Sales Insight - January, 2007

An “objective advisor” is a financial professional who meets high standards in many areas, including critical self-evaluation. You must be introspective to eliminate personal biases that undermine your objectivity – including those woven into the fabric of your industry, the financial media and clients’ values.

One acid test of objectivity is the ability to deliver an unbiased economic review and outlook (R&O) to clients near the start of each year. The R&O sets the stage for personal planning while demonstrating your objectivity and strengthening client relationships. Because global economic events have become so dynamic, and many clients are deeply confused about which trends are meaningful, an objective R&O has never been more valuable.

Unfortunately, some advisors have lost confidence in their ability to interpret economic events. Each day brings news that seems to fluctuate from good to bad, strength to weakness, soft landing to hard. The same economic trends that cause investment markets to cheer one day create gloom the next. Two eminent economists can examine the same data and interpret half-full and half-empty forecasts. How can an advisor offer clients more clarity than a Ph.D. economist?

If you harbor such doubt, this column aims to change your mind. It will explain the role that you can play in helping clients overcome systematic biases in how economic news is reported and interpreted. It will identify four specific types of economic data that you can help clients monitor long-term, just as you help them compare investment performance against defined benchmarks. It also suggests how you can use R&Os to suggest strategic adjustments in clients’ personal planning.

When you find yourself speaking in euphemisms, you have crossed to the wrong side of the line that defines objective advice. Today’s most ubiquitous economic euphemism is “soft landing.”

In the vernacular, this term means a temporary, benign lull in an economic expansion, during which the economy sinks low enough to cool inflation without dipping into recession. Common wisdom holds that “the Fed is trying to engineer a soft landing” in 2007, mainly because just about everyone with access to the press or airwaves has said so, repeatedly.

“Soft landing” sounds eerily similar to another euphemism that became a hallmark of the dot-com era – “new paradigm.” In the late 1990s, the new paradigm decreed that old rules about stock market valuations no longer applied. Similarly, in a soft landing scenario, historic patterns of economic cycles are repealed. Recessions can be permanently postponed by a wave of the Fed’s magic wand, and any economic downturns won’t last long or hurt much.
The media’s fixation on “soft landing” reveals a growing short-term bias in economic reporting. The focus is almost always on the period just ahead, rather than on deeper issues that may ultimately have more serious impact on your client’s pocketbooks and portfolios. Thus, objectivity begins by re-orienting your clients to the history of U.S. economic cycles.

According to the National Bureau of Economic Research (NBER), the current expansion has run 63 months into the 11th economic cycle of the modern era, since 1945. The average length of all 11 expansions has been 57 months, while the average recession has lasted 10 months. However, both of the last two recessions (1990-91 and 2001) were relatively short and shallow, and they were preceded by epic and strong expansions of 92 and 120 months, respectively. Since the end of 1982, the U.S. economy has been expanding a miraculous 97% of the time.

From 1983 through 2005, the U.S. economy caught a powerful wave of economic growth driven by positive secular trends. They included: 1) millions of U.S. women entering the workforce in the 1980s and 1990s; 2) historically low inflation and declining interest rates; 3) productivity gains driven by new technologies; 4) relatively strong rates of personal savings through the mid-90s; 5) a federal government surplus in the late 1990s, leading to deep tax cuts; 5) peaceful times, without the economic burdens of a prolonged or costly war (until 2003); and 6) global admiration for the U.S. economy as the dominant financial engine in the world.

In normal times, economies expand and contract much as individuals get strong and healthy and then tired and sick. When people begin to feel run down, doctors prescribe rest and medication. Likewise, when expansions become worn out, a brief recession can be the right medicine for recuperating personal finances and expelling irritants, such as excessive spending or burdensome debts. However, the modern bias is to associate recessions with negative consequences, not the recovery of economic health. The reason for this bias is difficult to decipher, but much of it may be plain old American salesmanship – to keep consumers spending and investors bullish.

Another bias in economic reporting is overconfidence in the Fed’s ability to engineer positive economic catalysts. Over two years (2004-06), the Fed raised the target Fed Funds rate in .25% increments 17 times. Yet, 10-year Treasury yields barely budged, as shown in the table below.

