A Couple of Debt Thoughts

I thought this was a really good point made by John Mauldin [who, as a side note, is from Texas and a Republican].

"As we bring government spending down, unless it is accompanied by private-sector growth, we will see overall real GDP shrink. That is just the how it works. Now, the smaller government expenditures and deficit will mean more money for private-sector investment and productivity growth, but the process of simply getting the deficit under control is going to mean slower growth. Wrap your head around that. While Republicans (including me) want to control Congress and the presidency in 2012, the policy choices made in 2013 will not be met with a robust return to 4% growth and immediate jumps in employment levels. It is going to take a lot of education to convince voters that there is no magic in spending cuts (or even tax increases) and that we will need to stay the course, even while there is a general malaise in the economy. My advice to my fellow Republicans? Do not sell the concept that voting Republican will provide a quick fix. It will get you slaughtered in 2014."

I think the real key is for the Republicans is to communicate the above very clearly in their campaigns. I don't have much hope for their ability to do that given their exceptionaly poor communication skills in the last two elections (and right now for that matter), but maybe more of the voters at least understand this than last election... maybe... hopefully...please? The way I see it, the solutions that need to be implemented are going to take a while and we will have to stick to the plan, even though it will hurt. If we decide, prematurely, that we would rather kick the can down the road then it is going to hurt all that much worse the next time we are almost forced to get our finances in order.


I also thought, given all the problems going on economically worldwide, that the following link to an article by Diane Swonk of Mesirow Financial is a great, down to earth, explanation of all of the pitfalls out there and how this all could play out. Obviously the U.S. debt and policy decisions made because of it are at the center of most of the problems. Click Here for the link.

Pulling the Splinter Out

“Where would U.S. incomes, earnings and corporate cash-flows be today if it weren’t for the $4.5 TN increase in federal debt over the past 10 quarters? Ponder for a moment the liquidity backdrop in the Treasury market had the Fed not intervened in the marketplace with quantitative easing (#1) and “QE2” - in the process convincing the marketplace that the Fed had committed to operating as a reliable market “backstop bid?” What would be the state of the household balance sheet today if not for the unprecedented fiscal and monetary policy response? Is it sound analysis to trumpet the pristine state of the corporate balance sheet and celebrate the improving household balance sheet - when the Fed is doing unconscionable things to its balance sheet and the federal government is in the process of destroying theirs?”

“How would global markets and economies be functioning these days had it not been for the almost $1.6 TN increase in international central bank reserve holdings over the past 12 months – or the $2.75 TN, 40%, growth in two years, to $9.45 TN?”

“Today, ECB President Trichet stated that “it is important that the dollar is a strong currency.” He also said that “fixing imbalances must focus on deficit countries.” To this day, Greenspan argues that foreign central bank Treasury purchases were instrumental for the rate environment that inflated our nation’s housing Bubble. And the argument that our trading partners – and their undervalued currencies and steady accumulation of American I.O.Us – are most responsible for global imbalances will not be resolved anytime soon.”

“Let the world adjust; just ensure that the Fed keeps doing what it's doing. And I just scratch my head in disbelief at how little we’ve allowed ourselves to learn over a turbulent 20 year period of interplay between “activist” policymaking and serial market Bubbles. After doubling mortgage Credit in seven years, our system is now on track to double federal debt in 4 years. And the markets couldn’t be more pleased with it all. It leaves one pondering what type of circumstance will be necessary to finally force us to start getting our house in order – to return to some semblance of disciplined central banking and fiscal responsibility.” David Nolan - Weekly Commentary


As I was reading the above quote I really started to think about everything our government has inserted itself into and had to start thinking: Where would our economy be if our government had not made money and services so easily accessible to all?

I think that really you can take two views on that. You can either say that we would be in a complete pit of depression for years (probably what the fellow I quoted believes) after each economic correction or you can believe that deep down that Americans are workers. When our backs are against the wall, and sometimes even when they aren’t, we step up to the plate and work harder putting us into a new boom cycle.

