The Service Based Economic Model Has Failed

The once popular rhetoric of the past decade has turned to a whisper as cracks in our service based economy continue to widen. The dinner bill is due and everyone is trying to pass the check off to the next person as they scramble for the exits. Unfortunately, the years of binging are much more expensive than anyone could have imagined as the sticker shock sets in.

The official March U-3 unemployment rate rose to 8.5% as the U.S. shed another 663,000 jobs in March, roughly in line with estimates. Even more concerning was the large January adjustment, pushing total job losses to 740,000 for the month. It's odd how the current month figures came in so close to estimates while there was such a significant adjustment to the January report. Originally, the BLS estimated that the U.S. "only" lost 598K jobs in its original January release. That's nearly a 24% margin of error from the most recent revision. Would the BLS ever consider transferring job losses to prior months in order to cushion the impact on the markets? I will let you decide for yourself, but I fail to see the point behind releasing a draft report that could include a 24% margin of error. The U-6 unemployment rate, which is far more reflective of reality, soared to 15.6%. As I previously stated, this figure factors in underemployed and marginally attached workers.
http://www.bls.gov/news.release/empsit.t12.htm

Treasury prices fell last week and yields rose to 2.9% on the 10-year note as the market anticipated the U.S. will sell an anticipated $59B in notes this week. Interest rates have climbed back to the levels prior to the Fed's announcement of its treasury purchase program in March. Yields would have risen to well over 3% had it not been for these note purchases. The Treasury has several auctions scheduled for next week, and investors will keep a close eye on the auction results, although the Fed will no doubt provide support in the face of waning foreign demand. Note that the CDS spreads on government issued debt has risen steadily over the past six months as risk is transferred from the private sector to the government with all the bailouts.

I want to take a step back and discuss where I think the general economy is headed over the next several years. Putting the recent equity market rally aside, I have long-term concerns on the U.S. economy. This stance is a matter of common sense and based on the following factors:

1) Slightly less than 70% of the U.S. economy is based on consumer spending. This debt-fueled spending has also supported 25% of the world economy, buoying export countries like China, Japan, and Taiwan. As American consumption increased, productive capacity declined, forcing the government and households to take on more debt to maintain their standard of living. There are more than $5T in outstanding credit lines and $500B was pulled in Q4. Prominent banking analyst, Meredith Whitney, believes that banks could pull more than $2.7T by the end of 2010. With rising unemployment and lower credit availability, it does not take a genius to see where consumer spending is headed over the next year....down.

2) The American standard of living has steadily declined over the past several decades. There are currently 32M people on food stamps in this country, representing over 10% of the population. This is an astonishing number for the largest economy in the world and indicative of a failed system. It was possible in the 1950’s and 1960’s for a factory worker to comfortably support his family on one income alone. Today, that quality manufacturing job has disappeared, while it often takes dual incomes to maintain a similar standard of living. In short, families have to work longer and harder for lower wages as the cost of living skyrockets. This often goes unreported in most media outlets because these fundamental shifts are easy to overlook.

3) Neither the government nor the private sector has come up with a long-term structural solution to resolve the growing trade deficit. The approach has been to throw more debt at the problem just as the economy tries to deleverage. There is a significant difference between this downturn and those in prior cycles. America had a stronger savings rate and manufacturing base to fall back on during the prior postwar recessions. Unfortunately, the spending programs outlined in the stimulus consists of too many one time handouts that add little long-term value to kick start the economy. In other words, this country must make a fundamental shift from over consumption to production, but no administration over the past 20 years has been willing to tackle these serious issues.



4) Putting the credit crisis aside for a moment, the economy was due for a significant correction based on the demographics of the U.S. population. The baby boomers have just surpassed their peak spending years at roughly 48 years of age. This will result in a severe spending slowdown that will dramatically reduce GDP growth for the better part of the next decade. It will not be until the echo boomers reach their peak spending years that you will see a meaningful rebound within the domestic economy.

The questions that bullish money managers and analysts cannot answer should also be the simplest. What will bring the quality jobs back? What catalyst will provide the foundation for a sustained economic recovery as consumers reign in their spending to reduce their debt levels? These are the fundamental questions that bullish analysts continue to dodge. Until these issues are resolved, the economic contraction will not see the bottom.