DEFICITS, THE DOLLAR, AND A BARREL OF OIL 8/25/2008

Rarely have we seen a time when there were so many obvious influences on the various financial markets than we’re experiencing right now.   When one stops and considers the impact of real estate, construction, energy, hurricane season, international conflicts, elections, credit, inflation, trade deficits, taxes, domestic economic growth, employment… it’s enough to give you a headache.  It has given you a headache.   In truth, it’s not that there are any more areas of focus for the economy today than at any other time, but elements in the economy are so clearly publicized today, and there are so many more people talking about them, that it raises the collective awareness level.  So… here are a few comments regarding some of the more impactful economic topics that we knew you just couldn’t live without:

The US Dollar has gained considerable strength over the last six weeks, though some pull back a few days ago.  Gold, oil, international trade, etc. have benefited by the improved dollar, and our economy will see meaningful improvements as a result.  But a strong dollar also means that it costs other countries more to purchase US goods and services – it also means that other countries will continue to search for capital investment opportunities in the US.

The US trade deficit has begun to decrease.  This seems like better news than it is, by the way.  The dollar value of goods we import has begun to decrease as the dollar has gained strength in recent months.  Conversely, the dollar value of goods we export has increased, bringing the trade deficit to lower levels.  The cost of oil is a major part of this; the price of oil is decreasing at the same time that we’re using less of it - this has had a positive impact on the trade deficit.  That’s only part of the story, and it’s largely the good part.  The bad news is that we’re also importing less because we’re consuming less.  At the same time, other countries are beginning to feel the effect of their own economic slow down and they’re beginning to purchase fewer US goods and services.  As the dollar strengthens and the US economy picks up pace in 2009, we’ll still have a substantial trade deficit, but we’ll be grateful for it.

Credit remains inexpensive, 30-year home mortgage rates hover at around 6.4%, but it is increasingly but hard to get.  All the talk of financial difficulties for Fannie Mae and Freddie Mac have only made this situation more difficult.  One of the biggest problems primary lenders have faced is that of maintaining capitalization requirements.  As the collateral value of loan portfolios has softened, it has had a chilling effect on the ability to extend additional loans, so banks are having to be more particular about who they extend loans to in order to not risk making the problem worse.    

Inflation appears to have peaked in July at uncomfortably high levels, though still low compared to many other important international economies - China, Brazil, and much of Europe support inflation in excess of 8% - and other periods of domestic economic uncertainty - think late 1970’s and early 1980’s.  Bernanke’s comments from Jackson Hole last week support the data suggesting that July represented a peak in inflation and that increasing price levels have begun to ‘cool’.  This was to be expected; personal incomes, adjusted for inflation, have decreased and while that’s bad news in the near term, it will help ward off a sustained inflation trend.  As consumers make alternative choices with their purchasing dollars, price increases begin to subside – this is clearly evidenced in the recent pull back in energy costs.  Inflation cannot be sustained without a substantial increase in personal income.  As the dust settles and we see the real relationship between personal income, energy costs, and inflation during this difficult period, we’ll likely see that it was only a short-term, though intense, inflation period that reduced the strength of personal incomes.

In 2004 and 2006, the US electorate ceded control of the house and senate to the Democratic Party, largely due to the unpopularity of the Iraq conflict and out of control spending.  In spite of promises to reign in that spending, our federal deficits have mushroomed to intolerable levels.  Many blame this increase on US military expenditures, but it’s just not that easy.  In his July 30, 2008 issue of Tea Leaves, Jeff Thredgold writes, ‘While the projected $482 billion deficit would be a record as measured in dollars, it would be something less when compared against the enormous American economy. A $482 billion deficit would be roughly 3.2% of annual U.S. economic output (GDP) likely to exceed $15 trillion next year. Such a deficit would slightly exceed the average deficit of the past 40 years.  The current record is a deficit of $413 billion in fiscal year 2004, while deficits approached 6.0% of GDP at times during the 1980s and 1990s.’

Oil prices, though somewhat expanded earlier this week, are well below their early July highs – by some 20%.  There is considerable disagreement over whether this is a sustainable pull back or simply a short term breather.  We expect to see oil at $100 per barrel or less in the coming months.  The retraction in demand is now evident across the globe, first in the US and now in consumption heavy China and India – people simply can’t sustain their former consumption trends with energy prices at all time highs.  At the same time, there is evidence that the speculation has voluntarily decreased and allowed a calming trend to occur.

I strive to stay as far away from politics as possible.  While I’m more conservative than liberal, like many, I eschew the republican or democrat labels.  If there was a ‘throw the bums out’ party I might actually offer it financial support.  State and Federal Taxes are a burden, plain and simple.  Though we should each bear our respective burdens, it is counter productive to begin shifting burdens from one part of the population to another simply because they appear as though they can handle it.  The unexpected slowdowns and stress that results can be catastrophic and this is exactly the fear many have relative to greater democratic control of the house, senate, and possibly the executive branch.  That said, I thought Steve Forbes’ comments in the ‘Fact and Comment’ section of the September 1, 2008 Forbes Magazine was excellent.  Under the title, ‘Truly Toxic Tax Boost’ he discussed what happens when politicians get creative with the tax structure.  It was followed up by a reprinted  Investors Daily article under the title, ‘A New (Raw) Deal’, and by another editorial written by Paul Johnson under the ‘Current Events’ moniker.  To see Forbes’ comments and the Investor’s Daily piece open the attached articles – they’re worth reading.

Finally, and perhaps on a lighter note, The Salt Lake Valley Parade of homes ended its run last weekend.  For those that participated in the parade, there was little sign of a weak housing market.  Many of the homes were, in a word, opulent!  One realtor present at a particularly posh home in South Jordan approached me with the following question, ‘Do you want to drive the Mazzeratti or the Lamborghini?’  Both were being offered as part of the package for the right home buyer.  Oh well…

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