The economic recovery continues on track.  1Q GDP was revised upward from 5.6% to 6.1% in the latest and final report.  Based on reports released over the last two months, growth should be in the 2½-3½% range  for the 2Q.  Over the last month, consumer confidence and spending have cooled-off marginally, but this has been offset by continued expansion in the manufacturing sector.

There continue to be those who are adamant that the economy is going to dip back into recession or worse (but then they always do).  At this point, there is no reason to expect a "double-dip" recession.  In this issue, I look at the issue of deflation.  It seems that more and more analysts are predicting that the US is headed for a "debt deflation."  In the pages that follow, we will look at the issue of deflation, what it means, how it might unfold and, most importantly, what signs and indicators you can watch for.  Bottom line: deflation is possible but not likely.

The equity markets have performed dreadfully over the last month.  The Dow Jones fell below 9,000, a drop of apprx. 15% in one month.  The S&P 500 fell apprx. 18% in the last month.  The latest WorldCom scandal has caused millions of investors to consider heading for the exits.  However, the markets are severely oversold at this point, and a potentially powerful rally may be unfolding as you read this.  The equity outlook for the next year or two strongly suggests market timing.

Bonds are likely to do well in the near-term due to the deteriorating situation in equities.  However, with the economy improving, bond yields should move higher over the long-term, again assuming no more major terrorist attacks.  Gold prices have traded lower over the last month, sending most precious metals mutual funds sharply lower.  This suggests that gold may still be in a broad trading range, only at a higher level.

Finally, be sure to read the article on pages 7-8 about the growing possibility of a National ID Card in the form of your Driver's license.  Also, be sure to read this month's issue of Between The Lines .  In it, we celebrate our independence in this "one nation under God."

BCA Is Still Optimistic. . . . But

Last month I gave you the latest long-term forecasts from The Bank Credit Analyst.  As you will recall, BCA remains confident that the US economy has turned the corner and will continue to expand with growth in the 3% or better range in the second half of the year.  BCA also reiterated its long-held view that the US economy is in a long-term upwave that should last another 5-10 years.  Yet all of this is contingent on there being no more major terrorist attacks in the US.

In their latest June issue, the BCA editors once again restate the forecasts above.  The editors noted, however, that the latest rapid deterioration in the equity markets could have a negative impact on the economy if stock prices continue to plummet.  Later on in this issue I will discuss this possibility along with other factors that could potentially derail the economic recovery.  For now, however, the economy appears to be on firm footing.

The Real GDP

As stated on the previous page, the Commerce Department revised 1Q GDP from +5.6% to +6.1%.  This was the government's final revision of the 1Q number.  There have been those who distrusted this number ever since the first estimate.  While the number is what it is, if we break down the number into its components we can see a better picture.  Simply put, the GDP number was higher than normal, largely due to inventory liquidation.  Since 911, businesses have rushed to dump unsold inventory, and this continued in  the 1Q.  If we strip out the inventory liquidation, GDP increased apprx. 2.6% in the 1Q.

Most analysts agree that inventory liquidation has subsided, and many businesses are rebuilding inventories now that the economic outlook is clearer.  Based on the GDP breakdown above, most analysts are predicting 2Q growth in the 2½-4% range.  The Wall Street Journal surveyed 55 leading economists and published their forecasts on July 1st.  The average estimate for 2Q GDP growth was 3.6%.

Whether one wants to consider that 1Q GDP was 6.1% as reported, or 2.6% after adjusting for inventory liquidation, the economy is clearly expanding.  Even if growth turns out to have been only 2½% for the 2Q, that will still signal that the recovery is ongoing.

Consumers Tap The Brakes, But Factories Pick Up the Slack

Consumer spending slowed in May and advance estimates suggest in June as well.  Consumer confidence fell slightly in May and June, which explained the slowdown in spending.  This occurred at the same time that personal income rose, and the result is that savings increased at a 3.1% annual rate in May.  This suggests (as discussed last month) that consumers are not tapped out as many have suggested.

