October 6, 2011

As I write this , the S&P 500 is at a level first reached on April 1, 2010. What has changed since then? Not much. What I wrote one year ago I could write today. To wit:

“…..our economic problems are not stemming from the business cycle as we came to know it over the past 60 years. They are deeply structural in nature.

The most overriding of our structural problems is, of course, the immense debt load the private economy assumed during the two decades leading up to the financial crisis, and which is now being whittled away by paydowns, foreclosures, and bankruptcies. As it is being reduced, the public debt has soared as a result of lower tax collections and higher spending, as we have attempted to stimulate the economy, both fiscally and monetarily.

The financial system has stepped back from the edge of an abyss, but remains stressed. Bank asset quality is still lousy, and many assets remain to be written down or off. …………….

State and local governments, experiencing lower revenues from property taxes, sales taxes, and income taxes, have found themselves face-to-face with the spending excesses and contractual obligations, e.g., pension guarantees, of a bygone era. At the federal level, our politicians seemingly ignore the ticking time bombs of Medicare and Social Security, and show no signs of producing a credible plan to bring the deficits under control.”

So, as the French say,” plus ca change plus c’est la meme chose” (the more things change the more they stay the same). All the political activity and rhetoric, all the economic forecasts, all the day-by-day machinations of investors, huge federal deficits, and massive purchases of treasury securities by the Federal Reserve, have combined to produce no significant change in the economy, the economic outlook, or the level of the stock market.

Retrospectively, what has become increasingly clear is just how the stage for the financial crisis was set by what has been dubbed the “uphill flow” of capital in the form of official currency reserves. China and other less developed countries made conscious decisions to promote exports by maintaining low real exchange rates. The decision of those countries to build foreign exchange reserves, which tripled over the past five years, was also a conscious one, influenced strongly by their experiencing the financial crises of the early ‘90’s. Consumers in the U.S and Europe gobbled up goods made in China and other developing Asian countries. Their foreign exchange reserves soared.

Very high savings rates in China and other developing nations made the domestic investment of this rapidly accumulateing capital unnecessary. Hence, this capital flowed back here mainly through purchases of U.S. Treasury securities, and the effects were enormous. This capital flow set the stage for an extended period of low real interest rates and bubbles in asset prices, first in technology related stuff in the late ‘90’s, then in residential real estate. At the same time, low real interest rates pushed investors further and further out the risk curve.

To be sure, slack regulation, too much faith in the power of free markets, and an immense wave of financial innovation played important parts in causing the financial disaster, but none of that could have happened without the stage first being set by these “uphill” capital flows.

Developments since the crisis peaked in 2009 have been dubbed by some as The Great Rebalancing. But any rebalancing is quite young, as indicated by the fact that China’s reserves are still growing, albeit at a slower rate. So we are still seriously unbalanced. Recent higher values for the Yuan are encouraging, but have considerable distance still to go. We can expect increasingly strident demands for China to float or at least revalue their currency.

Since the worst of the crisis, we have been seeing just what we expected: total credit market debt in the U.S. has registered its most significant and longest decline of the post-WWII era, but is still at 340% of GDP, up from 250% in just 12 years. The flip side of this contraction of private credit, of course, is the most anemic economic recovery we have seen since WW II. The deleveraging side of what now appears to be a long-term credit cycle (65 years??) is still young and the end is not yet visible.

As I have said many times over the past year, we should expect a continuing mix of lumpy, bumpy economic news. One day it’s encouraging, the next it’s the opposite. Growth estimates are raised, then lowered. In the markets, one day risk is on and the next day it’s off. Currently, we see fears of a recession and fears of sovereign debt problems dominating the scene.

The risks emanating from the sovereign debt burdens in the southern periphery of the eurozone are not trivial and are the biggest threat to the global economy. The disorderly collapse of the euro area, or default by a major economy, could trigger a second global financial crisis. Assuming that does not happen—my hopeful forecast is that disaster will be averted — the austerity measures now in force or being planned in many EU countries will still have a dampening effect on economic growth. In fact, fiscal austerity for a country like Greece, and other European countries with lesser problems, is self-defeating. Greece’s only way out is a growing economy, and austerity is not the path to growth.

The risks that would emanate from another recession in the U.S. so close on the heels of 2008-2009, and at a time when the central bank is out of ammunition and there is zero political tolerance for any fiscal stimulation, are also serious. But it’s my strong belief that even if we do enter an actual recession in GDP, it would be mild simply because there are no excesses to be corrected. Essentially, such a recession would be indistinguishable from what we have been seeing over the past several quarters

To be sure, there are some strong headwinds holding the economy’s growth at a very low level. Yes…..consumers are still deleveraging, but consumer debt service has receded substantially from its peak, thanks inportantly to foreclosures and extremely low interest rates. And yes…the decline of housing prices has slowed but not stopped, so consumer wealth remains depressed. But residential investment is running at only 0.75% of GDP, a record low level, and the inventory of unsold new homes is down significantly.

In fact, the aggregate of the economy’s cyclical sectors (consumer durable goods, construction, and capital spending) as a percent of GDP (now 20%) has barely bounced off its 2009 bottom, which was a 60-year low. Auto sales are at a 12-13 million unit rate, compared to the range of 15-17 million units for most of the 20 years from the mid-80’s to 2007. The low was about 9 million units for a short time in 2009-10.

I should give a nod here to one of the investment fraternity’s more successful integrators of economic forecasting and the stock market, John Hussman. He believes a new recession (not a double dip within the old one) is coming, if not already here.

