Deficits Are Here To Stay

Well, they tried. That’s probably the nicest thing that most people will say about the President’s deficit panel, which published its final report and disbanded. Government finances are in no better shape than they were yesterday, possibly worse. Chaired by Alan Simpson (former Republican Senator from Wyoming) and Erskine Bowles (former Clinton White House Chief of Staff), the panel tried to get people to at least think outside the box on taxes and spending. They started with lofty goals and a real world determination to change the discussion about government spending. They failed to get their package of changes approved by their self-imposed super-majority of the members, but did get a majority to sign-on to approach the budget from a different perspective.

The panel had six sitting Senators (3 from each party), six sitting Congressmen (3 from each side) and four civilians besides the two chairmen. There were some real liberals, some true conservatives, some moderates. Just about every constituency was asked to give up something. Their preamble stated that the only way to fix the fiscal mess we are in is to think long-term and spread the pain around. They spared no sacred cows, except the recently passed healthcare overhaul.

The panel had only a few objectives:

  • Achieve nearly $4 trillion in deficit reduction through 2020 (out of roughly $45 trillion expected to be spent).
  •  Reduce the deficit to 2.3% of GDP by 2015 (from nearly 10% today).
  •  Sharply reduce tax rates, abolish the AMT and cut backdoor spending in the tax code.
  •  Cap revenue at 21% of GDP and get spending below 22% and eventually to 21% (from 25% today).
  •  Ensure lasting Social Security solvency (instead of the drastic cuts that will be mandated in the future under the current system).
  •  Stabilize debt by 2014 and reduce debt to 60% of GDP by 2023 and 40% by 2035 (from roughly 90% today).

The policy prescription they wrote was bitter medicine for nearly everybody. Massively rewrite the tax code to eliminate most deductions while lowering both personal and business tax rates dramatically (how does a top personal rate of 28% sound to everybody). Extend the Social Security age and limit benefit increases to put Social Security on a more actuarially sound footing. Cut duplicative and unnecessary government spending which wastes billions each year. Derive better processes for budgeting so that less money is wasted on ‘emergency’ funding of one sort or another.

The Wall Street Journal argues that the whole panel idea was a cover to let the current administration spread the idea of a value-added tax as the solution to our budget woes. Surprise! The panel took the other path to lower tax rates on people and businesses. They also wanted to limit the scope of government to 21% of the economy, down from roughly 25% today. When even the sponsors of the whole deal aren’t happy with the outcome, you know there must be something good in there somewhere.

So, despite just about everybody’s ox getting gored a little bit, there was still support for the total package. 11 of the 18 members voted to approve the whole package. But, they needed 14 approvals to take the whole batch to Congress for a vote. A few liberals weren’t about to go along with limiting the socialist state’s willingness to take from the rich to give to the poor. At the same time, some conservatives didn’t like the dependence on higher taxes (roughly $2 in tax increases to every $1 of spending cuts) to make the whole thing work. Another grand attempt at governance hit a dead-end. Too bad, nobody is happy now, just like nobody would be happy with the deal. That’s the way compromise works or not.

Issue of the Week

This must be the third or maybe the fourth week in a row that we’ve had to try to explain the economic situation in the Euro-zone. You have to divide the Euro-zone in two parts, Germany and its highly productive neighbors Belgium, the Netherlands and Denmark along with some of the other Northern states and then the periphery of Europe, the PIIGS. France falls somewhere in-between, but that is a different story. The Germans and their economic allies are beneficiaries of the Euro and the common market created for it. Their industry was able to expand across national borders and grow with the introduction of the Euro. The PIIGS got low interest rates from the Euro, while their industry didn’t fare so well in the internationalization of Europe. (So, today you have only one major Italian Bank still independent of foreign ownership, the rest of Italy’s financial structure reports to Frankfurt, Paris, Geneva or Amsterdam.) We believe that this epitomizes the coming split in the Euro-zone.

