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The US Dilemma
Perspective | 14 March 2011
By: Andy Chiok
Articles (1) Profile

The Russell 2000 Index, consisting of stocks with a median market value of USD528.5 million, has risen 25 percent in 2010 and has yielded 3.34 percent to date. Similarly, the S&P 500 has chalked an increase of 12 percent for the same period last year and to date, is close to doubling since the low in 2009.

Every money manager is trumpeting the “slow but definite” recovery of the US economy. Even Bernanke is cautiously optimistic about it. “The economic recovery… appears to have strengthened in recent months, although, to date, growth has not been fast enough to bring about a significant improvement in thelabour market,” he is quoted by AFP.

How seriously is the US in staging a comeback? Recent data seems to be pointing to an increase in both the consumer price index and manufacturing activity. Sani Hamid, Chief Executive of Financial Alliance shares his views on the US economy:

SI: The US economy will not recover unless housing recovers.

“While it is likely that this could be the case, it is not a pre-requisite for a recovery.”

“The financial crisis has left individuals laden with large amounts of debt. Corporations, however, are in a much better position given the bail outs and various schemes introduced to help them tide through the crisis. The excess liquidity being injected into the system has also found its way into corporate balance sheets. As confidence returns you will see these excess cash being deployed in terms of capital expenditure or even new hires. This will likely aid an economic recovery albeit a slower one given that it will be corporate spending led rather than consumer spending-led.”

SI: The US is caught in a liquidity trap?

“It is probably fair to say that the US is caught in a short-term liquidity trap. However this is understandable given that it has been a financial crisis which has decimated the balance sheets of consumers. It will take some time for them to rebuild their confidence and be able to spend again. It will probably be a genuine liquidity trap if the consumers’ reluctance to spend continues for another year or so even after their balance sheets are repaired. That’s when it becomes apparent that the loss in confidence of the US consumer is resulting in a more permanent liquidity trap.”

SI: The US economy is running on the stock market. Wealth is not being re-distributed. Luxury items, rather than goods for the common folks, are driving sales.

“At this juncture, this phenomena is being experienced across many asset classes. For instance, while new home sales tumble to multi decade lows, sales for homes above USD 1 million are holding up very well. This is due to the availability of large amounts of liquidity, most of which sits with high net worth individuals and corporates. Eventually, economics tells you that there will be a redistribution of wealth to the middle class, for instance the trickle-down effect from high–end transactions.”

SI: The US is forced to raise rates or worse yet, finds itself in a stagflation.

“The US Feds will likely keep rates low until it is confident that the economy can stand on its own two feet. Ironically it is likely to welcome inflation for the fact that deflation is a worst scourge to fight. Stagflation is a possibility if the US is forced to raise rates before the economy is ready. This could happen if there is a

loss of confidence in the USD as the world’s reserve currency or if the rest of the world demands a higher premium for holding US debt.”

Don’t touch that champagne yet!

Before you bring out the champagne and start popping it, consider this:

The US current account deficit for third quarter 2010 stands at USD127.2 billion (preliminary). This has been the fifth consecutive increase since the second quarter of 2009 (deficit of USD84.4 billion). At the rate that the economy is going and with the possibility of another round of Quantitative Easing, this figure looks like it is going higher.

Just like a balloon that is being pumped with more air than it can be stretched to hold, there will come a time when the situation will ‘burst’. Having cheap money floating around will only exacerbate the situation. The US cannot afford to sweep everything under the rug any longer. One of the biggest issues it has to tackle is unemployment.

The US unemployment rate for the month of January 2011 stands at 9 percent. According to the Labour Department, the economy has added 36,000 non-farm jobs, far short of the 148,000 expected by analysts. When a nation has to grapple with unemployment, its receipts (in the form of taxes) will decrease while expenses (unemployment benefits, for instance) will go up. Furthermore, the unemployed will not be spending in an economy that is two-thirds driven by consumption. Ben Bernanke, the Federal Reserves Chairman, has told the US House Budget Committee that the unemployment rate will be likely to remain high for some time. So don’t bet on any miracles in the near future.

Economics also tells us that when unemployment is high, inflation, or interest rates, will be low. And this is precisely what the Fed is trying to raise. As it is, the Fed is concerned that consumer inflation is still below its annual target of 1.6 to 2 percent.

The diseased housing market is another area that needs attention. It is fair to assume that the home is the largest and probably the only investment for most US citizens – working class and otherwise. When the value of that investment plummets, net worth of the individual will suffer. Consumer confidence and consumption will be affected when personal balance sheets get hit. Maybe this is the reason why retail sales are stagnating and only the luxury items are moving (the rich, being less affected and probably better-off because of the rise in stock prices, are not really being affected). Combine this with the unemployment situation and there will be a mammoth of a problem for Obama to solve.

Notwithstanding the rise in global equity, the fundamentals of the US economy simply do not justify a rebound of the current magnitude. Allianz Global Investors in an email to clients has cautioned about an ‘overbought’ situation. “The more pronounced optimism is, the higher is the probability of a disappointment. With each climb, the air seems to be getting thinner and the risk of short term profit-taking seems to be increasing,”it says.

Though he is not bearish, Sani does agree that the US is not in the best of health. He believes that the US and Europe will remain vulnerable to shocks because their governments are laden with massive amounts of debt – which leads to the inability to pump prime the economy in the future should a crisis occur. “All this printing of money has worked for now, but it will take another crisis to deflate whatever confidence that people have with respect to countries who try to inflate their way out of trouble,” he says.

Currently a communications specialist, Andy has also spent 15 years in banking & finance dealing with derivatives, FX, Equities, and Wealth Management. He is a Certified Financial Planner (CFP) and holds an MBA from South Australia. Andrew also has a professional diploma in banking & finance from the Institute of Banking & Finance.

Please click here for more information about this author.

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