Hussman puts the blame for the Great Recession squarely on the policy makers for encouraging two successive bubbles and then refusing to recognize them for what they were in the name of free market economics. Hussman’s analysis of the continuing sluggish state of the economy is that the “fiscal bandaids” and “monetary distortions” applied to the economy have been entirely misplaced and are failing to deal with the core of the problem.

The problem, in Hussman’s view, is the refusal to restructure bad debts, particularly the residential mortgages still residing on balance sheets of financial institutions and that have stated values far in excess of the current value of the underlying real estate. His solution: restructure to bring down the debt of homeowners to levels more commensurate with current values, and create a pool of appreciation rights that would give the lending institutions a fair share of longer-term price appreciation. This is an interesting idea that should be aggressively explored, in my opinion. (To read more of what Hussman has been saying go to: www.hussmanfunds.com)

Obama has presented a “jobs bill” to Congress and the next few months will be spent in unproductive argument about its potential effectiveness and how to pay for it. Pretty discouraging! Meanwhile, Bernanke, looking for something the Fed can “do” to give the economy a shot in the arm, has led the way to “operation twist”, an effort to further reduce longer-term interest rates, as if that would actually do any good.
Recently, I heard Ed Lazear, Stanford prof and former head of the Council of Economic Advisers, say, “We should stop worrying about finding something that will work quickly. Nothing will work quickly.” Amen to that!

We need longer-term help that finally recognizes that it’s a structural, not a cyclical problem that we have. The debt restructuring that John Hussman suggests is one course of action. Another can be a properly structured, major infrastructure rebuilding program lasting a decade or more.

The Tea Party types will resist anything that costs money. Some strong leader must tell them that this is NOT the time to insist on fiscal austerity. Fixing the longer-term entitlements problems is applaudable, but cutting current spending is NOT okay in today’s situation.

The current mess has brought out every goldbug, every monetary kook, and every economic quack, all expressing fears of an economic/financial calamity. Professional economists have not been much help in cutting through all the nonsense and providing comfort. I’m afraid that just as it took a couple of generations of economists to figure what really happened in the 1930’s, what actually caused the Great Depression, so it will be some years before we really understand what is happening now.

Finally, I say simply, “Get used to it”; what you see in today’s economy you will continue to see for several more years.

But before we celebrate, take a look at some charts that provide context in which this has been happening. (all charts, unless noted, are fromwww.calculatedrisk.com , a quite worthwhile blog)

First, here are the good news charts of unemployment claims and job creation:

                                                           (click on any chart to enlarge)

Now, here is the context; not such good news; a most unattractive comparison with other recessions:

Here is the same chart except the data are aligned at the recession low points:

And here is evidence of widespread UNDERemployment:

If we take into account the fewer people looking for work and those working part-time but would rather work full-time, the “real” unemployment rate is close to 16%.  This is down only slightly from its peak.

                                                                                       (chart from ECONOMICPICDATA)

It is impossible to measure the human pain associated with uemployment. About all we can do is look at the duration of joblessness, as this chart does:

Finally, let me say that the idea for this posting came from a conversation I had with Susan Sipprelle, a talented journalist who has been documenting interviews with people over 50 and unemployed. These interviews are worth your time to see and hear. They are at www.overfiftyandoutofwork.com. My other motivation is a sense that many people deal with employment statistics as only numbers, without thought to their deeply human side.

 However, several of my respected friends and associates in the investment world are questioning the reality and sustainability of the improvement we are seeing. One of them, my friend Robert Marcin, an experienced and clever investor, calls the whole scene “illusionomics”.

 Robert’s view, one shared by David Rosenberg, formerly economist of Merrill Lynch and now with Toronto-based Gluskin Sheff, looks at the truly massive monetary and fiscal stimulus that has been applied to the U.S. economy relative to what has been accomplished in the way of recovery and asks, “Is that all we’ve got for our money?”

 Here are some quotes from Robert:

 “Ben (Bernanke) is selling real hard these days with infinite QE, 0% short rates, and a bailout for every bondholder extant. Don’t get me wrong, corporate profits and M&A activity are real. Global growth is decent. But until we have a normal budget, free market interest rates, and no Bernanke put, no one knows how sustainable economic activity and financial asset prices are. Until we have the death of the Fed salesman’s relentless manipulations in financial markets, we cannot know what’s real or an illusion, even if it feels good.

The structural imbalances that helped cause the Great Decession of 2008-2009 have not really been addressed and solved. Rather most of the world has borrowed and stimulated, back-stopped and printed its way to trillions of dollars/renminbi/yen/euros/etc in order to avoid restructuring the financial system and meaningfully reduce the excess leverage. Most countries/economies are guilty, and many are still vulnerable.

Quite simply its INSANE to believe in US economic normalcy with a one thousand billion dollar, structural federal deficit, US taxpayer ownership/guarantee for 50%/95% of existing/new mortgages, 0% interest rates, near record u-6 unemployment, record government transfer share of gdp, record food stamp usage, depression like housing price action, and debt/GDP at obscene and unsustainable levels.

However, near universal belief in this artificial stimulus policy of Illusionomics has generated a profound complacency regarding economic cyclicality and risk taking. And it has led to massive amounts of speculation in stocks, commodities, precious metals, and credit.”

My opinion? While I think Robert’s doubts about economic normalcy are on target, I believe his negative/cynical implications regarding monetary policy, and fiscal and other forms of stimulation are misplaced.

The idea that we have received so little for what has been expended gives no recognition to how serious the economic and financial situation was. The edge of a huge brink was very close, and we pulled back from it only because of the massive actions that were taken. It’s frightening to think about what might have happened had we been reluctant to be fiscally “irresponsible”, or too scared of inflation to have the Fed push new money into the economy. In my view, policy actions have been very effective, not in the sense that they have created real growth or reduced unemployment, but in preventing economic disaster.

