Mid-Year 2012 Economic Update
July 6, 2012
The questions we hear most often from our clients have to do with the Eurozone, U.S. politics, and closely related, the so-called fiscal cliff. We thought we would approach each of these in turn.
We think that there is a common theme to our thoughts about the Eurozone and U.S. domestic issues. As philosopher Bill Earle once said “If your outgo exceeds your income, then your upkeep will be your downfall.” This saying was likely intended to be applied to individuals, but it rightly defines the fundamental issue facing Europe as well as the U.S.
In order to solve the immediate fiscal problems there are only two options (or combinations of options) to avoid an eventual “downfall.” The “outgo” will have to be reduced which requires scaling back on previously promised benefits, or “income” has to increase which means tax revenues will have to increase. If neither of these paths are followed, the march towards a “downfall” continues.
With this as a general backdrop, let’s examine these concerns specifically.
Eurozone Troubles and the PIIGS
It is an open question whether the markets have already adjusted their sense of value to account for the European difficulties, but it is certainly widely expected that Europe is in a recession and will remain in one for the near future. As for the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) times are very difficult. Greece has already defaulted on much of its debt and despite the recent election, it remains to be seen whether or not they can or will continue as a member of the European Union. The conventional wisdom is that Spain, Italy, and Portugal will face a similar dilemma unless their governments can get their fiscal houses in order. All of this uncertainty makes for a very complicated situation and it is unclear how it will be resolved; however, the troubles are widely known.
We do not think that there is a great chance of a systemic meltdown like that which unexpectedly occurred in 2008 when Lehman failed. The likely outcome is more of the same—mini-panics met with incomplete solutions by the European Central Bank (ECB). Resolution to this will take time and will do so in fits and starts. The final step to solving Europe’s woes lies in significant structural reforms. Such reforms will likely include the further formalization of a fiscal union to reinforce the existing monetary union and a recalibration of the business environment and promised benefits to the populous of the profligate member nations.
For the Eurozone regulators, a more formal fiscal union likely includes the introduction of a common Euro-bond, backed by all of the member nations, which would allow weaker nations to benefit from the stronger credit standing of the European Union as a whole. The ECB is also likely to implement a banking deposit insurance program for all of the European banks, similar to our own FDIC, to restore confidence in the banking system and to mitigate the risk of bank runs. And finally, the ECB will likely require a higher level of inter-accountability among the member nations so that each individual country is required to act in a fiscally responsible manner.
For the citizens of the PIIGS nations, they will eventually have to accept the reality that their bankrupt nations cannot afford the generous benefits they were once promised. But, in order to get their economies growing again, many nations will have to reexamine the rules and regulations that have stifled business activity and created extraordinarily high levels of unemployment.
The problems in Europe are chronic rather than acute. The necessary reforms will take years to develop and implement, and the transition will not be smooth. What will change is the relative sensitivity of our markets and our economy to Europe’s troubles. The U.S. economy can succeed in spite of the problems in Europe, but it will take time for investors and business leaders to become comfortable with this new reality. There are signs that this transformation is already occurring.
Politics and the “Fiscal Cliff”
With the upcoming presidential and congressional elections and our fractious political system, there is a great deal of concern about who will be elected and what the results will mean. We think that in all events, we will see a continuing focus on deficits, government spending, and taxes. An essay published in the spring edition of National Affairs magazine by Jay Cost titled “The Politics of Loss” made an interesting point about the systemic nature of our current political quagmire. In Cost’s essay, he states “For generations after World War II, both parties agreed implicitly upon a great American share-out: The fantastic growth of the American economy gave politicians in both parties the enviable task of deciding how the annual surplus would be divided, meaning that everybody could be a winner. Republicans could cut taxes and dabble in generous social-welfare benefits; Democrats could distribute generous social-welfare benefits and dabble in tax cuts; both parties could push for an overpowering military; and all the while the annual budget deficit stayed more or less within a tolerable range. It was a true win-win, with political disagreements largely fought over which side would win more.”
During the boom time between the end of WWII and the late-90’s, the American economy grew so fast that we could both cut taxes and increase spending without harming the budget or racking up huge deficits. Cost continues that between our slowing growth and our unsustainable spending commitments “The days when lawmakers could give to some Americans without shortchanging others are over; the politics of deciding who loses what, and when and how, is upon us.” As our elected officials try to decide among the promises to be scaled back, the taxes to increase, and the growth or reduction of our deficit, solving this conundrum has led to the current state of congressional polarization and dysfunction. Politics makes the debate all the more difficult as no one is prioritizing the right answer. It is just the conflicts of short-term political decisions versus appropriate long-term policy decisions.
