Oct 03, 2011

It’s Hard to Be an Optimist

I still believed we could avoid a recession and a bear market, but I began to realize that there were some structural and secular problems that were holding the economy back.  I had long thought the United States, Europe and Japan were mature economies that would have trouble growing much faster than 3% for any sustained period.  I was now beginning to see that there are some impediments that might keep growth from even approaching that level.

The first is the dysfunctionality of governments on both sides of the Atlantic. In the United States this was dramatized by the August battle in Congress over the debt ceiling and the budget deficit. The extreme polarity of the views of Democrats and Republicans was disheartening to everyone and sure to have an impact on consumer sentiment. Nobody feels good about living in a country with serious problems where the government doesn’t seem capable of taking effective steps to deal with them.  In these circumstances consumers hold back their spending and businesses are slow to invest.

The second secular issue is the European credit crisis. This has been brewing almost since the signing of the Maastricht Treaty created a European Union. Europe has a common currency and a monetary agreement but there is no central fiscal authority which could force countries to conform to the original rules and which could impose taxes and issue bonds to deal with deficits.  The seriousness of this deficiency erupted last year when Greece, having reported it would have a 3% budget deficit, revealed it would be 13%, hardly a near miss.  The fiscal problems of Greece, Portugal and Ireland were papered over with loans last year, but this year when Spain and Italy indicated that they might have trouble meeting their obligations, the depth of the structural weaknesses of the monetary alliance became clear. 

I believe the European Union, the International Monetary Fund and the central banks around the world working through the European Financial Stability Facility will have the resources to deal with the problem. The situation is similar to what the United States faced in the subprime crisis of 2008.  At that time various federal programs were put in place to shore up the banks while they wrote off their bad loans and recapitalized.  In Europe, it appears to me, there must be a restructuring of the sovereign debt of the weaker countries. This will put a strain on the commercial banks that hold these obligations, and the consortium of financial authorities must step in to provide support. This process will restrain credit in Europe and retard growth but it will avoid a meltdown of the banking system.  The continent will go through a prolonged period of austerity as budget deficits are reduced and bank lending diminishes.  If the European Central Bank had a more accommodative monetary policy, that would mitigate the negative effects. 

All of this does not mean we have to slide back into a recession and a bear market, but the mood out there would suggest that both are likely.  In August and September the equity market experienced climactic behavior.  There were a number of trading days when declines exceeded advances by nine to one. Bearish sentiment rose, although it did not reach extremes for some indicators. Put buying exceeded call purchases day after day, a sign often seen at market lows.  Insiders were buying and money continued to flow out of the equity mutual funds.  All these indicators should have given traders and investors some encouragement, and produced at least a rally, but the market continued to decline.  On September 23rd the Standard & Poor’s 500 had declined 16% since its April 29th peak and was down almost 10% for the year.  There was almost no place to hide. The Russell 2000 smaller capitalization index was down 25% from its peak and the Morgan Stanley Capital International Emerging Markets Index was down 27% from its high. What was special about the current decline was its speed. This was especially discouraging to investors.

At this point the fundamental background is not that bad. Industrial production is still rising. Jobs are being created, although at a disappointing rate; auto production is improving; capital goods orders had a sharp pick-up; and there is evidence that housing may not be getting worse.  Retail sales have been reasonably good, corporate balance sheets and cash flow are strong, and quality dividend-paying growth stocks are at favorable valuations.  The yield on the Standard & Poor’s 500 is above the 10-year U.S. Treasury.  Coupled with the recent climactic market behavior, you would expect to see the market form a bottom.

Why is this not happening? The reason may be that investors expect the good news to change. The poor performance of the stock market may have a negative impact on consumer spending behavior in the all-important fourth quarter.   There is a high correlation between S&P 500 performance and Christmas retail sales. Growth may be below the modest forecasts now being made. Earnings estimates are moving lower as a result. Whereas the stock market is usually thought of as a discounting mechanism which anticipates the natural performance of the real economy, we may be seeing a case where the decline in equity prices is having an impact on the real economy and creating its own reality.

