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The Defining Battle: C vs. I

Posted August 17, 2009

Topics: Politics, Finance & Investing

Stock market trend: Up. Watch for pullback.

The University of Michigan consumer sentiment index fell in August to its lowest level since March, according to preliminary data. The index came in at 63.2, down 2.8 points from July and even more from the second half of last month. The decline from July was led by a sharp drop in assessments of current conditions, although assessments of expectations also fell.

The battle between consumption C and investment I in the GDP growth equation pictured above will define the success—or failure—of the nascent recovery. Two things are clear:

1. This is an investment-led recovery as bare bones inventories are finally stimulating the manufacturing sector to increase production again. This fact is evident in two leading indicators, the upwardly trending ISM Manufacturing Index (shown in last week's missive) and, most recently, industrial production illustrated above:

2. Consumption is lagging in the short term because of a weak job market and likely will lag in the longer term because of the absence of both rising incomes and any new bubble to fuel consumption. The short term problem is reflected in the latest news on consumer sentiment pictured below which brought the market down last week. The long term problem is really the crux of the matter. For almost a decade, America has been characterized by a declining manufacturing base and, not coincidentally, stagnant incomes. In this period, American consumers have funded their expenditure on first the tech bubble and then on the housing bubble, which turned America's housing stock into an armada of ATMs. With no new bubble in sight and with our manufacturing base continuing to wither, America's consumption patterns will inevitably retrench to a lower level. That will make any long term growth problematic.

From an investing point of view, it's critical to understand the tension between C and I in the GDP growth equation. In the bullish scenario, increased production will lead to more hiring, more wage income, and lift consumption by its bootstraps.

In the bearish scenario, one of two things can happen. Firms will increase production without hiring and the recovery will quickly wither. However, even if firms do hire and workers boost their consumption, it may not be high or fast enough to sustain the recovery. As a trader or investor, this tension between C and I is what you should keep an eagle eye on.

As for other key elements, the story playing out in Europe is fascinating. Both Germany and France are recovering smartly, with Germany in particular propelled by its capital goods exports to China. However, much of the rest of Europe remains flat or, in the case of countries like Spain, flat on its back. It's important to see how this plays out as we need to sell Europe exports if the American economy is to strengthen.

As a final comment, we know face the specter of two young Democratic Presidents—first Clinton and now Obama—falling prey to a Republican counter-revolution triggered by a misplaced health care reform plan. After eight years of the reviled Bush-Cheney and with a Republican party in tatters, it seemed unlikely just a few months ago that the 2010 elections could threaten the Democrat's super majorities in both the House and the Senate just as the 1994 Gingrich revolution ushered in a new era of split government. But now that possibility is very much beginning to loom.

Democrats in heavily contested districts need to get this message: If you want to get re-elected, don't vote for health care "reform." It's not that we don't need reform. It is simply that the legislation has been so perverted up to this point that nothing can save it in this cycle.