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Let's Stress Test Governments
Several years ago, Treasury Secretary John Snow was testifying to Congress about the federal budget. He worked for President Bush and, after a long career of opposing deficits, was trying to justify a deficit of about 3% of GDP. Representative Barney Frank was incredulous. He asked Snow how he could now justify deficits. Frank then came up with a theory: He said Snow was opposed to deficits when the president was a Democrat, but didnt care about them when the president was a Republican. Frank was being sarcastic, but he had a good point.
Dead Cat Bounce for Socialism
The Social Welfare State is dying. Like the Berlin Wall and the Iron Curtain, the cradle-to-grave social welfare experiment must eventually collapse. A system of taxing work and profits, while subsidizing leisure, sloth, and retirement, must eventually fail. The end of the Social Welfare State is painful for many, and it will not end quickly or quietly as the elections of this past weekend prove. Francois Hollande, a Socialist, was elected president of France, while Greece saw a surge in votes for anti-bailout political parties in parliament.
Here We Go Again
We are not saying the negative data is meaningless. Its not. But some of the reaction is, once again, overdone. Debating the worry-warts has become a full-time job and we cant prove them wrong until the future becomes the present. So, lets look back to last year when we said in a few months we will be looking back at recent reports as just statistical noise. Sounded good then, so lets not mess with success. The more things change, the more they stay the same.
The Plow Horse Economy
Like a plow horse, the US economy just puts one hoof after the other. It aint gonna win any races, but it aint gonna keel over and die either. After slogging through the mud last year, and slowing down to just 1.2% annualized growth in the first three quarters of 2011, things have improved. In the fourth quarter last year, real GDP grew a solid, work-horse-like, 3%. We expect that continued in the first quarter of 2012. If anything, other indicators suggest real GDP growth might be even stronger. Nonfarm payrolls rose 635,000 in Q1, the largest gain since 2006.
After the Speed Bump...
Slow down: Speed bump. After that, accelerate with care. Thats the essence of our near-term economic outlook. Although a tapping of the brakes is likely, there is virtually no danger of going off the road. The economic engine, having finally gained some sustainable momentum, will probably keep moving at a slow and steady pace, with a general upward trend overall for the rest of the year.
"On Your Own" Economics
The genius of capitalism is that it harnesses self-interest to get people to cooperate. Most observers, including us, describe capitalism as a system of competition. But on a day-in, day-out basis, this competition is not direct hand-to-hand combat to find a victor; its a race to see who can provide the best products at the best price. Its about service to others, not finding ways to force others to bow to our will. More importantly, we work in cooperative effort with others to accomplish these tasks. Government has a role, but economic growth is always strongest where it governs least.
Supremes Hear No Limiting Principle
Those who followed last weeks Supreme Court arguments on President Obamas health care law got a primer in Constitutional Law. The scope of the three-day hearings was breathtaking. While legal issues dominated the conversation, economics also came into play. The question: Is the market for health insurance so unique that the federal government can penalize someone for not buying it.
Heard the One About a "Fiscal Cliff"?
For three years the market has suffered from a severe case of economic hypochondria. Headline after headline proclaimed that this time, for sure, the recession would return. All of these have come and goneand yet the recovery is three years old. Now, some doomsayers are pointing ahead to a fiscal cliff in 2013. Bottom line: expect to hear more about the fiscal cliff for the next several months. Then, when it doesnt cause a recession, youll never hear about it again.
Regressing to the Mean Asset Values Returning to Low Correlations
Asset values are finally marching, once again, to the beat of their own drummers. This is a welcome change of tune. Among the many investing challenges of the past few yearsbeyond the aftermath of a near-meltdown of the financial system and a global economy that went into a deep recessionwas the high degree of correlation among different assets. Assets moved in tandem, whether in lockstep or with inverse moves, based largely on risk on/risk off investment decisions. Concerned about Europe? Sell stocks, buy bonds. Think the EU ministers will reach a deal? Buy stocks, sell bonds.
The Fed's March Madness
The best currency to be in over the next year or so is the US dollar. Yes, the Fed is loose, but everyone already knows that. Its priced in. The issue today is whether the Fed tightens policy faster than investors previously thought. And that looks increasingly likely. Momentum is now shifting toward the US, with some global investors looking at equity returns sweetened by currency gains. Add higher US bond yields and emerging markets should be even more willing to buy US assets. A self-sustaining, virtuous cycle is emerging, the kind that often forms in long-term bull markets.
