Macro Factors and Their Impact on Monetary Policy,
The Economy and Financial Markets
The Fiscal Cliff, Fiscal Cliff 2, Fiscal Cliff 3 . . .
Over the last 30 years, members of the media have routinely forgotten the phrase, ‘The President proposes and Congress disposes.’ This has led to the widespread misunderstanding that the deficits of the 1980’s were attributed to President Reagan (even though his annual budgets were considered DOA (Dead On Arrival) once they reached Capital Hill, and that President Clinton was responsible for the $1.9 billion surplus in 1999 and $86.4 billion surplus in 2000. Presidents can and do exert influence, but they have no constitutional authority regarding the budget. The U.S. Constitution lays the responsibility for passing a budget entirely on Congress. The Executive branch has zero responsibility. In 1998 the Supreme Court ruled in Clinton v. City of New York that the Line Item Veto Act of 1996 was unconstitutional, holding that the line-item veto violated the Presentment Clause of the Constitution. The Presentment Clause (Article I, Section 7, Clauses 2 and 3) states that ‘All Bills for raising Revenue shall originate in the House of Representatives; but the Senate may propose or concur with Amendments as on other Bills”. Perpetuating the myth that the executive branch of government is somehow responsible for the budget does provide Congress political cover.
After many months of campaigning and almost $6 billion spent by both parties on the 2012 election, we can all enjoy a sigh of relief that it’s over. Of the 535 members of Congress during the last 2 to 4 years, close to 510 members will be returning to Washington DC in January 2013. Unfortunately, these members are, for the most part, the same members of Congress who placed party ideology over the welfare of our country by failing to pass a budget in the last three years. Passing an annual budget that provides for the fiscal soundness of this country’s future is important and clearly a primary responsibility of each member of Congress. While they were fiddling, our country ran federal budgets deficits of $1.3 trillion in 2010 (9.0% of GDP), $1.3 trillion in 2011 (8.7% of GDP, and $1.1 trillion in 2012 (7.0% of GDP). Maybe they were just too busy campaigning for reelection, or possibly they simply do not understand or appreciate how the Fiscal Cliff, and more importantly, the Fiscal Grand Canyon threatens our nation’s future.
Since the beginning of 2010 (11 quarters), our economy has grown 2.1%. (Chart pg. 2)The Fiscal Cliff could be as large as 4% of GDP if all the tax increases and spending reductions are allowed to take effect in January. The image of a cliff, and basic math (GDP+2.1% minus 4% = -1.9% GDP) suggests the economy will plunge into recession by the end of January if Congress fails to intercede. That’s not going to happen, even if Congress continues to fiddle. It is the progressivity of fiscal tightening that will drag the economy down in next year’s first half. For instance, the 2% reduction in the social security tax is likely to be rescinded. Median income is about $50,000, which means the average wage earner in the U.S. is going to pay a $1000 more in Social Security taxes in 2013. After receiving $20 less in their first paycheck of 2013, will the average worker slam on the spending brakes? The Bush tax cuts are also likely to go away on those earning more than $250,000, so they will pay $11,000 or more in taxes next year. Will the most affluent stop going to the mall? Most consumers are more likely to tap into savings or use a credit card for awhile, before altering their current spending habits. However, slower growth in government spending and the cumulative impact of higher taxes would likely tip the economy into recession by mid 2013.
We may be incorrigible optimists since we would like to think those in Washington understand the gravity of the Fiscal Cliff and will address it by acting like rational adults. We can almost hear some of you laughing, and for good reason. There is certainly the chance that after trying to negotiate a deal, the talks reach an impasse. After the election, both parties had to proclaim to the American people their willingness to do what’s best for the country. But when the brief honeymoon is over, they will have to work out the details. And as we all know, the devil is in the details. Despite reservations, our expectation has been that Congress will minimize the 4% hit to GDP. They will accomplish this by allowing the tax increases on those earning more than $250,000 to take effect and rescinding the 2% reduction in social security taxes. On the spending side, they will allow most if not all of the unemployment insurance program to expire, and allow the defense department to determine which programs to be cut. This would minimize the immediate negative impact on the economy to 1.5% to 2.0% of GDP, while buying Congress time to address the remaining portion of the Fiscal Cliff. The deficit hawks will not be happy, and some will understandably call this kicking the can down the road. But Congress must address the Fiscal Cliff in a balanced way so economic growth is not unduly impaired. Going the way of Europe, and pursuing austerity for austerity’s sake, has not worked for Greece or Spain, which are mired in recession with little deficit improvement to show for their suffering.
