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Economics: Still in the Lead?
New York: November 27, 2006
By John R. Stephenson

Is the U.S. still supreme? Perhaps, but it may be losing its preeminence. Without doubt, the U.S. capital markets reign supreme, and thankfully so, as a raft of problems seems to be besetting us lately that could cause us to lose economic and world leadership. Among the concerns keeping economists up late at night, are a housing bubble that threatens our economy and a current account deficit (exports minus imports) that threatens the strength of our dollar.

But isn't it different this time? Maybe, but it's hard to see how things can be all that different this time around. For those who are true believers, the case is simple. We live in an increasingly global and inter-dependent world. In other words, while we may be facing a raft of problems that threaten our economic health, the rest of the world is as dependent on our well being as we are. The Asian nations, particularly China, need us as much as we need them. Or so the thinking goes.

The growing trade deficit (exports minus imports) isn't such a problem because it is mainly in the form of imported goods from Asia and energy. China and the rest of Asia need our markets to keep their economies growing and they are more than willing to buy boatloads of our treasury bills as credit for the exchange.

Never mind that the current account deficit is at record levels (soon to be 8% of GDP), which in the past has signaled a major correction in the currency. The reason? Like anyone who uses too much credit, countries that spend more than then earn become a credit risk. Riskier credits get downgraded and soon the currency takes a tumble.

In every other country where the trade deficit has climbed between 5 and 6 percent of GDP, a major correction (around 30% on average) has occurred. We are at 8 percent. Making matters worse is the fallacy that Asia needs us as much as we need them. U.S. exports account for a paltry 7 percent of Chinese GDP, which means that we need them quite a bit more than they need us.

Nonetheless, the game should continue for a little while yet. It just isn't in anyone's interest for it to stop. China and the rest of Asia will keep the game going for a while, or at least until they have developed consumer markets of their own. Over time, the world will come to the realization that they are awash in dollars and eventually they will sell dollars sending gold prices higher and dollars lower.

Of course, the U.S. is still the leading financier to the world. Our stock and bond markets are the most liquid, followed the most closely and in times of trouble they are the world's safe haven. Or are they?

Figure 1:Share of Worldwide Debt Issuance

The roaring Eurozone, as well as strong economic growth from Asia and restrictive listing requirements at home in the form of Sarbanes-Oxley, has meant that increasingly, the U.S. capital markets are not the most favored capital markets in the world. In terms of corporate debt issuance, once the near exclusive domain of the U.S. capital markets, have been falling steadily while the share of corporate debt issues floated in Europe has been rising. Not only that, but initial public offerings ("IPOs") of equity capital have been faltering of late, and Hong Kong is running neck and neck with the U.S. in terms of IPOs.

Strong growth in Europe and Asia, coupled with favorable regulatory regimes is behind this trend. Lately, the London Stock Exchange ("LSE") has seen an explosion in terms of listings as their more favorable listing requirements have made it attractive for firms of all stripes to list in the U.K. rather than raise capital in the U.S.

Figure 2: Share of Worldwide IPO Proceeds

If this trend continues, it could be bad news for the U.S. economy as the ability to raise capital easily underscores our economic growth. If the U.S. stock markets become overly burdensome and as a result companies prefer to list elsewhere, the U.S. will have been dealt a serious blow in terms of economic leadership. Strong, efficient capital markets have been the hallmark of U.S. economic leadership over the last fifty years.

Adding to the worry is the housing market. I am convinced that a housing bubble not only exists but also will likely burst with massive implications both here and abroad. This housing bubble is nationwide and has been driven by declining mortgage rates; loose lending practices and unrealistically high home appraisals.

From their peak in June 2005 through September 2006, existing single-family house sales have fallen 14% while prices have declined 4.6%. Making matters worse, is the rise in speculative activity, which has peaked of late. According to the National Association of Realtors, 28% of all home purchases in 2005 were for investment purposes (speculation) and 12% were for vacation homes (a total of 40%).

As house prices start to nosedive, speculators will be the first to give up their dreams of riches. Already, there is evidence that this could be occurring. In Massachusetts, the median single-family prices fell 8.3% in September from a year ago. Speculators are the most vulnerable to declining prices, since they've been banking on just the opposite. Rent alone can in no way compensate for the cost of carrying the taxes, mortgage and ongoing maintenance. If house prices start to tumble, look for speculators in your neighborhood to exit stage left.

The real trouble that the speculators will cause is a huge overhang of housing inventory for the 60 percent of homes that are owner occupied. With more housing on the market at lower and lower prices, prices on owner occupied homes will start to come under pressure.

The group in society that will be hardest hit will be those who can least afford it. Looser credit standards over the last few years have resulted in an explosion of mortgages to people with sub-prime credit. Adjustable rate mortgages ("ARMs") have burst on the scene allowing people who previously wouldn't qualify for a mortgage to become homeowners. According to the latest statistics, interest only adjustable rate mortgages accounted for 17 percent of all home mortgages in the first half of 2006.

Approximately 60% of subprime ARMs issued since 2004 have fixed interest rates for two years and float for 28 years thereafter. Making matters worse is that most of the subprime borrowers are especially stretched to meet monthly mortgage payments with little financial resources to fall back upon should they lose their jobs. Most are spending about 40% of their incomes (up substantially from traditional lending practices of 25%) on mortgage debt service. With rates about to leap higher, not lower, a perfect storm is brewing in the subprime sector of the housing market.

Adding to the concern is the fact that many Americans have been using their house as an ATM. The Federal Reserve estimates that last year, Americans took some $719 billion out of their houses and spent it on goods and services. Housing has become the Achilles heel of the U.S. economy.

As the U.S. economy reels from the bursting of the housing bubble and the staggering indebtedness from the current account, look for the currency to falter. This is good for gold prices which should continue to move higher. With economic headwinds on the horizon, investors should look to play great defense rather than offense. The play? Concentrate on holding great dividend paying stocks of companies that have a good history of increasing their dividend in the last five years or more. Utilities, financials and consumer staples are the segments of the market that should outperform in the years ahead.

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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