From Gluskin Sheff's David Rosenberg
Fiscal Contraction Is Coming.... This Is A Key Theme
What exactly are the reasons to be bearish on the bond market? Oh yes, fiscal deficits!
Well, if you haven’t yet heard, major budgetary restraint is coming our way in the second half of the year, and so we would recommend that you enjoy whatever fiscal and monetary juice there is left in the blender. There isn’t much that is for sure. The weekend newspapers were filled with reports of how the conservative wing of the Republican party have banded together to ensure that spending cuts will be in the offing — see In House, Republicans Close to Approving Record Cuts on page A13 of the Saturday NYT. The state and local governments are already putting their restraint into gear — see Wisconsin Leads Way as Workers Fight State Cuts on the front page of said NYT; and Wisconsin Democrats Keep On the Move on page A3 of the weekend WSJ. First it was Christie’s New Jersey that was a role model in terms of embarking on true fiscal structural reforms. The baton was then passed to Mitch Daniels in Indiana. Now it is Scott Walker in Wisconsin who is the new poster boy for fiscal reforms and necessary restructuring.
What is happening at the lower government level definitely has a grassroots Mike Harris ring to it, and for those that do not know who Mike Harris is go ahead and google him and the ‘Common Sense Revolution’ that gripped Ontario in the 1990s. Yes, it can be done. And shared sacrifice by the civil servant community, not widespread defaults at the state and municipal level, is going to be the solution — either accept higher contribution rates to your pension, higher payments for your health care, and wage cuts — or lose your job. Sounds like the deals that ultimately got struck across the lean and mean private sector in recent times from the auto sector to the airlines (wasn’t GM at one point nothing more than a health insurance provider?). To think that the President can stick his nose into local government budgetary affairs and accuse Wisconsin of an “assault” on unions (then again, didn’t he once accuse a police officer of being a racist?) at a time when he plans to actually EXPAND the federal government deficit this year to $1.7 trillion is truly remarkable.
In any event, the process towards fiscal integrity will continue unabated and we highly recommend added readings on the topic — see Battle Fuels Wider War Over Labor, Spending and Public-Pension Fight Surfaces in California. The free lunch is over and with it the expectation that there will be sustained growth in domestic spending. Yes, the corporate sector is cash rich but well over half of the so-called $2 trillion of dry powder sitting on U.S. company cash balances are locked in deposits overseas and will not be brought home due to American tax policy (see Why Investors Can’t Get More Cash Out of U.S. Companies on page B1 of the weekend WSJ). And yes, it is a big world out there and most of U.S. sales growth has come from the once-hot overseas economy, but between the massive fiscal restraint in much of Europe and the anti-inflation monetary tightening in the emerging market universe, that gravy train of strengthening domestic demand abroad will be sputtering before long.
What a market trained to focus on this quarter’s earnings reports cannot see right now are the inherently variable lags between policy shifts and the ensuing impact on real economic activity and profits. The investors that chose to focus on the rear and side view mirrors in 2000 and again in 2007, as opposed to looking through the front window, were the ones that emerged as the big losers. The folks that got greedy at the peak and did not lock in that last 13% gain in the S&P 500 in the year to the ultimate 1,565 peak in the fall of 2007, saw those gains totally vanish in front of their eyes in barely more than three months. Easy come, easy go.
Headlines that read On A Roll: Equity Bulls Have Taken Over on page 15 of the FT are sure to lure the last vestiges of investors who have waited, frustratingly, on the sidelines into the market at exactly the wrong time. When strategists concoct reasons why investors should ignore cyclically-adjusted P/E ratios, it conjures up the memory of why it made perfect sense to avoid classic valuation metrics back in 1999 and 2000 and focus on EBITDA and eyeballs per millisecond. Ahhhh ... the pain of “missing out” on a speculative 100% rally has replaced the pain of being involved in a 60% downslide just a short two years ago. Memories are short. That is what we have learned in this gigantic rollercoaster ride. The Fed’s policies, the ones that Bernanke defends, nurtured the post-LTCM rally that took the S&P 500 from 959 on October 8, 1998 (after the Fed cut rates intra-day to save the day) to 1,520 by September 1, 2000. It was a virtual non-stop 60% rally. But liquidity induced rallies only have a certain shelf life. The stimulus did end. The lags kicked in, and by July 2, 2002, the S&P 500 was down to 948 so all the speculative rally was undone and then by October 9th of that year, the S&P 500 had slid all the way down to 776.
