US Economy – Strong or Weak?
The Financialist • Issue 87 • July 2005
BY CORY HILL
Economics is more of an art than a science, and statistics are the lifeblood of economics. However the interpretation of these statistics is where economists and analysts "paint a picture" of an economy that could rival the vision of an artist. Thankfully, I doubt we’ll ever see an economic report hanging on a wall in an art gallery or museum!
In this article, I will focus on economics in the United States from a "macro" level. Are you wondering why I choose the US economy and not Canada’s? Given the size and scope of the US economy relative to the rest of the world, as well as the recent proposed changes to foreign content restrictions in RRSP’s, a thoughtful look at some of our neighbour’s economic statistics may help us with future investment allocation decisions.
The American Consumer
Much has been made of the US consumer’s propensity to spend. The spending "problem" of the US consumer is characterized by a high debt load relative to equity and income levels. We’ll hear terms such as debt-to-equity and debt-to-income ratio when commentators talk about the worrisome state of the US consumer’s financial health.
It is generally agreed that the US economy is being propped up in some measure by consumer spending, which cannot go on increasing at a high pace forever. The US economy is primarily a service based economy, whose day-to-day health is measured as much by the consumer confidence index as by debt-to-equity and debt-to-income ratios of the consumer.
But let’s look further at the numbers; consumers’ net worth (equity less debt) is at a historically high level relative to income due in no small part to the increase in real estate valuations. With the dynamic refinance (re-fi) market in the US, much of this increased net worth can be accessed with little delay or difficulty. These are both good things because it gives the US consumer a level of comfort and confidence, which is measured in the consumer confidence index.
Although rising interest rates may cause problems for some consumers, about three-quarters of household debt is at fixed rates, with the US consumer having the option to lock in a 30-year mortgage rate, and thus insulate themselves from future rate increases.
As well, the US resident can normally deduct mortgage interest on their tax return, so the mindset is not necessarily the same as that of Cnadians, who tend to pay off mortgages as quickly as possible. There is a school of thought that believes paying off debt on which the interest is tax deductible is not an effective use of capital.
The American Economy
Much has been made of the US dollar and its relative weakening in relation to other major world currencies over the last few years. What does this really mean from an economic standpoint? To listen to the dire predictions of some commentators, the recent devaluation spells the end of the US dollar as the global currency of choice. True, some countries have replaced some US dollars in their foreign reserves with Euros, but don’t count the US economy out too quickly.
From the American standpoint, a weak dollar is not necessarily a bad thing. Their products are cheaper to global consumers, but more importantly, US assets such as real estate and stocks are now cheaper, making new investments by foreigners more likely. Foreign investment stimulates economic growth.
Many say the Federal Reserve views a weak dollar as the inevitable consequence of a current account deficit. Essentially, the US economy imports goods more valuable than it exports, hence the deficit. Not all is explained so easily though. Over the last fifty years, the US has moved from a manufacturing-based economy to a service-based economy. If manufacturing is not as significant a part of the economy, then one would reasonably assume that exports would reduce over time.
This is not to say that the US does not manufacture and export goods that may skew the current account deficit somewhat. Recently I had the opportunity to sit down with Michael Quinn, President and Chief Financial Officer of Bissett Investment Management and manager of the Bissett Canadian Balanced Fund. The example he used to illustrate the US current account deficit as it applies to China is quite interesting.
Importing Profits
In Quinn’s example, we looked at the importing of a DVD player from China to the US. The DVD player is a combination of a computer circuit board, an optical reading device to read the DVD, a power supply, and a plastic or metal case. The product is almost entirely manufactured and assembled in China at virtually break-even pricing., except for one important (and most profitable) piece – the optical device is built in the US.
The cost to build the device is say, $5.00. The device is then sold to a factory in China for $20.00. The manufacturer of the device has made a profit of $15.00. When shipped to China, it is recorded as an export, valued at $20.00. When it arrives in China, all the other components are put together at a cost of $80. This brings the total cost to manufacture the DVD player to $100 (remember Quinn’s comment that the product built in China is done so with virtually no profit).
The player is then shipped to the US, where it is recorded as an import, with a value of $100. As you can see, this example shows the US in a current account deficit position with this product to the tune of $80. The company in China made virtually no profit on the DVD player; whereas the highest profit component (the optical device) was manufactured in the United States.
This information is not meant as a positive or negative stance on the US economy. It’s meant to illustrate that analyzing economic statistics can be subjective. Benjamin Disraeli and Mark Twain once said, "There are lies, damn lies and statistics".
You can discuss with your financial advisor how global economic factors may affect your portfolio.