So where do I think we would be without government “help”? I think we would be regularly going through the boom and bust cycles we have been, but with a lot less of the extremes like we saw in 2008, and in general we would be prospering. Of course the government and central bank did step in too much and now they will have to get out or we will again have a huge burst. When they do step out of the way it is going to hurt. This interference has become very much like a splinter that has been allowed to fester for too long. Sure we could leave it there and keep covering it up or we can remove it (with all of the complaining and whining that comes with it) and finally start the healing process. While I don’t believe that many of our current representatives have the stomach for it, some do. Also, while there is a lot of anger out there and most can’t agree on how to start getting the splinter out, most agree (according to some polls I have read) that it has to come out now.

If Only...

"Winds of Change in Unionland" by Holman Jenkins

How's the view from Solidarity House? Just asking.

Solidarity House is the headquarters of the United Auto Workers in Detroit, whose windows gaze figuratively across the labor hinterland of the upper Midwest. At least it used to be a labor hinterland, though its politicians this week are taking an axe to public-sector unions. In Indiana and Michigan, proposals even target private-sector unions with bills to turn those states into "right to work" states, like Tennessee or South Carolina.

It all serves to underline the improbability of the agenda rolled out in January by the UAW's new boss, Bob King. Mr. King's grand plan is to organize Toyota and other transplant factories in Southern states where unions already aren't popular, where the laws already are unfriendly, and where previous campaigns have yielded nothing but defeat.

That Mr. King is not dumb is illustrated by his success in a previous job. He led the UAW's successful drive a decade ago to organize the auto parts suppliers. He won by playing the only card the UAW has to play, its politically-protected labor monopoly over the Big Three. He leaned on the Big Three to lean on their suppliers to accept the union on a card-check basis—without a secret ballot vote. In return, the UAW agreed to stand aside while the Big Three shut down some of their own plants and laid off workers.

That was the deal, and the episode offers three important insights. The union had little else to offer supplier companies or their workers, who folded simply under threat of losing their Detroit contracts.

Secondly, the supplier campaign was a distraction from the fact that the Big Three's own workers were giving ground on jobs and job security.

The third lesson, bluntly, is that Mr. King is blowing smoke about Toyota. The UAW has no card to play. The union's labor monopoly gives it no leverage over the transplant factories, and the union's appeal to their nonunion workers, realistically, is less than zilch right now.

The UAW finale has begun. It's the beginning of the end for the union, except as administrator of its membership's retiree health-care benefits (which increasingly looks like a bone thrown the union by the Big Three to give labor honchos a reason for living).

Let us put away our Woody Guthrie records. Detroit's "turnaround" has come not because everyone got a warm feeling and pulled together as a team. Accurately stating matters, the New York Times recently noted that the homegrown industry's "cost structure has been reduced substantially, first through worker buyouts and plant closings and then by eliminating debt during its bankruptcy."

This has the virtue of getting the chronology right. The big labor concessions all came before a government-sponsored bankruptcy that reorganized GM and Chrysler in 2009. In each case, the union gave ground because it knew the one way to outrun its all-important political support in Washington would be to drive the Big Three into Chapter 11.

Bankruptcy came to GM and Chrysler anyway in the financial crisis, followed by a taxpayer bailout. Mr. King knows, in the current political atmosphere, he can't go back to playing his monopoly card to extract anticompetitive terms from the Big Three.

He says the union has changed and wants a new nonadversarial relationship with management. But what exactly has the UAW got to offer? Evidence is lacking that organized labor actually adds value, creating gains workers and stockholders can share. If it did, Toyota et al. would be clamoring to have the UAW in their factories. They're not.

Mr. King's dilemma is evident in his lukewarm response to the Big Three's opening gambit in this year's quadrennial contract talks, an offer of enlarged profit-sharing. Here's the problem: Incentive pay is earned pay; workers see profits as something businesses create, not something union bosses create. And the foreign transplants will only be too happy to compete on the basis of performance-related pay. If the industry is headed toward compensation based on success, what are workers getting for their UAW dues? Good question.

Mr. King must have figured out the handwaving about Toyota no longer is going to fly. Expect him soon to change the subject to management compensation, especially the stock option and bonus payouts white-collar workers are enjoying as a result of the turnaround. Look for the Obama administration to pitch in with rhetoric about workers being denied their "fair share."
All the while Mr. King will be praying, praying—beseeching the heavens for some change in the political atmospherics to allow the union to go back to playing its monopoly card. Don't bet on it anytime soon.

