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The Shape of Things to Come

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There have been lots of headlines recently about an emerging economic recovery. July unemployment ticked down to 9.4 percent from 9.5 percent, as the economy shed “only” 247,000 jobs. Pending home sales have increased for five straight months, signaling that housing prices may have finally found a floor. Overall economic activity seems to be in expansion mode, with a mere 1 percent decline in second quarter GDP — a vast improvement from the 6.4 percent decline in Q1.

The market has cheered all these trends, with the Dow up more than 40 percent from its March low. Indeed, Goldman Sachs rang in second quarter profits of $3.4 billion — the biggest gain in the storied firm’s 140-year history.

But financial advisors should not expect the good times to roll again. As our economics columnist Alexei Bayer persuasively argued in last month’s issue, the recent boomlet has no basis in the real economy. The Treasury through the TARP program and the Fed through its banking reserves have introduced nearly $2 trillion into the economy and the banks have spearheaded a stock-buying binge with this taxpayer money, creating a new equities bubble.

At the very same time, ballooning government spending — the Obama administration expects a deficit this year of $1.8 trillion, or four times last year’s amount — is creating a bond bubble as the government issues more debt to finance our insatiable appetite for spending money we don’t have. Our debt currently amounts to $38,500 per resident of the United States.

So here are a few things to think about while Congress contemplates seeding a new government entitlement with its first trillion-dollar installment. Remember the subprime mortgage crisis that precipitated all this economic unpleasantness? Well, delinquencies in prime mortgages have risen 13.8 percent in the second quarter, according to S&P research. The scale of financial problems this implies is vastly greater than the subprime crisis.

Will the government be able to credibly bail out the financial system in a Round Two prime mortgage crisis? Our current spending trajectory makes it clear that future large-scale bailouts will not be feasible, and the massive debt we are issuing implies rising interest rates, which would strangle any nascent economic growth.

And one more issue that merits special contemplation as we near the eighth anniversary of 9/11: Enemies of the United States continue to work feverishly day and night to undermine our country. Now more than ever they perceive a “weak horse.” Do folks realize that at the very same time the United States has been blowing trillions, we have actually been cutting defense expenditures — as if the world were becoming a less dangerous place? Will we be able to muster the resources needed in the event of an entirely foreseeable national security crisis?

With all the economic and geopolitical risks afoot, the V-shaped recession everyone’s been hoping for seems more likely to take the shape of a W. Advisors should prepare their clients for further tough times ahead.

Gil Weinreich, Editor

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