It may also be true that the three secular forces are taking their toll.  The wrangling in Washington saps the spirit of the electorate.  The Democrats don’t want to reduce entitlements and the Republicans don’t want to support any stimulative spending programs or raise taxes.  Europe seems to be moving toward solutions to its problems that are only temporary and is not facing up to the need for sovereign debt restructuring and providing capital for the banks that need recapitalization as a result.  And finally there is the realization, as Reinhart and Rogoff concluded, that we may be in for a long period of deleveraging and high unemployment.  With these secular forces confronting investors, most think it is better to stay defensive.  At the same time there are hedge funds out there that want to reduce risk and large investors are getting margin calls.  The combination of anxious sellers and apprehensive buyers created the freefall in September.

What could change this?  Many believe there will be no important policy initiatives until after the presidential election in November 2012. If there is a change in leadership at that time, the new administration will not take office until January 2013 and it will take at least several months for any program to be enacted.  I agree with President Obama that we cannot wait that long. The American people are yearning for the government to implement programs which will revitalize growth and create jobs.  While reducing the deficit is important to many, avoiding another recession is critical and we are perilously close to falling back into one. The Republicans are beginning to sense that if that happens, they could be blamed for it because of their unwillingness to agree to important spending initiatives in the debt ceiling debate. 

The hope is that the Super Committee of six Democrats and six Republicans assigned the task of coming up with the second tranche of deficit reduction on November 23rd will recognize that job creation must be a part of whatever they propose.  The recommendations we should look for would include spending for an infrastructure program which would provide jobs for construction workers who have been out of work since housing collapsed, spending cuts in entitlement programs including Social Security and Medicare, and improvements in the tax code which would include elimination of subsidies to agriculture, oil and gas, and other industries. Some tax increases also make sense, but the focus on the affluent seems wrong-headed. Most wealthy taxpayers are paying a substantial portion of their income in taxes, not less than their secretaries. Perhaps they could pay more, but to raise any serious money you are going to have to raise rates for a broader group than the top 1%.

Most Americans would agree that creating more jobs is the most important issue facing the country right now. You can create some tax incentives for hiring and dismantle some regulations, but what really makes businesses want to hire is the need to meet an increasing demand for products and services, and I don’t see how that is likely to happen without some additional government stimulus.  I know many think that any government program will be hard to implement efficiently and there will be some waste, but I think the odds of a recession will increase if we don’t take some stimulative action.

Looking around the world it would seem that the social unrest we have seen is economically related.  The Arab Spring was led by people who believed that the leaders of their countries were siphoning off their nations’ wealth for themselves and depriving the general populace of opportunity. The uprisings were not based on ideology or religious differences. Hopelessness leads to instability, and in the United States those without jobs for prolonged periods (almost half of those unemployed have been out of work for 27 weeks or more) could be an important factor in the next presidential election.  I have long feared a rise of populism in the United States as a result of a feeling of a lack of opportunity across the spectrum of the working age population. It is hard to know how this will influence politics but in my opinion it is likely to result in a rise in extremism at both ends.

Perhaps we are overreacting. Earnings may not be $100 for the Standard & Poor’s 500 over the next year, but they are unlikely to be below $80 and the market usually sells at a multiple of 15x during the year, which would put us above where we are now. The indexes have dropped so far so fast that investors are fearful of doing any buying until prices stabilize.  There is also some evidence that the emerging markets are slowing. Both the manufacturing and purchasing manager surveys in China have been moving lower.  The second quarter gross domestic product for Hong Kong shows contraction, indicating a softer economy in China may be coming. The expectation was that the developing world would prove to be the engine of growth to offset the slowdown in Europe and the United States, but now even that is coming into question.  I am still constructive on the economic outlook for the developing world, however.

The market is ripe for a positive move.  The strong rise in the last week of September was probably more than short covering.  If Europe could deal sensibly with its sovereign debt problem through restructuring and providing transitional support to its banks, that would be an important step, and I think it is likely we will see that happen.  Less likely, but not impossible, would be an eleventh hour series of compromises on the U.S. budget deficit which would include entitlement cuts, a rationalization of some aspects of the tax code, some revenue increases and some stimulative initiatives.  If we begin to see some of this develop over the next month, the market could end the year on a promising note and perhaps even be in plus territory for all of 2011.


Click here to register for the Wednesday, October 5, 2011, 11:00am ET Blackstone Webcast: “Outlook for Europe and the United States,” featuring Byron Wien, Vice Chairman, Blackstone Advisory Partners; and Joachim Fels, Managing Director and Global Head of Economics, London., Morgan Stanley.

The webcast presentation will be downloadable from the interface at the time of the event, and webcast replays will be available beginning Monday, October 10, 2011.

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Byron Wien
The Blackstone Group
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