Market Commentary
by Byron Wien
 
05/04/2012

Addicted to Easy Money

Back in 2008 when the banking system in the United States was in danger of melting down and the economy was sliding into recession, few tools were available to policy makers to prevent a financial catastrophe.  During that fateful period in mid-September, Hank Paulson, Tim Geithner and Ben Bernanke made a series of decisions that laid the foundation for the strengthening of the banking system and the recovery of the economy.  The balance sheet of the Federal Reserve, which had been stable below $1 trillion for some time, swelled sharply to $2.4 trillion as various support programs were implemented.  Money kept flowing to enable the economy to grow modestly, and today the Federal Reserve balance sheet has assets of almost $3 trillion, as shown in the chart below.  Whereas the balance sheet of the Fed consisted almost entirely of U.S. Treasury securities when it was $1 trillion, today the balance sheet holds substantial amounts of mortgage-related and other lesser-quality securities and financial instruments.

Fed Balance Sheet vs. ECB Balance Sheet (millions)

Source: Strategas Research Partners.

Across the Atlantic a similar program has been underway. The historical focus of the European Central Bank (ECB) has been on inflation because its mandate is to maintain price stability. The ECB expanded money supply in 2008 in sympathy with the U.S. financial crisis but when faced with the sovereign debt crisis in the weaker, so-called “southern tier” countries, the ECB began a similar program of monetary easing. The balance sheet of the ECB had been about €1.9 billion prior to the sovereign debt crisis. In a short period in 2011, it increased to €3 trillion to provide liquidity to the weaker countries so they could meet their obligations. Low interest loans coming due in three years eased the pressure on the “southern tier” and prevented a financial disaster. Monetary stimulus is also going on elsewhere. Developing nations that tightened money to bring down inflation over the past two years have reversed that policy. During the last eight months India, Brazil and China have lowered interest rates and the International Monetary Fund has doubled the lending capacity of the eurozone crisis fund.

Across the Atlantic a similar program has been underway.  The historical focus of the European Central Bank (ECB) has been on inflation because its mandate is to maintain price stability.  The ECB expanded money supply in 2008 in sympathy with the U.S. financial crisis but when faced with the sovereign debt crisis in the weaker, so-called “southern tier” countries, the ECB began a similar program of monetary easing.  The balance sheet of the ECB had been about €1.9 billion prior to the sovereign debt crisis.  In a short period in 2011, it increased to €3 trillion to provide liquidity to the weaker countries so they could meet their obligations.  Low interest loans coming due in three years eased the pressure on the “southern tier” and prevented a financial disaster.  Monetary stimulus is also going on elsewhere.  Developing nations that tightened money to bring down inflation over the past two years have reversed that policy.  During the last eight months India, Brazil and China have lowered interest rates and the International Monetary Fund has doubled the lending capacity of the eurozone crisis fund.

At this point the United States is experiencing a mild recovery in excess of 2% real growth.  The European countries that are enjoying trade surpluses, like France, Germany and the Benelux countries, are growing modestly.  The rest of the European Union, those who have trade deficits, are in varying degrees of recession.  In 2012 Europe as a whole will have meager growth at best in 2012 and a mild recession at worst, but countries like Greece and Spain are likely to have a rougher time of it.  One risk to the fragile economic situation in Europe is the possible change in political leadership in France.  François Hollande is opposed to the austerity program agreed to by Nicolas Sarkozy.  If the fiscal situation in France worsens, that could be a negative for all of Europe.  Housing starts in France have turned up and average hourly earnings are increasing.  A tenuous economic partnership has existed between Sarkozy and Germany’s Angela Merkel, and they have been leaders in creating a blueprint for the European recovery.  It is unlikely that a similar harmonious relationship could be forged between Hollande and Merkel.

In the April 22 first-round vote Hollande narrowly led Sarkozy, marking the first time in nearly fifty years that an incumbent president lost in the initial round.  The strong performance of Marine Le Pen (18%) may help Sarkozy in the May 6 runoff if some of her right wing supporters turn out and vote for the president; only a few immigration hawks are likely to vote for Hollande.  Some closer to the French political process than I believe that Hollande is not an extremist, and that some of his views were designed to win political support but are not likely to be pushed hard if he is elected.  What he does have going for him is that many in France believe as he does that severe austerity would drive the country into a painful recession.

Politics will surely play a role in the intermediate-term outlook for the United States as well.  Currently federal expenditures are running at a rate of 25% of Gross Domestic Product and tax revenues should come in at about 17%.  In order to close that gap, which both political parties say they want to accomplish, there has to be both a reduction in expenditures and an increase in revenues.   The Democrats are willing to make modest downward adjustments in entitlements and other programs and want to increase taxes on those earning higher incomes.  Under that program, in my opinion, the deficit would still be large.  The Republicans want to make more substantial cuts in entitlements and other programs and reduce taxes across the board substantially.  They argue that their program would stimulate growth, as tax cuts did under President Ronald Reagan in the 1980s.  My worry about the Republican plan is that the world is a much more competitive place today than it was thirty years ago and that tax cuts may not have the same impact on growth.

