Dec 07, 2011

Denial No Longer

On both sides of the Atlantic, we have finally come to the point where if we continue on our present respective paths the outcome is not likely to be pleasant.  In the United States the wake-up call was the failure of the Congressional Super Committee to come up with a credible plan to reduce the U.S. budget deficit by $1.2 trillion over ten years.  In Europe it was the rise in the cost of raising government funds in Italy and Spain, culminating in November with the lack of bids for part of an auction of German debt and a sudden rise in interest rates there.  Finally it appeared that doing nothing and muddling through were incompatible.  The verdict was delivered in both the European and American stock markets by a resumption of the free fall in equity prices that we experienced in August and September.

The failure of the Super Committee was part of the pattern of dysfunctional government that began last summer with the downgrade of U.S. government debt and the battle in Congress over raising the debt ceiling.  At that time political lines were drawn, with the Republicans not wanting to increase revenues and the Democrats wanting to limit entitlement reductions.  A compromise seemed unlikely even then, and perhaps it was wishful thinking to hope that the Super Committee would come up with a workable plan to reduce the deficit.  Nothing major seems to happen in Washington until a crisis is upon us and we weren’t at that point yet. 

Now few observers expect anything constructive to take place until the national elections a year from now and many, including myself, wonder if we can really wait that long.  I also question whether we can narrow the budget gap without raising some revenues.  Tax revenues have declined from 18% of Gross Domestic Product (GDP) for most of the past 60 years to 15% now.  Declining revenues account for about 40% of the increase in the budget deficit since 2007.  The recession and slow recovery account for some of this shortfall, but tax relief has been an important contributor to the problem.  The tax preferences enacted during the last Bush administration expire at the end of 2012.  If they are not extended, important additional revenue would be collected, but the absence of these benefits could severely impact the growth of the economy.  

At this point both parties are saying that the American people will decide which direction the country should move in when they vote for president in November, but the budget issue is likely to be a major campaign topic and should dominate the dialogue in Congress for all of next year.  In addition to the expiration of the Bush tax preferences, the automatic spending cuts in defense and healthcare will also go into effect at the beginning of 2013 as a result of the failure of the Super Committee to come up with a definitive plan for deficit reduction.  If anticipatory action is not taken on both these programs, the post-election period is likely to be a lively one for policy makers as they confront these major tax and budget issues, no matter who is elected.  The expiration of the Bush tax cuts and the automatic reduction in entitlements and defense occurring at the same time may force legislators to take action before the election.  We may get a preview of the willingness to compromise as legislators confront the imminent expiration of the payroll tax cut.

The irony is that the dysfunctionality in Washington which is discouraging investors is occurring at a time when the U.S. economy is showing some signs of improvement.  By now almost all of the Standard & Poor's 500 companies have reported, with 70% beating analysts’ estimates. The GDP for the third quarter has been revised downward from 2.5% to 2% as a result of inventory adjustments, but estimates for the fourth quarter are as high as 3%.  I'm not getting my hopes up; I still think real growth over the intermediate term will be between 2% and 3%, but at least we have moved away from the recession fears of last summer.

Among the indicators showing a positive trend are the regional reports of the various Federal Reserve banks, the unemployment rate, bank lending, durable goods orders, layoff announcements, railcar loading and consumer sentiment.  The general tone of the housing market suggests that conditions are not getting worse.  I have thought for a while that housing is in a bottoming process.  With a heavy overhang of unsold homes I do not expect a surge in housing starts any time soon, but at least the process of drawing down the inventory seems to have begun.  I continue to believe that a program of government incentives to improve American infrastructure is needed and would go a long way toward putting unemployed construction workers back on the job.  Early signs of retail sales in the all-important post-Thanksgiving period are favorable and consistent with my growth forecast.

Ultimately I believe Congress will have to pass legislation that will include entitlement cuts, some revenue increases and perhaps a few measures designed to reduce unemployment.  Such a program will require the political parties to compromise and soften their differences.  That seems unlikely now based on the current rhetoric and partisan hostility, but I think that is where we are headed. Democratic agreement to extend some of the Bush tax cuts may prove the key bargaining chip that gets the Republicans to agree to revenue increases in other areas of the tax code.