We are though realistic enough to acknowledge Congress’s proclivity to duck their budgetary responsibilities, as they have the last three years. But 2013 may prove different given the widespread media attention the Fiscal Cliff has received. As part of a short term solution to avoid the full brunt of the Fiscal Cliff before December 31 (or shortly thereafter and after an appropriate amount of drama and posturing), Congress will also authorize a Super Duper Committee to achieve an additional $3 to $4 trillion in deficit reduction over the next 10 years. This would be accomplished through revenue increases and spending reductions by July 4, just to show how patriotic they truly are. And to further prove their budgetary discipline, Congress will set another sequestration deadline (October 1, 2013) that will mandate additional tax increases and spending reductions, if the Super Duper Committee is unable to come to an agreement. If some of this seems like déjà vu all over again, it shows you’ve been paying attention to how a dysfunctional Congress behaves.
Even if Congress is able to accomplish all of the above, the reality is the budget deficit will not narrow as much as projected. When the Congressional Budget Office tabulates the amount of revenue it expects the government to collect from a tax increase, the CBO uses ‘static’ accounting, which assumes taxpayer’s behavior won’t change. This assumption flies in the face of human nature, since humans are wired to respond to negative and positive incentives. Historically, if the CBO projects $100 billion in additional tax revenue due to a tax increase, the government usually comes up short as taxpayers respond to the tax increase by making choices that reduces the impact of higher tax rates on their finances. Conversely, tax cuts have usually resulted in more tax revenue than projected by static accounting, as taxpayers elect to receive more income since the government’s take is less. This behavioral dynamic is especially true of capital gains, since investors have far more flexibility in when and how much capital gains they will claim in any tax year than income from wages and salaries. Even if Congress does address the Fiscal Cliff, the odds are the deficit will not decline as much as projected, since tax revenue will not rise as much as expected. We will also venture a guess that spending reductions will not curb the increase in government spending as much as expected. OK, call us optimistic cynics.
There is also the unintended consequence of relying too much on capital gains to close the budget deficit. In addition to investors exercising more control over when and amount of capital gains they will take in any given year, there is also the small matter of fluctuations in the stock market. During a bull market, the government will reap more capital gains tax revenue, which politicians invariably and gladly incorporate into baseline spending. This means future spending is dependent on capital gains tax revenue remaining high. The Clinton budget surplus years of 1999 and 2000 owe much to the technology mania that boosted the stock market’s valuation in those years and the resulting capital gains tax revenue boom. When the stock market declined in 2001 and 2002 as the dotcom bubble deflated, capital gains tax revenue collapsed, contributing to the budget deficit in subsequent years. If Congress wants to boost tax revenue through higher capital gains taxes, they should be required to use a five or ten year average of capital gains tax revenue to avoid overspending during bull markets, and needing even higher tax rates during bear markets to lower future budget deficits. This is too sensible to ever happen.
From the Hula-Hoop craze to environmental laws which resulted in cleaner air and water throughout our country, California has long been considered a trend setter for the rest of America. Mae West said, “Too much of a good thing can be wonderful”. But that isn’t always true for taxes, government spending, and regulation. California’s unemployment rate is 10.2% well above the national average of 7.9%. Inflation adjusted per-capita government spending in California rose 42% between 2000 and 2010. And according to the Census Bureau, at 23.5%, California has the highest poverty rate in the country, despite the substantial increase in government spending. The Bureau of Economic Analysis estimates per-capita personal income fell almost 1% between 2008 and 2011. The Mercatus Center at George Mason University ranks California as the fourth worse state in terms of business regulations. The Tax Foundation ranks California as the fourth most heavily taxed. The California Taxpayer Association has reported that California has the second highest personal tax rate and the highest sales tax rate in the nation. And that was before the top personal tax rate was increased to 13.3% and the sales tax was bumped up .25%. The Census Bureau estimates that between 2007 and 2010, almost 500,000 people left California for better pastures, and it’s likely the exodus out of California continued in 2011 and 2012. California projects the recent tax increases will garner an additional $6 billion in revenue. That’s likely to prove optimistic, as the negative incentives of higher personal taxes, sales taxes, and business regulations results in a shrinking tax base and less tax revenue. Unintended or not, public policy choices have consequences, whether it is at the state or national level of government.
