Keyness Is Still Dead
Well, they did it. After most pundits were telling anyone who would listen that S&P wouldn’t dare cut the Treasury rating until the ‘super committee’ (see below) had a chance to at least start the discussion of what to cut, they did it as soon as possible (evidently S&P wanted to do it earlier, but a mathematical difference of opinion with the Treasury held the process up for most of Friday). Thankfully, it took until after the market closed on Friday to release the change so everybody but the Japanese had a chance to digest the idea over the weekend (Japan has a short session on Saturday which started a couple of hours after the S&P action).
So, what does it mean to not be AAA/Aaa anymore? Evidently, not a lot. When your pundit went to turn-on the light this morning, the lights went on with the flip of the switch. When we went to turn the faucet to get water, there was water. So, the fabric of our daily lives is unchanged in most respects. What will it mean for the markets? Well, so far this morning it hasn’t really upset the Treasury market at all. In fact, Treasuries are higher in price, lower in yield, while most everything else is falling. So, the Treasury is downgraded by S&P while the market continues to treat Treasuries as the last bastion of safety in a world gone mad. Who’s right and who’s wrong will be answered over the next couple of weeks.
This action was a long time in coming. Most the ratings agencies were willing to see chronic deficits by the government so long as those deficits could be easily financed and would someday turn into a balanced budget. But, the scale of the deficits and the duration of the deficits looking out were just too much for S&P. No version of the long-term budget for the Federal government shows anything but deficits over the next many years. Even with the latest fix, the deficits over the next 10 years would more than double the existing debt. The US debt per capita is already over $40,000 and in ten years would be closing in on $100,000. That is just not sustainable.
We agree that the US government ought not be considered riskless. There are a whole host of reasons why. But, given the current circumstance, there aren’t a lot of alternatives to Treasuries as a quasi-riskless safe haven. So, on a day when the risklessness of the Treasury is questioned, the market thinks the decision has already been made, S&P is wrong and the market is right.
John Maynard Keynes is still dead
Last week the economic news segment that the US economy expanded by only 0.4% in the first quarter according to the latest revision and that growth in the second quarter was a disappointing 1.3%. You may have also noted that we failed to give that issue a title, that’s probably our fevered brain at work rather than anything else. We actually had a couple of good titles that we’d thought of – ‘We never promised you a rose garden ceremony’ or ‘Now that’s grand political theater.’ But, we forgot to put either of them in the title line. So much for trying to work when not up to snuff.
Well, you might suspect that we’re still a little out of it, but no, we’re just trying to come around to a point, albeit a somewhat soft one. The US economy is a lot like some old pundit trying to operate on antihistamines and sheer mental energy. The US economy is still suffering a lot of lasting effects of several ‘diseases’ that overcame us in the latest recession and haven’t really been purged from our system.
First let’s return to an old theme, the new normal. What is normal for the US and much of the developed world has changed slowly but steadily over the last 20 or 30 years. We are not much of a growth economy any more. If you look at the potential growth rate of the US economy over entire economic cycles that potential growth is not what it used to be. The easiest way to look at this, and also a fairly accurate way, is to add labor force growth to productivity growth. In the US of the 50s or 80s, that number used to come to 5%, maybe only 4.5%, with 2.5% to 3% labor force growth and 2% productivity growth. That same number today is less than 3%, with 1% labor force growth and 2% productivity, if we’re lucky. Interestingly were it not for immigration, we’d be close to zero labor force growth.
The new normal has all sorts of implications for job creation and wealth creation. Other countries with new normal attributes, namely Japan and most of Europe, have a similar outlook. The countries that don’t have new normal conditions, namely most of the emerging world, have much better economic prospects.
The other major trend that has become more evident lately is the growth of government as a share of the economy. While over most of the time since the Great Depression (the one in the 30s, not this latest recession) the Federal government has been slowly growing as a share of the economy, lately that growth has shifted much higher. From a little over 20% of GDP, government has swiftly risen to 24% of GDP. Part of that is from the drop in GDP during the latest recession while government expenditures have stayed steady or risen (for those who are confused by that look in Wikipedia under ‘automatic stabilizers’) and a big part of that is government trying to boost demand by way of stimulus spending. As that spending subsides, whatever boost we’re now getting from it will go away.
That last point brings us to the point, finally, of our missive this week – Wither the economy in an era of less government and general austerity? John Maynard Keynes is still dead. He died in 1946, right at the peak of his intellectual and political influence on the world economy and economic thought. Keynes believed that government ought to get involved in the economy to maintain demand in times when demand was slack due to poor economic conditions. He might be dead, but his economic ideas have lived on well past his contributions.
