Volume 58, Number 10 | March 11, 2011
In a week filled with crisis, the one conclusion that resonates most clearly is that the US is going to find it more difficult to finance its enormous deficit as our prime lenders all now appear to have a greater need for their own resources at home. The Federal Reserve is currently the largest holder of Treasury securities and they are scheduled to stop buying in July. The Chinese are now running a trade deficit as of January and February as they try and buy the raw materials needed to cool their domestic inflation. The Japanese have as yet undetermined calls on their foreign capital to rebuild after the worst disaster to hit that nation since the war. The Northern European savers are now committed to an even larger bailout package for Southern Europe – and the Irish question remains open. Finally, the Saudis and other petro-dollar nations of the Middle East are facing dissent at home that requires more domestic spending, as reflected in the Saudis promise of $36 billion in new programs just this week. With virtually all the deep pools of money from abroad shifting back home, it seems likely that US interest rates – especially at the long end — will rise to entice domestic funds currently parked primarily in corporate short term deposits to fund the government deficit. Bottom line, the shift of funds as the result of these crises would appear to benefit those countries, goods, and services that will now see improved fund flows and hurt those areas that will lose access to that cash. As most of the new uses are outside the US, that seems likely to make an already tough situation for US debtors and domestic debt financed activities even tougher.
A somewhat less cogent thought that keeps rattling around in our brain is that in this world of extreme interconnectivity, it is not always the initial crisis that is the worst. In Europe, the Greek crisis may have started things, but the contagion spread to Ireland, now Portugal, and there are increasing concerns about Spanish calls on Northern European surpluses. In North Africa, Tunisia was a sideshow to the events in Egypt, which were trumped by Libya, and now concerns about Saudi Arabia. The earthquake in Japan and the associated tsunami were crisis enough for any nation, but now three power plants and at least six of the nation’s 55 nuclear reactors are in various stages of distress. In 1997, the Asian crisis started in Thailand and ended up in Russia. The popped housing bubble dragged down Bear Stearns and helped breed the Lehman crisis months later. We simply think it is impossible in this globalized world to figure out over a weekend where the consequences will be greatest. Some will try and speculate on where they biggest bounce can be gained, but human nature is such that most will practice increased caution. Few people run into a dark room. Uncertainty creates caution, and caution is the enemy of growth. The US recovery was barely limping along before this week’s events, we are more concerned now than before about the durability of this expansion.
With so many foreign crises underway in the week, we were nearly distracted from the domestic conflict between those who want immediate reductions in government spending and those who remain opposed. The maneuvering in Wisconsin indicates that compromise is not high on the agenda for either side in the current state legislative battles. Nor does it appear likely in Washington where the need for continuing resolutions, raising the debt ceiling, and ultimately dealing with the extension – or not – of the Bush tax cuts are designed to bring conflict to a head in a pre-election year. Many of those at the opposite ends of the political spectrum exude confidence that their position is right and will prevail. At a macro level it is hard to see how such strong conflict will not result in someone being a sore loser. Again, history suggests that in such situations the loser feels the pain far more than the victor celebrates. Reagan’s greatest skill was to compromise at the last minute and make the opposition feel that they had a stake in the resolution and so to work for it even though they had started out adamantly opposed. We do not see Reaganesque grace in the most recent government battle within Washington and without. (Well, maybe in Europe.)
Limping through the First Quarter
After disappointing 2.8% real GDP growth — and even more disappointing 3.2% nominal GDP growth — in the fourth quarter of 2010, we do not see any acceleration in early 2011. We currently estimate first quarter real GDP growth at less than 3%, and do not see the GDP deflator breaking 1%, so again less than 4% nominal growth at an annual rate. This leaves little income growth to pay down debt even at these interest rates, never mind if they were higher.
The most optimistic reading during the week was the 1.0% rise in retail sales for the month of February, with a sizable upward revision to 0.7% (from 0.3%) for January. Unfortunately, much of the strength was again in the auto sector, where a wave of incentives helped pop unit sales up to a 13.3 million unit rate for the short month – a level which matches the industry’s outlook for 2011, suggesting limited upside without even more incentives. Meanwhile, core retail sales (excluding autos, gasoline, and building materials) was up 0.7%, after a 0.6% gain in January — but a -0.1% decline in December. The three month average compared to the previous three months was up at a 4.5% annual rate, matching the growth rate over the previous six months. Bottom line, other than autos, which are apparently being lifted by incentives and the 100% expensing rule (many small business car purchases appear in retail sales,) retail is holding its own but not improving. Growth in retail sales is stronger than in services as price pressures are greater in this area and the rebound from last year’s depressed levels is greater as well. Thus, total consumer activity is rising less quickly than retail sales, in line with the less than 4% nominal growth rate for total GDP.
A batch of other data added to the caution injected by the worldwide crises. The National Federation of Independent Businesses’ index rose modestly to 94.5, with better indicators on hiring but with little appetite for capital spending. The NFIB’s own website called this “not the hoped-for surge that would signal a shift into second gear for economic growth”. Talk about damning with faint praise. Other employment signals were also less optimistic as initial claims rose to 397,000 from last week’s upwardly revised 371,000. Improvement continues, but not at a faster pace than over the past six months suggesting stability, not acceleration, in the current economic situation. Meanwhile, the JOLTS (Jobs Opening and Labor Turnover) data saw a sharp decline in job openings in January, though this may have been impacted by weather like the payroll data. Finally, the University of Michigan consumer confidence index for March fell sharply to 68.2 from 77.5 in February, as soaring gasoline prices pushed inflation expectations higher and cut into consumers’ view of their current situation.
We continue to see a wide chasm between the way Wall Street sees the US economy and the way small businesses, consumers and government see the situation. While Wall Street may take heart in the strength of the equities market in the face of this week’s crises, the consumer is unlikely to be buoyed with oil still at $100 a barrel and fresh uncertainty about supply from Saudi Arabia and potentially larger demand from Japan. With the extreme volatility of the past few days working through the financial markets in coming weeks, we do not doubt that there will be a plethora of big winners in the midst of the mayhem. However, we expect that the rest of the world’s focus on their domestic issues will grow, as will the local use of their funds, leaving the burden of deleveraging on those still most in debt. Southern Europe may have a short term solution, but the US does not – advantage Euro, with the deleveraging ball squarely back in the US court. With the US corporate sector now the lender of last resort, we feel the most likely result is a higher bar for domestic investment and hiring — slowing an already suspect expansion.
Whether the rest of the world’s crises are enough to force the US to face up to its own significant imbalances is the key to continued moderate expansion versus potential slowdown to recession. Crisis has a way of focusing the mind on previously unpalatable solutions. We had expected that crisis scenario might develop next year as the result of a weakening economy in an election year. Maybe a scare over there will advance that time table allowing us to commit to addressing our problems while we still have some economic momentum. We suspect the key variable to watch is whether US long rates rise, threatening housing and banking again, or if slowing world growth gives the US breathing space – and whether we squander that opportunity again or not.