The Southern tier of Euro-states, Italy, Spain, Portugal and Greece, are not doing as well under the Euro as they would like. They got very little out of the deal except access to a much larger, cheaper bond market. They have now pretty much used up their borrowing privileges and are reverting to their former state of having to pay far more for their debt than the Northern states. Despite the rescues to date and the rescues to come, the Euro is probably doomed as a grand experiment in multi-nationalism. As we mentioned as long ago as April, the trouble the PIIGS are having is that they control their fiscal policy (even if badly done, they have no one to blame but themselves for it) but they do not control their monetary policy. If Greece had its own central bank, they would have trashed their currency to stave-off the crisis they have recently suffered. It would not have been painless, but it would have been drug-out over years instead of having to happen on the current, artificial time frame.

Even if the Euro is toppled, it will take time to get Europe’s house back in order. The Northern states will come through with few headaches, but the Southern states are in for a slog. Creating a central bank isn’t easy, but it is quick. Replacing a currency isn’t quick or easy. Doing both while in the midst of an economic crisis won’t be a lot of fun, but it should relieve some of the economic pain, eventually. But, how to manage the split is the tough part. The PIIGS will still have huge Euro-denominated debts. If they create weak currencies, those debts will become greater and greater to bear. If they create strong currencies (and though that may sound silly it could happen) the benefit of not being in the Euro will be minimal. Rock? Hard place? Does it matter?

There is the idea of creating two different Euros, one for the strong states and one for the weak. That is just a silly idea, which is why it might fly. Why would any state that just went through a horrible crisis because it couldn’t control its own currency opt for another version of not controlling its own currency? It makes no sense, but when has that mattered? (We must have stopped taking our cynical medicine again.)

Economic News

Case-Shiller home prices were surprisingly bad all of a sudden. The drop of 0.7% was a bit of a surprise, the drop in 18 of 20 cities was a bigger surprise. The case could have been made that housing was starting a recovery of sorts. At least, the worst may have been over and now we have this return to lower prices across most markets. What had been a year over year gain in house prices of 1.7% in August, has become a gain of only 0.6% by September. Another month like this and all evidence of a recovery will be wiped-out.

Consumer Confidence rose in November to 54.1 from the October reading of 49.9. This was a much bigger gain than was expected. Readings of 100 are the base for this index, so there is ample room for further improvement from this index.

The ISM manufacturing gauge was reported as a healthy 56.6. The number is slightly lower than the October statistic, but since this is a dispersion index a lower number isn’t a sign of weakness as much as a sign that business is still healthy. So long as the number is above 50, there is growth, 56.6 is very good growth. Almost all sections of the index also continued to grow. The employment index was at 57.5%, indicating that business is still hiring.

The ISM services index was reported at 55.0%. That is a rise from the 54.3% in October, but in this sort of diffusion index that doesn’t really matter. So long as the index is comfortably above 50% it is a good thing.

The Monthly jobless report from the Department of Labor was a big surprise, but not a very nice surprise. Rather than the 155,000 jobs that Wall Street was expecting, there were only 39,000 new jobs in the economy in November. Not only were the jobs not what was expected, but where the jobs came from was not what was expected. Rather than the seasonal gain in retail employment that we usually see at this time of year, we had a drop in retail employment. That could be just that the seasonal adjustment factors which correct for things like this did a very good job of adjusting or retail employment was weak. We suspect the former.

Also, there was another drop in government jobs. Federal hiring was positive but state and local government jobs fell. This is like the seventh month in the last eight or six out of the last seven when government hasn’t added jobs in the aggregate. Until the past year, economists usually guessed that government at all levels, Federal, state and local, would add 25,000 jobs a month. That hasn’t happened in a while. For a while in the spring and summer the adding and then subtracting of census workers jerked the jobs numbers around, now it is just hiring freezes and slow reductions in government workers.

