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Raul Elizalde - Thursday, June 2 2011
Six months into a long rally, American stocks faced serious bumps last March when confronting a tsunami and nuclear reactor blow-ups in Japan along with unrest in the Middle East and North Africa. Just as those events are finally being absorbed, a new set of hurdles, courtesy of Washington, has arrived, keeping markets in a narrow, fragile range. From here on, the potential for serious downside is real.
The new challenges stem from the realization that leaving behind the financial crisis of 2008-2009 is far more difficult than previously hoped. This has created an environment where the risk of making wrong decisions is high. Exhibit A is Tuesday’s defeat in Congress of a “clean” bill that would raise the US Federal Debt ceiling.
That vote, and indeed the very fact that a bill nobody expected to pass was brought to the Congress’ floor, can be attributed to a simple, frustrating fact: despite economic indicators that point to a much improved economy, regular households still feel deeply insecure.
On one hand, the economy went from losing 800,000 jobs a month in early 2009 to gaining 200,000 per month in 2011. Corporate profits and retail sales have reached record highs, and many indicators are essentially at the same level as before the crisis.
On the other hand, the rate of long-term unemployment is still very high. Home equity, a key figure that people use to measure their wealth, is still declining. Banks, despite hoarding very high levels of cash at negligible cost, have severely cut back credit to individuals. Gas prices have gone through the roof.
In Europe, the prevailing mood is not much better. Peripheral European countries are forced to make brutal austerity choices but rewarded by skyrocketing borrowing costs, credit rating downgrades, and resentment from the European core.
On both sides of the Atlantic politicians find an increasingly agitated public clamoring for fiscal rectitude. But when austerity measures are actually considered, the public revolts. As a result, politicians find no upside in compromising. Gridlock takes over.
This is the environment in which the Developed West has to make at least two major decisions.
The first one is the decision on whether or not to raise the US debt ceiling, and is the topic of this brief.
The second one is whether or not Greece should restructure its debt, and will be covered in the next brief.
Given how fragile the West seems to be, the margin for error on both issues is very small.
The US debt ceiling
For the last few years, total US debt (public plus private) has been roughly constant at three and a half times GDP. Public debt went up, but the increase is matched almost dollar for dollar by the decrease in financial sector and household debt.
As the graph shows, a consequence of the US financial crisis was a large transfer of liabilities from the private to the public sector after the government stepped in to prevent a major economic collapse. Indeed, the official reluctance to intervene aggressively is now the prevalent explanation for the Great Depression of the late 1920s. Not wanting to make the same mistake, the US government implemented large rescue operations.
The large US budget deficit was therefore not the consequence of irresponsible, careless spending but rather the price paid to keep the economy from going under. The end result was the large increase in Federal debt to the maximum level allowed by law.
Alarmed by this, Congress is considering linking any further increase in the Federal debt ceiling to spending cuts. Another reason is that many of its members are unconvinced that the collapse of Lehman Brothers or AIG or the evident fragility of Citigroup or Bank of America at the time were worth the cost the US faces today
Although controlling budget deficits is a key step in preventing public debt from growing, refusing to increase the Federal debt ceiling could have very negative consequences for the US and could actually make it more difficult to bring it down in the future.
Flirting with default would almost certainly disrupt markets, creating ideal conditions for a new crisis. This could force a new chunk of private debt to find its way to the public sector, further increasing the size of Federal debt even if government spending is cut across the board. One only needs to look at Ireland or Greece to see how draconian fiscal adjustments have failed to prevent continued injections of liquidity into the banking sector.
None of this means that the total level of US debt is adequate. The relentless rise of private financial sector debt over the last decade created a time-bomb that eventually went off. Even so, the sector remains bloated and the overhang may last for many more years. This is likely to prevent banks from lending freely, and will continue to be a drag on US growth. In this context, public sector debt needs to be managed with ample flexibility to prevent a deterioration of its credit quality, long considered to be “risk free.”
Markets seem calm but cautious about all this. The upside has been capped, since there is no assurance that policymakers will make the correct choices. Barring a surprising improvement in the economic front, this is likely to prevent any significant upside during the early summer.
Next: Restructuring Greek debt
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We use quantitative measures to build and maintain portfolios for our clients, which we rebalance every quarter. We described our investment process in previous newsletters. If you would like to know more about how Path Financial’s investment process works, call us or send us an e-mail at the address below. We’ll be happy to set up a confidential meeting to discuss new paths to financial success.
Raul Elizalde | raul@pathfinancial.net | 941-350-7904
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