In this article I discuss the benefits and risks of betting against the American economy and the best ways to do it. In part 1 I provide a general overview of America's economy and demonstrate that, with some exceptions, it is in serious trouble. The American economy runs the risk of entering a severe recession as a result of the following: (1) its reliance on Americans spending borrowed money and over-consuming as opposed to saving and producing real, exportable goods as evidenced by its perpetual negative trade balance (2) artificially low interest rates that have perpetuated Americans' lack of savings and over-borrowing, and (3) an aging demographic that is barely growing. These phenomena, which I discuss in greater detail below, have resulted in negative trade imbalances, over-indebtedness on the part of America's citizens and governments (federal, state, and local), rising prices, and perpetually high unemployment.
In part two I provide some investment ideas based upon the aforementioned scenario playing out. In particular I suggest that investors buy assets that will protect them from rising prices, and sell assets that will suffer as Americans are forced to consume less as they face rising prices and devote more of their assets to repaying their debts.
1: The American Economy
A: A Brief Description of America's Economy
There are two significant problems with America's economy. First, it is heavily consumer-based. In America consumption as a percentage of GDP has consistently been at least 60% for decades.
Second, America's GDP is largely driven by government spending. According to USDebtClock.org government spending in the United States (including federal, state and local governments) comprises 42% of GDP.
Unfortunately this leaves very little room for manufacturing, which comprises just 12% of America's GDP.
As a result one can conclude that Americans spend money to consume goods and to expand government programs while producing very few goods. This was not such a bad situation when the United States was a creditor nation, as its citizens and governments were in a position to afford this excessive consumption and under-production. Yet now, as I demonstrate below, Americans must borrow money in order to consume at the rate that they do, and consequently this consumption is unsustainable. This unsustainable state of affairs is reflected in America's daunting balance of trade and in the catastrophic debt-loads carried by its government and citizens (both of which I discuss in greater detail below): Americans are essentially borrowing in order to maintain their standard of living.
That being said there are some promising aspects of America's economy which bears must consider before taking the short positions I discuss in part 2.
First, America is essentially tied with the Russian Federation as the global leader in natural gas production. While the United States has not benefited the way Russia has, as natural gas prices are substantially higher in Europe and Asia than they are in America, natural gas prices seem to have bottomed locally, and the American economy should benefit as natural gas prices rise and new production technologies such as fracking lead to additional production.
America is also a major player in global agriculture. The United States is the top producer of corn in the world, and it is responsible for over a third of global supplies. The same can be said about soybeans. Additionally, the United States is fourth in the world in wheat production and second only to China in meat production. The American economy has benefited as a result of rising agricultural commodity prices, which have been moving higher over the past 7-8 years. Furthermore, if the bullish conditions for agricultural commodities remain in place (such as a rising global population, and shrinking inventories), then America can continue to see these benefits to its economy.
Nevertheless I doubt that these positive trends in America's economy can counter the severe problems I have discussed, and for which I provide data below.
B: America's GDP
While America's GDP has been growing over the past decade, this growth has been rather tepid, as the following charts indicate:
America's GDP has grown by roughly 50% over the past 10 years. This wouldn't be reason for concern if inflation weren't such a serious problem, as I discuss in greater detail below. Another issue is that America's GDP growth hasn't been "good" GDP growth. That is to say that America's GDP growth has largely been the result of increased government spending and a negative balance of trade as opposed to increased production spawned by savings and investment.
Furthermore, America's GDP per capita growth has been just 6.5% adjusted for the CPI over the same time period as the following chart indicates:
C: American Fiscal Policy
America's fiscal policy is horrendous. The following chart of the federal government's debt speaks for itself:
Furthermore, the federal debt (excluding unfunded liabilities) has recently exceeded 100% of America's GDP:
The federal, state, and local governments run enormous budget deficits and are projected to do so for years to come. While this excessive spending has propped up the economy for now, as debt levels grow this will become an ever increasing burden because more funds will be needed in order to pay the interest on this debt. Another possibility is that interest rates remain low as a result of the Federal Reserve's continued bond purchases. In this scenario, while the interest payment burden will not spike as in the previous scenario, the monetary base will grow which will likely lead to rapidly rising prices that will hit the American economy just as hard, if not harder.