While consumers appear to have pulled in their horns modestly,  manufacturing more than took up the slack.  Industrial production and capacity utilization both increased in May.  The factory operating rate has now risen for five consecutive months.  While still below pre-911 levels, manufacturing is on a steady course of expansion.

The housing sector continues on a roll.  Housing starts rose 12% in May, the largest increase in seven years.  New homes sales surged 8.1% in May.  (More on the long-term outlook for the housing market later in this issue.)

Unemployment dipped to 5.8% in May.  This suggests that unemployment peaked in April at 6%.  If the report for June shows a second decrease, that should confirm that unemployment has turned the corner for this cycle.

The bottom line is that even though consumers have curtailed spending modestly, the economy is still growing solidly.  The Index of Leading Economic Indicators rose .4% in May, suggesting the recovery will continue for at least a few more months if not longer.  Barring any negative surprises, as discussed below, the economy should continue to surprise on the upside.

What Could Derail The Economy?

While BCA and most sources I respect believe the recovery will continue, it is easy to paint a scary picture of the economy and the financial markets.  History shows that asset bubbles usually leave a trail of destruction after they burst.  The technology mania was one of the greatest asset inflations of all time, and it is clear this bubble has burst.  Couple that with financial imbalances that were not unwound during the brief recession, and the risks of an aborted economic recovery should not be ignored. 

Also, the stock market has frequently been a leading indicator of the economy.  The recent weakness in equities, especially at a time when so many conditions have been right for an advance (low interest rates and inflation, plentiful liquidity, etc.), is unusual by historical norms.  A huge factor in the recent decline in equity prices has been the accounting scandals.  Because the scandals were so unexpected and so unsettling to the investment public, one could argue that the stock market is no longer a leading indicator of the economy.  Still, the fact that stocks have not risen, and in fact have declined sharply, could be interpreted to mean there may be negative surprises ahead that we do not know about presently.

At the risk of sounding like a quasi gloom-and-doomer, let's discuss some of the things that could cause the economy to head south.

More Terrorist Attacks

This should be a given.  Clearly, if there are more major attacks in the US, the economy could contract again just as it did after 911.  We are being bombarded with all types of warnings about new terrorist threats, to the point at which most Americans don't know what to think anymore.  Yet the administration is at a point where they feel they have to put out the threats, even if they prove to be false later on.

While it is impossible to know how likely or unlikely additional major attacks are, nor in what form they might come, suffice it to say that more attacks could reverse the economic recovery and wreak even more havoc in the financial markets.

Even if there are no more major terrorist attacks in the US, the War Against Terror could still have negative implications for our economy.  The Bush administration seems intent on removing Saddam Hussein from power due to fears that he will provide terrorists with weapons of mass destruction.  As we saw in the Gulf War, US military action in the Middle East can destabilize the equity markets.  Should our military actions against Iraq prove to be more difficult than expected, and if American casualties are high, this could undermine confidence and thus, the economy.  Hopefully, this will not be the case.

A Debt Deflation

A lot of newsletters I read (including some that are not gloom-and-doom) are predicting that the US is headed for a deflationary spiral.  In the pages that follow, let's examine the deflationary threat and discuss the warning signs to watch for.

The last time the US had a serious debt problem was in the late 1980s.  There had been a major run-up in credit growth, especially in junk bonds and real estate loans.  Both of these areas blew up, triggering the worst banking crisis since the 1930s.  Meanwhile, things heated up in the Middle East, culminating with the Gulf War, and together these things pushed the economy into a recession and a feared debt deflation.

The US did not sink into a debt deflation in the late 80s/early 90s because the Fed pushed interest rates to near zero (inflation adjusted) and kept them there for 18 months.  At the same time, the government engineered a massive bailout of the banks and the insolvent savings and loan industry.  We all remember the Resolution Trust Company (RTC).  Stocks moved sharply lower during that period, but the recession proved to be relatively mild. 