It’s certainly true that we are far from “normalcy”, as ill-defined as that may be, and those that are betting heavily the other way may ultimately be gravely disappointed. The idea that recent stronger economic statistics are the beginning of a smooth, strong, and extended period of healthy growth is probably wrong.

Rather, we continue to be in an economy and financial system with serious structural problems ranging from federal, state and local government deficits, to stubbornly high unemployment, to energy profligacy, to huge numbers of homeowners whose mortgage debt is in excess of their home value, even while home values are still receding. Add to this list the over-promised, underfunded healthcare and retirement benefits, and a woefully inadequate educational system, and it’s enough to make one become more than a bit cynical, even depressed!

During the next few years we must and will chip away at these problems, and that chipping away will work to limit growth. Think about tighter lending standards, higher taxes, lower government spending, and reduced social benefits that will need to be offset by higher personal savings. Think also about the huge wave of baby-boomers passing from productive years into retirement. This is not the kind of environment that is productive of robust growth.

For the past two years, global growth led by the developing nations has proceeded to drag the rest of us along at sufficient strength to keep our heads above water. Now, however, commodity price inflation, particularly food and oil, are denting the growth of the emerging nations where food and energy costs absorb a much greater proportion of consumer incomes than in the developed world. Thus, still another headwind has appeared.

Fortunately, the profitability and financial strength of U.S. corporations has never been better. Their weathering of the financial and economic storm was truly remarkable, a fact which by itself has reinforced investors faith and carried valuations substantially higher despite the problem-laden environment in which they operate. Is the higher stock market just rampant speculation spawned by Ben Bernanke’s profligacy, as Robert has said?  I don’t think so. It is caused by increased confidence, spawned by evidence of a bit more economic strength, and the earning power, strong financial condition, and surprising recession immunity that the corporate world has demonstrated.

We are still nursing wounds, but maybe we are at the beginning of a beginning to reckon with huge structural problems. Yes, I know, we have many reasons to be cynical about our politicians lack of courage even while being full of courageous rhetoric. But I think the better bet is that we will peck away at the problems and see some progress over the next several years.

Shorter term, we face the withdrawal of certain sustaining economic forces, particularly the end of the Fed’s quantitative easing, known popularly as QE2, and the end (at year-end) of the suspension of the payroll tax. Additionally, government spending levels, both federal and state and local, appear certain to decline. Finally, while we can’t predict oil prices, if they stay where they are currently or move higher, the world economy will experience a heavy suppressant. Financial markets will not be immune.

So far the markets’ reaction to the North Africa/Middle East turmoil has been quite muted. That makes an anchor to the windward seem a sensible stance.

December 1, 2010

Beginning in the 1970’s, and after seeing some work by my good friend Jon Lovelace of Capital Research and Management, I have tracked U.S. stock total returns (S&P 500) by Presidential Years.

Now I know that many others have done similar work, but I think my studies have been unique in an interesting way. I have used Jon Lovelace’s idea of looking at years as politicians see them, that is, twelve month periods bookended by election days. For convenience I have used November 1^st to October 31^st.

Each November I have presented a forecast for the following twelve months based on the historical data for that presidential year. The forecasts have been in a range, using the standard deviation, plus and minus, around the historical mean return.  The range forecasts have scored pretty well, but often only because they were quite wide, and therefore of limited practical use.

In November 2009, for example, the forecast for the year just ended on October 31, 2010 was for a return of 7.2%, plus or minus a whopping 21%, or a range of 28.2% to negative 13.8%, hardly a courageous prediction! The actual return was 16.5%.

However, over time one presidential year, the Third has been very different:

• It has been, by far, the highest return year, with an average return of over twice any other year. The median return has also been more than twice Years One and Two and 90% higher than Year Four.
• There has never been a negative Third Year.
• Of the fifteen Third Years beginning in 1951, only one (1987, Reagan’s Third Year) had a return below 14.6%.
• The variability of returns in Third Years has been the narrowest by considerable measure. The standard deviation has been only 8.8%, a bit more than half the level of other years.
• After considering this data it may not be surprising that there have been no business cycle peaks in Third Years, while there have been five cyclical troughs.
• The Third Years’ lows in stock prices have only once (1975, Ford’s presidency) been more than 10% below the previous October’s close, and in only five years have the lows been more than 5% below the October close.

Based solely on this history, the forecast for the current year ending next October 31 is for a total return of 23.4%, plus or minus 8.8%, or a range of 14.6% to 32.2%. The low for the year, if historical average holds, will be only 2.6% below the October close.

I hope you find all this entertaining, but I’m sure you are asking whether there is causation here or simply coincidence.  Well, I can at least advance a hypothesis, one that I doubt can be either proved or disproved.

The hypothesis is that the party in power (in the presidency) should be expected to try  to take the bad economic knocks in Years One and Two, then gear up the economy in Year Three for the election push in Year Four. Some confirmation of this shows up in the timing of business cycle peaks and troughs. Eight of the eleven cyclical peaks experienced since 1948 have occurred in Years One and Two. To the extent that the federal government can significantly affect the economy, the politicians will try to take as much stimulative action as possible in Year Three, knowing that such actions have an effect only with a lag.

I know, I know, I hear what you say: what can be done this year with a split Congress, a bunch of new legislators arriving with ideological obsessions and no experience, and a huge continuing deficit staring at us??