The Congressional Budget Office will ‘score’ whatever the details are of any budget agreement reached by Congress, and make an estimate of how much the deficit will decline in coming years. The most important budget busting bogey is the expected GDP growth rate the CBO will use to estimate future tax revenue and spending. The higher the assumed GDP growth rate used by the CBO the more tax revenue it will project the government will receive and thus a smaller budget deficit. There is a high probability the CBO will assume a higher GDP growth rate than is likely, especially in the next few years. Given the structural challenges facing our economy, Europe, and China, it would be fortunate if GDP growth in the U.S. averages more than 2.0% in the next few years. Too pessimistic? Consider how much support our economy has received from fiscal policy and monetary policy during the last three years. We’ve run deficits greater than $1 trillion each year, which amounted to an average of 8.2% of GDP. The Federal Reserve has held interest rates near zero percent, and launched QE2, QE3, and Operation Twist to keep mortgage rates low and boost stock prices. Despite the extraordinary fiscal and monetary stimulus, GDP growth has been just 2.1% since the end of 2009, about half the post World War II recovery average. Our guess is the CBO will project GDP growth in coming years of at least 3% in their budget assumptions. Their estimates of tax revenue will be much higher than are likely to be realized if GDP growth is just 2% or less as we expect. This means the budget deficit will not narrow as much as the CBO will estimate over the next decade, so the budget deficit problem will be an ongoing challenge.
Hopefully, all the attention on the Fiscal Cliff will result in Americans learning more about the budget challenges facing our country over the next few decades, rather than just the looming Fiscal Cliff in January 2013. Our concern is that any deal which addresses the near term budget shortfall will engender complacency and the assumption all is well in budget land. Nothing could be further from the reality. All the recent hand wringing and headlines is over $600 billion. According to the Congressional Budget Office, the United States has unfunded liabilities related to Medicare, Social Security, Federal debt, military and federal employee benefits, and obligations of state and local governments of $65 trillion over coming decades. We have referred to these unfunded liabilities as the Fiscal Grand Canyon. The Fiscal Cliff is $600 billion, but the Fiscal Grand Canyon is 100 times larger. The fiscal challenge confronting us is far more a long term issue than a short term problem requiring a quick fix in 2013. The problem of unfunded liabilities has been growing for decades, so it is not a new problem. Nor is the lack of Congressional leadership in passing an annual budget that provides for the fiscal soundness of this country’s future. If Congress focuses simply on the Fiscal Cliff next year, without adequately addressing the Fiscal Grand Canyon, we will have to endure Fiscal Cliff 2, Fiscal Cliff 3 . . .
If Congress fails to achieve a deal that minimizes the full 4% impact to GDP, the economy is likely to experience at least one quarter of negative GDP in 2013, if not an outright recession. Should Congress reach a compromise that lowers the drag on GDP to less than 2%, the economy may only flirt with a recession in first half of 2013.
While the stock market may throw a party if a deal emerges avoiding a swan dive off the Fiscal Cliff, there could be an unpleasant hangover when investors realize growth will slow and earnings decline anyway. There could however be a small silver lining if a deal is struck. Many companies and small business owners have delayed investment decisions until they have better clarity on tax rates and confidence that Congress is capable of responsibly handling the Fiscal Cliff. After last year’s debt ceiling debacle, Congress has certainly earned a level of skepticism. According to the Commerce Department, in the third quarter, business investment in equipment and software was flat. It was the first quarter without growth since the fourth quarter of 2009. Although the details of any deal may be unpopular, knowing the specifics with some certainty will allow business leaders to plan accordingly and will likely result in a modest rebound in business investment. This would offset a small portion of the coming fiscal tightening.
The bottom line is the economy in 2013 will look a lot like 2012, only slower. This suggests job growth which has averaged around 150,000 each month in 2012, will be less, so the unemployment rate will not fall significantly. The Federal Reserve has targeted the unemployment rate as a policy driver and has pledged to keep QE3 in place as long as the unemployment rate remains elevated. They will have no reason to end QE3 before the end of 2013. Weak growth in 2013 will also mean the underemployment rate (U6), won’t fall much from October’s 14.6% rate. Over the last year average weekly earnings have increased 1.5%, while earnings for production and non-supervisory workers are ahead a paltry .8% The Consumer Price Index is up 2.2% from a year ago, and according to the Labor Department real earnings are down .7% from October 2011. The purchasing power of workers has declined in the past year, so their paychecks are not stretching as far to meet their monthly bills.
