Macro Strategy Review September 2012

by Jim Welsh, Macro Strategy Team, Forward Markets

In recent weeks, the European Central Bank (ECB), Federal Reserve and Bank of Japan have announced plans to expand their balance sheets through purchases of debt in various markets. Each central bank is fighting the same war with a shared goal: strengthening economic growth to prevent a deep global slowdown/recession that could lead to a debt-deflationary spiral.

History suggests that post-credit bubble battles with deflation are especially daunting, with deflation dominating. Since 2010, coordinated responses by central banks whenever deflation has appeared to be gaining traction, has resulted in an ebb and flow in the financial markets, which we expect to continue.

However, if central bank programs fail to engender sustainable economic expansions in the U.S., Europe, Britain and Japan by mid-2013, then equity markets will be mispriced and potentially very vulnerable. With global growth slowing, any rise in protectionism, either in the form of currency devaluation, tariffs on imports or trade barriers, would only serve to slow global growth further. We expect protectionism to increase during the next two years.

Fiscal Cliff or Fiscal Grand Canyon?

Much attention has been focused on the looming tax increases and federal spending cuts that are due to hit next January. Estimates vary on the total impact on GDP. But a range of 3.5 to 4.6% seems reasonable. In the second quarter, GDP grew 1.7%, so the full impact of the tax increases and spending cuts would likely cause the U.S. economy to flirt with recession in 2013.

According to the Congressional Budget Office (CBO), if all the tax increases and spending cuts go through, GDP could contract by 1.3% in the first half of next year, with growth of 2.3% in the second half. For all of 2013, GDP would grow 0.5%. Based on their mid-point assessment, the CBO estimates 2 million jobs would be lost in 2013, and the unemployment rate would climb to 9.1% by year-end. As we will later discuss in more detail, we think the CBO’s analysis played a significant role in the Federal Reserve’s decision to launch the third round of quantitative easing (QE3) now, specifically targeting unemployment, and to continue QE3 until the desired improvement in the labor market is achieved. Underlying the Fed’s decision is that the contraction in fiscal policy will be a drag on GDP in 2013.

However, the unknown is how much of a drag, which has only increased the level of uncertainty. That in itself is an impediment to economic growth.

The odds of the entire enchilada being allowed to take hold are extremely low. That isn’t as bold of a statement as it may sound. After all, we are dealing with Congress, and Congress has rarely confronted a tough decision it didn’t decide to postpone or only partially address. However, the issue of government promises that cannot possibly be fully funded is the elephant in the Capitol that neither party can ignore any longer. This issue will dominate political discussion for the next three to five years at a minimum. And, ultimately, how we as a nation choose to close the gap between funding and promises made will reflect our true character.

Between 1947 and 2011, Federal government spending averaged 19.05% of GDP, while tax receipts averaged 18.26%. Our economy experienced significant changes during this 64-year period. Both inflation and interest rates soared from low levels in the early 1950s, to coincident peaks in 1981, only to fall again. There were 10 recessions, ranging from shallow and short to pronounced and extended. Politically, both parties at times controlled the White House, majorities in Congress, and briefly both the White House and Congress. The top marginal income tax rate reached a high in 1953 of 92%, and a low of 28% between 1988 and 1990. And this 64-year stretch was marked by the Korean, Vietnam, Iraq and Afghanistan wars, as well as the Cold War and extended periods of peace.

Despite all of these changes, which seem to matter so much, the level of federal spending and tax receipts remained remarkably stable, with the exception of brief fluctuations above and below the averages.  To us, this consistency over six decades amid such diverse circumstances, suggests that spending of 19.05% of GDP and tax receipts of 18.26% represent a natural equilibrium.

The enacted budget for this year calls for spending of $3.796 trillion, or 24.8% of this year’s $15.3 trillion in GDP. Tax receipts are projected at $2.469 trillion, or 16.1% of GDP. The short fall between spending and receipts is estimated at $1.327 trillion. This represents 34% of the $3.796 trillion in spending, and means we are borrowing 34% of this year’s budget. With spending near 24.8% of GDP and receipts just 16.1%, the gap is 8.7% of GDP.

Compared to the 64-year average of 0.79% (spending 19.05%, receipts 18.26%), this seems more like a “fiscal grand canyon” than a cliff. Building a bridge over our fiscal grand canyon will take years and a high degree of compromise. Unfortunately, one party refuses to consider tax increases, while the other party will not even accept a reduction in the spending growth rate.

In the 1940s we came together as a nation since we perceived the threat from Germany and Japan was real. We had a sense of urgency because we understood there was no time to waste dickering over the details. We took pride in making the necessary sacrifices, however small, while many others made the ultimate sacrifice.

There are several differences between the fiscal crisis we face today and World War II. Most Americans do not realize or accept that the fiscal grand canyon is real, and poses a serious threat to our country. As a result, our political parties believe they have all the time in the world to indulge in ideology rather than compromise. In the 1940s, the threat came from outside our borders, so it was far easier to unify the nation. No one outside our borders created the fiscal grand canyon. We did this to ourselves incrementally over a period of decades. It takes humility to accept responsibility for our mistakes, and wisdom to resist the temptation to point fingers at others. The best news is since we created the fiscal grand canyon, we can fix it. All we have to do is build a bridge based on compromise, common sense and determination.

We put a man on the moon in less than nine years, so we can get our economy back into balance within 10 years if the plan is based on common sense and we are determined. One of the mistakes Europe has made is forcing countries to slash government spending while a country is in recession. The Europeans (Germans) have a staunch belief that getting a country’s budget down to 3% of GDP as fast as possible is some sort of panacea, or retribution on the spendthrifts in the EU. Under the current circumstances, it’s a financial form of bloodletting, which is why Greece and Spain continue to weaken.

Our economy is recovering from a credit bubble that took 30 years to create, and it will take time for all the imbalances to be righted, whether we like it or not. The plan must be gradual so the adjustments, some combination of tax increases and slowing down the growth rate of government spending, are spread out over the next six years. The goal is that within six years, government spending will be down to 19.05% of GDP, and receipts up to at least 18.26%, their long-term averages. With tax receipts currently at 16.1% of GDP and spending near 24.8% of GDP, we have two problems, so we need two solutions.