A Tale of Two U.S. Economies

Did you hear about the economist who drowned in a stream with an average depth of six inches? Averages, like appearances, often are misleading and in 2008 will not begin to tell the tale of two U.S. economies (not to be confused with presidential candidate John Edwards’s “two Americas”).

One U.S. economy will be focused on fall-out from collapsing regional residential real estate prices and attendant mortgage debt write-offs, of which sub-prime-related loans, CDOs, SIVs, ABSs and derivatives will constitute the bulk of, but not the entire, exposure as the once-thought “contained” spill of toxic financial waste slowly oozes forth to envelop a much more significant portion of the nation’s financial sector.

This U.S. economy is situated in all the current real-estate meltdown hot spots: Los Angeles, San Diego, San Francisco, Portland, Seattle, Las Vegas and Phoenix in the west, Miami and Tampa in the sunbelt and Chicago, Detroit, Cleveland and Boston in the industrialized north, and as we have suggested previously, difficulties in these areas will be magnified under the scanning electron microscope of the media circus known as the 2008 Presidential Campaign. (New York City, staggering under the enormous burden of a record pile of Wall Street bonuses, about $38 billion despite the growing debt market mess which began in mid-2007, temporarily will defer its own forthcoming real estate correction.)

The other U.S. economy will show evidence of regional resilience and growth, areas where real estate prices did not vault skyward since 2000 and where business segments focused on non-financial services, technology, agriculture and energy help drive meaningful economic results. For many markets in the nation’s midsection (Oklahoma, Texas, Colorado) and the Southeast (North Carolina and Georgia, if the drought moderates) economic growth and strong employment trends can continue apace despite higher consumer inflation from food and energy. In fact, energy-rich areas should do very well comparatively, much the opposite of when the midsection was flattened by a cratering energy economy in the 1980s but other parts of the nation saw extraordinary growth.

Our media thrive on bad news, naturally, and this year’s presidential campaigns provide the lens through which all economic data will be filtered, parsed and spun, thus subject to far more distortion than usual. (January 4th’s 5.0% unemployment rate report, up from 4.7%, and lackluster December 2007 jobs growth are relevant examples which will prompt much political rhetoric, along with plans to “do something about it.”)

With Michigan and Florida primaries later in January, these high-profile contests will concentrate inordinate attention on rapidly deteriorating economic conditions in those states as candidates seek to fit perceived problems to promised solutions and desired outcomes bearing little or no relation to the original concern (and sometimes – as voters are aware and must remain vigilant – proposed cures can be worse than the maladies).

On Super-Tuesday, February 5^th, another 22 states will hold primaries after which more than half of delegates will have been allocated. By then, unfortunately, the nation will have been portrayed schizophrenically by presidential hopefuls, aided and abetted by media coverage, as either already suffering from the worst economic downturn since the Great Depression or as in really good shape needing nothing more than a few more Fed rate reductions and a couple more tax cuts to resume full throttle, depending on which presidential candidates are offering an assessment.

Neither depiction will be remotely accurate but both extremes contain grains of truth hidden within after slicing through the thick layers of political rhetoric. The key issue for 2008 and beyond, however, is whether the economically viable portions of the country are sufficiently insulated from spillover effects from the economically imploding regions and whether surging U.S. exports stemming from a weaker dollar mitigate other weakness.

By the end of the year many of our predictions likely will have been proven wrong to the point of hilarity, but the prospect of that outcome in no way diminishes our enthusiasm to forecast against the odds, knowing, like a hole-in-one in an otherwise bogey-golf round, we are bound to have guessed correctly at least something by year-end. Keeping in mind our tale of two U.S. economies and the fallacy of averages, here we go:

Social mood drives financial markets and the economy, not the other way around, and the onslaught of negative reporting of the news this year will make recession a self-fulfilling prophecy as now upward of 70 percent of surveyed Americans already believe the economy to be contracting. The recession will be ugly in a few areas, far less so in many and non-existent in still others, including Oklahoma. On average – and long after an ensuing recovery has begun – the recession of 2008 will be pronounced “mild.”

Gasoline prices stubbornly will remain above $3.00/gal and oil above $100/barrel, even in the absence of some event-shock. The Federal Reserve will continue rate-cutting, bringing short-term rates as low as 2.50% from the current Fed Funds target of 4.25% (it is an election year) fearing deflation more than inflation, about which it will worry another day. Fed action, “flight-to-quality” and a weakening stock market and U.S. dollar continue to drive down longer-term U.S. Treasury rates early in the year but a post-election bond-market inflation hangover induces a steeper tilt to the yield curve, with 30-year bond rates reaching toward 6.00%.

Sovereign Wealth Funds, the huge (more than $2 Trillion in aggregate) foreign-country investment funds established to recycle their current stockpiles of dollars and Treasury bonds accumulated in two decades of U.S. import binges will be the most-cited buzzword of 2008.

SWFs already have been busy selling some T-bond holdings to help re-capitalize several money-center banks and brokerages and much more activity will be forthcoming this year, becoming, in itself, a major campaign issue for all candidates.

Political instinct to prohibit “in the national interest” excessive sales to foreigners of U.S. assets and chunks of American businesses will be tempered by the economic realization of the sheer size of SWF dollar holdings and the mischief which could be created if SWFs, frustrated by an inability to buy U.S. investments, decide to divest from bonds and dollars anyway (which would further weaken the dollar and force bond yields higher) and invest in other parts of the world, say, Central and South America.