When Confidence Fails

For the better part of three years now, we have seen the impact of the fearless and resilient American consumer. Given access to abundant and easy credit, and encouraged by a host of government and business officials, the American consumer has supported not only the U.S. economy but also the world economy. We have wondered for some time now, just how long this can go on, when and how the borrowing and spending might slow, and what the fall-out might be.

We may start getting some of these answers at around the end of the year.

Some argue that the borrowing and spending never has to stop, that debt and deficits don't matter. We will see. It seems that in the long run, debt and deficits do matter, or at least they should - that it's really just a matter of how long the long run really is. Surely, it is not nearly as long as it was when the nation first charted this course of debt and consumption during the Reagan administration, guided by the steady hand of Fed Chairman Alan Greenspan.

Stephen Roach frequently refers to the American consumer as "savings-short" and "asset-dependent". It seems many are hooked on easy credit, low monthly payments, and rising asset prices. The rising asset prices enable more credit, which in turn enables continued consumption, and all the while many believe that this is just the way that things work, that somehow Americans are special.

At the same time that they borrow and consume, the American consumer maintains supreme confidence in the fundamental soundness of the economy. Unwavering confidence in the rightness of what they do and the ability to continue doing it.

But the vast majority of American consumers do not look beneath the surface. They have not the time, inclination, or in many cases the ability to scratch at the shiny exterior - to question what they are told about our collective economic well-being. They do not wonder about low unemployment rates when jobs seem scarce, they feel comfortable with the levels of debt they carry because they are told that it is OK. They do not question the official economic statistics and pronouncements. Perhaps too many people have too much confidence in our economy, and maybe we are all a bit too giddy about the rising value our homes.

It is natural to wonder how easily this confidence might be shaken, or what would happen when confidence fails.

We don't make predictions here - we learned our lesson a few years back when assessing the prospects of the U.S. economy in the aftermath of the bursting of the stock market bubble. We were little aware of the lengths to which central banks, government fiscal policy, and lenders would go to inflate another asset bubble, which by most accounts is much more dangerous than the one it replaced.

Absent predictions, we simply note an intriguing set of events and trends, all of which seem to be converging in time at around the end of the year. These events and trends have the potential to shake the confidence of the American consumer like it hasn't been shaken in quite a while. The fundamental soundness of the economy may be brought into question.

Today we mention these events and trends briefly (in no particular order). We will return to this list, filling in details as necessary over the coming weeks and months.

Derivatives

We mention this first only because of this news yesterday. It is not clear what this all means, but if Warren Buffet calls interest rate derivatives "financial weapons of mass destruction", and now there is concern that "the $8.4 trillion industry is rife with unconfirmed trades", there is potential for disaster. If memory serves, back during the LTCM meltdown, it was several months before details of the LTCM problems became public - yesterday's news may be the beginning of the derivatives disaster of which Mr. Buffet warned, and the full impact may not be known or understood until closer to the end of the year.

Rising Home Inventory and Stalling Home Prices

Inventory continues to build, while volume declines, and prices continue to rise - an indication of the early stages of a stalling real estate market. The yellow line that is the San Diego year-over-year change to median home price will get very interesting in the next few months. On it's current trajectory, it will cross the x-axis of the second graph sometime around November. This should get the attention of most everybody in Southern California, and may dramatically alter the ingrained belief of many that real estate is a safe investment. There are some other aging real estate bubbles around the country which may experience similar trends - San Diego is closest to home, so we follow that one closely.

The New Bankruptcy Bill

The recent rise in bankruptcy filings and the potential for a mad rush to file for bankruptcy in October could have a chilling effect on the confidence that many people have in managing their debt. Many of the provisions of the new law take effect on October 17th and in the coming months there will be a stepped up campaign by bankruptcy professionals on afternoon television and radio to compel individuals to take advantage of this last opportunity to clean up their balance sheet without the pain that will be involved after October 17th.

Rising Oil and Gas Prices

With oil now at $67 a barrel, it may be only a matter of time before economists will no longer be able to calm people's fears by saying that "on an inflation adjusted basis, oil prices would need to hit $90 a barrel to match what they were 25 years ago". With the supply/demand fundamentals that exist today, if there is a supply shock, then $90 oil could become a reality rather quickly. That would translate to about $3.50 per gallon for regular gas , with no assurances that prices would stop there. Without a supply shock, the price of oil may make it to $90 by the end of the year anyway. After a few more months of high gas prices, people may begin to question their consumption habits rather than just shake their heads when they fill up.

Politics and War

Thankfully, these topics are not covered on this blog. We feel obligated to mention them, however, since they have tremendous potential to influence consumer confidence over the course of the next six months.

Higher Short Term Rates

Like the recent rise in gas prices, the rise of short-term interest rates has been like a slow and steady water torture for borrowers servicing home equity lines of credit and other revolving debt. Or perhaps, the better analogy is the boiled frog. Rising short term rates have affected adjustable rate mortgage rates as well, but sadly, it appears that today's wacky lending practices are not nearly as interest rate sensitive, at the margin, as they once were. However, with the Fed Funds rate likely to be at either 4.0% or 4.25% by January, this will have some impact on debt service and home loans in the coming months.

Greenspan Retirement

Maybe the most significant of all trends or events over the next six months is the transition from Alan Greenspan to a new Fed Chairman, scheduled for the end of January. If the White House takes the same approach with this appointment as it has with some others, markets and consumer confidence are sure to be rattled. But, even if the transition goes smoothly, there is still great potential for danger. It was only weeks after Paul Volcker stepped down in 1987 that the Dow dropped precipitously, some 22% in a single day, only to recover gradually and steadily over the following months and years under the watchful eye of the new Fed Chairman. There is a big difference, however, between 1987 and 2005.