Government Programs

"The government's mortgage assistance program has helped just one in four of the 2.7M homeowners who applied to the program. The bulk of the applicants either failed to qualify for HAMP or were disqualified after initially being accepted into the program. As a result, just $1B has been spent on HAMP, a far cry from the government's initial estimate that $75B would be needed for the program."

So do we see this as being successful?

I was reading another article which pointed out that whenever the government tries to remove the consequences of the risk people/corporations (yes, there is risk when you purchase a home) take they create a more disastrous bubble within the economy, than the normal cycle bubbles we will always see.

While I believe the economy will be able to withstand the bubble that has probably been created from all of the recent government activity, we are going to see this pop later on, and it isn't always in a predictable sector that the bubble manifests.

The President's Budget

My new favorite line regarding the President's budget:

"Claiming budget savings by freezing spending at today’s levels is like an alcoholic who says he’s sober because he’ll never drink more than yesterday’s bender. Trouble is, this alcoholic doesn’t even pay his own tab." - Brian Wesbury

2011 Outlook

With 2011 already speeding by I thought it would be a good idea to get my annual outlook to you. There are so many things going on in the world and in particular here in the US that it has been difficult to narrow down exactly what we wanted to focus on. However, I feel that really there are four key themes that we will be watching play out this year which will have the greatest impact on the direction the economy and the market take: Politics, Debt, China, and Inflation.

Politics
I find it a little funny that over the last year people have become downright furious about the deficits. The topic itself isn’t funny at all, but what is funny to me is that these deficits are not new. We have spent in excess for quite a while. It is the result of asking for more and more “handouts” from our federal government and even getting some for which we didn’t even ask. Now, rather suddenly it seems, we have become enraged by this excess spending and have demanded it stop.

The problem of course comes when what we think is a misuse of federal funds happens to be the bread and butter (quite literally sometimes) of someone else who isn’t willing to part with that money. Who are we to say that funds sent to states for higher education is more important than the subsidies a farmer receives for continuing to farm?

Obviously there are the “easy” ones. Some were even outlined in the State of the Union recently (can we say too many federal government departments?). Unfortunately cuts to these programs is not really going to knock down the annual deficit in a meaningful way. What really has to be cut are the entitlements. We can’t keep increasing what and who we pay for social security. We also have to reign in Medicare and Medicaid. If you mention cuts to these of course you’ll get the massive push back from those about to or already receiving these benefits. It would almost be political suicide to disrupt those outflows. I don’t personally have the answers to the problem, but what the Social Security trustees have proposed seems fairly reasonable and necessary (i.e., push out full retirement age, raise tax slightly, and/or reduce payments).

Entitlement programs and the other necessary spending cuts aside, the real problem to be discussed right now is how much of these cuts can be done without severely hurting the system. Let’s face it, whether we agree with it or not the government has wormed its way rather deeply into the economy right now. If they were to rip themselves out now there would be some pain and perhaps so much pain we would relapse into another severe recession. It is an exceptionally difficult balance that those in Washington are trying to keep between supporting job growth (currently the focus of the Fed despite their dual mandate) and reducing spending.

While I’d like to tell you I am confident that the right long-term decisions will be made, I am concerned that the short-sighted mindset in Washington doesn’t appear to be going away quickly. It will be important to watch throughout the year as the election gets closer what we hear from Washington. Will tackling the deficit continue to take precedent over job creation or will they somehow be able to find the balance necessary to keep the economy moving while reducing spending? I have found it somewhat confidence boosting to hear that discussions are in the works to lower the corporate tax rate and more pressure has been placed on China. It will be interesting to watch those discussions continue and see what, if anything, comes by way of change to corporate tax laws after the President’s speech.

The good news is that job growth is expected to improve this year. However, even with job growth we will not likely see the unemployment numbers drop by much. This will likely keep the consumer on a slower spending rate than where we were at the peak (though the consumer spending numbers as measured by GDP for the 4th quarter of 2010 were impressive), but consumer spending will be one of the most important numbers to watch throughout the year.

