This article is based upon Woody Brock’s recent essay “FORECAST OF THE US ECONOMY – Who Can be Surprised by What is Happening?”.
The focus of analysts throughout the world upon the US economy is entirely appropriate because most of us believe that when America sneezes, we catch a cold. Although, our quality of life is determined by what happens in the United Kingdom, what happens in the United Kingdom is very much determined by what happens in the US. For that reason, this essay by Woody Brock is of great importance. Unfortunately, we only have space enough to pick out a few gems.
The Fed, he says, can be expected to continue to do a reasonable job in growing the monetary base in a non-inflationary manner but he finds it unforgivable that in recent decades they have disregarded leverage. He argues that the housing bubble as well as other bubbles, were not caused by a low Fed funds rate but by the uncontrolled use of leverage with no controls imposed that the Fed might have insisted upon, such as minimum levels of deposit. In neglecting to address the issues of leverage, the Fed abandoned their responsibility and asset market bubbles were created.
He sees no significant inflation risk, believing that inflation will settle back down to about 2.25%. But that could go even lower, dependent upon what happens to GDP growth.
Housing and Consumption. Right through into 2007 he says that virtually all forms of housing will be in decline, causing a notable hit to the economy both directly and indirectly.
A pronounced slow-down will impact upon the economy in three different ways.
1. The rate of home equity extraction will fall significantly, thus depressing the growth rate of consumption.
2. The drop in construction starts alone could depress GDP growth by over 1% during the next four quarters.
3. The Fed’s interest rate hikes will increase borrowing costs for those with variable rate mortgages – as will the kicking-in of higher optional mortgage rates between 2007 and 2008. Higher borrowing costs are projected to impact $1 trillion of mortgages this year and $1.8 trillion in 2007.
Of this essay, in our opinion, the most insightful observations concern the “Transformation of the Wealth Effect” which, below, we reproduce using his words.
What makes an analysis of all this so difficult is the transformation of the housing wealth effect that we are witnessing. Traditionally, when a family’s net worth changed by $100 (in financial or housing assets), the impact on spending was about $3.50. this is the so-called ‘wealth effect’ or the marginal propensity to consume out of wealth. In distinction to this very small 3.5% multiplier, the impact of a change in income of $100 was traditionally in the range of $95. That is, the marginal propensity to consume out of income was 95% – as large as the wealth multiplier was small.
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In this regard, it is our view that we are witnessing a morphing of the traditional housing market wealth effect into an income effect. People view changes in the value of their home the way they view a Christmas bonus. In both cases, they can now cash in the bonus and spend it. Moreover, the habit is infectious! In the past, such behavior was neither sociologically acceptable nor technologically feasible in the case of rising house prices.
If our view is correct, then the impact on consumption and the economy of a given change in household wealth will be very much greater than in the past. For readers familiar with past SED analyses of the increased stability of Main Street during the 20th century, this development points in the opposite direction: It represents one of the few ways in which spending on Main Street may be more unstable than in the past, since a given change in housing wealth now has a much greater impact on spending than before.
The uncertainty we now confront about the impact of housing on the economy stems from precisely these developments. We are skating on very thin ice, and history offers little guidance as to what to expect.
If US consumers cease to be the engine of economic growth, then many are hoping that capital spending by companies will save the day. On this point, he says the outlook for business spending is more pessimistic than expected given dimming economic prospects, and given squeezed profit margins due to rising labour and energy costs. The unwarranted prediction that capital spending would magically carry the economy forward because many companies were flush with cash is proving wrong.
He concludes this essay as follows:
Given all these considerations, we foresee US GDP growth decelerating to 0.5%-2.5% by year-end, and continuing to be weak through the first half of 2007. Everything will depend upon what happens to housing and its impact on consumption. We stress that the ‘income effect’ of house price changes identified above is new, and thus a very wide range of uncertainty must attach to any forecast. A full-fledged recession with two or more quarters of negative growth cannot be ruled out, although we deem this unlikely. Yet we are currently more bearish than the consensus.
Woody Brock is an economist of independent thought who is always ready to stand outside of consensus thinking. His analysis, particularly of the ‘wealth effect’ is, we think, quite brilliant and fresh. Many have referred to equity withdrawal as a form of cash withdrawal from a hole-in-the-wall, he has taken that concept a stage further. US consumers have forgotten the difference between the wealth that arises from a surplus of income over expenditure and wealth that arises from the embracing of debt, that debt has been used as if it were surplus income.
The ultimate consequences for deluded consumers could turn out to be more painful for the US economy than anyone today thinks possible. Those chickens are currently coming home to roost big time and the world needs to watch out for what follows.
By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.
For more from RHAM, visit https://www.rhasset.co.uk/