Thinking Things Over     June 4, 2012

Volume II, Number 22:  There’s a Brighter Future Ahead….but When?  By John L. Chapman, Ph.D.          Washington, D.C.

In a world of pure theory, stock and bond prices rise and fall according to the fundamentals of market reality, and exclusively so.  The strength of profits and free cash flow, sustainability of a firm’s competitive advantages, technological innovations that change firm boundaries or economic models, household saving patterns and time preferences and so on all combine to move financial markets and interest rates.  Friday’s market rout, which nearly completed the wipe-out of all of 2012’s gains, was another reminder of the degree to which politics now dominates economics.

The Dearth of Economic Common Sense in Current Economic Policy Debates

Military historians will well recall that precisely 72 years ago, on June 4th, 1940, the evacuation of the British Expeditionary Force and other allied divisions at Dunkirk was completed.  Roughly 340,000 British, French, Belgian, Dutch, and Polish soldiers were brought off the beach-heads surrounding Dunkirk harbor, in a week-long miracle that involved nearly 1,000 craft, the smallest of which was an 18’ fishing vessel.

That afternoon, Winston Churchill took to the floor of the House of Commons and delivered one of his very great speeches of the war, closing with these stirring words:

We shall not flag nor fail. We shall go on to the end. We shall fight in France and on the seas and oceans; we shall fight with growing confidence and growing strength in the air. We shall defend our island whatever the cost may be; we shall fight on beaches, landing grounds, in fields, in streets and on the hills. We shall never surrender and even if, which I do not for the moment believe, this island or a large part of it were subjugated and starving, then our empire beyond the seas, armed and guarded by the British Fleet, will carry on the struggle until in God’s good time the New World with all its power and might, sets forth to the liberation and rescue of the Old.

We are reminded of Dunkirk at the moment because the great part of the world, while not engaged in a death-struggle such as World War II was soon to become, is nonetheless in an extended torpor now deep into its fifth year.  And, just as Dunkirk epitomized the dark days of 1940 and served as a warning of what was to come, Friday’s global sell-off, sure to have more legs in coming weeks, well-captured the essence of our current economic challenges  — an economy dominated by government policy whose productive actors suffer from an elevated fear of what is coming next.

Happily for the British, Dunkirk proved to be salvation: it is likely the British government would have been forced to sue for peace had those 340,000 troops not been carried off to pose a severe threat to a German invasion force, in spite of the considerable loss of materiel.  And perhaps in the same way, the events in recent weeks will serve as a catalyst leading to better public policies in the time ahead. For as the Wall Street Journal noted, it is a slew of poor policies that have led directly to days where, in a country with a $15.7 trillion annual GDP, only 20,000 net new jobs for the prior month are announced, in what is now an “economy built to stall:”

Well, this week makes it official. The weakest economic recovery since World War II has become weaker still, sinking into a spring slowdown for the third year in a row. Are we finally ready to debate a change in the policies that have led to this pass?

On Thursday the government reported that growth in the first quarter was 1.9%, even weaker than the 2.2% initial estimate. Then Friday delivered the third slower jobs report in a row, which qualifies as a depressing trend. Employers created only 69,000 net new jobs in May, and April’s total was revised down to 77,000 jobs. Stocks were crushed in the backwash.

The jobless rate of 8.2% marks more than three years of unemployment at or above 8%, despite an economy that ostensibly emerged from recession in July 2009……..

Maybe Milton Friedman was right that “temporary, targeted” tax cuts don’t change the incentives to invest or hire because people aren’t stupid. Maybe each $1 of new federal spending doesn’t produce a “multiplier” of 1.5 times that in added output. Maybe the historic burst of regulation of the last three years has harmed business confidence and job creation. And maybe the uncertainty that comes from helter-skelter fiscal and monetary policy has dampened the animal spirits needed for a durable expansion.

This is precisely correct.  It does not take an advanced degree in economics but rather merely common sense – and casual empiricism – to see the veracity in the thesis that business confidence is lower in recent years than it has been at any time since the 1930s, and, pari passu, unemployment and underemployment in the United States have also been at elevated levels for an extended period not seen since then.  If the first stipulation of the Hippocratic Oath is to do no harm to the patient, perhaps the equivalent axiom for the political class would be directed at the economy.

And thus, we cannot agree with Paul Krugman when he says that the coming tax increases next January 1 are immaterial, and that it is not “lack of confidence”, but “lack of demand”, that plagues the global economy.  To be sure, in any deleveraging process, spending reductions in some quarters ensue – particularly in the case of the indebted, insolvent, or bankrupt.  But it is classic Keynesian aggregative over-generalization to sweepingly declare the entire world has begun to hoard incomes, and thus only more massive government spending in the multi-trillions will end this “depression.”