China
Before we dive right into the issue of China, I want to review a few concepts which are directly related to the relationship between China and the United States. The current economical relationship between the majority of developed counties and developing countries is that developed countries are increasing their debt levels to fund their spending habits. This contributed to developed countries importing more goods than exporting. This relationship is known as ‘vendor financing’ and occurs when vendor countries (i.e., China, Germany, Brazil, etc.) buy bonds sold by major importing countries (i.e., the US and UK) and the money received by the importing countries for their bonds is then spent on purchasing goods from the vendor countries.

Over the years, this type of relationship between the US and China has been frustrated due to China’s currency devaluation policy of having the renminbi tied to the US dollar. This devaluation policy has the objective of holding the renminbi at a consistent price level below the US dollar. Basically this means that China is manipulating their currency so Chinese goods are cheaper than US goods and consumers are more inclined to purchase Chinese goods than more expensive US goods – of course there is the discussion of quality but that has yet to deter consumers to a large degree.

Of course, the Chinese are able to maintain their currency peg to the US dollar by either printing or selling bonds to control the amount of cash in the market. In the current situation of the US-Chinese currency relationship, the US is increasing the money supply (aka Quantitative Easing and QE2) in hopes of helping the recovery process. Keep in mind they have the dual mandate of keeping inflation in check and supporting the economy primarily through low unemployment; they have prioritized the latter mandate as the more important lately. With an ever increasing money supply in the US, China, has had to “print” large amounts of their own currency so it will stay below the deflated US dollar value. The Chinese currency which is now flooding the market due to the governments’ policy has the potential to cause inflation and move asset prices skyward. If the Chinese government does not stop pegging the renminbi to the US dollar or at least let their currency appreciate a greater amount than they have conceded of late, we could see more severe Chinese inflation.

You also need to factor in the effect of foreign investors heavily investing in developing markets because they currently offer the highest returns in the global market. This massive inflow of money is causing developing countries to experience a large amount of inflation which has begun to erode their production edge of cheap labor and raw materials. You will need to keep this in mind with your international investments this year.

China has recognized this potential issue and has implemented domestic policies with the objective of controlling inflation and drastic asset price increases. These policies have been somewhat successful and the rise in Chinese asset prices has not been explosive, but has been creeping upwards. I believe that the current Chinese policies are just a band-aid for the problem and need to be addressed in the near future lest we see severe inflation which has begun to erode their production edge of cheap labor and raw materials.

Our politicians have started to chime in on China’s policies and have even threatened stiffer trade regulations. I’ve talked about our focus on exporting our way out of this mess and China’s policies are making it hard to do that. Ben Bernanke has also joined in on highlighting this problem when he explained:

“Current policies of export dependent growth countries [China] have led to an unnatural balance of import/borrowing countries and export/savings countries. There should be a continuous balancing act between importing/borrowing powers and exporting/savings powers which is dependent upon the natural changes of currency prices. This means that countries with weaker currencies should be in the exporting/savings seat while those with stronger currencies should be in the importing/borrowing seat. Over time the export/savings countries accumulate wealth and their currency begins to rise in price while the importing/borrowing country’s currency begins to weaken and the countries switch places. It should be a continuous cycle of switching places, but China is purposefully keeping their currency price artificially low to stay in the export/savers position so they can fuel their growth through exports”

Bernanke believes that for the world to recover at a faster rate, China needs to relinquish control of the export/saving position and let their currency price rise. He does not want China to drastically decrease their GDP, but to focus on GDP growth through internal investing rather than relying on exporting goods.

U.S. Deficit
The main topic on everyone’s mind of late, it seems, has been the skyrocketing deficit, however, it seems that it is rare to find the reasoning written out as to why it is such a big deal (other than the rather ubiquitous statement of we are burdening our children). What it comes down to is: What is the lending rate we are paying on our debt?

As we add to our debt each year through excess spending (i.e., the deficit) the interest we are paying on the debt we owe becomes larger. For now we have a fairly low lending rate on our debt, however, should that rate rise even a small amount, we would begin paying more to interest payments than most other government programs. It is the excess spending that must be stopped. As mentioned before however, the government is in a little bit of a bind. How much can they cut spending while not sending unemployment shooting up again? What programs should be cut and what programs should remain?