I am also concerned about the broader outcome of the election.  If President Obama wins and the Republicans retain control of Congress and gain control of the Senate, it may be hard to get any economic legislation passed.  If the Republicans sweep the election and control both the White House and both houses of Congress, I worry that the bills passed may not bring down the deficit.  Right now the odds favor President Obama winning a second term but facing a Republican Congress.  With little progress likely in fiscal policy the burden on monetary policy becomes even greater.

In the United States there is a great deal of handwringing over whether there will be a third round of quantitative easing.  Federal Reserve officials have said they are keeping an eye on the data as reported and if an additional round of liquidity injection is necessary, the central bank will provide it.  In any case, interest rates will be kept low until 2014.  Europe has said it is reluctant to provide more liquidity, but money seems to be trickling into the economies there, nonetheless.  The real question is whether both Europe and the United States have become addicted to an easy money policy and whether the economies of both of these developed regions can sustain themselves without continuous monetary easing.

Of the two, the United States has a better chance of breaking free of the stimulus.  The lower dollar has helped reduce the trade deficit, consumer confidence has improved, capital spending is reasonably strong and the unemployment rate looks like it will continue to head lower.  While there is considerable debate over the pace of the economy, growth in excess of 2% is likely and growth in the 2.5% to 3% range is quite possible.  The fear is that on January 1, 2013, the end of the Bush tax cuts and the automatic implementation of the sequestering of funds for health care and defense caused by the failure of the congressional “super committee” to come up with a $1.2 trillion budget reduction package last fall will provide sufficient fiscal drag to pull the U.S. back into recession.  In Europe there is substantial resistance to the austerity programs promised by every country.  Work rules across the continent are very inflexible and it will be virtually impossible to implement the austerity programs quickly, if at all.  As a result, Europe should grow sluggishly and unevenly, but not have a serious recession.  I view this favorably because a deep recession in Europe would slow the U.S. economy as well.  Historical studies have shown that our two economies are coupled to a significant degree and it is doubtful that growth in America could continue satisfactorily if Europe were in a serious recession.

One factor that could change the outlook for the U.S. economy favorably is housing.  In past recessions housing recovered along with the general economy, but that has not happened in this cycle.  The reason is that we overbuilt the housing stock in the decade between 1997 and 2007 as a result of the “ownership society” concept.  The percentage of families owning their own home or having some equity in it rose from 64% to 69%.  Many of those people bought homes they could not afford because the initial payment terms were favorable and house prices were appreciating 10% a year.  When house prices flattened and began to head down in 2007, home construction, which had provided a boost to the economy, turned down abruptly.  At its worst there may have been an excess inventory of as many as four million homes throughout the country, but today the excess may be down to one million, which could be absorbed through family formations in a little more than a year. A collateral aspect of this is the number of people who were employed in various aspects of the housing industry who are now looking for jobs.  If housing started to come back, some portion of those two million workers could be re-employed.  No other “swing factor” could have the same positive impact on the economy.

There are reasons to be hopeful.  The Case-Shiller index of home prices in twenty major markets is still negative, but only slightly.  Housing starts began to show some improvement over the winter, but the unusually warm weather may have had something to do with that.  Mortgage rates are low and housing has never been more affordable.  Existing house sales have been trending higher for almost two years and prices for existing homes have headed higher over the past quarter.  Housing equities have already begun to reflect this favorable shift, but the fundamental data for housing has yet to turn definitively positive.  We may have to wait until next year for that to happen.

After a strong first quarter, the U.S. stock market has been consolidating.  The principal reason for this is that sentiment was negative at year-end, and as investors received favorable economic news, they became more willing to expose themselves to risk assets.  By the beginning of April they were optimistic and the market was overbought; it was time for a corrective pause.  I still believe the economic background is positive and that real growth will come in at 2.5% or better.  On that basis the Standard & Poor’s 500 will have operating earnings of $100 or more and should sell at 15x, so there are higher highs ahead.  First quarter earnings are beating expectations so far.  About a quarter of the S&P 500 companies have reported and 81% have beaten estimates. The economic news has been somewhat softer recently, but I do not believe that is the beginning of a trend toward weakness.  The big question remains: how dependent are the economies of Europe and the United States on the easy money policies of their central banks and will these policies continue?  In the democracies on both sides of the Atlantic there is considerable political dissention.  My view may be somewhat cynical, but in the intermediate term the governments are likely to do what works rather than what is right.  Monetary expansion works.  There may be a danger of inflation looming out there, but as long as wage increases remain tame and house prices don’t soar, that is not likely to be a problem in the near-term.

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