We think the trouble with Keynesian economics, or demand management, is that it gives politicians a tool to impact the economy. Much like the idea that to a man with a hammer everything is a nail, to the politician with the tool of demand management, everything is a short-fall in demand. Our politicians are apt to use Keynesian tools at every opportunity. The outgrowth of Keynes’ demand management is the modern welfare state.
Why is today an apt opportunity to bring this up? Because the debate over the debt ceiling deal isn’t about whether we had to raise the debt ceiling or not, it was about whether the politicians ought to put demand management back in the tool shed. There really never was a question of whether we had to raise the debt ceiling. We were going to raise it no matter what. The question was whether there was going to be a quid pro quo for raising the debt ceiling that entailed more taxes or less spending in the future. Whether we would continue to stimulate demand all the time or whether we were going to stop it. It seems we have chosen austerity over Keynesianism.
So, what does this mean? It probably means that we’re going to have somewhat slower growth in the immediate future than otherwise would have been the case (whether you like government spending or not, it counts in the national income accounts). So, the trillions of dollars of prospective spending that the government won’t now do will mean the economy won’t get that spending. We also won’t rack-up an even more enormous debt. Which you think is worse tells you a lot about where you stand on the economic question of the day. (As an aside, the pols have been talking about trillions of dollars in spending, in cuts, in taxes, and in debt. The latest deal calls for $2.4 trillion is cuts over ten years. The 2012 impact will be about $50 to $60 billion in actual cuts out of a $3.6 trillion budget. Over the next 10 years the US GDP will add up to something on the order of $175 to $200 trillion. Government spending may be $45 to $50 trillion.)
For most of the European economies, the question of austerity or expansion of the welfare state has been decided. The welfare state can’t get any bigger since the taxpaying part of the economy could no long support it. They have to dial-down their social contract to live within their means. We are not so bad-off here, as our government sector is not as large as it is in most of Europe. But, we have a similar issue ahead of us and luckily we are getting a chance to face it before it gets outsized. (For those who argue that our tax burden is much lower than most of the developed world, that is why – we don’t have as big a welfare state to support, so we don’t need the same high tax rates.)
Issue of the Week
Ceiling watch part four. This is one part more than we had expected to write on this topic, which should have been put to bed a week ago, but, now the aftermath. The debt limit brouhaha is going to be blamed for every crappy economic statistic for the next couple of months. We’ve already seen how the latest ISM report (see below) is blamed on the debt ceiling uncertainty. We wonder just how many people would have ordered a couple truckloads of corrugated paper boxes if only they weren’t so worried that Congress wouldn’t raise the debt ceiling?
But, the issues that surface now since we are allowed by statute to borrow another $2.4 trillion are coming into focus (assuming a lot of other ducks line-up over the next several months – see below). First, this deal has certainly unnerved a lot of veteran Washington watchers. The willingness of both sides to resort to campaign mode during the negotiations tells us that we are already running for 2012. No opportunity for a sound-bite or a slogan was missed. This is a recipe for gridlock from now until early 2013.
The super committee to be selected by the Congressional leadership will be given a mandate to fix our tax system, our entitlement state and our budget. We suspect that few of the opportunities that could be grasped by this group will see any progress. The idea that moderate Republicans or Democrats will be heard in this group is absurd. It is in the best interest of both the liberal wing of the Democratic Party and the conservative wing of the Republican Party to have a voice at this table. Given the high profile of the members, we would see leading members from both houses serving.
The alternative to a big new deal on entitlements or taxes is a broad, across the board spending cut to meet the needed reduction in spending so that we can borrow more money. According to the new statute, half of any cuts will come from defense spending and half from discretionary domestic spending. This was supposed to be an incentive to both conservatives and liberals to act in good faith, or their favorite part of the budget was going to get clipped. It is unlikely we will meet any of the spending goals without touching entitlements or taxes. It is also unlikely that we can adequately address either area in this committee.
As it stands now, we will be back renegotiating this agreement just before the holidays. The committee is scheduled to report to Congress by November 23rd and the Congress will have until December 23rd to debate the findings and translate them into law. Good luck with that.
Institute of Supply Management released the weakest report in two years on Monday. The July reading of 50.9% is just above the 50% line which indicates that manufacturing is expanding or contracting. The June reading was 54.3%, with a comfortable margin for error in favor of growth. Above 50% is still a good thing, but 54.3% is better. The last time the ISM was below 50% was in 2009, just before the beginning of the current expansion. The employment sub-index fell to 53.5% from 59.9% and new orders went below 50%. On the good news side, prices paid fell to 59.0% from 68.0%. (We went through most of the 1990s with this index stuck below 50% and things seemed to work out, but who knows.)