True, there certainly are obvious ways that this year is different from the past. The economy is more global in scope than in earlier years, we are still exiting the worst recession and financial meltdown since the Great Depression, there is no room to either lower interest rates or expand federal spending, state and local governments are on the financial ropes, and consumers are still paying back debt.  What can government do? Not much, in my opinion, except to get out of the way and let the private economy continue to expand slowly but surely.  Also, a credible plan to reduce the federal deficit would help confidence. Maybe that combination will be enough to give us another good Third Presidential Year.

Am I willing to make the prediction for a good market year based on this data?  Sure.  It may not be scholarly or the result of deep economic/financial analysis, and I may not bet the ranch on it,  but do you know a better way to forecast the stock market?

Here is some of the data.  If you want more I may be able to send it by email….it’s voluminous!

THIRD PRESIDENTIAL YEARS

Here is a summary table covering all years:

With interest rates close to zero for short maturities, and at modern record lows all along the yield curve, little can be gained from even lower levels.  And with the Fed having full employment as part of its mandate, the central bank is in a “what do we do now?” dilemma.  The dilemma is accentuated by there being little political likelihood of any further fiscal stimulation to the economy.

The Fed’s answer is to pump additional bank reserves in to the system by open market purchases of longer-maturity government bonds, hoping to see a further decline in longer maturity yields, and an expansion of the money supply that will kill the deflationary forces that are holding back economic recovery, and hopefully even put some inflation back in the system.

Well, you can hear the screams from some of Wall Street’s prominent economists. They maintain that lack of money is not the problem; high unemployment is structural and needs to be dealt with as such. The Fed’s action, they say, will further assure an ultimate takeoff of serious inflation and trash the dollar, while doing nothing to stimulate the economy. What the Fed is hoping for, they claim, is to bolster asset prices, particularly stocks and real estate, which is a weak and unsustainable way to stimulate confidence and spending.  Some say it’s yet another case of the Fed promoting a bubble.  Others say it’s Japan all over again; it didn’t work there and it won’t work here. Leaders of emerging economies are complaining about a lower dollar adding to already booming economies.

The markets’ reactions so far seem to confirm these fears; the dollar has fallen, commodity prices have risen sharply, and the stock market has been strong. But wait a minute, isn’t this exactly what the Fed is trying to accomplish? A lower dollar stimulates exports and inflates import prices; higher commodity prices create a tad of inflation without beginning a wage/price spiral, and higher stock prices raise wealth levels and give confidence a boost. And all based only on the announcement of QE2, not its implementation. Sounds pretty good to me!

I agree that the unemployment problem is importantly structural in nature. Manufacturing activity is less and less reliant on labor in general and lower skilled labor in particular. Service industries are much the same; information technologies have reduced the use of people. Our education system is lousy. The growing efficiency of emerging economies is giving us stronger and stronger competition in an increasing array of products and services.

But these are not problems the Fed can address. Besides, the structural issues are not 100% of the problem. Cyclical forces holding back the economy are also at play.

It appears that the critics’ cynicism stems from watching the Fed make twin mistakes a decade apart.  In the mid to late 1990’s Greenspan and Co. shunned any actions to cool the dotcom stock market bubble. Then early in the current decade there was no recognition within the Fed of the housing bubble and the dangers it contained. Following the stock market bust of 2000-2001 interest rates were kept too low for too long, letting the financial engineers of Wall Street drastically over-exploit the new markets for securitized debt, especially mortgages.

I concur that the Fed made these two bad mistakes. But that was then not now. A new bubble growing out of the current economic environment seems highly unlikely to me. Utilization of both physical capacity and labor are simply too low to worry about any bubble/inflation for some time to come.

Conclusion: I don’t have perfect conviction that QE2 will produce significant results in terms of significantly goosing economic activity, but my education and rearing as a monetarist lead me to bet that way.  It’s the same bet I made in early 2009 based on the Fed’s quantitative easing. It worked. Just as I thought then that the Fed had taken a depression off the table, I now believe that we will be witnessing a stronger and more sustainable tone to the recovery, at least partly because of the Fed’s actions.

The key questions for the future, of course, are whether, how, and when the Fed reverses course.  Can they really take back out of the system the funds they will have put in? Can they time any such actions appropriately? These are bothersome and unanswerable. Not because the Fed doesn’t have the tools to reverse course. It does. But the questions bring threats to the Fed’s independence into sharp focus. I am considerably discomfited by the increasingly loud voices calling for inhibiting the central bank. A stark historical fact is that never in economic history has there been a case of hyperinflation in a country with an independent central bank. Let’s hope that our politicians recognize that.

The main ingredient still missing for the economy and markets is a credible plan for reducing the federal deficits. Let’s hope that the election brought at least a tough-minded beginning to that process.

Perhaps we, all of us, practitioners and policy makers included, have been blinded into thinking too much in conventional cyclical terms. Mohammed El-Arian, the CEO of PIMCO and a person whom I respect highly, has said that we must discard the cyclical context for economic policy and adopt a structural context. I believe he is correct. Put differently, our economic problems are not stemming from the business cycle as we came to know it over the past 60 years. They are deeply structural in nature.

The most overriding of our structural problems is, of course, the immense debt load the private economy assumed during the two decades leading up to the financial crisis, and which is now being whittled away by paydowns, foreclosures, and bankruptcies. As it is being reduced, the public debt has soared as a result of lower tax collections and higher spending, as we have attempted to stimulate the economy, both fiscally and monetarily.

The financial system has stepped back from the edge of an abyss, but remains stressed. Bank asset quality is still lousy, and many assets remain to be written down or off. And because the private demand for credit among qualified borrowers is weak, the Fed is unable to increase the money supply.