This brings us to the looming “fiscal cliff,” which refers to automatic tax increases and spending cuts that were agreed upon to resolve last summer’s debt ceiling debate. The first issue is the automatic rise in tax rates (sometimes referred to as “taxmaggedon”) if the Bush tax cuts expire as scheduled at the end of this year. The expiration promises sharp increases in personal income taxes for everyone. On top of these tax issues, there is the added burden next year of an increase in the Medicare tax rate on investment income. The second part of the fiscal cliff is the sequester which refers to $1.2 trillion in automatic cuts in military and domestic discretionary spending over the next decade.
In a period of slow GDP growth, each of these thorny issues could at best stifle growth, or at worst, move the economy back into recession. The fact that the fiscal choices are so unappealing probably means that the necessary measures will not be fully addressed before the November elections and there is a real possibility that changes will be yet again deferred. Our economy, however, will eventually have to pay the price. In the event that these changes in both taxes and spending become effective, it could have a decided and immediately negative effect on the U.S. economy.
However, most believe this drive over the “cliff” is unlikely to happen. The probable outcome is a last minute compromise in which both parties gain a little and give a little, and the truly painful decisions are again deferred for a while longer. Unfortunately, we can’t really expect the people who got us into this mess to get us out. It takes an entirely different mindset to make decisions from a position of limited financial resources than one of permanent excess. There must be a reordering of our priorities by a thoughtful, serious group who can reach compromise on some significant and complicated issues.
One of the commentators we follow, Michael Aronstein, has suggested that investors have difficulty differentiating between governments and economies. Put simply, our government is not our economy. Economies are indeed influenced by governments, but they function independently and often in spite of government action. We are in for a long and frustrating period of change—getting this right will take a long time. However, we must not forget that governments are not economies.
Persistently Pervasive Pessimism
Combine the uncertainty about current events with the recent memories of two terrible bear markets, namely 2001 and 2008, and it is not surprising that people are pessimistic. Economist Arthur Pigou said, “The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born, not an infant, but a giant.” Clearly we remain in a period of great pessimism.
Added to this, there has been a certain déjà vu quality to the market’s performance so far this year. It is very similar to the pattern in 2011 and 2010 before that, with a stumbling recovery in the U.S. and ongoing flare ups in the Eurozone. Combine the similarity with the pervasive and persistent pessimism that seems to infuse people these days and you have a recipe for anxiety, and among many, a sense of dread.
Spiro Agnew once labeled the media as “nattering nabobs of negativism,” and the tenor of media reporting seems no better today. After all, bad news sells. This truism applied together with our negative experience through the recent financial crisis adds insult to injury in our worrying brains. However, as investors, we need to temper our lack of enthusiasm and thoughtfully consider which information we should heed and which information we should ignore. With this in mind, and despite all of the dire forecasts, we call your attention to a number of hopeful signs in our domestic economy:
- Central banks around the world have created an environment of unprecedented easy monetary policy, which should bode well for economic growth and asset prices.
- Corporate profits are at record levels and companies have massive cash balances available for anything from capital expenditures and hiring to stock buy backs and company acquisitions.
- There are many signs that the housing market has “bottomed out,” signaling that prices are likely to move sideways, and eventually up. The excess supply of homes is beginning to decline and homes are more affordable now than they have been in more than a generation. This decrease in supply should eventually lead to more building, which would have a very positive impact on employment.
- U.S. manufacturing is experiencing a renaissance as business conditions and wages have become much more competitive with those in foreign countries. Consequently, many U.S. companies have begun to bring their manufacturing back into the U.S.
- We are experiencing a resurgent domestic energy industry in the U.S. as production of natural gas from the many domestic shale formations has become more successful and economical. In addition to the possible prospect of “energy independence,” this promises lower long-term energy prices for businesses and consumers as well as the possibility of creating a new export market for domestically produced oil and gas. The increased exploration and production should also increase job growth in the energy and related businesses.
- As a contrarian indicator, pessimistic investor sentiment is usually a very bullish sign. As we describe above, investor sentiment remains very pessimistic—normally positive for future returns.
- And finally, the value of stocks relative to their underlying earnings is at a level that historically has led to very good long-term returns.
For the most part, these hopeful signs are unreported and generally under-appreciated, but they are nonetheless true and quantifiable. They provide hope that the worst of our domestic troubles are receding and the future may turn out better than most expect. But given all of the lingering uncertainties, it will take time before all of the entrenched pessimism can finally pass. For most, the best opportunities to invest will have passed long before they feel comfortable again. Accurately forecasting the exact timing of the final turn upward is impossible. As such, our advice to our clients remains consistent; build your financial plan around what is known and what you can control, and then remain patient and committed to your plan no matter what the “nattering nabobs of negativism” lead you to believe.
(c) Horizon Advisors