The Bears' Five Stages of Grief
The economic bears have had it rough the past few years. They keep bashing the economy, but it keeps recovering. Watching them fight through the five stages of grief is educational. First there was denial, then anger (some are still in this stage), now its bargaining.
Viva La France?
Its not happening just in America. France will also elect a President this year. The two top candidates are current president Nicolas Sarkozy and Francois Hollande. Last week, Hollande announced he wants to raise Frances top income tax rate to 75% from the current peak of 41%. He said patriotism and justice should convince French citizens to support his candidacy and his tax hike. We are not friends of higher tax rates. Nonetheless, we see Hollandes proposal as a win-win for global supporters of small government and free market capitalism. Ether through repudiation or bad example.
Don't Bet on a Correction
There may be a trader who can capture all of this, but in the end, the history of America is clear. Bears make money every once in a while, but its the long-term bulls, who believe in the steady progress of technology and wealth creation, that make money most consistently. Dont bet on a correction.
Stocks Rising, But Still Cheap
The rise in equities so far this year is not just a sugar high. The Fed has done nothing new, while Keynesian pump-priming is on the wane. Federal spending peaked at 25.3% of GDP back in 2009. Its still way too high, but has fallen to 23.7%. Meanwhile, despite shenanigans like the temporary payroll tax cut, federal revenue has risen from 15.1% of GDP to 15.4% in the past year. Spending is down and taxes are up. Fiscal policy is contractionary. Yes, the Fed is loose and is holding interest rates down. But even if we assume normal interest rates and stable profits , stocks are very cheap.
Be Confident in the Recovery
Two prominent measures of consumer confidence dropped unexpectedly in recent weeks. This provided plenty of fodder to those who still think the US economy is teetering on the brink of a long awaited double-dip. But when it comes to the consumer confidence data, the only thing were confident about is that confidence doesnt matter. Not one bit.
Despite Naysayers, The Recovery Is Real
The US economy is far from perfect. Economic growth has been positive, but mediocre over the past year and a half. The unemployment rate, at 8.3%, is still elevated, higher than it ever was from 1984 through 2008. When it comes to bashing government policies, from either party, we do not take a back seat to anyone. What we cant do, because it makes no sense, is allow our dislike of current government policy to influence our view of the actual economic data. There really is a recovery underway. If it quacks like a duckit must be a duck.
Fed Forecasts Depend on Data
Last summer, the Fed promised to hold rates down through mid-2013. Headlines from last week suggest that the Fed now thinks 2014. But, how committed is the Fed to this strategy? What will it take to change course? Some analysts argue that this is an ironclad commitment and there will be no course changes. We believe this is a misreading of the Feds intentions. There are 19 potential economic views that are important at the Federal Reserve 7 are on the Board of Governors and 12 are Presidents of regional banks. There is more disagreement at the Fed than meets the eye.
Fed Language Goes Dovish, But Policy Unchanged
Investors should take note that at his press conference today Chairman Bernanke made it clear that if the Feds economic forecast proves either too optimistic or too pessimistic, that it would change its forecast and alter its policy expectations for the funds rate as well. The importance of this statement cannot be underestimated. We anticipate faster economic growth, lower unemployment, and higher inflation than the Fed projects over the next few years. As result, we believe the Fed will start raising interest rates well before late 2014.
Rally Not Built on Complacency
No matter how we make our argument, and no matter how consistently the economy grows, the doubt and fear and disbelief just wont go away. We noticed this recently, when conventional wisdom started to say that investors were being complacent these days. In other words, when the equity markets go down, investors are living in reality and accepting that the economy and financial markets just arent in great shape. But when the equity markets go up, they are being schizophrenic, overly optimistic, and now some are saying complacent.
Q4 GDP - No Recession In Sight
Three months ago, we added up the major components of real GDP for the third quarter and predicted a solid annualized growth rate of 3.5%. Instead, the advance report came in at 2.5% and was later revised down to a tepid 1.8%. We were too high on inventories as well as government purchases, and that made our overall forecast too high. However, our estimates of consumer spending, business investment, home building, and the trade balance were all pretty darn close to the mark. Final sales (GDP excluding inventories) grew at a 3.2% annualized rate.
Nonsense Arguments About Jobs
The better the employment reports get, the more ridiculous the assertions from those who deny the improvement. Fridays report, was the best since the recovery started. Private payrolls rose 212,000, while the number of hours per worker and earnings per hour went up as well. As a result, total workers earnings are more than keeping pace with inflation. Even the unemployment rate went down again and is now at 8.5%, almost a full point below where it was a year ago. Our observation is that most of these arguments against optimism are driven by politics and border on the ridiculous.