State and local governments, experiencing lower revenues from property taxes, sales taxes, and income taxes, have found themselves face-to-face with the spending excesses and contractual obligations, e.g., pension guarantees, of a bygone era. At the federal level, our politicians seemingly ignore the ticking time bombs of Medicare and Social Security, and show no signs of producing a credible plan to bring the deficits under control.

Both residential and commercial construction remain extraordinarily depressed and no sharp recovery for either is likely for a long time ahead. Temporary tax credits and other stimuli have proven unable to jumpstart either housing or auto demand.

We also have some very basic structural problems including a public primary and secondary educational system that is “the pits”, and a public transportation structure that is woefully inadequate and inefficient

Overcoming these structural issues will take at least 3-5 years for some of them and a generation for others. We, both politicians and business, need to think in terms of providing an environment for the private economy that encourages risk taking and entrepreneurial energy, and less in terms of stimulating immediate job creation.

Economic Policy Mix Has Been Successful (Though it May Not Appear So)

So far, most observers view the results of our economic policy mix as disappointing; unemployment remains high, and private final demand has risen only very slowly and modestly, more so than in any previous economic recovery. But rather than thinking solely in terms of how little economic recovery we have engineered, we should recognize what serious economic problems been circumvented before judging success or failure.

In that spirit, let me refer to an interesting paper just published by Alan Blinder and Mark Zandi entitled How the Great Recession Was Brought to an End. It is an econometric analysis of the results of both the monetary and fiscal stimuli that have been applied to the U.S. economy since the financial crisis/recession began. Those interested in the paper may access it here: http://www.princeton.edu/~blinder/End-of-Great-Recession.pdf

(Alan Blinder is an economics professor at Princeton University, a member of the President Clinton’s Council of Economic Advisors, and former Vice-Chairman of the Federal Reserve Board.  Mark Zandi, who has a Phd. in economics from my alma mater, the University of Pennsylvania, is Chief Economist at Moody’s Analytics.)

Their conclusions are quite staggering.

They found that the effects on real GDP, jobs, and inflation have been huge, and probably averted a serious depression. For example, they estimate that, without the government’s response, GDP in 2010 would be about 11.5% lower, payroll employment would be less by some 8½ million jobs, and the nation would now be experiencing deflation.

Before telling you more, let me say that my impression is that the numbers are so big that they don’t seem entirely credible. Even so, they convince me that I have tended to underestimate how truly bad the Great Recession was and how big a positive difference monetary and fiscal actions have made.

Econometric models are complex things, but they are built on a foundation of past interrelationships of the many variables. They have proven to be quite good in measuring the impact of changes in variables of a normally expectable magnitude. However, they have never before had to digest changes of the immense magnitude of the recent past. Consider, for example, that the total budgetary cost of this anti- recession fight will be about $2.4 trillion or about 16% of GDP.  The savings and loan crisis of the early 1990’s cost $350 billion, or 6% of GDP at that time. So, what if the bottom line of Blinder/Zandi model is a bit exaggerated? I am still impressed because the model assuredly catches both the direction of change and the general magnitude of that movement. (It is, of course, unrealistic to compare what happened to what would have happened had we done nothing. We would have done something!)

The model indicates that monetary actions have been substantially more important than fiscal stimulation, although fiscal moves did have significant effects, raising 2010 real GDP by about 3.4%, holding the unem­ployment rate about 1½ percentage points lower, and adding almost 2.7 million jobs to U.S. payrolls.

In December of 2008 and again in March 2009, I emphatically stated in these Musings that the Federal Reserve had taken a depression off the table. I still hold to that view, and the positive magnitude of the effects of the Fed’s actions, as estimated by Blinder/Zandi, exceeds what I would have estimated.

The dilemma for policy makers at this juncture stems from the political unpopularity of federal deficits on the one hand and the powerlessness of the Federal Reserve, already having interest rates close to zero.  Congress is very unlikely to pass any further significant stimulus. True, the Fed can push more reserves into the banking system, but stagnant private demand for credit by qualified borrowers makes the “pushing on a string” analogy an apt one.

I have written before about an economic outlook that variously has been called The New Normal, The New Mix, and a Rebalancing. By whatever handle, it’s an economy that is expanding very slowly and irregularly, begrudgingly creating jobs, and flirting with deflation.

The Brighter Side

A brighter way to look at it is that consumer deleveraging is continuing, as it must if we are to regain a sound economic footing. Every month that consumer debt contracts brings us closer to where we want to be.

Meanwhile, housing starts are scraping bottom. Even if they rose 50% they would still be badly depressed.  Housing has become quite affordable as prices have declined and mortgage rates are at record lows. While I can’t forecast any near-term strength in housing, I also can’t believe that it will become more depressed. I can say this: the next major move in housing activity will be up, probably sharply.

The same is true of many consumer durable goods.  Appliances and home furnishings, reliant as they are on new housing and the turnover of the existing housing stock, are quite depressed, and demand backlogs are building. Autos, selling at an 11 million annual rate, are below the normal scrappage rate and 5 million or more units below where we were in the years before the Great Recession. It may be that the scrappage rate has declined as a result of higher quality vehicles, but this will ultimately work its way through the system.

Technology has continued to produce new and attractive products that experience strong demand (think iPads, ereaders, smart phones).  Cloud computing is on our threshold. Electric cars are here. So there is plenty of stuff to captivate us.