Despite extraordinary monetary accommodation, aggregate demand has remained tepid, which is why GDP growth has been barely above stall speed. The primary reason the economy has been unable to achieve a self sustaining recovery trajectory is weak job and income growth which diminishes demand from consumers. Higher social security and income taxes in 2013 will lower disposable income, leaving less money for consumers to spend. Aggregate demand will also be negatively impacted as the Federal government reduces the rate of increase in government spending. Congress is expected to terminate the extended unemployment benefits and other income transfer programs, when they discuss how to lower next year’s budget deficit. Since 2008, fiscal policy has helped to support and sustain aggregate demand with $1 trillion deficits annually. In 2013 and beyond, fiscal policy will shift from a tailwind, to a headwind, and there is very little the Federal Reserve can do about it. The Fed will keep rates low, continue QE3, and hope the stock market does not swoon.
Last summer the stock market held up, despite numerous economic reports reflecting the slowdown the economy experienced in the third quarter. Institutional selling remained muted though since money managers interpreted the slowing as more reason for the Federal Reserve to launch round three of quantitative easing. The expectation was that QE3 would lift stock prices just as QE1 and QE2 had. It made no sense to sell during the summer despite punk economic news, since QE3 and a higher stock market were right around the corner. Ironically, the stock market peaked on September 14, the day after the Fed announced QE3.
The same pattern may develop around the Fiscal Cliff. Although the ride may be a bit bumpy, most investors expect Congress to reach a compromise that avoids the Fiscal Cliff. Any deal is expected to result in a big stock market rally, so selling now makes little sense for institutional money managers. This raises the possibility of a market high within days of an agreement, since after the deal is announced, investors will only have the prospect of slower economic growth and more pressure on corporate earnings to look forward to. As we discussed last month, the Shiller Price/Earnings Ratio uses trailing 10 year earnings, rather than current estimates for earnings as most analysts. Over the last 130 years, U.S. stocks have traded about 17 times trailing earnings. Most analysts estimate S&P earnings for 2013 around $100 and, with the S&P trading near 1,400, they conclude the S&P’s P/E is roughly 14. However, the Shiller Ratio pegs the S&P’s P/E at 22, which is almost 30% above its historical mean, and 57% above the conventional P/E of 14. Nobel Laureate James Tobin created the Q Ratio as a method of estimating the fair value of the stock market. The Q Ratio is the total price of the market divided by the replacement cost of all its companies. The mean average of the Q Ratio has been .70 since 1900, and as of June 30, 2012 was at 1.10, or 44% above its historical mean. The stock market does not decline just because valuations are above average or high. Stock market declines occur because investors are given a reason to sell. There is a grab bag of reasons that may give investors a reason to sell in 2013, with the Fiscal Cliff being just one of them.
Europe has been off the front page for the last few months, since Mario Draghi pledged on July 26 that “The ECB is ready to do whatever it takes to preserve the Euro.” His comment calmed the European credit markets and led to a significant decline in 10-year bond yields in Spain and Italy. We suspect the window of tranquility will be closing soon, since the Euro-zone economy is continuing to weaken. Slower growth will generate less tax revenue, keep government spending elevated, and make achievement of the 3% budget deficit targets in Greece, Spain, and other EU countries more elusive.
At the beginning of this year, we expected the Eurozone to remain in recession throughout 2012. After falling .7% in the second quarter, GDP in the 17 countries in the European Union contracted .2% in the third quarter, according to Eurostat. Industrial production fell 2.5% in September from August, the largest decline since January 2009. The weakness also enveloped Germany, where industrial production slumped 1.8% from August. Retail sales in the Euro-zone dropped .2% in September, and are down .8% from a year ago, and are lower over the past 18 months. The unemployment rate rose to 11.6% in September with 18.49 million people out of work.
In Greece, the unemployment rate is 25.4%, with youth unemployment at 58.0%. Since 2009 Greece’s economy has shrunk by 25%. After implementing numerous austerity programs to receive additional funding and debt forgiveness, Greece is in a depression. The goal of the austerity programs was to narrow its budget deficit from near 15% in 2010 to 3%. The debt forgiveness was intended to lower Greece’s overall indebtedness. While Greece may be able to get its budget deficit down to 3% of GDP in 2014, its debt to GDP ratio just hit a new high of 170%. We don’t hear anyone proclaiming austerity a success. In order to survive, Greece will require another debt forgiveness program that will be very hard to negotiate.
