Apparently, the Fed feels very strongly – both ways! Corporately, they are guarded about the economy, but individually the members extol continued growth and recovery. Most put on a game face that denies the possibility of a double dip recession; however, for housing and jobs, there remain plenty of challenges. As former Fed Chairman Alan Greenspan said: “The trouble is there’s always a possibility in both directions.” He feels strongly both ways too! He said “it’s more than likely” that the U.S. is experiencing a “pause”. A ‘pause’ is a polite way of saying no growth! Recent housing data has been anemic and consumer credit fell nearly $24billion in April and May. That’s anti-growth! The Fed remains concerned that lenders are reluctant to lend, but recent legislation is anything but ‘lender friendly’.
In second half, growth may slow down to 1.5%. Technically that will mean no recession and no double dip; however, the slow down in growth will be so significant that it will feel like a recession in the U.S. and like a stall of activity in the Euro zone. Unemployment will feel worse and home prices will still have trouble. Tax policies, cash for clunkers, investment tax credit, 1st time home buyer credit, cash for green appliances, etc., all boosted near term spend at the expense of future spend. Re-leveraging of the public sector and fiscal stimulus has occurred, but at some point fiscal policy needs to become contractionary (or else we’ll have a fiscal crisis) and that will be a drag on economic growth. The big dilemma is damned if you do and damned if you don’t. At some point, the private and public sectors need to deleverage; furthermore, Basel III will force banks to extend less leverage.
On public debt and deficit,… the public deficit is very large, over 10% of GDP. Expect over $1 trillion per year for the next decade for unchanged fiscal policy. The paradox is that although bond vigilantes have woken up to the problems with the PIGS of Europe (Portugal, Ireland, Greece, and Spain), they have not woken up yet in the U.S. nor Japan. We know that given the current path of fiscal policy, U.S. public debt will rise to 90% of GDP, not including another 60% of unfunded liabilities from Social Security and Medicare, nor the 20% of GDP debt from state and local governments, nor the 10% to 20% of GDP from the unfunded pension obligations of state and local government – add it all up and you reach about 200% of GDP.
So with the public debt so high, why is the 10-year Treasury yield below 3%; why aren’t the markets demanding a higher yield? Because, in the short term we have low economic growth, low and falling inflation, the Fed committed to low rates and more quantitative easing (stimulus) if things get worse, bouts of risk aversion from Europe and abroad creating demand for ‘safe’ U.S. Treasuries, China still effectively pegged to the US dollar, everybody else effectively intervening because they don’t want to lose market share to the Chinese through currency revaluation, and for the first time in a decade, we have domestic financing of the public deficit through private savings. But at some point, by 2011 or 2012, something may trigger a correction. We cannot run a trillion dollar deficit this year, next year and so forth without something happening. The U.S. is kicking the can down the road; and it will continue along that path because there is grid lock in Congress, there is lack of bipartisanship, the Democrats are against spending cuts, the Republicans against tax increases, this year is an election year therefore no fiscal consolidation and if anything more stimulus is expected in 2012 as it is a Presidential election year, thus no fiscal consolidation then; thus, the only window is going to be next year, but then the political economy is going to imply no fiscal adjustment next year either. At some point the bond market may snap in the US, but that is something down the line, not this year. On the other hand, if short term rates remain below 1%, the U.S. can afford to run Trillion dollar deficits indefinitely.
Michael Ashley Schulman, CFA
Hollencrest Capital Management