The stock market continues to be range-bound, with no net movement in almost a full year.  But I have been able to find high quality companies at prices I believe will prove to be attractive given a couple of years.  I listen to the talking heads on CNBC who seem to be consumed by trying to make money from short-term market movements.  A few of them will succeed. Most will not.

So hang in there

(Click on an image to enlarge)

This metaphorical sentence, which came from PIMCO’s annual Forum, nicely encapsulates the uncertainty I feel; the sense that all is not quite right, and that we don’t yet understand exactly what it is that’s not quite right about it.

For now, as I have predicted for almost a year, we are in a recovery that is moving in an irregular and sluggish fashion, and insufficiently strong to reduce unemployment.

The two spare tires in the metaphor, fiscal stimulation and monetary ease, have been used and are wearing thin, and the next crucial step must be to construct a credible plan to reduce the federal deficits. On this point I see no progress.

• Housing and commercial construction remain in a distressed state, with no recovery yet in sight.
  
• Employment gains remain anemic, below previous recoveries
• Personal income minus transfer payments, relative to the previous peak, is at the lowest level of any recovery in the past 50 years.
• Inflation is dormant, even bordering on deflation.
  

• Retail sales are still well below (about 7% on a per capita basis) pre-recession levels.
  
• Auto sales are bumping along at about 11 million units, down from over 16 million.
  
• A rise in net exports that I and others had hoped for has not developed; exports have risen but imports have risen more.
  
• States and municipalities, facing serious fiscal problems, are reducing spending and employment.
  
• While there has been some strength in infotech spending,  it’s not a large enough sector to significantly affect overall activity or employment.
  
• The stimulus package is close to having run its course, and any new stimulus faces strong political headwinds.

I do not believe we will see the much-feared “double dip”.  GDP gains will be positive, in the area of 3%.  But what we have been seeing, irregular pockets of strength alternating with disappointments, is what we will continue to see for some considerable time (6 to 12 months) ahead.

At Last….A Tiny Bit of Help From China

In several postings to this blog I have expressed the hope for a revaluation of the Chinese currency, but until a few days ago, the Chinese stonewalled the rest of the world on this. Now they have said they will make gradual adjustments.  From 2005 to 2008, the yuan was allowed to rise at a 3% annual rate, inadequate at best. Will the appreciation rate now be allowed to rise faster than 3% annually?  I seriously doubt it.  I think it’s very safe to say that China will remain a very strong net exporter for some time to come.

The Coming Social Contract Fights

I have written several times about social contracts, both here and abroad, coming under stress as it becomes both more obvious and more urgent that we deal with unaffordable social benefits.

After watching Greek workers riot in the streets, and the French unions striking in protest over raising the retirement age to above 60, I was both chagrined and amused by a recent Blackstone-Byron Wien incident.  It seems that Byron, a respected Wall Street strategist now with the Blackstone organization, made a public statement about state and municipal retirement benefits being too high. Here is what he said:

“The retirement benefits for state workers, really not only in New York, California and New Jersey but throughout the country, are very generous, too generous……………… We literally can’t afford the benefits we have given our retirees in state and local governments and we have to change that.”

The problem is that Byron works for a firm that is a major manager of City of New York pension money. So the next scene was Blackstone’s management apologizing on bended knee to their client.

I cite these instances because they are forerunners of the immense controversy, political fighting, and nastiness that is coming.

It will not be confined to state and municipal pensions.  Social Security and Medicare tax revenues and benefits must also be modified.

Social Security, according to the report of The Senate Special Committee on Aging, can be “fixed”  by tweaking some combination of eligibility requirements, taxes, and benefits.  Such changes don’t appear to be very painful, and are conveniently outlined in the Senate Committee report on pages  12-15. But there seems to be no sense of urgency about doing anything.

A bigger problem is Medicare.

While the tax burden on Americans will be increasing to begin to address the problem, the sheer magnitude of the promised entitlements makes a solution solely based on taxation a practical impossibility. I admit to complete puzzlement and skepticism about the CBO’s conclusion that the healthcare legislation will actually shrink the deficit. The necessity of moving toward reduced and/or more tightly controlled benefits and means-based testing will be painfully obvious at some point. What a political circus that will be!

Some Comments on the Stock Market

The U.S. stock market has been range bound now for over seven months, responding to fluctuating degrees of optimism about the economy. Only two months ago I remember listening to the talking heads at CNBC who were slightly mocking the “new normal” outlook originated by PIMCO. At that point the economic news seemed to be all good, and some analysts were saying that we were in an “old normal”, robust variety of economic recovery.

I warned against that thinking, and it has now become painfully obvious that a robust recovery was just a fleeting mirage.

What has not been a mirage is corporate profits. The benefits from cost-cutting have been quite dramatic as volume, even though still well below pre-recession levels, has recovered from the depths of late 2008 and early 2009. The more optimistic analysts are now estimating 2010 S&P 500 earnings at $85-$90, and 2011 at over $100. If they are correct, and such earnings are sustainable, the stock market is historically quite inexpensive.  It’s important to recognize, however, that such estimates have often been too optimistic, so use them only with caution.  Here’s a chart covering the past 25 years to prove that:

Hyman Minsky, whose thesis was that long periods of economic stability would lead to instability created by the financial system was right and Greenspan was wrong. We now know that. But we’re not sure what the instability is leading us toward.

The knee jerk response is that it will create a lengthy period of risk aversion. The way the stock market has soared back, and bond spreads have calmed down seems to belie that. But the raised lending standards of banks, the relative absence of financially-motivated equity buyouts, low venture capital fund activity, and the avoidance of equity mutual funds by the investing public support the actuality of increased risk aversion in financial markets.