Indeed, we are already four years into deleveraging in the United States, balance sheets have been repaired to a  great extent, corporate profits and cash flows are at record heights, and consumer spending hits new record levels (in the aggregate) with each new quarter.  Behind any “lack of demand” is the real problem, or rather, the twin-sided problem. First, a lack of capital, borne of severe losses in recent years coupled with hesitance to renew the process of investment or, said precisely, replenishment via capital formation.  This in turn is coupled with a latent fear in an unknown future highlighted by turmoil abroad, and here at home, higher taxes and more burdensome regulations, along with a perceived permanently higher level of government intervention.  Added into this mix in some quarters is concern regarding an unknown fate for the U.S. dollar: while its trade-weighted value has firmed considerably in recent months, U.S. investors and the elements of the business class steeped in global trade all understand that dollar strength of late is more for reasons of turmoil abroad, rather than inherent confidence in U.S. policies moving forward.  Hence currency volatility in the months ahead, and likely Fed activism, are all but assured, and none of this is good for long-horizon investing.

In sum then, when added all up, it is not a Krugman-described lack of demand – and associated “confidence fairy” that plague us.  It is an extreme loss of common sense in the political class that has created a very real confidence problem.  Any politician who actually bothered to talk to investors and business owners and decision-makers would quickly come to realize this – or, if too lazy for such conversations, said politicians need only have watched the play in U.S. equity markets on Friday on their nearest television, to see fear in action.  “Confidence” is of course not analytically tractable, and cannot be modeled on the blackboards of economics department classrooms at Princeton University – but to therefore assume it away as not a problem to be solved via either general equilibrium analysis or in the real world shows how out of touch some very smart people can be.  Even Keynes understood the root problem, even if his solution – government-induced demand creation – only worsens rather than solves it.

Where are We Headed in the Time Ahead?

(1)  Having stated the above with some gloom, we actually remain resolute in our belief that the S&P 500 will end the year higher than current levels (1310.33; and, knowing the hazards of forecasting and the likelihood of having our head handed to us, still like 1375 at year-end), though we readily concede trading could go lower in the weeks ahead.  For one thing, Greek elections on June 17, Spanish banking system solvency and bailout discussions, Italian government refinancing and the like are all going to be front and center now, and all are a source of nervousness (not to mention events in the U.S., including the Supreme Court health care decision, the circus of the political season itself, the debt ceiling talks, let alone “Taxmageddon” and the “fiscal cliff”).  Bluntly, another 10% or so downward for U.S. equities is certainly possible, and one unfortunate aspect to the time ahead is that U.S. valuations will be more dependent on what goes on in Europe – and in turn, what that does to business confidence here – than on anything here or elsewhere.

If a Eurozone Götterdämmerung were to happen (viz., Greece exits, Spain devolves into a de facto civil war and breakdown, Italy follows and devalues), due to the total inability of the political class there, aided by the ECB, to come up with some sort of fiscal consolidation that is both enforceable and enforced, it is true that global equities would suffer severely in what would turn into a mini-replay of the 2008 panic. (The downdraft to U.S. asset prices would be less than most, as a de facto “safe haven”, but stocks would fall further and bond prices would bid up).

But this is not the likeliest of cases in our view, notwithstanding the game of brinksmanship that has begun between Berlin and the rest of the bedeviled continent.  There is still time for what in the end would likely be an orderly exit for Greece (perhaps forced by Berlin?), and a fiscal pact leading to austerity more for governments than for the private sector in Europe.  One model worth studying may well be the Swedish nationalizations and banking system bail-outs there in 1992: Sweden suffered two years of negative GDP growth, and unemployment quadrupled from 3% to more than 12%, in the wake of a housing bubble burst there.  But at a total cost of somewhere between 2-4% of annual GDP, the banking system was recapitalized, and equity holders there were completely wiped-out.   (Similarly now, Spain could agree to recap its own banks, after write-offs, via Spanish tax-payer backing and a long-term fiscal commitment, as a price to both remain in the Eurozone and achieve ECB and Eurobond support.)

The reason for our semi-optimism on this issue is that it is in everyone’s interests, ostensibly, including Germany’s, for some such agreement to be reached with the recalcitrant countries.  And in the long term, it is in these countries’ interests to participate in such an arrangement.  But given that politics everywhere trumps economic common sense, such an enforceable agreement that would ultimately calm markets is not assured – and best case might be months if not a few years away.  All of this pressures U.S. equities now, however, to the point where U.S. corporate profits may have already peaked.

(2)  We have always believed the U.S. Federal Reserve will act again as well, in this instance more to coordinate with global central banks in need of offering dollar liquidity. But the end result will be a continued de facto monetization of U.S. debt, and until a push for major monetary reform in the U.S. in the years ahead has a chance to become reality (a policy regime change that would affect markets in a big way, and hence is an issue we follow intensely closely and ultimately expect), the Fed’s balance sheet is unlikely to change materially.  In the long run debt monetization is harmful and immoral, but in the shortest of short runs, given current global investor mindsets, will put a floor on asset prices.

