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U.S. economic growth will endure in a deflating world

This morning’s “Daily State” report was penned by Robert Barone (Ph.D., Economics, Georgetown University), a Principal of Universal Value Advisors (UVA) based in Reno, Nevada and a fellow Investment Committee member with Dave Moenning at CONCERT Wealth Management. We are pleased to be able to offer Roberts’s thoughts on the state of the economy this morning. Robert’s firm focuses on core value investing using Benjamin Graham’s “Margin of Safety” approach. We hope you enjoy Roberts’s view on the economy.

In the middle of October, the equity markets became quite volatile, worrying about such things as a growth slowdown in Europe, China and the developed world, the impact of a stronger dollar on multinational corporate earnings, and Ebola, ISIS and other geopolitical issues. The worry was that any one of these could have a negative impact on growth in the U.S.

No doubt external issues, like Ebola, or perhaps another devastating terrorist attack, could derail the current economic upswing. But, absent such an exogenous shock, there is significant evidence that the economic issues mentioned above do not pose a threat to the U.S. economy.

I will take it as a given that the reader is already aware of the significant consumer benefits that lower gasoline prices have ($1+ billion for every penny of decline at the pump), and will add that the strengthening dollar also lowers the prices of imported goods. If these two were the only items underpinning the U.S. consumer and economic growth, then there may be cause for worry. But this is not the case. The fact is, unlike their counterparts in Europe and the rest of the world, the U.S. consumer and the U.S. corporate sector have deleveraged and have capacity to either take on additional debt and/or higher interest rates. And, believe it or not, even the federal government’s debt costs will not be a budgetary constraint in the current rate environment. As a result, it is likely that GDP growth will continue at a fairly brisk pace for the foreseeable future.

The Consumer

As a percent of Disposable Personal Income (DPI), debt service payments (principal and interest) in Q2/2014 were 9.91%, the second lowest level in the history of the series (which began in1980). At its peak in 2007, this ratio was 13.2%. The lowest level, 9.84%, occurred in Q3/2013, and the slight uptrend since is consistent with the large increases in auto sales and revolving credit (credit cards) we have seen in 2014.

In addition, if we only look at the interest portion of debt service payments, in Q2 they stood at a series low of 4.8% of DPI. Recessions don’t occur when consumer debt costs are this low. From this point of view, interest rates can rise 300-400 basis points before the consumer begins to have issues. With the Fed so reluctant to raise interest rates (see below), it appears that the consumer has a lot of capacity to take on additional debt.

The Corporate Sector

The same is true for the non-financial corporate sector. In Q2, the debt/equity ratio of this sector was 33%, down from 73% at the peak of the recession. And the debt service ratio (Net Interest/Pre-tax Income), at 10% is near its 1970 level. It appears that, like the consumer, the corporate sector has a lot of room to leverage at current interest rates.

The Federal Government

That leaves the federal government. Given record deficits not that long ago, it is hard to believe that interest cost as a percentage of the revenue take, 15%, is at a four decade low. A rise in the interest cost of the debt would be required to cause major issues. And, even as rates rise, because of the maturity structure, it will take several years for such costs to permeate the debt structure.

The Fed Looks for Excuses

Of course, rate increases of even up to 300 basis points (3 percentage points) are possible, but they aren’t likely and are certainly not on the horizon. I say that for good reason, as it appears that the Fed continues to look for excuses not to raise interest rates despite a strong economy. Don’t be fooled by the various Fed speakers’ recent emphasis on the potential impacts of a strong dollar on the economy’s future growth. The fact is, the use of labor market “slack” as an excuse not to raise rates has become stale, as the labor market has continued to show significant strength. No doubt, the Fed is looking for new talking points to keep interest rates low.

The newly stated fear is that “deflation” in the rest of the world will find its way to U.S. shores. Yet, despite globalization, the U.S. economy is still a relatively closed economy with exports accounting for about 13% of GDP, the lowest level, by a wide margin, of any developed nation. In fact, a 2008 study done by the New York Fed (Goldberg & Campa, The Sensitivity of the CPI to Exchange Rates…), found that “the United States has the lowest expected CPI sensitivity to exchange rates and import prices of all countries examined, at about a third the level of the sensitivity calibrated for other industrialized countries.” Because not much has structurally changed in the U.S.’s foreign trade sector relative to GDP since 2008, such a conclusion still appears to be valid.

