RUDE AWAKENING

*(look for Sat Morning Post sometime tomorrow)

BEST OF KURT RICHEBACHER
August 8, 2006
A RUDE AWAKENING AHEAD
Pundits worldwide are pondering what is irking the American investor. Is he scared of rising inflation and interest rates? Or is he scared of Fed overkill and weaker economic growth?
We have no idea what people in general are thinking or expecting. But what we have been reading until quite recently suggests to us the complete absence of any serious concern about the U.S. economy. Forecasts even from the international organizations envision economic growth above 3% as far as the eye can see. Some admit the probability of a little slowing in the second quarter, but after that, it is off to the races again. There is no talk even of a soft landing, because nobody sees any serious slowdown of the economy in the first place.
Economic data are, admittedly, mixed. So they certainly appear to most people. Not to us, though. Recent data have shown a sharp slowdown in economic activity in conjunction with continued acceleration in inflation. For the CPI, the annual inflation rate reported for May surged to 4.2%, from 3.6% in April. Focusing on the most important aggregates, we observe a distinct downshift in economic growth now in its third or fourth month, and accelerating.
Manifestly, these most important components are consumer spending, employment, income growth, residential building and asset prices.
In the last letter, we expressed the view that a recession and a bear market in asset prices are inevitable for the U.S. economy. It goes without saying that this will have very serious consequences for the rest of the world. Recent economic data leave no doubt that both are on their way. What keeps triggering rebounds in U.S. stocks is only the "bad news is good news" syndrome, reflecting the hope that economic weakness will stop the Fed’s rate hikes.
During the last three months, March–May, for which full data are available, consumer spending has risen 0.3% (1.2% annualized). Reported retail sales for June are down 0.1% before inflation adjustment. Year over year, they increased 5.7% before and 1.4% after inflation.
Nonfarm payrolls grew in the second quarter by 108,000 per month, well off the first quarter’s 176,000. It was the slowest quarter since Q3 2003, when the economy finally pulled out of the jobless recovery. The private sector added only 86,000 new jobs during the quarter.
Residential building contributed 0.38 percentage points to real GDP growth during the last two quarters (Q4 2005–Q1 2006). This compares with 1.18 percentage points in the first half of 2005. Consider that building has the highest multiplier effects, generating jobs and additional spending. Retail trade and residential building together account for 75% of GDP.
It is no secret what has mainly pulled the U.S. economy out of its 2001 recession. The Greenspan Fed succeeded in offsetting the depressive impact of plunging stock prices and business investment on the economy by inflating house prices, which lubricated an unprecedented consumer borrowing-and-spending binge. For the first time in history, a central bank systematically engineered an asset and credit bubble for the explicit purpose of precipitating economic growth.
"Asset-driven" economic growth became the new conventional label for this new pattern of growth. Policymakers and quite a few others have apparently come to appreciate it as a valid alternative to the traditional income-driven economic growth. It is not. It is the road into the next asset bust.
Appearances of a few years are deceptive. Asset-driven economic growth is a badly flawed and dangerous alternative for two reasons: First, asset prices cannot rise in perpetuity; and second, it involves exorbitant credit and debt growth, lured by the rising asset prices and excessively optimistic expectations.
Growth by way of the old-fashioned business cycle never ended, because it was self-sustaining. Bubble-driven growth invariably ends when asset prices stop rising. In the U.S. case of the late 1920s and Japan’s case of the late 1980s, asset prices collapsed, with huge damage to the balance sheets of banks, firms and private households…….
It is by now a moot question whether the U.S. economy will slow down. It is happening, and at a pretty fast clip. Most important aggregates — employment, retail sales and housing starts — are generating solid recession warnings. Firing people is apparently the first response by businesses. Over the past three months, private sector job gains were 44% below the average monthly gains in 2005. Recall it was a labor-intensive bubble.
Most people, apparently, expect a brief, mild economic downturn, followed by a quick economic rebound. First of all, the high inflation rates are sure to put considerable restraint on the Fed’s easing.
But what are the demand components that will probably respond to the new easing? After so many years of prior spending excess and, moreover, asset prices in a sharp fall, the consumer is sure to retrench. Nor is there, for sure, pent-up demand in residential building. There is talk of pent-up demand in business fixed investment. We see mostly companies, which appear to have a strong preference for mergers, acquisitions and stock buybacks, boosting shareholder value. In short, the U.S. economy’s rebound after a brief "pause" is an illusion.
There will be a rude awakening.