The Race is On – Why U, V, W is Not Important

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Although you probably won’t hear this from the economic analysis or similar palaver at your quarterly investment manager meetings, the crucial issue facing the US economy today is not the letter of the recovery. In fact, you may feel like your friendly economist is telling you that the economy is brought to you by a letter, U, V, W, much like an old Sesame Street episode.

But, the sad truth is that the US economy is facing a series of races between desirable and undesirable outcomes.

Submitted for your approval, here are a few inconvenient, yet likely truths.

1 – We are saddled with large zombie banks focused on drinking the blood of risk free net interest margin (between US Treasury purchases and zero cost reserves provided by the Fed) at no additional cost of required capital. This blood is important for the ongoing existence of most of the zombies (who try not to act like banks by earning net interest margin on the difference between loan and deposit rates).

These zombie banks realize they will slowly be losing body parts in the form of credit losses. Those losses are hidden from sight due to loosened accounting rules, but they will eventually surface. And when the do, look out. In fact, soon, the FASB may require many SIVs and the like be put back on the balance sheet of sponsoring banks. Ouch!

So, the question here is which zombie banks will get enough blood to offset credit losses and at what rate. Thus, ‘more blood’ is the refrain from these zombies and the US Government is obliging.

The race is on.

2 – In response to the ‘Greatest Deleveraging in the History of the World’, the US Government has responded with the ‘Greatest Releveraging in the History of the World’. Add the increase in fiscal debt with the increase in monetary debt (Federal Reserve) to increased indirect and direct guarantees (FNMA, FHLMC, GNMA, FDIC) and there is little wonder why the economy is recovering.

The Government can not only ‘print money’ (mainly in the form of bank reserves right now), but they can ‘encourage’ bank purchases of US Treasuries to bridge the divide of a record fiscal deficit by providing zero percent (reserve) financing at the Federal Reserve.

However, US Government actions are subject to public scrutiny and therein lies the rub.

The Federal Reserve was designed to be independent of the US Government (including the US Treasury) and acted as such for decades. However, the actions noted above call this into question. I recently read an article about China’s ‘bubble economy’ and how a key for future Chinese economic growth will be the development of an independent monetary authority. Undoubtedly, the same could be said for the US.

And, one wonders how a possible next stimulus bill (it may not be called that from a political perspective), or added funding for the FDIC, or a bailout of the FHA/VA, etc, will be received by a wary public.

It should be noted that the on again, off again economic recovery during Japan’s lost decade was occasionally thwarted by those who felt the prior stimulus was ‘working’, so why vote for another one. It should also be noted that during the Great Depression, FDR’s calls for more aid for the unemployed was met with cries of concern about people just deciding to go ‘on the dole’. So, there is history on the side of those who think the releveraging of the US Government cannot continue unabated.

Of course, a growing economy can make the size of the deficit, national debt and even the Fed’s bloated balance sheet seem a lot more reasonable.

Thus, the race is on between economic growth (and it is on the way in a big way, per the reliable Economic Cycle Research Institute) and the limits to growth of the ‘greatest releveraging’ of the US Government.

3 – Most sentient economists believe that ‘sustainable growth’ of the US economy will not come from releveraging, but from remixing the components of GDP. Decreased participation from consumers would be offset by increased participation from net exports (now a negative contributor to GDP). However, changing the US from a net consumer of foreign goods and services to net producer of such is no easy task.

Thus, step one is the slow downward glide of the US dollar (despite its recent rally), including increased pressure on countries with currencies tied to the USD (aka China). However, declining currency valuations can also mean eventual inflationary pressures.

So, the race is on between a declining dollar, fewer net exports and incipient inflation.

The discussion of whether this economy is brought to you by the letter U, V and W is truly not the point. The key point is how these races are won and lost, and how they will impact each other as well as many other segments of the economy. A careful consideration of each will assist all investors in determining how best to position their portfolios.

Always contact a professional before acting on any recommendations or opinions noted in this article.

Source by Alton Cogert

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