Closing Thoughts

1. There are clearly tailwinds now at the backs of U.S. consumers (falling oil prices, stronger dollar leading to lower import prices) which should easily translate into a very good holiday buying season.

2. The worry about the U.S. importing the world’s deflation is exacerbated by the fact that the U.S.’s economy is relatively closed, but more importantly by the fact that the U.S. consumer, the corporate sector, and even the federal government have deleveraged since the financial crisis and have large capacities to take on additional debt, the beginnings of which we have seen in both the consumer and corporate sectors in 2014. All sectors have the wherewithal to withstand significant rate increases.

3. And the Fed seems determined to delay any such rate increases for the foreseeable future. Barring any unforeseen exogenous events, the U.S. consumer and corporate sectors are fundamentally sound and will propel the economy forward even as the rest of the world struggles.

Robert Barone, Ph.D.

Robert Barone (Ph.D., Economics, Georgetown University), an advisor representative of Concert Wealth Management, is a Principal of Universal Value Advisors (UVA), Reno, NV, a business entity. Advisory services are offered through Concert Wealth Management, a Registered Investment Advisor. Dr. Barone is available to discuss client investment needs. Call him at (775) 284-7778.

Statistics and other information have been compiled from various sources that Universal Value Advisors believes to be accurate and credible but makes no guarantee to their complete accuracy. A more detailed description of Concert Wealth Management, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.

– See more at: StateoftheMarkets.com

In the middle of October, the equity markets became quite volatile, worrying about such things as a growth slowdown in Europe, China and the developed world, the impact of a stronger dollar on multinational corporate earnings, and Ebola, ISIS and other geopolitical issues. The worry was that any one of these could have a negative impact on growth in the U.S.

No doubt external issues, like Ebola, or perhaps another devastating terrorist attack, could derail the current economic upswing. But, absent such an exogenous shock, there is significant evidence that the economic issues mentioned above do not pose a threat to the U.S. economy.

I will take it as a given that the reader is already aware of the significant consumer benefits that lower gasoline prices have ($1+ billion for every penny of decline at the pump), and will add that the strengthening dollar also lowers the prices of imported goods. If these two were the only items underpinning the U.S. consumer and economic growth, then there may be cause for worry. But this is not the case. The fact is, unlike their counterparts in Europe and the rest of the world, the U.S. consumer and the U.S. corporate sector have deleveraged and have capacity to either take on additional debt and/or higher interest rates. And, believe it or not, even the federal government’s debt costs will not be a budgetary constraint in the current rate environment. As a result, it is likely that GDP growth will continue at a fairly brisk pace for the foreseeable future.

The Consumer

As a percent of Disposable Personal Income (DPI), debt service payments (principal and interest) in Q2/2014 were 9.91%, the second lowest level in the history of the series (which began in1980). At its peak in 2007, this ratio was 13.2%. The lowest level, 9.84%, occurred in Q3/2013, and the slight uptrend since is consistent with the large increases in auto sales and revolving credit (credit cards) we have seen in 2014.

In addition, if we only look at the interest portion of debt service payments, in Q2 they stood at a series low of 4.8% of DPI. Recessions don’t occur when consumer debt costs are this low. From this point of view, interest rates can rise 300-400 basis points before the consumer begins to have issues. With the Fed so reluctant to raise interest rates (see below), it appears that the consumer has a lot of capacity to take on additional debt.

The Corporate Sector

The same is true for the non-financial corporate sector. In Q2, the debt/equity ratio of this sector was 33%, down from 73% at the peak of the recession. And the debt service ratio (Net Interest/Pre-tax Income), at 10% is near its 1970 level. It appears that, like the consumer, the corporate sector has a lot of room to leverage at current interest rates.

