Investing in a fool's paradise
By Jephraim P Gundzik
The rapid slowing of America's economy has been shrugged off by stock markets worldwide, which continue to vault higher on the increasingly misplaced notion that corporate profits will grow perpetually.
In sharp contrast, currency markets have grasped the idea that the US economy is falling into recession, punishing the dollar. As economic weakness intensifies in the months ahead, expect
dollar depreciation to accelerate. The dollar is likely to drop by at least 15% against most currencies by the end of 2007.
Cracks in the facade of America’s economy first appeared in early 2006 when the housing market abruptly began to whither. Rather than tightening credit conditions, the housing market’s decline was initiated by plunging affordability of new and existing homes combined with rampant overbuilding across America.
The growing weakness of the housing market was ignored by investors and analysts who assumed that very easy credit conditions engineered by the Federal Reserve would prompt a rebound.
Instead of rebounding, weakness intensified. According to statistics produced by the Department of Commerce, new home sales plunged by 18% in 2006, a decline unmatched since 1981. Though Commerce statistics showed that new home prices edged higher in 2006, this data was greatly distorted by enormous incentives that home builders lavished on buyers, which artificially propped up prices.
Adjusting these statistics for the impact of incentives like free swimming pools, landscaping, custom kitchens and even new cars would show that actual new home prices fell sharply in 2006, an event unprecedented in the US since 1970. As the housing market collapse unfolded in 2006, it was joined by collapsing private investment.
Initially, the collapse of private investment was driven by plummeting residential fixed investment, which was flat in the first quarter but dropped at an annualized rate of 17% during the final three quarters of 2006. The decline of residential fixed investment was the predictable outcome of falling home prices and the subsequent drop in home equity traditionally used to finance such investment.
During the fourth quarter of 2006, nonresidential or business fixed investment also began to weaken, falling by three percent. This sudden decline of business investment signaled that economic weakness emanating from the housing sector had begun to spread throughout the economy. It also signaled that much leaner economic times were close at hand.
Equity investors and analysts universally ignored the obvious weakening of the US economy and its negative implications for global economic growth, relentlessly pushing stock markets around the world to record highs during the final months of 2006 - a trend that has continued during the first four months of 2007.
While stock markets have come to view economic recession as benign, the same is not true for currency markets, which pushed the value of the dollar down against most currencies beginning in late 2006. Dollar weakness has accelerated in the first four months of 2007. The dollar has plummeted to 25-year lows against sterling and has reached record lows against the euro recently.
More broadly, the trade weighted value of the dollar is also falling off a cliff. The Federal Reserve’s Trade Weighted Currency Index dropped to a record low last week, indicating that dollar weakness has become pervasive. Economic statistics showing the US economy weakened further in the first quarter of 2007 were the principal factor prompting renewed downward pressure on the dollar.
From silver to lead lining
Like equity investors, most economists refuse to believe that growing weakness in the economy portends economic recession later in 2007. As of early April, the consensus forecast for US economic growth in 2007 among leading economists was 2.3%-plus. At the same time, less than 25% of economists surveyed expected the economy to fall into recession. Such bewildering optimism has inspired the world’s financial media and fueled stock market advances.
This optimism will fade as America’s very weak economic reality dissipates the clouds on which investors and economists are floating. Last week, several important economic indicators were released all of which showed America’s economy continued to weaken in the first quarter of 2007. Commerce Department statistics showed that new home sales fell by 23% in the first quarter of 2007 compared to the same period in 2006.
Statistics produced by the National Association of Realtors showed a similar decline of existing home sales and sliding home prices. The housing market collapse is prompting a surge in foreclosure filings, which were up 35% in the first quarter of 2007 compared with the same period in 2006. During this period, one of every 264 households in America was under some type of foreclosure. Rapidly rising foreclosures are the main factor undermining America’s besieged subprime mortgage lenders.
Commerce Department statistics on durable goods orders, which showed a rebound of 3.4% in March, impressed investors, prompting a stock market rally. Somehow these investors ignored the fact that this rebound was entirely driven by unusually large orders for aircraft. Unnoticed within these statistics was data showing that business capital spending orders went into freefall, contracting at an annualized rate of over 15% in the first quarter.
The coup de grace of course, was the preliminary estimate of first quarter growth released on Friday. According to the Commerce Department, domestic growth was just 1.3% in the first quarter of 2007. Economists had expected growth to be closer to two percent, revealing again that unfounded and widespread optimism is coloring perceptions. This preliminary estimate of growth will be revised lower as neither private consumption nor business investment was as strong as initially indicated.
With foreclosures and subprime defaults spreading and credit standards tightening across the banking system, a rebound in America’s housing market during 2007 is extremely unlikely. Without a housing market recovery, business investment will continue to decline, prompting layoffs, and much weaker private consumption growth. The probability that the US economy will fall into recession during the second half of 2007 is about 75%.
As the US economy continues to weaken in the months ahead, the dollar’s depreciation will accelerate. A further decline in the value of the dollar of at least 15% against most currencies is likely by the end of 2007. This depreciation is likely to be fed by plunging US equity values as economists are forced to revise their economic growth forecasts much lower and America’s weak economic reality overtakes strong economic dreams.