The following editorial was published in Price Perceptions issue #1380 on February 21, 2009
Recession of a Different Kind - Part II
It is becoming clearer each week the life we have known has been changed forever. No longer can many afford to dine at fancy restaurants, buy designer clothes, make payments on a new Porsche, or purchase a McMansion. We have enjoyed the longest period of leveraged prosperity in history.
We came to believe our retirement would be financed by profits in the stock market... We took out home equity loans to pay for vacations... We sent the kids to college by strapping them with loans requiring years to pay back... We measured wealth by the limit on our credit cards. Now, the dream of perpetual prosperity has ended.
The famous economist, Keynes, developed a simple way to measure whether we were earning enough to maintain our standard of living. It is called the marginal propensity to consume (MPC). The MPC is the percentage of after tax income growth utilized for consumption. From 1950 to 1990, the MPC averaged 89%. Or, the growth in consumption was 89% of income growth. However, from 2001 to 2007, the MPC averaged an historic 108%. In other words, we have been consuming much more than we produce.
Unfortunately, we can no longer consume more than we produce. Credit card companies are reducing credit limits... Banks now require a sizeable down payment and proof of income to buy a house... Car loans are no longer available for those owing more than the trade-in is worth. The global economy has moved into a deleveraging and deflationary cycle.
This economic cycle is different than those we’ve experienced in the past. A recession cycle is a period when the Federal Reserve tightens monetary policy to curb inflation. In other words, the economy is weakened enough to curb inflation, then the Fed eases monetary policy and economic expansion resumes. The current economic cycle is much more complicated and difficult to control. It is termed a debt deflationary cycle. Following a long period of debt financed consumption; income no longer supports debt service. This cycle requires restructuring of debt.
In recent months, companies and individuals have cut back spending to better service debts. The global economy has gone through a significant shift from debt creation to debt contraction. This has caused prices of things to fall, most importantly the value of real estate. In many cases, asset values are now below the loan or mortgage value. Therefore, loans must be written down and assets sold. This is the restructuring phase of the deflationary cycle. It will probably require several years of bankruptcies and economic contraction before the cycle can once again move into an extended period of expansion.
It is important for commodity traders to realize this is a recession of a different kind. Government programs should be expected to come and go for months and years to come as world leaders grapple to find solutions. There will be periods of hope and promise, only to be followed by disappointment. This period of turmoil will provide many excellent profit opportunities in commodities. However, traders must remain flexible and avoid believing prices can only move in one direction.
TRADING IN COMMODITY FUTURES OR OPTIONS INVOLVES SUBSTANTIAL RISK OF LOSS. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.
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