One novel and optimistic viewpoint revolves around the thought that we had a glimpse of what a depression looks like, and through prompt governmental reactions were able to avoid it. According to this view, this success in preventing economic disaster should minimize the lurking worry about economic depression that has hung over the markets since 1932. This view notes that during the 1950’s and 1960’s, as we conquered every recession, the valuation level of equity assets rose. Perhaps that will happen again, they say.

The fear of depression died gradually and only by the late 1960’s was it no longer significant. Then inflationary fears took over in the 1970’s and were conquered only slowly with some very big medicine. There followed the so-called Goldilocks economy…not too hot, not too cold, just right. The tech boom came along and became a bubble. But we overcame the dot.com bust that followed, then created the mother of all modern bubbles, in real estate. It was fed by easy credit, relaxed lending standards, and financial engineering that created securitization (which created anonymity between borrowers and lenders), CDO’s, CMO’s, and credit default swaps The latter became a huge side-bet market, similar to the side bets that are prevalent in a noisy game of craps. Just as you didn’t have to be the person rolling the dice to play, you didn’t have to own the bonds to bet for or against their default.

Then…Kazam!!…subprime mortgages became a problem and a possible depression was in front of us. Hey! Wow! Good reaction time team! Stimulus packages, easy money, many pieces of special legislation, prevent big failures……and to hell with the cost. Now that we know how to run that play let’s go on to the really big game!

Translated: Now that we have proved that we know how to conquer inflation and prevent depression the world is our oyster! Spend! Borrow and spend! Buy stocks! Speculate! Have some financial fun!

I don’t think this will happen, nor do I think it is a credible view. It lacks any reference to the continuing high cost of what we have done to avoid depression, namely our soaring debt with no plan to bring it under control. Financial markets are of true global scope, and with our federal debt increasingly held by foreigners, these markets will force the creation and execution of such a plan. We have just witnessed in Europe what financial markets can force politicians to do. Our politicians are not immune. Even California may be forced to do something! It’s enough to dampen the most optimistic scenarios.

Yes, ladies and gentlemen, significantly higher taxes are in your future. At every level, from local to federal. And they will be accompanied by inter-generational and ideological squabbles as we start to grapple with the unavoidable problems of entitlements. If you have been chagrined by the high degree of political and ideological turmoil in recent years, you ain’t seen nothin’ yet! All the while the baby boomers will be retiring, putting increased burdens on the younger population. (Europe’s demographics are much worse than ours, and Japan is out of sight.)

Just what kind of taxes will be imposed, while not irrelevant, is not our major concern, which is the increased tax load in general and its effect on growth. (My personal preference is a sizeable value added tax because it’s not subject to avoidance, is very efficiently collectible, and can be well-tailored to protect the most vulnerable populations.)

It’s not going to be a lot of fun. We will be seeing first-hand and in real time the conclusions of Professors Rogoff and Reinhart in their book, This Time is Different, to wit: countries that have debt to GDP ratios of 100% experience a reduction of their annual economic growth of about one percentage point. Yep. That’s where we will be very shortly, and that’s what is happening, even as I write this

By year-end 2010 we will be urgently seeking sustainable growth forces to take command of the economy. The effects of stimulus actions will be gone. Unemployment will still be high ………. and we have to raise taxes at all levels of government. Lousy timing.

Back to what it is that instability breeds, we can now see the true cost of avoiding financial collapse and depression. If the long-term trend growth of the developed world is 3%, and we may be pushing that by at least 0.5%, we have probably knocked off as much as full percentage point for some years to come. That’s big time stuff. As is the political infighting that comes from a combination of high unemployment and a lack of fiscal capacity to do anything about it.

Another outcome of instability is increased regulation. Our wonderful congress is very busy trying to fix the blame for letting the horses out of the barn before they do anything about closing the door. My personal view is that much needs to be done in securing better and more effective regulation of financial institutions. Banks should be prohibited from proprietary trading. Derivatives need to be standardized, derivatives trading should be on an exchange with the parties remaining anonymous to each other, hedge funds must be registered and forced to be transparent, credit and debit cards must be at reasonable cost, and we must have a super regulator whose job it is to continuously assess systemic risks.

A final thought on inflation and interest rates: this morning the core inflation rate was reported as zero, which means the Fed can keep interest rates low for some time to come. In my opinion, inflation is likely to remain dormant for a considerable period ahead. In fact, I believe that the so-called bond market vigilantes are a bigger threat to the bond market than inflation and Federal Reserve action. Europe is currently getting a taste of this, and unless we get our act together to reduce deficits we will too. Time is running out.

To summarize: the aftermath of instability will be that risk aversion will subside slowly, taxes will rise significantly, political turmoil will increase, and the intermediate-term economic growth rate will be frustratingly low. Not a confidence inspiring environment. Nor one in which returns to shareholders are likely to be high.

PIMCO has labeled it the “new normal”, others have called it the “new mix”, and The Economist, in the current issue, calls it a “rebalancing”.  All three labels are, in my opinion, apt descriptions. It seems inescapable that both the private economy and financial markets will be considerably less leveraged than in the decade preceding the recession and financial crisis.  That means that personal consumption will be tied more tightly to changes in disposable income and considerably less dependent on borrowing as an income supplement.

