A Small Dose Of Reality

While I was gone on my short business/golf trip the politicians managed to avert disaster by agreeing to continue arguing about the federal budget for a few more months before we face another self imposed debt deadline. The stock market took the reprieve as a positive since it means the Fed will keep up its heroic efforts to stave off recession through the magic of its monetary perpetual motion machine. Banks and private equity funds will continue to have access to cheap capital and the speculative juices will continue to flow. Grandma will continue to cash in her CDs to buy stocks and junk bonds. A complete lack of fiscal responsibility may cause the rest of the world to wonder if we’ve lost our minds. It may be a threat to the Dollar’s role as the world’s reserve currency. It may be reason to question the very viability of our political system. But it surely isn’t any reason to interrupt a bull market.

It is quite simply amazing to me that with all the troubles facing our economy and our body politic that the stock and bond markets continue along their merry way seemingly oblivious to the facts. Monetary policy may have lost its effectiveness in the real economy but its effect on mass psychology appears intact. The idea that Quantitative Easing can offset the drag of truly awful fiscal and regulatory policies must rank among the all time greatest feats of mass delusion. The fact is that QE has been a miserable failure when it comes to generating actual economic activity in anything but the most speculative arts.

The US economy continues to struggle through periods of weakness and periods of relative strength. Activity waxes and wanes but with a continued downward drift. If one is charitable to Bernanke and QE, it could be said that the Fed’s massive intervention has been just enough to keep the economy in this economic purgatory where growth continues but never at a pace that is sufficient to warrant the removal of the “stimulus”. If one is less than charitable, QE has actually hurt the economy and growth is less than it would have been without it. That view was expressed in three different papers presented at the Fed’s Jackson Hole meeting this year. I tend to hew to the second view but like so much in economics, the correct view is impossible to determine. Whatever the truth there seems little reason to continue the policy.

What we do know for sure is that if fiscal and regulatory policies were better, we wouldn’t be debating the merits of QE. Of course, we would have to debate what constitutes better fiscal and regulatory policy but at least we’d be talking about something that really matters. QE is, at best, a salve, a balm that makes the current conditions bearable for anyone who happens to own stocks. If you don’t own stocks – or junk bonds or real estate – well then you’d probably be hard pressed to find anything positive about it. It is the economic equivalent of bread and circuses, keeping the masses in check by inflating the value of their 401k and their home (if they were lucky enough to hold on to it over the last few years).

So, a dose of reality about the state of the US economy:

  • GDP, as Jeff Snider has pointed out repeatedly, is growing at just about stall speed. Every time in the past when growth has fallen to this level, a recession has followed fairly quickly.
  • Median household incomes are falling and are now no higher than in 1988.
  • Corporate profits are at an all time high as a percentage of GDP while net investment remains less than half its long term average. Meanwhile corporate debt is at an all time high.
  • The housing market, which has been one of the few bright spots in the economy, appears to be stalling again. Robert Shiller is warning about another bubble in the same states that had them before. Banks are laying off thousands in their mortgage departments.
  • Oil prices, despite the surge in US production, are still at $100/barrel. The official inflation rate though is still below the Fed’s target of 2%.
  • There are 47 million Americans receiving food assistance (food stamps), an all time high as a percentage of population.
  • A record number of Americans are receiving disability pay from Social Security.
  • The labor force participation rate has been falling since 2000 and accelerated downward after the Great Recession. It now stands at 63.2%, about the same as 1980.
  • The personal savings rate is just 4.6%, well below the long term average. 28% of Americans have no savings. Another 20% don’t have enough to cover 3 months worth of their expenses.
  • The federal government deficit in 2013 will come in at about $560 billion. That is down from last year but still large. Total government debt now exceeds GDP while total US debt, public and private, is still above 300% of GDP. Despite talk of “deleveraging” there has been no significant reduction in total debt in the US.

Despite that list, I am not pessimistic about the US economy over the long term. There are still a lot of positives about the US that bode well for our future and I don’t think the problems we have are all that hard to solve. Other countries have faced more difficult problems and solved them. Interestingly, most of these countries followed the same template. Canada and Sweden, to cite just two examples, both faced fiscal problems in the 1990s that make ours today look mild by comparison. Both countries reformed their social security systems, cut real spending, cut and simplified taxes and deregulated. On the tax side, both countries concentrated on making their corporate tax code competitive. Canada’s federal corporate tax rate today is just 15% versus 35% in the US. The point is that we know what works for fiscal consolidation. And we have an advantage that Canada and Sweden didn’t have in the 90s – the market isn’t forcing reform on us as it did in those countries where interest rates on their debts rose. If we wait until the real crisis hits, until rising rates truly break the budget, this will be much more difficult.

Our problems are economic but they are perpetuated by politics. Getting the US growing at 3 or 4% again is not that hard but it won’t come from increasing taxes or by cutting Head Start. It will come from both political parties slaying some sacred cows. Democrats need to learn that not all problems should or can be solved by Washington, DC. Republicans need to learn that cutting spending is only part of the answer and that what you cut is as important as how much; growth policies are necessary to complete the equation. And both parties need to learn that they can’t depend on the Federal Reserve to keep the economy out of the ditch. Sound money is possibly the most important reform but it won’t happen until we solve our fiscal problems. We can’t afford to keep putting off the reforms that are so obvious. Unfortunately, I don’t see a grand bargain on the horizon and therefore I don’t see any relief from our slow growth in the short term.

In the meantime, the markets have apparently decided to ignore the problems and concentrate on what the Fed does. That will work until it doesn’t and I have no idea what will cause investors to once again concentrate on fundamentals. When they do, what they find won’t be pretty. Weak economic growth, weak revenue growth and weak earnings growth don’t bode well for a market trading at an above average price. So far, nothing has been able to knock down the bull and rumors of its demise – including from yours truly – have proven at best premature. I would just urge all investors to think about a full market cycle rather than just the bull portion. At some point, reality will intrude on the perpetually bullish and the downside to current prices is probably considerable.

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For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@alhambrapartners.com or   786-249-3773. You can also book an appointment using our contact form.

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