AA’ was possible by mid-2013 without decisive federal action on the issue. After the super committee conceded defeat on November 21, S&P, Fitch’s and Moody’s stood pat regarding a possible downgrade.^5,6 

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Memories of 2008 are still fresh: The credit crisis; the collapse of Lehman Brothers and Washington Mutual; the federal takeover of Fannie and Freddie; the market downturn. There’s little doubt Wall Street would like to erase it all from its conscience, and maybe it has.

Part of the anger of the Occupy Wall Street movement comes from the perception that nothing has changed. While the Dodd-Frank Act (designed to make the financial system more accountable and transparent) is now taking effect, the Volcker Rule (intended to stop banks from trading for their own accounts) may be watered down or put off. Beyond that, the U.S. economic recovery from the Great Recession has sputtered and made people question the recent bullish sentiment.

Stocks have rebounded strongly since 2009, but there are still many factors to worry about; this may lead to a little contrarian thinking.

This bull market may be a diversion from a secular bear market. For most of 2011, the S&P 500 has been above 1,200 (a great rebound from the March 2009 low of 676). What was behind that? The short answer: a weak dollar. We haven’t exactly had a boom economy in that timeframe.^1,2

Some analysts look at Wall Street right now and see a rerun of the 1970s, when you had momentous rallies masking a bear market that went from 1967-82. In addition, researchers at the Federal Reserve Bank of San Francisco are concerned about the possibility of a generational sell off; a potential market “headwind” for 10 or 20 years stemming from greying Baby Boomers getting out of stocks as they get closer to retirement, countered only partly by overseas investment.^3,4

What has changed on Wall Street since 2008? Perhaps not much. The general perception that the CEOs of the big investment banks and mortgage companies whose thoughtlessness contributed to the Great Recession met with no real consequence seems to be taking hold, as evidenced by the Occupy Wall Street movement.

By the way, remember the furor directed at risky derivatives trading? In September 2011, the Comptroller of the Currency had recorded an 11% year-over-year increase in derivatives investment in the banking industry. Banks now hold almost $250 trillion of the contracts.⁵

A truly severe punishment of Wall Street would come at a dear price for Washington. Some of the biggest names from Wall Street (and the real estate sector) have also been major lobbyists and campaign contributors. According to the nonpartisan Center for Responsive Politics, the National Association of Realtors has contributed more than $40 million to federal-level political campaigns since 1989; Goldman Sachs has contributed almost $36 million since then, and Citigroup nearly $29 million. The financial, insurance and real estate industries have collectively spent over $4.6 billion in lobbying efforts since 1998.^6,7

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