It also means we will have new drivers of growth.  These will be capital spending, particularly spending on infotech and telecom related equipment and software, and net exports.  At some point, not yet visible, growth will also be seen in residential construction, which, even if it rose by 50% would still be at a depressed level.  Even automobiles have some hope for an eventual recovery. Currently, auto sales have been at the annual rate of between 10 and 11 million, below the scrappage rate and far below the 16-17 million range of a few years ago

For those of us trying to make sense of the economy and financial markets there is a huge amount of sheer noise that can confuse the picture.  We are endlessly exposed to talking heads who anxiously await the next important set of statistics on jobs or retail sales or GDP and then call upon three or four experts to analyze the data instantly. Earnings results stream across the TV screen being instantly compared with “the estimates”.  At a time when being correct about the big picture is paramount, most of the stuff we see and hear is providing more obfuscation than clarity.

So, okay, what is the big picture?

Here is the broad economic/political context for the next two years as I see it:

Even though net job creation is likely to begin soon, the economy’s response to the huge monetary and fiscal stimuli has so far has not been adequate, particularly in a political sense. I have called it a “low quality recovery”. Private-domestic-final demand has simply not yet kicked in a substantial and sustainable way. Consumer income has become quite reliant on government transfer payments.  Financial markets are too accustomed to extremely low interest rates. Politicians are restless. But the mood of the electorate seems dead set against any further big fiscal stimulation.

Interest rates are certain to climb.  Even if the Federal Reserve is not vigilant as the economy recovers (I think they will be) and inflationary expectations begin to rise, the bond market will be standing guard and will react quickly.

The most cyclical parts of the economy (consumer durable goods, residential and commercial construction, and capital expenditures) are all extraordinarily depressed.  Together, these components currently have only an 18.5% share of GDP. Their average share for the past 50 years was about 24%, with cyclical peaks soaring to over 26%. An 18.5% share appears to be unsustainably low if the economy is to generate any significant growth.  Eventually, demand backlogs in these sectors will begin to grow, ultimately resulting in a somewhat faster and more sustainable growth pace by 2011-2012.

Conversely, personal consumption is at a record 71% share of GDP, higher than a year ago, and while the personal savings rate has risen from plus or minus zero to  over 3.0% it is still low by historical standards. Further consumer deleveraging would seem to be ahead of us. Spending will be tightly tied to growth of disposable income, largely unsupplemented by borrowing.

One phenomenon of the recession is worth noting. Imports acted like a big shock absorber to domestic economic activity.  That is, as domestic aggregate demand declined, imports fell substantially more than exports.  Both exports and imports peaked in the 3^rd quarter of 2008. Net exports at the time were negative by $758 billion. By the 2^nd quarter of 2009, net exports were negative by $339 billion, thus contributing a positive difference to GDP of $419 billion.  Over that same period, Gross Private Domestic Investment (construction, capital expenditures and inventory change) plummeted by $582 billion.  That’s where the decline in aggregate demand was centered. But the performance of net exports offset over 70% of that decline. Query: As the economy recovers will imports reverse course and increase faster than exports and thereby be growth limiting? The president, in his State of the Union speech, adopted an objective of doubling exports in 5 years. That’s 15% per year when global demand is likely to grow 5-6%, implying a huge gain in share of market. Can we really do this without devaluing the dollar?  I seriously doubt that we can reach the president’s objective, but I do think that we have a shot at growing exports faster than imports, especially if China becomes more realistic about the value of the yuan.

The question uppermost in the minds of investors concerns how and when the federal government can gain a credible degree of control over the budgetary process. Proceeding along the current path, camouflaging the problem with overly optimistic growth projections for the economy, and coming up with incremental solutions without a credible master plan will not be long tolerated by global financial markets. Longer-term, how will we deal with the unimaginably huge liabilities facing us over the next 20 years from Medicare and Social Security.  Currently, I see nothing that even remotely suggests that the political system has the will to face these problems.

Okay, so sizeable tax increases at the federal and state levels, are both necessary and inevitable. But tax hikes are growth dampeners.  Thus, we have a growth conundrum. How do we simultaneously get higher, sustainable growth along with higher taxes and higher interest rates? By late 2010 or early 2011 the economy, even as fiscal and monetary stimuli wind down, will begin to show some solid, sustainable growth possibilities.  But both higher interest rates and higher taxes will be growth limiting at the very time when higher growth is the best answer to the problems of debt and deficits. (The only other answer is to inflate)  We seem to have painted ourselves into the proverbial corner. It’s what happens when you treat the ills of an over- leveraged economy by increasing debt in excessive amounts.

Another important question has yet to be answered. How do we best put our financial system back in order? Do we have the political guts to overcome the Wall Street interests lobbying for no substantive change in the way the financial system is structured?  It may be true that the “Volcker Rule”, which would prohibit banks from engaging in proprietary trading, private equity, and hedge funds does not address directly what got us into the mess, but such activities are full of potential conflicts of interest and put the financial integrity of an entire enterprise at risk. And how about the badly needed standardization and regulation of derivatives and the way they are traded?  Such changes are absolutely crucial to creating confidence in the markets.

The brightest force in the mix for investors is the performance of corporate earnings.  As volume turns from negative to positive, the cost-cutting efforts of American companies are paying off big time.  Analysts who are better equipped than I to estimate earnings are forecasting S&P 500 earnings for 2010 in the range of $75-80.

In the table below are the operating earnings of the current constituents of the S&P 500, including estimates for 2010 and 2011.

Source: BankAmerica Merrill Lynch

What I find quite remarkable is the earnings’ resistance to decline in the worst recession since the 1930’s. This is especially true if the earnings of the financials and energy are removed. Looking at these numbers it is hard to spot the recession.  This relative earnings stability for so much of corporate value is a legitimate reason for longer term confidence in earnings, and is a key reason for the sharp advance in stock valuations since last winter.

So There! Now you have no need to listen to the talking heads in the morning.  Just keep the Big Picture in mind.