We Were Too Optimistic
When government tilts toward redistribution, the growth rate of potential GDP slows down.This hurts job creation.We should have more fully accounted for this in our forecast last year. Some will ask: Then how can you forecast 3% growth in 2012?The answer is relatively simple.1) The Fed is even more accommodative today than it was last year.2) Government spending will be basically flat in 2012 for the third consecutive year.3) Technology continues to advance. These developments mean the tailwinds are stronger at the same time the headwinds are diminishing.
Was the 2011 Economy a Miracle?
Government spending may be falling as a share of GDP, but it is still very high. This limits job creation and holds back real GDP growth from its potential. Excessive regulation does the same.And while an easy Fed boosts growth, it also creates inflation, which will become more of a problem in the years ahead.
Netting all this out, the scale is still tilted toward growth.New US technologies and the productivity that they create are so powerful that they are overwhelming the drag from bad government policies.Compared to forecasts of recession, its a miracle.Look for another one in 2012.
Greedy Innkeeper or Generous Capitalist?
The Bible story of the virgin birth is at the center of much of the holiday cheer at this time of the year. The book of Luke tells us Mary and Joseph traveled to Bethlehem because Caesar Augustus decreed a census should be taken. Mary gave birth after arriving in Bethlehem and placed baby Jesus in a manger because there was no room for them in the inn. Over the centuries, people have come to believe that because Jesus was born in a stable, and not in a hotel room, Mary and Joseph must have been mistreated by a greedy innkeeper.
Obama's 8%: Sounds Right
Given his advisers track record, you would think President Obama would be very cautious when making predictions about the unemployment rate. As we all now know, even though the stimulus bill was fully implemented, the jobless rate kept heading north, peaking at 10.1% in October 2009 and never once falling even remotely close to 8%. Nevertheless, President Obama is doing it again and predicting unemployment will be 8% around Election Day. This time, we think hes right.
Economy Improving, Stocks Cheap
Remember the big fat zero jobs reports back in August? The US was supposedly teetering on the brink of another recession, or maybe depression. Democrats wanted more government spending stimulus. Republicans said President Obama was the equivalent of a zero. With all this negative sentiment, the Dow fell 250 points that day. But something happened on the way to the bank. One month later, that big fat zero was revised up to a +57,000, the next month it was revised up again to +104,000. All that recession talk in early September was highly misleading.
Occupy The Shopping Mall
No one knows exactly what the near future holds for Europe. We still think the odds favor tough austerity programs that reduce the size of government a long-term plus. But more sovereign defaults are entirely possible and problems with European banks have yet to be thoroughly addressed. What we do know is that US consumers are ignoring the experts, appear more confident about their future and want to spend their hard-earned income. Instead of panic, weve seen a lot of joy,on both sides of the cash register.
What's So Special About America
Thanksgiving is about the bounty of this great land, and the plenty that ingenious and hard-working people have been able to create. Other countries have been around longer, but none has been as generous, or had a more positive impact on the world, than America. So, pardon us when we express shock about some recent polling by Pew Research that showed only 38% of Americans believe the United States stands above all other countries in the world. We are stunned by the difference among age groups. Only 27% of people aged 18-29 agreed, while 50% of those over 65 agreed.
Don't Fret the Foreign Stuff
Guess what? Japans real GDP grew at a 6% annual rate in the third quarter, a sharp snapback from the downturn following that awful earthquake and tsunami. Much of the rebound was auto-related, as manufacturers overcame problems with electricity and the supply-chain. While the swings in Japan are more dramatic, US economic data shows the same pattern. Real GDP accelerated in the US to a 2.5% annual growth rate in Q3. If we exclude the large drag from an inventory slowdown, real final sales grew 3.6%.
Time to Raise the "Natural Rate"
We think the jobless rate is headed down in the next few years and think it will decline a bit faster than the Fed believes. But the only way to get it down to 5.6% is to dramatically reduce the size of government or to push so much money into the economy that it artificially pushes unemployment below the natural rate. But that second method can only work for a short period of time. Eventually, a monetary policy loose enough to lower the unemployment rate that much would create a 1970s-style inflation. That would make todays inflation problem look minor in comparison.
What's Going Right?
Everyone knows housing is still weak. And, everyone knows jobs are growing, but not fast enough to seriously lower the unemployment rate (9.1%). Everyone also knows real GDP has expanded for nine consecutive quarters, at an average annual rate of 2.5%. No one is satisfied with this; but it is a recovery, not a recession. So, how can real GDP grow when housing and employment are so weak? Well, it turns out that the strongest part of the economy has been business investment. Equipment and software investment has grown five times faster than GDP-12.9% over the past nine quarters.
