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Economics: Are we Facing the Perfect Storm?
New York: October 04, 2004
By John R. Stephenson

The past few sessions on Wall Street have shown something quite remarkable — a rally. All of this in spite of some news that should have sent stock traders running for cover. Oil closed above $50/barrel and the latest fiasco to hit Wall Street — a scandal involving the accounting at Fannie Mae (a quasi-governmental organization that holds about a trillion dollars worth of mortgages). Adding to the strain is the ever-increasing debt burden that we have hoisted on taxpayers in the form of a massive current account deficit (exports minus imports) and a huge governmental debt. As well, house prices have been on a tear lately, rising three times faster than incomes over the past four years. Can all of this be sustained taking stock markets ever higher? Probably not.

The likelihood is that we are on a collision course with an economic disaster. There may well come a time where we can no longer keep all the balls in the air. The reason for all the doom and gloom ? We are living well beyond our means. As Stephen Roach, Morgan Stanley's chief economist writes: "The United States — long the main engine of global growth and finance — has squandered its domestic saving and is now drawing freely on the rest of the world's saving pool… East Asian central banks — especially those in Japan and China — have become America's financiers of last resort. But in doing so, they are subjecting their own economies to mounting strains and increasingly serious risk." But just how bad is the current situation?

The U.S. consumer, who has been the engine of global economic growth, has taken his/her personal savings rate down (as last measured in July) to a paltry 0.6%. To maintain economic growth, the U.S. is using up some 80% of the world's surplus savings to finance excess consumption by American consumers and open-ended government budget deficits. The U.S. used to be the world's largest creditor nation and in 1980, the United States had a net international investment surplus of $360 billion. But by the end of 2003, that surplus had been transformed to a deficit of negative $2.4 trillion, or 24% of GDP.

This transformation from the world's greatest creditor nation to the world's largest debtor nation is in large part due to the ever-widening current account deficits (a nation's exports less imports). The problem of a growing current account deficit appears to be picking up steam as the trade gap has widened from 4.5% of GDP at the end of 2003 to 5.7% of GDP by the middle of this year. The reason for this expansion of the current account deficit? The American consumer is buying a lot more foreign made manufactured items than foreigners are buying our Boeing aircraft or IBM Solutions. The likely victim of a growing current account deficit? The value of the U.S. dollar. A recent study by the U.S. Federal Reserve (U.S. central bank) demonstrated that currencies drop on average by about 30% when trade deficits get to 5% of a country's GDP. Currently, we stand at 5.7% but the dollar so far is down a mere 12% on a trade-weighted basis.

It is impossible to say when the massive debts will collide with the irresistible force of excess spending and the resulting financial reckoning will occur, but at some point, it is certain to occur. With a personal savings rate of just 0.6%, the American consumer can ill afford a fall in real estate prices as has started to occur in the overheated market across the pond. Prices this summer for London flats have fallen by as much as 20% in some locations. Not only is real estate a potential point of vulnerability but oil prices, which are more likely to rise than to fall, could be another. Also, the war in Iraq has been a huge drag on the U.S. government's finances with no end in sight. Throw in a massive government bailout of Fannie Mae all at a time when the overall economy appears to be weak and you might have the recipe for a perfect economic storm.

The party will likely come to a crashing halt when China and Japan stop enabling America's credit habit. When that occurs, asset prices will fall, real interest rates will rise and people will be poorer. Eventually, America will run out of time, out of money or out of luck.

So what's a savvy investor to do? Load up on things that will do well if the dollar tanks as most market observers believe it will. A likely beneficiary of a weaker U.S. dollar is gold which for centuries has functioned as a currency. It would be wise to consider buying into a gold mutual fund or investing internationally — particularly through a mutual fund that invests in Chinese companies.


StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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