Furthermore, the "official" data to which I am referring does not take the federal government's unfunded liabilities into consideration, and the following chart illustrates that these far exceed the federal government's "official" debt-load:
This estimate of the federal government's unfunded liabilities, like many others (it is not a number that is set in stone), shows that the federal government's real debt load is several times greater than America's GDP, and as a result the American economy will suffer that much more as its citizens must service this debt in one of the two ways I suggest above.
D: America's Balance of Trade
America consistently imports far more than it exports as the following chart of its balance of trade indicates:
As a result America's economy appears to benefit short-term, as America's trade deficit leads to increased consumption which boosts its GDP. Yet this improvement is unsustainable: the United States must borrow money, as I indicated in section C, in order to pay for its excessive imports, and ultimately one of America's leading exports is its government bonds and currency. These, of course, are claims on American goods, and when America has to make good on these promises the prices of the limited amount of American goods will be bid up, further damaging the economy.
E: Monetary Policy and Money Supply
America's monetary policy is extremely loose, as is necessary to support America's excessive borrowing. The Federal Reserve's benchmark interest rate is near zero and it is currently implementing a policy of quantitative easing whereby it purchases $85 billion worth of bonds on a monthly basis, or nearly $1 trillion per year.
The Federal Reserve's benchmark interest rate has been low for a long period of time as the following chart indicates:
Furthermore, as the following chart indicates, the CPI, assuming it is an accurate measure of inflation, has risen on average by about 2.3% since the turn of the century:
(*I am skeptical of the accuracy of the CPI. For a detailed discussion as to why see my instablog Money, Inflation, and the CPI.)
Given that the rate of inflation as measured by the CPI is greater than the Federal Reserve's benchmark interest rate, the real interest rate (the nominal interest rate minus the inflation rate) is actually negative.
Furthermore, the Federal Reserve has said that they expect that their benchmark interest rate will remain low for years to come: at least until 2015, or until inflation expectations rise or the U3 unemployment rate drops to 6.5% or lower. As a result both the monetary base and the M2 money supply have been soaring:
The monetary base is up five-fold over just the last 10 years, while the M2 money supply has nearly doubled. The latter would be much higher except that the poor U.S. economy has led banks to restrict lending, and so the M2 money supply has not risen nearly as much as the monetary base. Nevertheless the rise in the Federal Reserve's monetary base and the rise in M2 money supply indicate that there is a high probability that prices will rise in the future, which should put additional pressure on the American economy.
The American demographic situation does not bode well for the economy. The population is rising, albeit at a very slow rate:
Since 2000 the U.S. population has risen from 282 million people to 312 million people, which equates to an annualized growth rate of just under 0.8%. Furthermore, the American population is getting older, as the following population pyramid charts indicate:
This implies that as time goes by fewer people will be working. The size of America's workforce has already begun to decline from its 2007 peak, as the following chart indicates.
Additionally, more people will be living off of Social Security and income from bonds, stock dividends, and bank interest. Given that interest rates are so low those people who are retired will have a more difficult time maintaining their current living standards. Furthermore, as more people in the United States retire, more capital produced by younger working people will be needed in order to fund social security, which will not only hurt the younger working people economically, but which will also reduce their motivation to work hard and produce more than they consume. This will further cripple the U. S. economy.
The following points summarize the U.S. economy:
1: The American economy is driven primarily by consumption and by government spending. Very little is driven by manufacturing. Some strong points, however, include natural gas production and agricultural commodity production.
2: America's GDP has been rising at a slow rate. The growth of America's GDP is largely driven by growth in government spending.
3: America's government has an abysmal fiscal policy as the national debt soars annually. This data is far worse if we take unfunded liabilities into account.
4: America consistently has a negative balance of trade. While this temporarily lifts our standard of living, eventually foreign holders of U.S. dollars and bonds will exchange them for real American goods, which will drive prices higher.