Aside from what is happening or not happening in Washington the fundamental background for U.S. equities in terms of earnings and the economy is reasonably positive.  Investors, however, are closely following events in Europe and are becoming increasingly anxious.  If Europe slips into recession, which seems likely at this point, that is bound to have a negative impact on the U.S. economy and its financial markets as it has in the past.  European policy makers are facing an impasse over their sovereign debt problems just as we are facing one in the United States over the deficit.  The countries unable to meet their obligations, like Greece, Portugal and Italy, believe the European Central Bank (ECB) should print money, buy their bonds, fund their deficits, keep their governments running as usual and lower interest rates.  The ECB and its principal backer, Germany, have been buying debt in the open market in an attempt to defer the crisis point from occurring, but the troubled countries seem unable or unwilling to implement the reforms necessary to get back on a sound and sustainable path.  The trigger point has come in the form of rising interest rates.  Greece has long had double-digit rates on its sovereign debt, but this is considered a small enough factor not to be systematically threatening to all of Europe.  Spain and Italy are another matter.  With 10-year sovereign bonds for those countries approaching or exceeding a 7% yield which is unaffordable over the long run, the crisis is here.  Even Germany, whose yields are closer to 2%, had trouble selling all the debt it wanted to bring to market in late November, and economic data in Germany has been softening as well. 

Clearly neither the ECB nor Germany wants to continue to provide funds to economies that are doing little to improve their fiscal circumstances.  Italy has a total debt of 120% of its GDP and is the third largest debtor nation in the world after the United States and Japan.  Its previous Prime Minister, Silvio Berlusconi, valued loyalty over merit and believed, according to a Council on Foreign Relations report, that “the rule of law was only one option among many.”  Politicians in Italy enjoy high salaries, generous annuities after a few years in Parliament, and 600,000 official cars, compared with 75,000 in the United States, a country with five times Italy’s population.  The pension system needs reform, the barriers that limit access to professions and trades need to be removed and tax evasion has to be tackled.  Italy will not get major aid until Mario Monti proves he can institute reforms, and he is going to have a tough fight with many Berlusconi holdovers in the Italian Parliament.  I believe a combination of the European Union, the European Financial Stability Facility, the International Monetary Fund and perhaps the central banks of other industrialized countries can provide transitional aid to help the weaker countries during the reform process, but help will not be forthcoming until it is clear that improvements are underway, and there is sure to be a lot of popular resistance to the austerity that will be required.

The long-term solution for Europe has got to be some form of integrated fiscal entity.  So far no country has been willing to surrender its sovereignty to achieve this, but the issue is now on the table and the urgency of the present situation may bring Europe closer to a political as well as monetary union.  European countries have already surrendered some of their sovereignty through involuntary fiscal tightening in exchange for funds to keep operating and have forced changes in leadership.  Germany and France are working on a plan for a closer fiscal union and they differ only on how sanctions would be administered when countries get out of line.  Europe as a whole does not want to abandon the euro, and I believe they are on a path which will enable it to endure.  The Continent has invested too much in money and time and the benefits in terms of trade among countries have been huge.  In spite of the challenges now facing policy makers a solution must be found.

Europe may be providing a warning to the United States.  The rise in yields on government debt in the troubled countries is forcing the leadership to take constructive action toward reform.  I have long felt that the fact that the United States can borrow money for 10 years at 2%–3% is relieving Congress of the pressure to take action on the budget deficit.  The reasoning goes that if investors will loan us money at low rates, the situation may not be as bad as the critics say.  Only when rates rise to an alarming level will remedial action be taken.  With so much fear around the world and the United States viewed as a safe haven with a strong military and a Treasury that can print money, that day may be a long time in coming.  

The financial markets yearn for clarity on these issues and as we approach year-end with some hedge funds closing and other investors wanting greater liquidity we are again in a situation where there are some impatient sellers and uninspired buyers, which has resulted in the markets drifting lower.  On the basis of historical valuations the United States and other markets offer some good opportunities, particularly in high-quality, dividend-paying companies.  For investors to act with conviction, however, they will have to believe that policymakers on both sides of the Atlantic will come together to come up with workable solutions to the problems facing them.  That has to happen in 2012.

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