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Wesbury on Today's Economic Hot Zones

Scott Burns

Scott Burns: Talking economic hot zones.

Hi there. I'm Scott Burns, Morningstar's Director of ETF Research coming to you live from Morningstar's ETF Invest 2011 Conference. Joining me today is Brian Wesbury, chief economist with First Trust Advisors. Brian, thanks for being here.

Brian Wesbury: You are welcome.

Burns: We're going to play a little game now called "economic hot zones."

Wesbury: All right.

Burns: So, we've got a couple of hot zones out there for concern. I am going to throw them out there to you. Is it hot? Is it something you should worry about? And if so, what inning of the hotness are we in?

Wesbury: Sure.

Burns: So, let's start off with housing. A lot of houses, a lot of empty houses. Where are we in the housing crisis?

Wesbury: I think we are at the bottom, and I think it's probably inning number seven out of nine. We're very, very close to the end. I am not saying that we're going to go shooting straight up from here. There is clearly lots of problems with getting a mortgage, or the financial system itself today. But overall, we are beginning to see price discovery even in Florida, even in California. So the hottest zones are, everybody knows where they are, Nevada, Arizona, and Florida and California.

But the bottom line is that housing starts are about at rock bottom. We're seeing the inventory of unsold new homes plummet. It's at the lowest level it's even been. Houses under construction today are at the lowest they have ever been in recorded history--that goes back to about 1970. And as a result, I think what we're seeing is the process of working through the excess inventory happen, and I think we're very close to the bottom.

Burns: All right. So, hot zone topic number two: European debt crisis. So: Hot? What inning?

Wesbury: It is definitely hot, and this is a harder one. I'd probably say we're in the middle innings. The Europeans are taking their time. They cannot seem to figure this out. Greece has to default.

What they really need to do is come up with some sort of Brady bond, like we did in the early 1980s, to stretch this debt out. I think they can avoid a major crisis if they do.

The question then becomes, does it affect us. Well, there are two ways I think about this. One is, our direct exposure to the PIIGS, let say. So, the five biggest banks in America--that would be Bank of America, Citi, J.P. Morgan, Morgan Stanley, and Goldman Sachs--have $54 billion of exposure to the PIIGS. Now, that's sovereign debt, that's also businesses--so, let say, they are lending to Fiat--and it's also individual debt, so the Onassis family has borrowed from one of these banks. I don't know if they have or haven't, but that's what it would be.

So, that's $54 billion of debt. Obviously, not all of that is going to go bad. There are assets behind much of it. But there is $713 billion worth of capital at these five institutions. So, we could lose every dime of that and still have lots and lots of capital left. That's not the issue.

The issue then becomes what about the indirect debt, the counterparty risk that people talk about? And my view there is, is that the European banking system, the ECB, and European governments are gone to backstop these banks in the sense to keep the potential of default for any of these institutions from spreading and taking down the rest of the world.

So, I look at it as a hot zone, but I think it's viewed as hotter than it really is.

One last point on this, Scott, and that is in the early 1980s, every single Latin American and South American country except for Chile and Colombia went into default, and our banks, the eight biggest banks in the United States, had 260% of their capital lent to those countries, directly to those countries in sovereign debt. In other words, when they went into default, our eight biggest banks were technically in default. They were bankrupt. But we invented the Brady bond, stretched things out, and the U.S. economy actually boomed.

I think what we really need is just to resolve this issue. They need to force the pain on Greece and once we do that, we'll move very, very quickly past the hot zone.

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Burns: Got you. So, it's definitely hot. What inning would you say then?

Wesbury: I'd say we're still in the fifth inning there. It's going to be causing volatility for quite some time.

Burns: All right. So, let's bring it back to the home front. I think the last numbers I saw in unemployment were 9.1%. We're hanging kind of over that dreaded 9% mark for a while, bouncing around in-between 10%. Economic hot zone: unemployment. What's the impact, what inning are we in?

Wesbury: What's interesting here is that we can have a recovery even with unemployment this high. Obviously, we've seen it: GDP has grown 2.4% over the last two years, despite unemployment in the 9s and 10s. Europe has grown for 30 years with unemployment 8%, 9%, 10%. So, in the sense of, is it an economic hot zone, can it drag the economy down? No. I think we're 9th inning. We are past the worries about that.

It's a reflection of the dynamism of our economy, and that's where I think it becomes a hot zone. It's a political issue. I'm worried that we are going to continue to spend and go from 99 weeks to 199 weeks of unemployment insurance and keep interest rates too low for too long. So, what that high unemployment rate really does is forces the government--it shouldn't, but it does--to do things that they shouldn't be doing--increasing spending, running a loose monetary policy--and that is a recipe for stagflation, and we are coming closer and closer to stagflation every day, which reminds me of the 1970s. I've reread Nixon's Economy recently. It's a great book.

Burns: Just a nice easy read.

Wesbury: (laughing) It's actually kind of a fun read if you're into economics because it talks about all the politics of the '70s and Arthur Burns and all of that stuff. But it's a fascination thing, because that's where we are. We seem to be stuck politically, and the unemployment rate is the hot zone and the reason why.

Burns: So, we're in the 9th inning of the actual problem, but the political problem…

Wesbury: Right, the political problem, I know exactly where we are. However long this game is, we have 13 months left. So, November of 2012, we will find out…

Burns: We will have resolution one way or the other.

Wesbury: The hot zone will be over.

Burns: All right, so one last one; economic hot zone. Consumer spending, that GDP growth you were talking about, I think the unassailable consumer confidence that we have out there. You know, we've seen some kind of movement in that number. It's been flagging. It's been bouncing around a little bit. Is that an economic hot zone?

Wesbury: This one, I'm going just say, it's not a hot zone. I have long ago learned not to pay attention to consumer confidence. Consumer spending right now, overall consumption, is $600 billion higher than it was in '08. It's the highest it's ever been, and yet consumers are less confident than they've ever been. So, I've just found out over history that consumer confidence: People talk the talk, but they don't walk the talk.

Burns: I feel that way at home. I go home and tell my wife, we really need to cut back, and then we bought a dining room table.

Wesbury: Exactly, that's exactly what it is, and maybe that's it: The person that's answering the question is not the one spending. It could be just that simple.

Burns: It could be that simple.

Wesbury: And ... I know you like data and I've ... tried it every single which way you can run statistics, but if you take consumer confidence today and try to figure out how much of the retail sales over the next six months it forecasts, it's 3%. Literally, there is no relation, so there is no correlation that I can find to today's consumer confidence and future spending, and I've used an average of three months and the average of six months. I mean, I've tried every single way I can, and I cannot come up with a good forecasting equation using consumer confidence. As a result, I threw it out.

Burns: Well, Brian thanks for playing hot zone and what inning is it.

Wesbury: Absolutely, Scott.

Burns: I am Scott Burns with Morningstar. Thanks for watching.