The US economy is the next 9/11

So how weak will the US economy become? First of all one has to be concerned about the recent sharp money supply growth deceleration. The 12-months rate of growth in M2, at 3,6%, year-over-year, is at the lowest level since 1995 and the 13 week percentage change of MZM has now just turned negative.

As a result of the decline in the rate of growth of money supply, 'excess money', as defined by the growth in money supply in excess of nominal GDP, has over the last 18 months also plunged. Usually, when money supply growth slows down so rapidly and when 'excess money' plunges, the economy follows with a brief time lag.

The second reason, I have strong reservations about a sustainable recovery is that employment gains are still dismal and most unlikely to improve much. The problem, now, compared to previous recoveries in the US is that China in the manufacturing sector and that India for tradable services will continue to gain employment market share at the cost of US employment and also lead to a worsening of America's trade and current account deficit.

The more China gains of the US import market, the more jobs the US is losing. This trend has become particularly worrisome since year 2000. Moreover, what weak employment gains mean is that the US labor force has no bargaining power and, therefore, has declining real (inflation adjusted) incomes.

Under these conditions one has to wonder why US consumption expanded after 2001 rather rapidly. The reason for this anomaly were the tax cuts, which increased after tax personal incomes and the favorable conditions in the housing market, where negative real interest rates led to strong price gains and the refinancing boom.

Mortgages boost US consumer

Since 2001, homeowners have taken out much higher mortgage loans on their homes than the volume of mortgages required to finance new construction activity.

So whereas recently mortgage borrowings were running at an annual rate of almost $800 billion, the financing of new home construction only required mortgages of around $450 billion. In other words, homeowners extracted almost $300 billion a year from their homes, which they could then spend on consumer goods such as cars, appliances and other discretionary items.

However, it should be clear that consumption driven solely by asset inflation in residential real estate is not sustainable in the long run. One day, home prices will fail to rise, either because interest rates won't decline any more or because affordability for the new buyers who have declining real incomes will become an issue.

Possibly supplies will also exceed demand as home builders all want to take advantage of the appreciating housing markets across the country by building a large number of units in the hope to sell them later at inflated prices.

What we, therefore, find at the present time is that US inventories of new homes for sale are at a record because, in recent months, housing starts have been rising at a far higher rate than new home sales.

I concede that the recent renewed decline in interest rates could keep the housing market buoyant for some more time, but since housing prices have increased at a far higher rate than consumer prices in recent years, some kind of housing bubble is in the making and, by now, we should all know what eventually happens to bubbles!

I would also add that once home price appreciation slows down or interest rates rise - or a combination of both - refinancing activity will come to a halt. Since there has been a close correlation between the refinancing index and retail sales a significant slowdown or even decline in consumption is only a matter of time.

Aside from poor employment gains, negative real income increases, mortgage credit which is driving home prices higher and hence consumption, but which will inevitably slow down in future, there are some more reasons to be cautious about the American economic outlook.

Tax cut impact over

The impact of the tax cuts has ended, consumer debts are in the stratosphere and will become burdensome the day interest rates will rise and the stock and bond market are not suggesting anything else than economic weakness. Bonds have, as we expected, rallied from their June lows by about 10% while stocks of economic sensitive companies have performed poorly.

I am always interested in the performance of economic sensitive stocks such as retailers, high tech and auto companies as a lead indicator for the economy, which is incidentally far more reliable than all the hogwash Wall Street publishes and one has to endure watching CNBC.

Recently specialty retailing stocks have been acting poorly while high tech stocks have tumbled. General Motors, about which one used to say that it closely reflects the health of the US economy is hovering just above its 52 weeks low and it looks as if its price will shortly break down.Certainly not a very encouraging sign for the economy and the stock market!

In sum, I still regard the upside potential for the US stock market to be limited and would sell strength rather than buy weakness. Still with a Bush victory now likely, the strength in the bond market, and the oversold position of high tech stocks, some additional gains are a possibility.

However, bonds are now no longer over-sold and their upside potential appears to be limited too. We still like selected commodities such as Corn and Coffee, and especially Sugar and Orange Juice. Gold should be accumulated continuously, as it is the only sound money.