Wednesday, December 19, 2007

A Discussion about the Economy with an Old Friend

Every year near Christmas time, a good friend and client comes visiting with Christmas presents for our staff. After the hub bub of the diet-killer delights he brings, he and I settle into a casual discussion of prospects for the coming year. I listen as much as I speak because I have found him to be a keen observer and a very good student of the markets, particularly human nature.

This will be the first of two or three items that we discussed.

Friend: Everyone seems to be bracing for a recession. I'm having trouble believing that a recession is imminent when most of the economic sectors are doing well with the exception of financial and retail. What do think the odds are of a recession?

GCD: I think they are less that 50/50, and I believe the consensus of our investment committe is that growth will slow, but recession is not the best bet. I have one chart I'd like to show you that I believe is not well understood and most people forget to take into consideration when they project recession.

The chart at the right is of US Net Exports of Goods and Services since 1970. The chart clearly shows that exports have not only been falling relative to imports since 1980, but that their rate of descent has accelerated dramatically since the early 1990s. That trend has been firmly in place until just in recent months when exports have turned higher relative to imports. Indeed, in the most recent quarter, exports represented nearly 20% of total real GDP.

Friend: So you are saying that exports alone may keep us out of recession?

GCD: No, I personally think the economy overall will be stronger than most people think. The housing issue is a tough hurdle to overcome, but I just don't believe that housing in most parts of the country got as overheated as in did in California and Florida, for instance; consequently, I don't think the unwinding of the excess housing stock in the country will linger as long as most people seem to believe. Export growth will almost certainly continue, so any good news in housing will produce more overall growth than Wall Street now predicts.

Friend: Exports are rising because of the fall in the dollar, correct?

GCD: I have said many times that oftentimes the seeds of destruction and the seeds of regeneration are in the same pod. The US's consumer mentality and heavy use of imported petroleum have caused a trade imbalance with almost every country in the world. In essence, we were trading dollars for goods. As those dollars were translated back into the home country's currency, dollars are sold and the home currency bought, ie., a weak dollar.

Friend: But for net exports to have turned higher, the dollar must have fallen sufficiently that our goods and services are now very competitive in the global economy? That still seems hard to believe. Most people think the dollar is destined to fall a far as the eye can see.

GCD: My best explanation for the power of a weaker dollar is the following: In the case of a citizen in Windsor Canada, a year ago a Cadillac at the local dealer and the one across the river in Detroit cost about the same. As a result of the collapse of the US dollar vs the Canadian dollar, the same Cadillac in Detroit is now nearly 20% cheaper than the one in Windsor. Thus, it pays the Canadian to drive across the bridge and "buy American."

Friend: I just saw where the big European consortium, Airbus -- Boeing's biggest competitor -- is saying that as a result of the collapse in the dollar, they will move $2 billion dollars of research on their new planes to a dollar denominated country. That would seem to mean that some, if not all of that work may come to the US.

GCD: I know we are speaking anecdotally, but this is happening all over the world. The fall in the dollar has made us more competitive and companies the world over have to deal with it.

Friend: Then I guess we are saying that the great bugaboo of a falling dollar is not all bad.

GCD: Yes, it eventually brings itself into an equilibrium level and begins to stabilize. That appears to be happening now, and I don't see it turning around anytime soon. I believe those people who are calling for a recession are missing the contribution of imports to the US economy .

Friend: That is what I have been thinking, as well.

Next time: Are US stocks overvalued?