In the last half of the 1990s to the present, we have seen a similar surge in credit growth, both in the corporate and consumer areas.  Debt-to-income ratios reached new peaks.  Yet as discussed last month and previously, the current debt levels appear to be manageable, and the trend has begun to improve in the 1Q.  The personal savings rate actually went up in the latest report.  However, if we embark on a major military campaign in the Middle East, this would raise the odds that the economy could once again go into recession, and possibly even a debt deflation.

There are some obvious similarities in the current cycle with the earlier one.  Specifically, debt levels are once again very high, stocks are down sharply and the recession has been quite mild.  Thus, one might conclude that we will avoid a deflationary cycle this time around, just as we did in the late 80s/early 90s.  Yet in the "what could go wrong" category, there are some important differences this time around. 

For one thing, the stock market is much weaker this time around, and household exposure to equities is much higher than it was in the earlier period.  Household holdings of equities are almost double today what they were in the recession of 1990, even though it is down from the peak reached in early 2000.  Also, inflation is much, much lower than it was in the late 80s/early 90s.  Inflation would not have to fall much further to go negative.

If we were to go into deflation, it would undermine the ability of individuals and corporations to service their debt.  This could result in forced selling of other assets (especially financial assets) to make debt payments.  A debt deflation implies a vicious cycle of falling incomes, imploding asset prices and even greater debt burdens. 

With interest rates as low as they presently are, the Fed has limits on what it could do to head off a deflationary trend were it to develop.  Short-term rates, adjusted for inflation, are near zero already.  Furthermore, liquidity is already very high.  The Fed could add more reserves in an attempt to head-off deflation, but it could find itself "pushing on a string."

What Could Cause Deflation to Unfold?

The GDP price deflator (an indication of inflation) was only 1.3% in the 1Q.  While perhaps too obvious an observation, inflation is not that far from zero already.  Many sectors of the manufacturing side of the economy have faced deflationary pressures for several years.  However, this downward pressure on goods prices has been offset by rising prices in the services sectors of the economy.  However, inflation in the services sector is now slowing, and if the economy were to slip back into recession, downward price pressures could develop here as well.

As noted earlier, falling equity prices are one of the influences that could spark a deflationary trend.  The investment public has held onto their stocks and mutual funds, generally speaking.  There has not been a stampede out of the market.  However, if equity prices continue to plunge, there will no doubt be a point at which a great deal more money heads for the exits.  If the downward spiral in equity prices continues, this would imply decreased consumer spending, increased unemployment and reduced incomes.  Thus, a further plunge in equity prices could, by itself, push the economy back into a recession, thus raising the odds that deflation could develop.

Remember, I am not predicting this will happen.  I am merely laying out a possible deflationary scenario if certain triggers were to happen.  Maybe they won't. The latest decline in equity prices could be about to end.  As this is written, the broad markets have held just above their September lows.  If the markets begin to rebound from these levels, the technical picture will look very encouraging, and a potentially powerful rally would likely follow.  Some investors will no doubt look to increase their equity holdings at these levels near the September lows, with a strategy of cutting losses short if the old lows are broken, and if not, then riding the ensuing technical rally. . . .  But I'm getting ahead of myself.  More on the deflationary scenario.

What If Home Prices Topple?

The housing market has been one the most powerful drivers of the economy throughout the 1990s and even today.  Housing prices have remained firm despite the brief recession, and as noted on page two, housing starts have even set new records in recent months.  For the last several years there have been those - especially the gloom-and-doom crowd - who consistently predicted that the housing bubble had to burst at some point.  It hasn't.  However, in looking at what could cause a deflationary trend, one has to consider the possibility that housing prices could turn south.

If home prices were to begin to fall significantly,  this would be a far more deflationary event than a further decline in equity prices.  While equity holdings have increased significantly over the last decade, most Americans still have far more of their net worth in their homes than in their stock and bond portfolios.  Were home prices to begin a broad-based trend lower, that would undermine consumer balance sheets and confidence, and it would almost certainly push the economy  back into recession.  This would be a prescription for a debt deflation. Fortunately, there was some good, long-term news released about the housing market in the last week.  I will discuss that later on.  