	Fed Funds Target Rate	10-Year Treasury Yield
6/29/04	1.00%	4.70%
6/29/06	5.25%	5.22%
Increase	4.25%	0.52%

The Fed wielded limited power to move 10-year Treasury yields in 2004-06 because of buying pressure from Asian investors and OPEC oil producers, both of which were disposing of vast trade surpluses. The 10-year Treasury has become perhaps the most influential interest rate in the U.S., with many types of home mortgages, lines of credit and business loans keyed to it. Yet, the fate of 10-year Treasury yields in 2007 and beyond may depend more on fiscal policies abroad than on the Fed.

Below are four key data sets that you can review now and in future R&O briefings. For each set, we have also included: 1) data that you and your clients can monitor as benchmarks or progress; and 2) related personal planning ideas.

Data on personal savings illuminates overall U.S. financial health at the household level. As calculated monthly by the National Bureau of Economic Analysis (NBER), personal savings measures many forms of personal income (including dividends, interest and government benefits) less personal consumption expenditures. Historic data on personal savings is available at:

During the 1980s and early 1990s, the U.S. personal savings rate fluctuated between about 5% and 10% annually. However, in the late 1990s, this rate slipped below 5%. In every month since April of 2005 it has been negative. The culprit has not been an inability to save or invest, because U.S. retirement plans and bank accounts keep grower fatter. Rather, the culprit is profligate consumer borrowing that has fueled excessive personal consumption.

To maintain constant savings power, the U.S. personal savings rate must match the annual rise in wages, which has been running about 4%. Thus, an annual savings rate below 4% represents a deficit – borrowing from the future for current consumption. Using a 4% annual savings rate as a benchmark, the cumulative shortfall in U.S. savings in 2005 and 2006 totaled about $700 billion.

The average annual rate of economic growth (GDP) in the U.S. in 2005-2006 was 3.1% per year. But about .6% of this was “phantom growth” produced by consumption that should have been saved (assuming a 4% savings rate). Thus, a chunk of the “prosperity” of the past two years has been borrowed from America’s future. Future economic growth built on top of this inflated GDP, without a period of retrenchment, will only aggravate a serious and ultimately costly U.S. savings shortfall.

Monitor: The personal savings rate (see URL above) and monthly releases at the NBER site:

In 2007, it will be a positive sign if the U.S. personal savings rate gradually trends from negative numbers to positive. But to achieve even a zero savings rate, U.S. consumers must cut back on their borrowing and spending. Because personal consumption is by far the largest component of GDP, consumption cutbacks could create a short-term drag on economic growth and possibly trigger a mild recession.

Personal Planning: The only type of “personal income” not included in the personal savings rate is capital gains. Over the past decade, many consumers have felt flush with gains in the stock market or home equity, and as a result they have felt free to increase personal debt through mortgage refinancing or revolving credit. Now, down periods in stock markets (2000-02) and home prices (2006-07) have washed away part of the gains, leaving the debts behind. As a result, many Americans feel poorer, and that should soon trigger consumption cutbacks, increased savings, and perhaps a brief reduction in GDP.

Encourage clients to continue making steady progress with savings and investments, particularly in “sticky” types of long-term accounts such as retirement plans. Also, help them monitor their own personal savings rates – and caution against using appreciation in portfolios or home values as an excuse to borrow or spend more.

The United States’ recent consumer spending spree, combined with domestic manufacturing declines, and service outsourcing, has led to a deepening foreign trade deficit. The historic trend in U.S. imports less exports (called the “Balance on Current Account”) can be monitored here:

For 2006, the total trade deficit was about $900 billion, and in 2007 it is expected to top $1 trillion, representing more than 7% of GDP. In addition to the factors mentioned above, the deficit keeps growing larger because of rising imported oil consumption and artificially low exchange rates in some Asian currencies, which make Asian exports more enticing to free-spending American consumers.

With the soaring trade deficit has come unprecedented foreign hoarding of dollar-denominated assets (especially U.S. Treasury securities). Government and private investors in China and Japan collectively hold more than $1 trillion in U.S. Government debt. The six large “Gulf Arab” oil-producing nations are believed to have several hundred million dollars of U.S. debt in official reserves or secretive government-controlled investment funds. As dollars pile up abroad, the value of U.S. currency becomes vulnerable vs. other currencies in foreign exchange markets. .