(3)  We are also more halcyon than most with respect to prospects in the U.S., based on recent data:

(a).  True, the first quarter GDP growth rate was revised downward Thursday to 1.9%.  And non-farm payrolls were up 69,000 in May, but only 20,000 after revisions to the prior two months.  Education and health care sectors gained (+46,000), as did manufacturing (which continues to be a stellar part of the U.S. economy), while construction (-28,000) led the losers.  The results were less than half consensus expectations, and thus led to the market rout (for better or worse, the monthly unemployment data in the U.S. is now the single most-watched high-frequency statistic in the world now, in terms of what moves global markets in a mundane and regular manner).

In our view this was an over-reaction, to the extent that the prior six months have averaged more than the gains in the 27 months since the recession trough for jobs (175,000 in the last six months, versus 140,000 since February 2010), but may have been front-loaded due to mild weather this past winter, alongside bad weather this spring.  And, while the unemployment rate increased to 8.2% from 8.1% in April, it is actually at least mildly encouraging that part of the reason for this was the big increase in the labor force participation rate, which hit a 31-year low last month only to increase by 642,000 job-seekers this month.  Cash earnings also rose at the margin in May, and are up 1.7% year-on-year (while total wages and benefits are up 3.5% in this time).  In short, better prospects for U.S. policy in the time ahead should at least maintain a 2% to 2.5% growth rate in national output here – and would move higher if there were more clarity around the globe (and indeed, eventual improved policies here).

The downward GDP revision was also not a bad thing, all things considered.  Down from 2.2%, to 1.9%, GDP changes evinced an underlying rationale that was not bad: inventories, government spending, and personal consumption were revised downward, but investment figures for both commercial construction, and equipment & software, were revised up.  Corporate profits were also revised up to show a +6.5% print, year on year, and are at an all-time high in the United States.  The declining inventory data suggest to us that American corporations are as efficient as ever, and will lead to an uptick in output in the time ahead.

(b).  Personal income increased +0.2%, and consumption +0.3% in April; year on year totals are +2.8% and +4.0%, respectively. Disposable personal income (after taxes) was likewise up +0.2% in April and +2.4% from a year earlier.  Private wages are up +4.1% in the past year.  After adjusting for inflation, consumption was up 0.3% in April and is up 2.1% from a year ago. Further and of most import, consumption is rising not only due to rising incomes that are slightly ahead of inflation, but also because of decreasing household debt burdens, which are now the smallest share of income since 1984.

None of this is consistent with an economy teetering on recession, Eurozone sclerosis or not.

(c).  The ISM manufacturing index declined to 53.5 in May from 54.8 in April, but is still up for 34 straight months now (and some regions, such as the upper Midwest, are showing strong gains in hiring and output).  The index for production fell to 55.6 from 61.0,  and the employment index declined slightly to 56.9 (from 57.3).  On a positive note for manufacturers cost of production, new orders were up, and the prices paid index dropped sharply to 47.5 in May from 61.0 in April (this ratifies general inflation movements of late:  the Producer Price Index (PPI) declined 0.2% in April and likely will show the same for May; producer prices are up 1.9% year on year now, showing declines in recent months.

Per the above, declining inventory build-ups hurt GDP growth in the immediate timeframe, but portend a bounce-back in production later on.  And declining costs will buttress corporate profits as the year unfolds, which can only aid in any hiring induced by the return of some level of animal spirits.

(4)  In summary, we view the current flow of data as a continuation of the muddle-along progress characteristic of an economy growing at 2%.   Europe’s problems are considerable, but so are their resources, if they choose to attack the present torpor with pro-growth policies that in the end appear to us to be axiomatically inevitable (as, for example, Sweden has already shown).

Investors do need to be wary of further near-term market pull-backs this summer, as news about gyrations in the Eurozone – or a slow-down in China, India, and Japan – come streaming forth.  But in the U.S., a spate of positive – that is to say, pro-market and pro-economic growth – developments may also soon be in the offing, including news of the protection of fiscal consolidations made in Wisconsin after Tuesday’s election there that would serve as a model for the rest of the cash-strapped state and municipal governments across the U.S.  Later in June, the Supreme Court may well hold that the big spending thrust created by more government-centric health care is not constitutional, thus allowing for a return of more market-based competition along with the promise of sensible reforms in the U.S. health care system in the time ahead.

And ultimately, the prospect of better policies in the U.S. next year and beyond, beginning with the forestalling of very damaging tax increases due in just seven months, would serve to cheer the entire global economy.  For as always, a fretful world waits upon American economic leadership to re-assert itself with growth-inducing policies, and the sooner the better.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@4kb.d43.myftpupload.com. The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.

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