A Freefall In The US Dollar

The real trade-weighted value of the US dollar has dropped apprx. 8% against a basket of major currencies since the peak in February.  However, even with the recent drop, the US dollar is still 17% above its average level of the last 30 years.  Most of the sources I respect, including BCA, believe the dollar will fall further in the months ahead.  Most expect a decline of 15%-25% from the peak, depending on who you read.

There are some reasons to welcome a fall in the dollar.  It will reduce the current account deficit, boost US growth through improved trade competitiveness and corporate profits.  Higher import prices will actually reduce deflationary pressures.  As long as the decline is gradual, it should not result in major disruptions in the economy or the financial markets.  There is also the argument that the US dollar will not drop too far because the economies (and their currencies) of most other regions, including Europe and Asia, have even more problems than the US.

With all that said, if the dollar begins to plunge, this could well have a deflationary outcome.  Normally, we think of a falling dollar as an inflationary event.  However, if the dollar were to plunge, foreigners would be quick to pull assets out of the US financial markets.    This could lead to a freefall in equity prices which, as discussed earlier, could erode consumer confidence in the US and lead to another sharp slowdown in the economy.  Again, this would suggest deflation.

How Will We Know If Deflation Is Coming?

There are plenty of indicators that should warn us if a deflationary trend is developing.  Here are a few:

1.  While loan delinquency rates rose over the last two years, as is normal in economic slowdowns and recessions, they moved lower in the 1Q.  If this trend  toward reducing debt reverses upward again and should move to a new high, this would be an indication that debt burdens have reached a dangerous level, and that deflation could be just around the corner.

2.  Credit spreads will also warn that deflation is coming.  Currently, the TED spread (eurodollar minus T-bill rate) is low, as is the yield spread between bank bonds and other corporate bonds.  These spreads would widen if deflation is unfolding.

3.  Corporate profits are recovering from their deep slump (accounting scandals not withstanding).  With the economy expanding, this trend in profits should continue and actually improve.  Should this trend reverse itself, it could mean a whole new round of cost cutting, higher unemployment and another slowdown in the economy with deflationary implications as discussed above.

4.  Likewise, if home prices were to enter a broad-based decline across the country that, too, would be an indication that deflation is unfolding.

5.  The Index of Leading Economic Indicators (LEI) has moved sharply higher since the low at the beginning of last year.  The LEI has a very good track record as an indicator of trends in the economy.  If this index were to turn sharply lower and fall into negative territory, that would cause concern about deflation. 

6.  The Institute For Supply Management (ISM) Index gauges the manufacturing sector.  The ISM Index has risen sharply since its low late last year and is now solidly in positive territory.  Like the LEI Index, should the ISM Index reverse decisively lower, this would be another cause for concern about deflation.

7.  Capital spending must increase for the economic recovery to continue to grow.  Despite what you may hear in the media, the  decline in capital spending reversed last year.  While still not in positive territory, the trend has been in the right direction this year.  A reversal lower would be a warning for deflation.

Conclusions

A deflationary scenario could certainly develop as discussed above.  The real question is, how likely is such a scenario?  If you read the gloom-and-doom crowd, you know that most of these writers say deflation is inevitable.  I would hasten to remind you, however, that many of these people have been predicting a debt deflation for 10-20 years or longer!

The fact is that the US economy has consistently surprised on the upside for the last 20 years.  The recession in 1990/91 was milder than expected, as was the recession last year.  BCA believes that the economy will continue to surprise on the upside, generally speaking, for another 5-10 years.

As discussed above, there are events and circumstances that could occur and throw the US economy into a deflationary cycle.  That could either be a gentle drift lower for a time, or it could be a vicious, self-feeding cycle that sends us into a severe and prolonged recession.  But again, is this the most likely scenario?  Probably not.