The Fed then dug deeper into its bag of tricks and massively re-stimulated until the stock market carved out a bottom and embarked on a 100% rally from that low of 776 to 1,565 on October 9, 2007. The writing had been on the wall for so long but like today, bonds were the enemy and the good times were destined to last forever, didn’t you know. The fear that was rampant on October 9, 2002 had morphed into greed on that same day in 2007. Instead, we had another recession nobody saw coming, and all sorts of reasons to dismiss the overvalued and overextended nature of the market. Those who refused to drink from the Fed’s spiked punchbowl were viewed with the same derision they faced when they were considered old-economy dinosaurs back in 1999-2000. In contrast to rallies based on sound economic fundamentals as we had during the secular bull markets in the past, liquidity-infused rallies are truly dangerous animals and need to be handled with great care and a dose of trepidation because the thing about liquidity is that it is your best friend one day, and a coward the next. So it was with the downdraft from the 1,565 highs in October 2007 to the 676 lows in March of 2009.
Now, after an unprecedented experience of fiscal and monetary ease, ranging from bailouts, to TARP assistance, to guarantees, to government buying of shares, to accounting rule changes, to verbal market manipulation, to massive expansions of the central bank balance sheet, and record levels of deficits and debts, and not just in the U.S.A. but globally, the S&P 500 has soared from 676 to 1,343. It took five years to double in the last cycle; two years this time around.
What to do, what to do, what to do? If jumping in after a “double” in the last liquidity cycle proved to be the wrong thing to do, what makes anyone think it won’t be the same this time around?
The S&P 500 actually followed the Fed balance sheet more closely last year than anything else ? including the flow of corporate earnings reports. And if the Fed does not embark on QE3 in June, there could be a problem lurking ? especially since the other spigot, fiscal policy, moves from stimulus to restraint in the second half of the year. It would have been nice to have been 100% in equities since the March lows, especially the lowest quality, most expensive and deepest cyclical stocks. Ah, the benefit of hindsight, but one could have said the same in the fall of 2007 ? the ignominy of sitting out a double!! But to throw in the towel at this stage could prove fatal to your wealth and we don’t recommend an overweight position right now. Remain patient. Understand that once things turn, and eventually they do, there will not be anyone to really support the market since practically all fund managers are fully invested and have as much cash on hand as they did at the October 2007 highs.
Our advice is to sit tight, get paid an economic rent, and then opportunistically capitalize on the eventual corrections that are a normal part of any market cycle, and tend to be more pernicious after rallies that were built on sticks and straws of government liquidity than the bricks that are generally laid by organic economic growth and an expanding private sector capital stock.
Sadly, the past recession did not resolve the glaring imbalances permeating the U.S. economy. By expanding their balance sheets, the Federal government and Federal Reserve have really only managed to create an illusion of prosperity. Maybe this is what they have to do ? buy as much time as possible. Kick the can down the road just far enough in the hope that something ignites the economy to the point that growth can be sustained without reliance on government-administered steroids. Printing money does not create wealth. It actually risks eroding real purchasing power. And governments may be able to redistribute income but in no way can create it ? government’s tax, spend and borrow. The national debt is now $1.41 trillion.
The United States is a 236-year old country, and almost 40% of the entire public sector debt has been built up by the current Administration in barely more than two years. The United States has a monetary base of $2.06 trillion, and nearly 60% of that has been created since Helicopter Ben took over the cockpit in early 2006. A 236 year-old country, and well over half of the stock of money has been created in just the past half-decade. Remarkable. Maybe the real question we should be asking is why the stock market has only managed to double from the lows with all this massive intervention?
Well, as Dandy Don used to bellow out on Monday evening blowouts back in the 70s and 80s, “turn out the lights, the party’s over. They say that all good things must end ...”
Indeed, while every economist has raised the 2011 GDP forecast because of the fiscal stimulus initiated late last year, nobody has adjusted their projections for the looming fiscal drag. Not only that, but it is becoming crystal clear that the Treasury debt ceiling is going to emerge as a potentially destabilizing issue very soon ? see U.S. Faces Deadlock Over Budget on page 3 of the weekend FT as well as Deficit War May Lead to Gov’t Shutdown on the front page of Monday’s Investor’s Business Daily.