The average workweek was unchanged and average hourly earnings gained a penny from $22.74 to $22.75. The unemployment rate rose to 9.8% from 9.6%. The number of people in the labor force appears to have risen and many unemployed began to again search for work when it appeared that the employment picture was getting a bit brighter.

One thing that bugs us routinely is that no one ever seems to look at this data in the right context. This employment number looks pretty bleak on the surface, but when you take a minute to get the whole story it isn’t quite so bad. First, there was a massive revision to the prior month’s data that softens the blow. Rather than the 151,000 jobs gained last month as originally reported, now it looks like there were 172,000, so 60,000 jobs appeared in November, but 21,000 were attributed to October. In October, the revisions were even bigger. So, by the time February comes around and all the revisions are in, this may not be all that different than what economists have predicted.

Another thing that bugs us is that we look at each number in isolation and not in the context of the trend. It was just over a year ago when we were losing jobs every month and now we are pretty consistently gain jobs. At the worst part of the jobs decline, we were losing 700,000 or more jobs a month, from the vantage point of losing 700,000 jobs, gaining 39,000 looks pretty rosy. But, from the vantage point of gaining 151,000 jobs last month to gaining ‘only’ 39,000 this month we are all disappointed. Just lighten up!

Factory orders slipped by 0.9%.

Weekly Stuff

We get asked all the time whether the market is going to go up, down or sideways between now and some really short end period, like quarter-end or year-end (yes, we know those are the same period right now). Our answer is usually that we have no idea. We have seen really bad times when months of patient stock gains have been wiped-away by some news event or other. Anyone who lived through Black Monday back in 1987 can attest that really bad days can come along. The flash crash back in May shows that it can even happen now. Those days don’t matter all that much. What matters is that over longer time periods, years, decades, centuries, stock prices tend to go up. Why? Because what we are measuring isn’t day to day news or events, we are measuring the development of companies as they grow, mature and then recede. New ideas spawn new companies which thrive, grow, expand and mature. Through all this they usually gain in value, but not all the time. At any moment, we are trying to put a value on the earning power of Corporate America, the good, the bad and the ugly all wrapped-up together. That value tends to go up most of the time. Most companies have record profits most years. Most companies that pay dividends raise their dividends most years. They grow, improve, advance. That is why the value of the market tends to go up most of the time.
The new companies growing and developing overwhelm the companies that are slowly going away.

The trouble we have in the financial management business is that we haven’t got any patience with this slow process of development. We want action. We want it now! But, what we tend to get is volatility around that long-term upward-sloping line that is the big trend. We lose track of the simple idea that time is generally on our side as investors, especially when the recent past has been below that long-term trend. Over time, the wiggles tend to wash away and the upward trend goes on. Stick with the trend.

Stocks had to overcome the renewed negativity on the Euro (well, actually the ‘dollar carry trade’ people selling indiscriminately whenever the dollar goes up) early in the week to make gains on the whole week. The good news on the Euro-zone was greater than the negative. The good news came with the rescue of Ireland and a plan to rescue all the recalcitrant PIIGS in due course. Foreign stocks were the big winners for the week with gains in the developed markets that averaged 5% and in emerging markets that averaged 4%. By comparison, the gains in large cap US stocks of 3.75% look rather paltry.

The sovereign bond markets of the world were pretty much beaten up. Rising rates in the highest quality bonds was a global affair. Corporate middle-rated and below were comparative winners as the trend of high yield following the stock market returned. Most highly-rated sectors, municipals, mortgages, top-rated corporate were lower following the Treasury market. The long-end of the Treasury curve was especially hit. The dollar was down over 2% against a basket of other leading currencies.

Real estate securities were generally higher, following financial shares. Foreign real estate markets outperformed the US, but then with a dollar tail-wind that part was easy.

Commodities were broadly higher with energy prices leading the way. Agricultural prices, industrial metals and precious metals were generally higher.

Have a great week.

Karl Schroeder, RFC, CSA
Investment Advisor Representative
Schroeder Financial Services, Inc.