As investors, we should be aware of the warning signs, watch the trends in the indicators I have discussed, and be ready to take action if it looks like deflation is really unfolding in earnest.

The economy is improving.  The 6.1% GDP figure for the 1Q is overstated if we factor in the big boost from inventory liquidation.  Yet even then, growth is in the 2.6% range, which does not suggest a deflationary cycle.  And let us not forget that those inventories have to be rebuilt, which is why the manufacturing industry is showing such strong growth.

My suggestion is that you invest with a mindset that the economy will get better rather than worse.  While deflation and a double-dip recession can't be ruled out, I wouldn't structure your portfolio  based on a worst-case scenario.

More On Housing Trends

During the first half of the year, I read at least a dozen articles that talked about how the housing bubble had to burst.  Just as we can't rule out deflation, we also cannot rule out a possible plunge in home prices.  However, a new study released this week indicates that demand for housing will continue to accelerate over  the next 20 years. 

Harvard University's Joint Center for Housing Studies released a new report entitled "State of the Nation's Housing."  This report projects that the number of US households will increase 22.6% to 129 million over the next 20 years.  That translates into apprx. 1.19 million new households a year, which is only slightly lower than the 1.26 million a year average  in the decade of the 1990s.

While some economists have been predicting a significant slowdown in household creation, due to Baby Boomers retiring, the Harvard study disagrees due to two major points.  First, Baby Boomers continue to move up to higher priced homes, as well as buying second and third homes.  Second, the number of immigrants buying homes has surged over the last five years.  The Harvard study expects both these trends to continue in the years ahead.

The report also focuses on the growing scarcity of land available for home and apartment construction around the US.  Due to constraints and restrictions, builders are having a hard time finding enough available land to keep pace with the number of homes and apartments that need to be built in order to keep up with demand.  This should support prices in general.

All of this, the study argues, will serve to keep home prices high and rising, generally speaking.  Obviously, economic conditions will have a great bearing on home demand.  If we have an extended recession(s), or a deflationary period, or if mortgage rates go up significantly, then the study's  projections will prove to be overstated.  Yet the most likely scenario is that even if home prices were to take a dip in the shortrun, they are very likely to be higher in the next 10-20 years, and perhaps substantially higher.

Congress Is At It Again

Right now, the House of Representatives is debating in committee what could be the single most power expanding bill in American history - HR 4633, the "Driver's License Modernization Act of 2002."

Since its passage last October during the post-September 11th hysteria, many Americans thought the  "Provide Appropriate Tools Required to Intercept and Obstruct Terrorism Act" (PATRIOT) was intended to bring about a federally-enforced police state.  I didn't make a big deal out of it because the PATRIOT Act was mostly a house-cleaning bill.  The act provided a few new powers, but mostly it was just minor changes to the code.  The government had already given itself enormous powers well beyond its constitutional limits.  As one analyst put it:

"The PATRIOT Act was a sheep dressed up in wolf's clothing to scare us with its ominous name.  HR 4633, on the other hand, is a rather large, rabid wolf in the sheep''s clothing of a deceptively benign name."

The rather mundane-sounding Driver's License Modernization Act of 2002 isn't nearly as scary sounding as the PATRIOT Act, so most Americans don't even know about it, much less realize it is intended to be a National ID Card.  HR 4633 says its purpose is:

"To amend title 23, United States Code, to establish standards for State programs for the issuance of drivers' licenses and identification cards, and for other purposes."  [Emphasis added, GH]

The question is: WHAT OTHER PURPOSES?  I'll come back to that in a moment.