Spain’s unemployment rate climbed to 25.0% in September, with 54.2% of those under 25 without a job. In the third quarter, Spain’s GDP declined by 1.7%, after falling by 1.3% in the second quarter. Spain is cutting government spending and increasing taxes in an effort to pare its budget deficit from 9.4% in 2011 to 3% in 2013. The full impact of the government cutbacks and higher taxes will continue to weigh on its economy well into 2013. Economic conditions have deteriorated so much in Spain that Catalonia, a region in northeast Spain that includes Barcelona, is considering whether it will become independent from Spain. This is serious since Catalonia produces 19% of Spain’s GDP and 21% of its tax revenue. According to the Catalonia government, Catalonia receives less than half of the taxes it sends to Spain. Given Spain’s financial difficulties it cannot afford to send more money back to Catalonia, and it certainly can’t afford secession by Catalonia.
The ECB has significantly expanded its balance sheet and pushed liquidity into the European banking system. A recent analysis of the 12 largest European banks by the Wall Street Journal revealed those banks have $1.43 trillion on deposit with the ECB as of September 30. According to the European Central Bank’s quarterly lending survey, a net 15% of Eurozone banks tightened loan criteria in the third quarter versus 10% in the second quarter. Demand for business, consumer, and home loans fell in the third quarter, which is symptomatic of recession as even credit worthy borrowers find no need to seek credit. As long as credit availability continues to contract, Europe is not likely to emerge from its recession in the first half of 2013. Eurozone banks also told the ECB they intended to increase lending standards in the fourth quarter, which suggests a turnaround in lending is months away.
Our view has been that China’s economy would slow in 2012, but avoid a hard landing, and that GDP growth would stabilize in the 6% to 8% range. The National Bureau of Statistics reported industrial production rose 9.6% in October from 9.2% in September and 8.9% in August. Retail sales improved in October, showing a gain from a year ago of 14.5% versus 14.0% in September. Fixed investment and electricity usage have also strengthened. These reports suggest stabilization and a modest improvement in GDP as we forecast. Although we anticipate additional signs of improvement from China, there are issues that are likely to become problematic in coming years.
From 2000 until the financial crisis in 2008, much of China’s GDP growth resulted from a surge of investment spending that significantly expanded China’s infrastructure. Cities for millions of inhabitants were built along with the power grid and power generation to keep the lights on. China also expanded its export capacity to capitalize on its lower cost of production, expanding exports to Europe and the United States. As a result, investment as a share of GDP rose from 34% in 2000 to 49% at the end of 2011, while domestic consumption shrunk from 46% to 34%. By comparison, in the U.S., consumption is 70% while investment is 12%. China has vowed to correct its overreliance on investment, which represents an imbalance, by increasing domestic consumption. This transition is going to take many years. In the short run, weaker exports and overcapacity in many industries are going to make the transition more difficult and tempt China to revert to its old ways.
In the wake of the financial crisis, China depended on the same growth formula, only relying much more heavily on debt to finance investment spending. In the years prior to 2008, Chinese corporations held debt equal to 1.2 times GDP, according to Fitch Ratings. In the last four years, corporate debt leverage has increased to 1.9 times GDP. Servicing the additional corporate debt will be a challenge since capacity utilization rates are down in a number of key industries, squeezing profit margins and profits. According to the International Monetary Fund, China’s auto and steel industries are operating at just 60% of capacity, with many other sectors not faring much better. Since 2007, wages have surged 73% in the manufacturing sector, which will help increase domestic consumption in the long run, but near term hurts China’s competitiveness as a low cost producer. The ratio of inventory to the last four quarters of sales was 20.4% in the third quarter, down slightly from the second quarter’s 20.5% level. However, inventories are still higher than the 2009 peak of 18.3% when Chinese firms were blind-sided by the financial crisis. This will continue to keep China’s demand muted for raw materials, until excess inventories are worked off. According to CapitalVue, net profits for the 2500 firms listed in mainland stock exchanges was up a thin .4% in the third quarter, after falling 1.8% in the second quarter.
The new leadership in China is likely to lower interest rates, probably in the first quarter, which should reinforce the better news coming out of China. This might prompt some analysts to suggest that China was coming to the rescue of the global economy. Since China represents just 10% of global GDP, we don’t think China is capable of solving the problems afflicting Europe or the consequences of the Fiscal Cliff and Fiscal Grand Canyon in the U.S. Besides, until domestic consumption can replace its dependence on investment and exports to Europe and the U.S., China is likely to be beset by its own banking problems in 2013 or 2014.