As the dollar has weakened over the past two years, U.S. exports have staged a modest rally. But the gap between imports and exports is so large that it will take a significant decline in U.S. consumption of foreign goods and services for the trade deficit to decelerate.

Monitor: The Balance on Current Account and two exchange rates: dollar-euro and dollar-yen.

During 2002-2006, the dollar lost 31% of its value against the Euro but only 12% against the Japanese yen. However, the more important of the two currencies for monitoring dollar declines in 2007 may be the yen. Japan has the largest holdings of U.S. Treasury securities of any foreign nation (about $640 billion), and the Japanese government is being challenged to promote internal domestic growth above exports, which could lead to gradual dollar divestiture. Also, the yen is a benchmark currency for other nations in the Asian sphere, and its strength vs. the dollar could influence other Asian dollar-hoarders to divest dollars. The euro has become the emerging alternative currency (to the dollar) for OPEC producers, so it also should be monitored.

In 2007, gradual declines in the dollar of up to about 5-10% vs. the Euro and 10-15% vs. the yen could be a positive for the U.S economy. This trend could make U.S. exports more attractive while curtailing U.S. consumers’ appetite for increasingly expensive imports. The major foreign investors with large dollar holdings are working to keep the dollar’s decline gradual, which will help them avoid large or sudden currency mark-downs.

However, there is a growing worry that “hot-money” currency traders and speculators will make a run against the dollar at some point in the future. This could sharpen the dollar’s short-term decline and cause major foreign dollar holders to accelerate dollar divestiture. The result of a sharp dollar decline could be higher inflation in the U.S. and rising long-term interest rates, despite any efforts by the Fed toward rate easing.

Personal Planning: This may be a good time to suggest greater portfolio diversification into foreign stocks, bonds, hard assets or direct foreign currency exposures. While a dollar-driven currency crisis is only a remote possibility, not a probability, it would negatively impact both U.S. stocks and bonds. Despite the financial press’ infatuation with the Fed, clients should be cautioned not to base 2007 planning on the anticipation of specific moves by the Fed, because the Fed has limited control over the U.S. trade deficit and foreign dollar holdings. Because the Fed is interested in fighting inflation, it will keep one eye on domestic prices and the other on the trade deficit and foreign exchange markets.

The combination of federal tax cuts and the Iraq war has led to an increase in federal public debt of $1.2 trillion over the past two years, to a total of $8.4 trillion as of 6/30/06. A gradually rising level of federal debt should not create long-term economic problems unless the rate of increase in the debt far exceeds GDP growth. In 2005 and 2006, federal debt increased by about 9% per year, almost three times GDP growth. The long-term cost of the Iraq War, projected to exceed $800 billion (including interest), has been financed by federal deficit spending.

The interest on the federal debt now exceeds $400 billion per year, about 3% of GDP. However, the interest tab was reduced in 2006 by an inverted yield curve, which kept rates on intermediate- and long-term Treasuries relatively low. If a normal yield curve returns in 2007, it would increase the interest cost at a time when the U.S. government is already burdened by the continuing cost of the Iraq War, and also possibly health care and Social Security reforms. This could create a further drag on growth while perhaps leading to political pressures to raise U.S. taxes.

Of $5 trillion in federal debt “held by the public” (as opposed to intra-government holdings), about 43% is in foreign hands. Roughly half of the marketable debt held by the public is in Treasury notes with maturities ranging from two to ten years. Foreign Treasury note buyers have driven the demand behind the inverted yield curve, and they also hold the key to where longer-term rates will go in 2007.

Historically, it is rare for inverted yield curves to continue very long, and the weak U.S. dollar makes it even less likely that foreign Treasury note holders will maintain such a voracious appetite for Treasuries in the future. While any softening in the U.S. economy should eventually lead to Fed rate cuts on the short end of the curve, it is also possible that the return of a normal curve will result in higher rates for longer maturities. The “good news” would be any events that can extricate the U.S. from additional war costs while increasing international confidence in the dollar. Any reductions in the trade deficit, driven by pullbacks in U.S. consumption, could be catalysts that increase dollar-confidence.