The Federal Government

That leaves the federal government. Given record deficits not that long ago, it is hard to believe that interest cost as a percentage of the revenue take, 15%, is at a four decade low. A rise in the interest cost of the debt would be required to cause major issues. And, even as rates rise, because of the maturity structure, it will take several years for such costs to permeate the debt structure.

The Fed Looks for Excuses

Of course, rate increases of even up to 300 basis points (3 percentage points) are possible, but they aren’t likely and are certainly not on the horizon. I say that for good reason, as it appears that the Fed continues to look for excuses not to raise interest rates despite a strong economy. Don’t be fooled by the various Fed speakers’ recent emphasis on the potential impacts of a strong dollar on the economy’s future growth. The fact is, the use of labor market “slack” as an excuse not to raise rates has become stale, as the labor market has continued to show significant strength. No doubt, the Fed is looking for new talking points to keep interest rates low.

The newly stated fear is that “deflation” in the rest of the world will find its way to U.S. shores. Yet, despite globalization, the U.S. economy is still a relatively closed economy with exports accounting for about 13% of GDP, the lowest level, by a wide margin, of any developed nation. In fact, a 2008 study done by the New York Fed (Goldberg & Campa, The Sensitivity of the CPI to Exchange Rates…), found that “the United States has the lowest expected CPI sensitivity to exchange rates and import prices of all countries examined, at about a third the level of the sensitivity calibrated for other industrialized countries.” Because not much has structurally changed in the U.S.’s foreign trade sector relative to GDP since 2008, such a conclusion still appears to be valid.

Closing Thoughts

1. There are clearly tailwinds now at the backs of U.S. consumers (falling oil prices, stronger dollar leading to lower import prices) which should easily translate into a very good holiday buying season.

2. The worry about the U.S. importing the world’s deflation is exacerbated by the fact that the U.S.’s economy is relatively closed, but more importantly by the fact that the U.S. consumer, the corporate sector, and even the federal government have deleveraged since the financial crisis and have large capacities to take on additional debt, the beginnings of which we have seen in both the consumer and corporate sectors in 2014. All sectors have the wherewithal to withstand significant rate increases.

3. And the Fed seems determined to delay any such rate increases for the foreseeable future. Barring any unforeseen exogenous events, the U.S. consumer and corporate sectors are fundamentally sound and will propel the economy forward even as the rest of the world struggles.

Robert Barone, Ph.D.

Robert Barone (Ph.D., Economics, Georgetown University), an advisor representative of Concert Wealth Management, is a Principal of Universal Value Advisors (UVA), Reno, NV, a business entity. Advisory services are offered through Concert Wealth Management, a Registered Investment Advisor. Dr. Barone is available to discuss client investment needs. Call him at (775) 284-7778.

Statistics and other information have been compiled from various sources that Universal Value Advisors believes to be accurate and credible but makes no guarantee to their complete accuracy. A more detailed description of Concert Wealth Management, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.

– See more at: http://stateofthemarkets.com/report/49701/#sthash.hFKoTO9g.dpuf

David Moenning is Chief Investment Officer at Heritage Capital Management, a Chicago-based registered investment advisory firm. Mr. Moenning began his investment career in 1980 and formed Heritage Capital in 1989. Dave’s firm focuses on “active management” and focuses on managing market risk on a daily basis. Dave is also the proprietor of StateoftheMarkets.com, which provides free and subscription-based portfolio services. Mr. Moenning is the 2013-14 President of NAAIM (National Association of Active Investment Managers) an organization dedicated to active management strategies. Follow Dave on Twitter at @StateDave.

Dave Moenning

David Moenning is Chief Investment Officer at Heritage Capital Management, a Chicago-based registered investment advisory firm. Mr. Moenning began his investment career in 1980 and formed Heritage Capital in 1989. Dave’s firm focuses on “active management” and focuses on managing market risk on a daily basis. Dave is also the proprietor of StateoftheMarkets.com, which provides free and subscription-based portfolio services. Mr. Moenning is the 2013-14 President of NAAIM (National Association of Active Investment Managers) an organization dedicated to active management strategies. Follow Dave on Twitter at @StateDave.