The Consumer Is Not Dead
Not a day goes by where we dont hear a talking head say something like, the consumer is weak. A headline from the WSJ was more specific. It said, Spenders Become Savers, Hampering Growth. The WSJ based its theory on some interesting anecdotes, but the authors missed some very basic facts. Organic changes in consumer behavior are not responsible for any lack of rapid economic growth. Instead, the economy would be growing much faster if we had a better set of policies coming from DC the past few years, focusing on restraining the size of government rather than expanding it.
Solid 3.5% Growth in Q3
When real GDP growth barely budged in Q1 (0.4%) and sputtered in Q2 (1.3%), conventional wisdom became convinced that a recession was on its way. Many argued that unless the US stimulated the economy with more spending, temporary Keynesian tax cuts, or another round of quantitative easing, it was in for another recession. With the Fed accommodative, and productivity strong, we never believed the pessimistic narrative. Conventional wisdom has been wrong. With most monthly data in, it looks like real GDP grew at a 3.5% annualized growth rate in the third quarter of 2011.
The Economic Twilight Zone
The pessimists say, we will scare ourselves into recession. And they ask; what about Europe? We dont ignore either of these possibilities. It might be possible to scare ourselves into recession. But true panics are very rare. And Europe could theoretically take us out, but mark-to-market accounting no longer can cause a contagion like it did back in 2008. Some investors say they wont invest until this episode of the Twilight Zone ends. But, the market is cheap and the economy is growing. Accumulating assets, with values so battered down is successful long-term investing.
Forecasts, Confidence and Facts
When fearing recession, investors can rely on three different sets of information forecasts, confidence and facts. These days, forecasts and confidence are both very negative. Recession fears have been on the rise. But, the facts dont back up all these fears. The economy is not contracting. Fear overlooks these facts and fear has driven stock prices to undervalued levels. When the facts win and thats what we expect equity markets will get over the fear and move significantly higher.
A Whiff of Volcker
Equities will soon shrug off last weeks news. The economy is not in a recession and while European problems are a real issue, US banks have plenty of capital to sustain the system in case of further crisis. Despite all the dour language and the volatile market reaction, we like the downward move in gold. What it says is that the Fed will no longer follow a path of policy that seemed to print money with no regard for any historical lessons. As Paul Volcker showed us, tighter money can be in a countys best interest. Gold investors should look out below. But, for equities, this is a good sign.
No Recession, No Panic
Online markets (at Intrade) put the odds of a recession in the next year at 40%. The consensus of economists (in a Wall Street Journal poll) has the odds of recession at one in three. These elevated fears are hitting consumer confidence, creating political pressures and causing volatility in financial markets. We think the actual odds of a recession are much lower than the consensus thinks. We place them at 20%, barely above the 15% that history tells us exists in any year.
The Long Run is Now
President Obama delivered his long-awaited economic address Thursday night and Fridays reaction in equities was a major Bronx cheer. Obviously the news from Greece, with that country teetering on the edge of a default, was also a big negative. But we believe the lions share of the problem is that, once again, a president is proposing policies that are both primarily oriented toward the short-run and unlikely to succeed at lifting the pace of economic growth.
Want Jobs? Have Faith
The private sector created 17,000 new payroll jobs in August and the government lost 17,000. The net was zero. Nadazipzilchnothing. Some would say that this is a perfect metaphor for the economya big fat zero. The stock market is getting drilled, politicians are frothing at the mouth, the Fed is having longer meetings, and investors are scared. So, whats going on? First, let us say that we have been overly optimistic. We expected better growth in jobs and the economy. We have been wrong, but we still dont expect another recession.
Stocks Undervalued by 65%
Market turmoil and a cycle of shrill headlines and worrisome breaking news convinced many to evacuate the equity markets. That was a mistake. The odds of recession are low, but the stock market seems to have priced one in, anyway. We use a capitalized profits model to value stocks, dividing corporate profits by the 10-year Treasury yield. We compare the current level of this index to that from each quarter for the past 60 years to estimate an average fair-value. Not only are 10-year yields low (2.2%), but corporate profits are growing strongly.