There is also the much discussed predictions of state and municipal governments defaulting on billions of dollars of their debt in the coming year. The current situation facing most states and municipal governments are high debt levels and underfunded obligations. At the start of the crisis the federal government swooped in on their white horse and gave the states lots of funding and helped states raise or refinance their debt. Now, however, the federal government is not going to be able to do as much for individual states or municipals. As a result non-federal level governments will have to cut their deficits the old fashioned way by decreasing spending and increasing their revenue through budget cuts and taxes respectively. There is the chance that some will go bankrupt, but I do not believe that the problem will be as wide spread as many are predicting. States and municipalities will get their budgets back in line, albeit with a good amount of pain, and as we have seen plenty lately, refinancing the debt is possible and at reasonable rates.

These federal, state, and municipal issues will mean that throughout the year more research will have to be done for your fixed income investments. We will continue to keep an eye on the state and municipal levels to monitor the risks and plan accordingly.

Europe
News out of Europe has played a major factor in economic and market movements of late, and I believe that with some decisions that must be made we might see that role diminish. The critical decision point for Europe that I believe must be made within the upcoming year must be made by the European Central Bank (ECB). They are currently faced with a situation where a relatively small portion of European Union (EU) countries (i.e., Germany) are prospering due to their well established economies and manageable debt levels while the rest of the EU (i.e., Spain, Portugal, Greece, etc.) are experiencing high levels of debt and unemployment because of excess spending and the inability to export their way out of their problems due to the relatively high currency value. This situation will force the ECB to make one of two decisions:

1 – Maintain a strong currency and high interest rate thus keeping inflation stable in Germany and helping Germany attract new investment. For the southern European economies, this will result in increased competition with different export dependent countries with lower valued currencies and possible deflation resulting in a much slower recovery rate from their current recessionary states.

2 – The ECB will provide some form of stimulus by increasing the money supply and/or lowering interest rates. This will weaken the euro and cause Southern European goods to become more competitive in the export market. It will cause high inflation levels in Germany and the country will begin to shift from an exporting/saver model to an importer/borrower model.

I believe the ECB will eventually change to following a policy that is catered to the larger number of member states thereby following the second option, but no one should discount the power of Germany’s position.

So, what do you think? What are your thoughts on these four areas and is there some other critical area we should be watching for the year?

"Higher" Education

I thought this recent study was interesting. If it is true (I haven't read the actual study, just this article about it), then we need to stop focusing so much on cranking out more college grads and focus on how we can increase the quality of education being provided. I would say that a big part has to do with the students not really going to learn, but to complete the next requirement, so I'm not sure how much the government can do for it, but obviously something has to change.

http://www.cnbc.com/id/41139685

China

I have been reading as much as I can lately about China. I don't think I have a full grasp of it yet so there will probably be a better post later, but I came across this article and wanted to share and get some opinions.

Personally I don't think China can keep playing its game for too much longer because it has already started to hurt its own citizens enough to cause rumblings (it's hard to find evidence of these rumblings but they are there).

Anyway, here is the article: http://www.cnbc.com/id/41134710

"It's Not As Bad As You Think"

I have to say that I really like Brian Wesbury. He is labeled as a perma-bull and I don't think he would have a problem with that in that long-term he believes in the US economy. Oddly enough however, one of the times he was named the top economist for the year it was back in 2000 and he was one of the few who was calling for a bear market. I think that too many out there are pessimistic in regards to our country's future. I think we can partly thank our politicians and media for that attitude because all of them have been saying that things are horrible and the world will end because the "other" party is in power and if you would just elect them they would be able to work on fixing the mess. Personally I think we should all take a step back, look at history, and start believing in what Americans are capable of accomplishing.

I love this video that he posted to their blog, which brings me to the other reason why I like Wesbury. He is with an independent firm and they say what they think without a care to who they might offend; unlike some of the other asset managers out there.

http://www.ftportfolios.com/retail/blogs/Economics/index.aspx

I would suggest that after watching the video you take a look at the pictures below it. Too funny!