As for monetary policy, inflation is simply going to be too high for the Fed to be able to embark on QE3 as early as June, which is when QE2 expires and this is too bad for the bulls because it is very evident that the liquidity rush had a much bigger impact on equity valuation since the end of last summer than either the economy or earnings did ? see Betting on Ben: Central Banks Have Been Supporting Share Prices in the always excellent Buttonwood column in the Economist (page 83). Caveat emptor. At the same time, QE2 has only been a success in terms of generating a speculative and liquidity-induced rally in equities, it has not helped redress the dismal job market backdrop ? the decline in the labour force participation rate did a far better job in pulling the unemployment rate down than Fed policy ever did.
The Fed’s policies, by triggering a pro-risk investment landscape, led to money being pulled out of the bond market to such an extent that mortgage rates have skyrocketed back above 5% and thereby further impaired the housing market. At the same time, the Fed’s policies have at least played a partial role in stimulating this most recent up-leg in commodity markets, and this in turn has an impact on real consumer spending since the surge in food and fuel prices in particular will exert a negative impact on discretionary expenditures. All the more so after the fourth quarter drop in the savings rate, which looked to be one part wealth effect and one part pent-up demand (the recovery is six quarters old and Q4 was the only one that could remotely be called decent as far as consumer expenditure growth is concerned).
But from the spreading political turmoil in the Middle East to real spending power here at home, there is no question that the global food crisis is a real game-changer as far as the macro and market forecast is concerned. Current corn stockpiles now represent 4% of annual consumption, according to the WSJ, perilously below the 15-year average of 13.5%. This is a shortfall equivalent to around 10 million acres. Look at the ingredients of any packaged food and you will see something related to either corn, or soybean, where there is an estimated four million acre shortfall. In turn, this is one reason ? inflation ? as to why the emerging equity markets have so woefully underperformed so far this year ? down 3.5% versus the 5% advance in developed markets. Inflation in China is around 5% (and likely under-reported) and 8% in India. And when you go back to August 2010, when QE2 was announced, U.S. core inflation was 1.1% and headline was 0.1%; by June of this year, we will probably be looking at 1.5% on the core and as high as 3% on headline inflation. That combined with the reality that the S&P 500 is 300 points higher now than it was then would certainly suggest that the case for extension of the Fed’s QE program will not be there, at least not by the time QE2 runs its course. So this is what we would be looking for in terms of chronology (it may be too late to sell in May this year).
- March: Irish elections. Default back on the table. Euro weakens. Flows into front end of the Treasury curve.
- April: Debt ceiling is hit. Political gridlock in vogue. Market volatility ensues. Gold and silver firm.
- June: End of QE2. Stock market wobbles like it did last year under similar conditions. Bonds and the U.S. dollar rally. High-beta stocks slip.
- July: Start of fiscal year for state and local governments. Big retrenchment begins and takes a bite out of economic activity.
- October: End of fiscal year for the federal government. Fiscal restraint replaces three years of radical fiscal expansion. Big rally in bonds. U.S. dollar should firm up too.
- December: The payroll tax cut and the bonus depreciation allowance both expire, creating a huge air pocket for first quarter growth in 2011. Talk of recession accelerates. Bull flattener in Treasuries likely to ensue. Equities will still be in corrective mode as double-dip risks re-enter the market mindset.
Besides the sluggish labour market environment, rising food and energy prices, which is one-quarter of the spending bucket, renewed deflation in residential real estate values and the sudden loss of fiscal and monetary policy support that is around the corner, another impediment to a sustained spending cycle in the U.S.A. is the very poor financial shape that the boomer population finds itself in after years of spending far above its means (which is one reason why it seems so incredulous to read Bernanke Defends U.S. Policies on page A6 of the weekend WSJ seeing as Fed policies over the years have increasingly been geared to fuelling excessive consumption via asset inflation).
Have a read of the sad but true article on the front page of the WSJ (weekend edition) titled Retiring Boomers Find 401(k) Plans Fall Short. The statistic in there was pretty scary but it does tell us that the savings rate will resume the upward trend that was temporarily broken last year. The median household headed by a person between the ages of 60 and 62 with a 401(k) account has put away less than one-quarter of what is needed to meet their standard-of-living needs in retirement. Yikes. Remember, there are 78 million boomers that are going to turn from being net borrowers and spenders towards net creditors and savers. This is definitely bullish for long-duration bonds, by the way, which is the most detested asset class on the planet right now, confirmed by the latest Merrill Lynch survey of global portfolio managers.