Europe, Not a Repeat of 2008
Some are drawing parallels between todays European debt problems and the sub-prime problems of 2008. We dont think European debt problems will cause a recession in the US. However, there are clearly similarities between the two events. Those similarities result from the role of government. Both the 2008 panic and todays European debt crisis result from policy mistakes. In the US politicians of all stripes decided that using subsidies and regulations to boost homeownership was a legitimate goal. All of these policies came together in a perfect storm of over-investment in the early 2000s.
Fed Looking in Wrong Tool Shed
The Fed made history again last week when it specifically committed to near-zero short-term interest rates through at least mid-2013. This commitment was a first for the Fed, and while it can always renege, the bar for doing so is now very high. The Fed also said it had discussed a range of policy tools to strengthen the economy. If theyre the ones the Fed has been leaking to the media, count us as unimpressed. One option would be to launch QE3, modeled after round two that ended in June. Trouble is, other than boosting commodity prices, QE2 had little visible affect on the real economy.
Focus on the Economy
Investors remain on edge and stocks are down about 2% around the world today. Combine last weeks sell-off, the debt ceiling debate, financial instability in Europe, the recent soft patch, and a downgrade by S&P and this fear is understandable. Short-sellers and pessimists are in their glory. And for the umpteenth time, Nouriel Roubini said that a double-dip recession is on its way. We understand the uncertainty. What we dont get is why it's so hard for economists to look at economic data. There was a soft patch but, it is not getting worse. In fact, data has been improving.
US Debt: Moody?s AAA / S&P AA+
If this move by S&P helps the US get more serious about cutting spending, then it will have been a very positive development. If it influences the political environment by pushing the US to a more conservative set of fiscal values it will be even more positive than that. There is a titanic battle of economic and political philosophy taking place in the US today. S&P wants to be a player in this battle, but in the end it will have a relatively minor role.
Dow Down 500, But Fundamentals Still Strong
Major stock market indices are down 4-5% today as investors move into panic mode. There is no single piece of news driving the sell-off; rather the market seems to be gathering downward momentum on its own. Selling is creating more selling. Like 1987, the sell-off does not appear to be driven by fundamental factors. In fact, the fundamentals suggest the market is undervalued and getting more so as it drops. Many investors assume (or wonder) if the sell-off is indicating deep economic problems. However, there is no evidence that this is true.
Hysteria and the Debt Debate
Contrary to popular belief, the debt ceiling has turned into the investors best friend. Professional politicians dont like it, because they dont want to limit their degrees of freedom. But the limit on debt, forces a debate about the size of government before a country gets to the point of no return. In other words, the debt ceiling is a good thing. Moodys has said that the US should get rid of the debt ceiling altogether, but this is backward. Greece never had this debate and spent its way into oblivion. The debt ceiling could very well keep the US from that fate.
Looking Past a Weak Q2
While some economists are reducing their projections for second half growth, we remain confident in a relatively strong rebound from a weak first half. We forecast that real GDP will grow at a 4% to 4.5% average annual rate in Q3 and Q4 2011. Productivity is strong, monetary policy is loose and fiscal policy is getting no worse. Jobless claims are falling again and auto production is set to surge. In addition, with full expensing allowed for tax purposes this year, record levels of both profits and cash will fuel growth in business investment.
Jobs Versus Government
After the very strong ADP employment report on Thursday, many economists marked-up their forecasts for Friday?s official payroll report. We moved ours up 5,000, and went into the report at 140,000 net new private sector jobs. Ouch?the official report showed just 57,000 new private sector jobs and equities immediately headed south. For bulls, this data was a huge disappointment. But employment is a lagging indicator. Other data have already been into, and out of, a ?soft patch.? Moreover, as a forecasting tool, employment data has not always been perfect.
Hasta La Vista, Soft Patch
The big report this week will be on employment for June, to be released early Friday morning. Private sector payrolls only expanded 83,000 in May. But, given the drop in unemployment claims, we think the job market re-accelerated in June. It?s no surprise to us that the Dow has now fully recovered back to where it was when the soft patch started to materialize. Despite the end of QE2, the economy is going to surprise the consensus to the upside. Monetary policy is loose, tax rates are relatively low, and the technological revolution continues.
Inflation Now and Later
The Fed believes with all its heart that inflation only occurs in economies that are producing at or above their potential. As a result, with unemployment above ?normal? and growth below ?trend,? the Fed sees little threat of inflation. As far as the Fed is concerned, any increase in commodity prices is temporary and any increase in the consumer prices due to commodities (like energy) is transitory. We wish we could be as sanguine about inflation as the Fed, but we heard all the same arguments back in the 1970s. The Fed was wrong then, and we think it is making the same mistake(s) today.
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