Green Shoots and The Economy
By Richard L. Kesner, President
The CommonWealth Group
August 2009
I have been accused by a number of people as being too negative on the economic recovery, the economic situation, the administration and the current policies of the Fed. I have been told that I should not be negative as it is self-defeating and leads to worry and pessimism.
All of you are intelligent, experienced and educated investors who can make up your own mind as to the “State of Affairs” but I believe it is my job to give my opinion as to what has been happening and what I believe will happen in the short term. This is opinion, not fact, but it is based on a lot of research and reading that I have been doing over the past few months.
After being accused of being “right of Attila the Hun” by a couple of people and being accused of “being too liberal” by some others, I feel that I am right in the center. For the record I favor neither the current Republicans, who certainly contributed to the crisis with their spending, nor the Democrats who have decided that spending your way out of debt is logical and the only way to save the country. I only hope that the government is correct and that I am wrong on my opinion.
We have been talking to a lot of clients over the last few months. For many of you we have made adjustments in the portfolio allocations to try and reduce volatility. We continue to monitor the asset allocation and look for opportunities that all markets provide.
Many of the data and comments below are paraphrased the from Bud Conrad’s recent column in this month’s Casey Report. I have been subscribing to Casey Research for a while and I find their comments informative and accurate.
Second Quarter Rally
The rally that the stock market has experienced in the second quarter was nothing short of fantastic, certainly surprising almost everyone. While most experts felt that the lows experienced in March were too severe, not one expert predicted that the S&P would gain just under 16% for the quarter and the DOW would jump 11.96%. What caused this jump in the markets is anyone’s guess and we are certainly happy that this occurred, but where we go from here is most important.
Most of the improvement in the economy is directly attributable to government intervention. Back at the beginning of the crisis, commercial paper spreads rose to such a great level that the source of short-term funding of credit basically stopped. These spreads have now returned to normal, which is a very good thing.
Mortgage rates, which were at one time in the 4% range dropped because the Federal Reserve launched a program of purchasing $1.25 Trillion of mortgage-backed securities. The Treasury has poured billions into Fannie Mae and Freddie Mac and provides guarantees for these mortgages. Does this sound familiar to anyone? It appears that these “green shoots” are artificial stimulus which really does nothing to stimulate the economy long term.
Interest Rates and Deficits
The Fed has slashed interest rates to near zero, purchased huge amounts of toxic waste and bought up Treasury debt with Billions of freshly printed money. At the same time, we are experiencing a continued increase in unemployment (lower unemployment increases are still increases and the fact that only about 300,000 jobs were lost in a month instead of 400,000 jobs is not good news), falling retail sales, housing price declines and a collapse of world trade
In 1933 the U.S. Debt was 301.4% of GDP. At the end of the first quarter of 2009 U.S. Debt was at a record level 372% of GDP. Massive debt growth is what fostered the over-leveraged economy to begin with. Now it is at its worse level in HISTORY. The Congressional Budget Office’s (CBO) own projections show that this debt is going to continue to get worse without any healthcare reforms.
The real problems which I eluded to last quarter are that politicians are short term sighted and are doing things to get reelected. Republicans and Democrats alike do not care about long term consequences; they care about keeping power and getting re-elected. The debt problem will not be their concern as they keep pushing the problems further and further into the future. This will be a definite problem for our children and grandchildren if spending is not curtailed.
How to Pay Off Debt
We have to stop increasing the debt and creating programs that cannot be paid for out of current revenue. It is called living within your means, which is what we all should be doing and what government ignores. What ever happened to the concept of a balanced budget? If we cannot afford a program then we have to do one of three things; (a) take money away from other programs to fund this program, (b) eliminate other programs or (c) raise revenue to support the new programs.
However, once you have printed money and put it in circulation you cannot just pull it off the table and burn it. Maybe you can do this by raising taxes, and that is a solution that is sure to come in all kinds of different forms. You can curtail the money supply in the future by not putting more into circulation, but what about the trillions of dollars already in circulation? How do you pay off the large amount of borrowing with interest rates that are very low?
Current interest rates are currently about zero. The economy is not growing. When you raise interest rates to attract investments into Treasuries you are going to hurt or stifle economic recovery. This could increase the depth of the recession.
Oversupply of any item reduces its value. When you print large amounts of money you reduce the value of the currency already in circulation. It is the same with stocks. If a company increases the stock available it dilutes the value of the shares outstanding. By increasing the money supply to record levels the Fed has a problem with the value of the dollar. A falling dollar may be good for exports, but not for anything else.
The Government Plan
The government is trying to stimulate the economy through borrowing in an attempt to create inflation and get people and businesses to borrow. The problems with this are twofold: (a) the banks are not lending and people are not borrowing, (they are saving) and (b) the government is replacing consumer debt with federal debt which it has no ability to pay off.
The government debt is a result of the government buying up toxic assets and putting them on their own books. This rationale should lead the banks to start making new loans to restore the economy. This may work (however not so far), but ultimately the government is going to have to deal with the bad debts it has taken on. The plan is that over time these bad debts will regain value and go away or even make a profit. How long that is going to take is anyone’s guess. But if it works the problem is solved and we can go back to borrowing and spending.
This is just moving paper around, not solving any problems. The toxic paper still represents a claim on mortgage holders who can’t or won’t pay the debit owed on their greatly depreciated properties.
What this means is the financial institutions which created the bad debts get a free pass and the taxpayers get stuck with more levels of ugly government debt. So far the amount of this ugly debt is somewhere around $12 trillion in a combination of guarantees, outright purchases and loans. Simply moving bad debt from one balance sheet to another does not make this debt better. It is still toxic. What is really disturbing is that most of this toxic waste is being ignored on the government balance sheet. It just disappears by being ignored.
All of this leads to an ever increasing federal government deficit. The deficits under the Bush Administration, which were the results of cutting taxes, initiating two wars, and a gradual slowing economy grew to $400 billion. The projected 2009 budget deficit is expected to be about $2,000,000,000,000. That is a lot of zeros and it reads $2 Trillion.
All told, the federal government debt held by the public is now approaching 50% of GDP but is likely to grow to 80% in the next few years as the deficit increases by $1 to $2 trillion per year. To be fair, the CBO (Congressional Budget Office) expects that the deficit will only be about $800,000 billion which is still twice the Bush Administration deficit.
This spending concept has been tried before with little or no success. I find it hard to believe that it will work this time, but I do hope it does. However, as the market continues to climb above the 9000 level from a low of 6400 it does seem to be frothy. Earnings for the quarter continue to be better than expected, but the expectations were about the lowest in history. Earnings of the S&P 500 stocks are actually at 1998 levels so in retrospect we have had no growth for the last 11 plus years. Is that really good news?
Again, I hope that things are getting better and that the “experts” are correct, but I am very nervous.
On a final note, we are hosting an “Economic Forum” on September 17th at the Marriott Hotel in Boca Raton. We are bringing in four outside speakers for the event. Admission is $60.00 which will include a continental breakfast. Proceeds are going to the Palm Beach Zoo. You will be receiving more information on this in the next few weeks.
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