Nattering Nabos of Negativity

The United States economy is quite confusing right now. As those of you who read this blog know, I'm quite negative on the economy. But the economic numbers continue to look really good? The most recent GDP numbers, the measure of overall economic output, showed an amazing 4.3% growth in the last quarter. Yet, consumer pessimism remains at unprecidented high levels. So what's the deal? Why this disconnect?

From The Big Picture, we get an excellent overview of a typical economic recovery:

In a typical healthy recovery, Government spending often leads the way as we come out of the bottom of a recession. Pent up consumer demand then takes over, as shoppers re-emerge from their self-imposed frugality and begin spending again. Businesses ramps up their CapEx [capital] Spending and Hiring to meet this new demand. This begets a virtuous cycle that runs on until it eventually shows signs of overheating, which begets Fed rate hikes, which (typically) go too far and cause the next recession. Then the cycle starts over again.

We've recently had many Fed rate hikes. Thus far, the economy doesn't seem to show any signs of being slowed by these hikes, although the housing market has seemed to slow significantly. However, consumer confidence during this particular time in the cycle is usually great (consumer perception usually is behind reality). The Big Picture continues:

The present cycle has not followed the script. As outlined in the Cleveland Fed's Economic Trends (November 2005, p. 12) the sectors contributing to GDP growth are rather atypical at this stage of a recovery. Personal consumption continues to increase - despite a decrease in real income and a negative savings rate. Nominal personal saving was a negative $133B in Q3 (that's a -1.5% savings rate); the U.S. consumer's spending via debt and savings amounted to an additional 1.4% nominal GDP. Without that profligacy, GDP would have been more like 2.9%. That a third of GDP is based upon consumer borrowing is hardly a sign of healthy, sustainable economic growth.

Put simply, consumers are borrowing like crazy (despite their negativity) to continue spending on really really important items....like X-boxes. Let me emphasize what is said above. A full 1.4% of all GDP is made up of consumer spending done on credit, likely using home equity as an ATM. That can't keep up forever. I suspect that the disconnect between consumers spending, and the perception of negativity is because the credit is coming in the form of long term home loans (what, me worry?). And, consumer's know where the money is coming from.

There's also this:

Despite some rumors to the contrary, Business Fixed Investment also decreased last quarter. At the same time, government spending is still accelerating. And we all know how significant Residential investment has been to the economy - its begun to cool in earnest in Q3. Surprisingly, 4 years into this recovery, GDP growth it is not a function of increasing corporate CapEx. GDP strength is coming largely from real estate driven consumer borrowing and spending, and from Government deficit spending (more borrowing and spending).

Businesses are not spending on capital improvement. The housing bubble is over and flattening, if not declining. And as we all know, government spending is out of control. Essentially, the current GDP success is built on a very temporary house of cards.

Will the economy collapse tomorrow? Probably not. But it is impossible for the massive economy of the United States to continue to be built on credit. The longer is persists, the more drastic the correction is likely to be.

And a little personal anecdotal evidence.

I subscribe to a famous, and highly successful, investment advisor's newsletter. He continues to be bullish on the stock market, a proxy for the economy. However, even this dyed-in-the-wool conservative thinks that the current bull market in the economy is a temporary upswing in an otherwise down market. In other words, we are in the middle of a very long term bear (going down) stock market, with a brief (several years) period of a bull market (going up). If, indeed, the stock market is a proxy for the economy, even this conservative investors sees the long-term prospects for the United States economy as being poor.

This is a good time for individuals (despite Bush's speeches) to be saving, paying off credit, and for conservative investing assuming you even have anything left over to save.