5: America has a very loose monetary policy. Interest rates are extremely low and the money supply continues to grow. While this policy helps to maintain the American lifestyle of borrowing money to consume, it will likely lead to rising prices.
6: America's population is rising slowly, and unfortunately it is getting older which will negatively impact productivity and drive up Social Security liabilities.
Given these points I can safely say that the American economy is in poor shape. In the next section I will discuss ways for investors to benefit.
2: Betting on America's Poor Economic Outlook
If you accept my aforementioned claims then you will want to buy assets that will benefit from a decline in the U. S. dollar's purchasing power and sell assets that will suffer as a result of declining American consumption. Here I will focus primarily on the latter. For investors looking to bet against the dollar's value I recommend reading my article Portfolio Strategy For An Inflationary Environment in which I recommend that investors purchase the following: (1) commodities with a high value to weight ratio (gold (GLD, GTU, PHYS, IAU…etc.), silver (SLV, PSLV), platinum and palladium (PLTM, PALL, SPPP), Heavy Rare Earth Elements (OTCPK:DCHAF), and uranium (OTCPK:URPTF)) (I should note that I do not like GLD and SLV as gold and silver investments. I discuss this in my article Buying And Owning Gold Part 2: Specific Investments In Gold, my article Buying and Owning Silver Part 2: Specific Investments In Silver, and in my instablog 11 Reasons To Be Suspicious of the SPDR Gold Trust.), and (2) commodity-related stocks.
Investors looking to benefit from a decline in the American economy and the American consumer should consider taking short positions in the stocks of companies that get a vast majority of their sales from the United States, and ETFs (or long positions in inverse ETFs) that focus on these companies. Consequently investors acting specifically on the information provided in this article will not want to take short positions in the S&P 500 (SPY, SH, SDS) or the Dow Jones Industrial Average (DIA, DOG, DXD): while doing so may be a good decision for reasons not discussed here, the companies that comprise these indexes get a lot of their sales outside of the United States. Investors looking to take a short position in a broad index should consider a short position in the Russell 2000 index because it holds small-cap companies that get most of their sales from the United States. They can do so by shorting IWM, or purchasing RWM or TWM.
Investors may also want to consider taking short positions in individual sectors that would suffer most if my above claims are correct. Two sectors in particular include financials and retailers. In shorting financials I would focus on regional banks rather than the large global banks for the same reason I would avoid shorting the S&P 500 or the Dow Jones Industrial Average. While these companies may perform poorly it will not be entirely because of the reasons I outline in this article. Instead investors should consider taking a short position in the SPDR KBW Regional Banking ETF (NYSEARCA:KRE). The banks held by this ETF are smaller than JPMorgan (NYSE:JPM), Bank of America (NYSE:BAC), etc, and operate regionally. Consequently, they will suffer directly if my aforementioned claims are correct. Investors can also consider taking individual short positions in some of KRE's holdings such as Regions Financial (NYSE:RF), Zion's Bancorporation (NASDAQ:ZION) or KeyCorp (NYSE:KEY), although shorting individual stocks is far riskier than shorting the regional banking index via the KRE.
Investors should also consider taking short positions in retail companies that get most of their sales in the United States. One way to do this is to short the SPDR S&P Retail Index ETF (NYSEARCA:XRT). While some of the companies in this fund get a sizable portion of their sales outside of the United States, it generally gives investors exposure to the United States and its consumers. However, this may not be the best way to maximize profits as several of these companies are taking market share from the others. Consequently, investors may also consider taking short positions in individual companies that sell predominantly in the United States that are losing market share, such as Sears Holdings Corporation (NASDAQ:SHLD) and J. C. Penny Company Inc. (NYSE:JCP). These companies already have declining sales and they are losing money. Therefore, if there is a recession in the United States that forces American consumers to spend less, then these trends should become exacerbated.
Disclosure: I am long PSLV, OTCPK:DCHAF, OTCPK:URPTF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.