Personal Planning: Clients should be prepared for strong medicine, whether or not it happens in 2007 or later: 1) higher long-term interest rates, which likely would carry over into higher mortgage rates; and 2) political talk about tax increases to reduce the deficit. Higher long-term rates could prolong the slowdown in housing and increase foreclosures, especially in the subprime mortgage market. Serious talk about tax increases would produce short-term pain in financial markets but could bolster confidence in the dollar and U.S. government debt long-term. This is a time for clients to be nimble in their bond holdings and able to lock in higher long-term rates later, if they develop. Some clients may want to take advantage of tax pre-payment strategies (e.g., Roth IRA conversions) before tax-hike talk heats up in Congress.

For optimists who believe the U.S. economy will remain strong, a low unemployment rate has become Exhibit A. But unemployment data is drawn directly from unemployment insurance claims, an outdated measure in this era of job mobility. The U.S. now has millions of “permanently temporary” workers who hop from job to job (especially in good times) and rarely file for unemployment benefits.

For purposes of measuring long-term economic health, a more useful measure is the civilian employment-population ratio.

This ratio measures people who are employed as a percentage of the total U.S. adult population. Over extended periods, economies are able to sustain economic growth for two basic reasons: 1) more people join the work force; and 2) workers become more productive through skills improvement or better capital equipment. A big influence behind the U.S. economic miracle of 1982-2005 can be seen in the graph of this ratio.

From 1982 through 1999, the ratio increased from 57% to 64%, and job growth was driven mainly by women leaving homes and going to work. Also, per-worker productivity increased as women increased job skills, and as new technologies enhanced all workers’ productivity.

After dipping briefly in the recession of 2001, the ratio has begun trending up again with a strong employment market. However, the macro-trend of the future is the emergence of millions of Baby Boomers on the threshold of retirement. If large numbers of Boomers leave the work force too quickly, they will produce a serious drag on economic growth.

Monitor: Trends in the civilian employment-population ratio for a sign of how quickly Boomers are leaving the workforce.

If the ratio starts to move toward 60%, the U.S. economy could be in store for a period of stagnation. One possible remedy could be a more liberal immigration policy that would bring several million undocumented workers out of the shadows and into the work force, with concurrent increases in their skills, productivity and tax payments. So, also watch Washington for developments in this area, including better relations with Mexico’s new President, Felipe Calderón.

Planning: Urge Boomer clients not to be too quick to ride into the sunset. At minimum, they may want to wait until the next recession has run its course to see its impact on their planning, portfolios, income taxes and future Social Security checks. Clients who keep working well into their 60s, even if part-time, will be in the best position to adjust to economic changes while stretching assets over full retirements.

In the U.S. today, there is a strong tendency to view economic events through rose-colored glasses that focus on the short-term and see the Fed as savior. However, almost all of the Fed’s own statements and actions indicate that it would prefer to exert limited, surgical influence over an increasingly global economy, rather than attempt to wield a heavy hand and fail. One of the best pieces of advice an objective financial advisor can give clients today is: “Plan wisely and ignore the Fed!”

Many Americans have developed a sense of infallibility about their nation’s economy. They think it is the American way to work out of tough jams, including economic difficulties. But America’s dominance and prestige in the world has been weakened by faster growing economies in Asia, oil dependence, trade deficits, and the economic and psychological costs of a four-year war in Iraq. This is a good time for clients to plan conservatively while hoping for the best and implementing strategies to guard against the worst.

The global economy has already moved into uncharted waters, where many of the old economic maps may no longer function. Here is an insightful comment about the U.S. made by economist Kash Mansori of Salem College:

“Never before has any country been able to run such a large current account deficit for so long. Never before has any country borrowed such a massive amount of money from the rest of the world in such a short period of time. Never before has the world changed its preference for international assets (particularly U.S. assets) so rapidly. Never before have global central banks accumulated such staggering quantities of foreign exchange reserves. Never before has our domestic financial system been so dependent on international capital for its low interest rates, and by extension, been so vulnerable to events in the foreign exchange markets. And never before has the country most at risk for a painful exchange rate adjustment – been the owner of world’s dominant reserve currency.”

An online interview with extended comments by this economist and others is located here:

Never before has an objective financial advisor been more valuable, especially when that advisor is able to deliver an economic R&O to clients now – while there is time to plan ahead for either the best or worst of times.