The Weight of the Global Economy

November 3rd, 2012
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If the $400 billion in tax increases and $200 billion in spending cuts are allowed to hit the economy as projected, the U.S. economy will tip into recession as roughly 4% is shaved off GDP in 2013. The fiscal cliff is real. However, the more important issue is the $65 trillion of unfunded liabilities we are indebted to pay in coming decades. The fiscal cliff is $600 billion, but the fiscal grand canyon is 100 times larger and the main event. The fiscal challenge confronting us is far more a long-term issue than a short-term problem requiring a quick fix in January 2013. If Congress focuses simply on the fiscal cliff next year, it is more likely to agree on a partial solution that minimizes the fiscal cliff, but completely ignores the fiscal grand canyon. 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 dealing with it.

We expect Congress to reduce the 4% hit to GDP from the fiscal cliff, by allowing only 25 to 40% of the tax increases and spending cuts to take effect in 2013. This would minimize the immediate negative impact on the economy, while buying Congress time to address the remaining portion of the fiscal cliff.  As discussed in the September Macro Strategy Review, a six-year plan that realigns spending and tax receipts to their long-term averages of 19.5% and 18.0% of GDP would allow the economy to grow while addressing the short-term fiscal cliff issue. This approach could lower our budget deficit from -7 to -2% gradually, thus smoothing out the fiscal drag over time.

The European Union pushed Greece, Portugal and Spain to lower their budget deficits to less than 3% too quickly, and while in recession.  This has made it more difficult for each country to narrow their deficits, since a weak economy fails to generate the necessary tax receipts. Congress can minimize the economic damage, if they adopt a disciplined plan that gradually lowers the budget deficit over a period of years. And, the plan must be structured so Congress has no wiggle room to fall off the fiscal wagon in the future.

In 1999, there was consternation about Y2K, which was based on computer clocks handling the change from the 20th to the 21st century on December 31, 1999.  Needless to say, all the hand wringing and talk show discussions wound up being much ado about nothing. The looming fiscal cliff bears some similarity since it is an event that will occur at a specific time in the future.  Most of the discussion centers on how bad it could be, which is understandable. However, as inveterate contrarians, concern about the fiscal cliff could provide the set up for a nice rally.  The timing will be dictated by Congress. While the negative potential is certainly real, the odds do favor a congressional deal that minimizes the impact.

We would be surprised if a compromise is reached before January 1, but a “lame duck” Congress could provide political cover for the newly elected by voting to delay the implementation of the tax and spending cuts. Prior to any deal, there will be a fair amount of posturing by both parties, as they try to make the opposition look bad. Investors will be hanging on every rumor, so volatility will perk up until a deal is struck at midnight, just before some deadline.

If a deal minimizing the damage is attained, the stock market would likely rally on the belief the worst had been averted. While a compromise on a part of the fiscal cliff may provide a satisfying short-term solution, it will do very little to address the much larger fiscal grand canyon.

The chart below shows the allocation of expenses, from last year’s budget, and each category’s trajectory over the past 50 years.  Defense spending has fallen from representing almost 50% of the 1962 budget to less than 20% in 2011.  Entitlement spending, which includes Social Security, Medicare and safety net programs has climbed from 25% of the budget, to almost 60% last year.  Of that total, 20% went to Social Security and 21% was spent by Medicare, Medicaid and the Children’s Health Insurance Program (CHIP).  Another 13% of the budget was spent on earned income and child tax credits, Supplemental Security Income for the elderly and disabled, unemployment insurance, food stamps, school meals, low-income housing assistance, child care assistance and various other programs. Benefits for federal retirees and veterans totaled 7% of budget outlays last year.

Each of these programs is a compassionate response to help fellow Americans. Unfortunately, projections suggest that as a nation we will not have enough money to meet the future obligations of these worthy programs. The longer Congress delays in addressing the growth in entitlement spending, this fiscal problem will only become larger and more difficult to manage.

Between 1983 and 1998, interest expense consumed around 15% of the annual budget. At the end of 1982, federal debt totaled $1.195 trillion, but the average interest rate on the debt was 10.72%. At the end of September 2012, total federal debt was $16 trillion, but the average interest rate was just 2.59%.   The risk going forward is any increase in interest rates will cause interest expenses to claim a larger portion of the budget. The payment of interest on outstanding debt is mandatory, so the money to pay for higher interest expense will have to come from all the other programs.

Should Treasury yields begin to rise meaningfully from current levels, we have no doubt the Federal Reserve would consider increasing the size of its QE3 purchases from $40 billion per month, and expand it to include Treasury notes and bonds.  A significant rise in interest rates would send us down the path taken by Greece. Needless to say, if the Federal Reserve is unable to curb a meaningful rise in Treasury yields, the budget deficit will soar to unsustainable levels, again.

The financial obligation ratio is an estimate of the ratio of total debt payments to disposable income, as calculated by the Federal Reserve. Since peaking at 17.63% in the third quarter of 2007, it has fallen to 13.97% as of June 30, 2012, an improvement of 20%.

Half of the improvement has come from defaults and the balance from lower interest rates. This means the average household has more disposable income, which has helped lower household debt as a percent of GDP from 98% in 2007 to 82% in 2012. This is constructive, but it will likely have to fall closer to 60% before the household balance sheet is strong enough to support the next long-term economic expansion.

Even if Congress lowers the impact of the fiscal cliff from 4% to just 1%, as we expect, it will still dampen GDP growth in 2013.  Eventually, Congress will have to deal with the balance of the fiscal cliff, probably in 2013. Households will continue to lower their overall debt burdens and save more in 2013.  These two factors are likely to keep GDP growth under 2%, even if there are no unexpected shocks. If this proves close to the mark, the Federal Reserve will continue with QE3, since unemployment is not likely to decline significantly if GDP grows just 2%.

However, as we noted in our August commentary, QE3 is also targeting the stock market, in hopes those with oodles of discretionary income will keep spending. While money managers and investors might like the positive effects quantitative easing has had on the U.S. stock market, there is a risk that the stock market could become disconnected from the real economy, and that rarely ends well.  The Shiller Price/Earnings Ratio uses trailing 10-year earnings, rather than current estimates for earnings as most analysts do.  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 above 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 50% 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 0.70 since 1900, and as of June 30, 2012 was at 1.10, or 44% above its historical mean. These measures of valuation suggest the stock market has been buoyed by the Federal Reserve’s quantitative easing programs and is not ‘cheap’. Since QE is also being used in Europe, Japan and Great Britain, this could become a global risk for equities. In the September commentary, we wrote,

“If central bank programs fail to engender sustainable economic expansions in the U.S., Europe, Britain and Japan by mid-2013, then equity markets are mispriced and  potentially very vulnerable.

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