Personal income rose 0.1% in June. The rise did not keep pace with inflation and in inflation-adjusted terms workers actually have less buying power than the month before.
Consumer spending slipped in June as Americans put away their credit cards and put-off buying more stuff. Well, most of the decline was from having to spend less on gasoline. But, with rising unemployment, uncertainty over a host of issues and the constant drumbeat of politicians railing against other politicians and painting an unsavory picture of the future, who could blame the common man for putting away the pocketbook in favor of having a few extra dollars in the bank?
The savings rate rose to 5.4% in June from 5.0% in May.
Motor vehicle sales rose to 12.2 million (seasonally adjusted annual rate) in July from 11.6 million in June. The gain comes amid a return to more ‘normal’ levels of production not impacted by parts shortages due to the Japanese earthquake and tsunami.
ISM non-manufacturing hangs in there are 52.7% in July, down from 53.3% in June. The decline was worse than expected. The services sector employs roughly 80% of workers in the US and generates more than 70% of GDP.
The monthly Employment report gave investors a break by reporting a gain of 117,000 workers in July. With forecasts of a mere 75,000 jobs being the norm and many forecasters looking for maybe no jobs at all, the 117,000 number was a huge relief. It didn’t get us much real relief from the unremitting selling, but it was better than having a report that agreed with the bears that the world is coming to an end. We saw the expected drop in state and local government jobs, but, it wasn’t as many lost jobs as expected. Also, the prior two months were revised higher, which added some 56,000 more jobs to the total count.
The unemployment rate actually fell to 9.1% due largely to a drop in the labor force as more workers became discouraged.
Average hourly earnings rose 0.4% to $23.13.
Well, that wasn’t a lot of fun. Luckily, it happened in August and nobody noticed.
We don’t often see times like last week, or today, thankfully. But, when we do, they are often the end of something rather than the beginning. It is human nature to get scared after something shocking has happened, not before. So, now that the cow is out of the barn, it seems like prudence to close the barn door.
Let us take a minute and recall just how markets work. Markets evaluate risk, return potential, alternative returns and fundamentals and arrive at a price. The most likely element in that list to change rapidly is risk. Our evaluation of risk tends to be the most dependent on short-term elements, such as recent market behavior. But, price has a way of compensating for changes like that and this is why prices go down when risk goes up, but they don’t go down forever. Prices adjust to compensate for the new, improved risk parameters and then they stop going down. Then, when risk seems to recede, prices go back up. We doubt there is much more bad news to come in the next few days, since the concentration of bad news we’ve just had comes only once a month. There is only one GDP report a month, one employment report, one ISM report, one inflation report and one most everything. We don’t get S&P to mouth-off about the Treasury that often. So, now that this is all behind us for at least a little while, things should start to look better. Maybe it will be the eye of the storm, but it will look better.
We really like the price we’re getting on a lot of assets today. Who’d have thunk that at this stage in a bull market you’d get another chance to buy at really attractive prices?
Yes, stocks went down last week and they are down again today, but we are reacting to news, not looking forward. Forward looks increasingly good to us. Maybe not for everyone in every walk of life, but for most folks life is good. Most industries still look to have some growth left, some industries are just getting started. Most companies are still cranking-out good earnings and raising their dividends and trying new products. Some companies are hiring new workers and expanding their businesses.
You couldn’t tell from last week that the trend is still higher for most companies. The large cap indices fell by 5% to 7% and small caps fell 10%. Foreign stocks fell by 8% to 10% as well. Selling got pretty indiscriminant.
Bonds rose, despite being the center of attention in the slow change in fundamentals. The exceptions to that are high yield bonds, which are more like stocks frequently. By and large, foreign bond markets were also higher even with the dollar up.
Real estate got slapped silly as the trend turned from pro-growth to no-growth and commercial real estate needed pro-growth to make its case that the future was going to be okay. Real estate was down more than equities on the week, but no worse than financial stocks, which were bad.
Corn, wheat and gold were higher last week, so stuff you need to live and stuff you don’t need to live go together. All the pro-growth parts of the commodity spectrum were down, industrial metals, energy along with the pro-wealth parts, livestock. Gold set new highs amidst the turmoil and that almost makes sense for a change. But, the dollar was up through most of the same turmoil too. This was a safe haven trade, nothing more. Is it about time for another rant about tuna fish and shotgun shells?
Have a great week.
Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.