Computer Chips in Driver's Licenses

HR 4633 requires that "a State shall embed a computer chip in each new or renewed driver's license or identification card issued by the State."  It further demands that "a computer chip embedded in a driver's license or identification card...  shall: contain, in electronic form, all text data written on the license or card; encoded biometric data matching the holder of the license or card; encryption and security software or hardware (or both) that prevents access to data stored on the chip without the express consent of the individual to whom the data applies, other than access by a Federal, State, or local agency (including a court or law enforcement agency) in carrying out its functions, or by a private entity acting on behalf of a Federal, State, or local agency in carrying out its functions; accept data or software written to the license or card by non-governmental devices if the data transfer is authorized by the holder of the license or card; and conform to any other standards issued by Secretary." [Emphasis added, GH]

I am not making this up!  It's straight from the Bill itself.  The Feds want to put a chip in your State driver's license with your biometric data encoded and accessible by any "agency" (not just law enforcement) or an unspecified "private entity."  This is scary!

This chip will be programmable by "non-governmental devices."  What are those?  And it will "conform to any other standards issued by the Secretary."  Since when was the Secretary of Transportation authorized to violate the Tenth Amendment (and a few others), take over a State's control of its highways, and be empowered to issue "any other standards?"  What standards could those be?

HR 4633 states: "Standards for the encoded biometric data that must be contained on each computer chip and requirements to ensure that such biometric data will be used only for matching the license or card to the presenter and will not be stored in a central database."  [Emphasis added, GH]

This sounds good, right?  Your blood pressure just went down a notch or two, I'll bet.  But read this:

"A State shall participate in a program to link State motor vehicle databases in order to provide electronic access by a State to information contained in the motor vehicle databases of all other States." 

Let me get this: all States will link-up their information, yet this is not a central database??  Remember, they believe we are all really dumb!

There's more.  HR4633 would appropriate a whopping $315 billion to be made available to the States to implement this new driver's license program.  Obviously, this would be a massive undertaking, and every State would look to the government for the money.  But read what happens when they do:

"A State carrying out activities using amounts from a grant under this section shall be treated as an executive agency and part of the [U.S.] Department of Transportation when carrying out such activities."  [Emphasis added, GH]

Can Congress really make State agencies part of the federal government?  I don't remember seeing that power expressed in the Constitution!  Did you?

"If the Secretary determines that a State receiving a grant under this subsection has not met the requirements ...  on or before the last day of the 5-year period beginning on the date of enactment of this section, the Secretary may require the State to repay, in whole or in part, the total amount received by the State in grants under this subsection."

What this effectively means is that there is no "opt-out" provision for the States should their leaders (or more likely their citizens) decide that this is a really bad deal.  How would they repay billions of dollars doled out by the government?  They will be stuck.

Here's another troubling section of HR4633:

"TRANSITION FROM NATIONAL DRIVER REGISTER. - after the last day of the 5-year period beginning on the date of enactment of this section, no amounts may be appropriated to carry out chapter 303 of title 49.  The Secretary shall provide for the orderly transition from the National Driver Register maintained under such chapter 303 to the program established under subsection (b)(3)."

I'm not sure exactly what this section means, but it certainly doesn't sound good!  How does a "National Driver Register" not qualify as a central database? 

I could go on and on as there is more bad stuff in HR 4633, but space does not permit.

What You Can Do

Check out HR 4633 for yourself on the Web.  There's plenty of info on it.  Also, contact your legislators about this issue.  For information on how to contact your legislators and other government officials, check out the Electronic Frontier Foundation's "Contacting Congress and Other Policymakers" guide at: http://www.eff.org/congress.html

Late Note:

Stocks On The Rebound

This issue is going to press on Friday, July 5th.  As this is written, the stock markets are soaring, with the Dow up 325 points, the S&P up 35 points and the Nasdaq up 70 points.  As suggested earlier in this issue, the markets are rebounding due to the fact that the September lows in the broad market were not violated.  The bear market in stocks may not be over, but the new rally could continue for some time. 

Whether the latest powerful rally marks the end of the bear market, or not, market timing strategies are becoming increasingly popular.  Most analysts agree that stocks are not going to deliver 20+% returns in the years ahead.  In fact, many believe the market will do well to deliver its historical 8-10% returns going forward.  I tend to agree at least for a couple of years.  If so, it will take some market timing to enhance returns and reduce risks.  If you agree, call us at 800-348-3601 and check out our recommended Advisors.