Volume 61, Number 10
As we look into our admittedly murky crystal ball for 2012, we are troubled by the fact that many of the key imbalances that hampered growth in 2011 remain at the start of 2012. Perhaps we should not find this surprising, as we appear to be in a long grinding workout after a severe financial collapse as detailed in Reinhart & Rogoff’s, This Time Is Different. Bottom line, we expect growth to continue to muddle through at 2-2.5% real GDP growth with nominal growth at 4%. This leaves the economy teetering on the edge of stall speed – so our perception of risk is still to the downside. The US economy remains vulnerable to external shocks like the Japanese earthquake and tsunami on March 11, 2011. For 2012, the most obvious risk is from a developing European recession of unknown severity as austerity is imposed as the solution to their imbalances. The contagion of this misdirected policy via instability in the European banking system and a slowdown in the emerging markets is already affecting the US economy. Still, in 2012 – as in 2011 – it is a failure of domestic policy to address our own imbalances that holds the greatest risk to the US economy.
Zombie Banks and Fortress Businesses
In our view, the two biggest threats to the US economy remain banks that will not lend and businesses that will not spend on either capital equipment or hiring. The federal government has no policy levers left to pull with deficits already exploded, interest rates at record lows, and now the dollar strengthening as Europe’s problems are bigger than our own. We do not believe another round of quantitative easing is likely unless the US situation gets much worse first. Moreover, as continental Europe and the UK are both likely to be pulling that lever in 2012, QE in the US will not weaken the dollar as it did in the first round. While markets worry about the Fed inflating its way out of this crisis, it still takes bank lending to translate an expanded balance sheet into economic activity and banks won’t lend as long as their collateral base is shrinking – and demands for additional capital are increasing. The central bank could directly fund the government, which would use expanded deficits to generate economic activity – but that solution seems more likely in Europe at this point than in the US. Bottom line, it looks like stronger US economic growth in 2012 will depend primarily on improved lender and CEO sentiment and we do not yet see the political environment for that change.
We remain extremely bearish on the outlook for the housing industry and home prices in the US. We are not particularly concerned with housing as a driver of economic growth, given that the value of new construction has shrunk to less than 0.8% of GDP. The boom in multifamily construction now underway may double, or even triple, that sector’s contribution to GDP over the next two years. However, that would add only 0.1% to GDP each year as the total value of multifamily construction in 2011 was just $15 billion. It is the addition of over 650,000 new housing starts (450,000 single family and now 200,000 multifamily) over the next year to an already overstocked inventory that risks further significant declines in existing home prices. In 2011, home prices fell roughly 4% depending on the index chosen as newly completed units swamped growth in demand. There is simply no indication that household formation is recovering at anywhere near the rate needed to absorb even the current meager offerings from the housing industry. Hope springs eternal among those hawking homebuilder stocks and multi-family investments – and given real estate is always local some projects may well flourish. However, at a macroeconomic level, the main consequence of a revival in homebuilding (no matter what kind of units) is even greater risk of declining home values, which undermine both consumer confidence and the collateral value of the US banking system.
Unfortunately, both demographics and economic growth suggest that there will be little household formation over the next decade. Population growth for those between 18-64 is slowing to just 0.6% a year – but more critically, the growth in the 18-24 year old group most likely to form new households will rise just 0.1% a year for the next five years and then begin to decline. Meanwhile, the ability of these new potential households to gain employment in order to be able to afford even rental units is likely to be challenged as well. Youth unemployment levels are twice their normal high levels and colleges report the toughest job markets ever for new graduates. True, there may be some pent up demand for new homes due to the recession, but there is also a massive excess inventory of foreclosed and vacant homes to clear in the market. Case-Shiller shows that prices have collapsed a stunning 13% in Atlanta over the past three months as banks there have started to accelerate their resolution process. Similar risks exist in many markets where political and legal barriers to foreclosure have limited the impact so far. With mortgage rates already at record lows and affordability at all time highs, demand is still far short of supply. One can blame down payment requirements, but even in strong employment markets like Texas there is no strength in the housing demand. Consumers appear to have made a significant reevaluation of the importance of housing in their consumption and investment portfolios, and we expect an ongoing downward adjustment in the share of total income directed at this sector. That leaves the banking system at significant risk until it can adjust its capital base. We need either less houses or more new capital in the banking system — and the politicians seem determined to allow neither destruction of houses nor start ups of new banks. Protecting the status quo is extending the problem, limiting growth to a sub-potential muddle through a la Japan of the past twenty years.
The second great domestic imbalance is the huge stock of savings built up in corporate America. Ultimately, in a capitalist economy, growth is a function of CEO confidence as they hold the key to investment and hiring decisions. Keynesian deficit spending is all about limiting the hit to corporate profits in a downturn by sustaining income to consumers who have become laid off employees. The expansion of the government deficit via increased transfers allows businesses to rebuild their savings, with additional boost coming from business tax cuts and subsidies. Bottom line, profits explode at the start of the cycle as businesses cut costs but transfers maintain revenues. The critical phase comes when businesses translate fatter profit margins and reestablished savings into investment and hiring decisions. Increased investment is the key as it raises the income of workers (even as transfers retreat) without increasing the supply of new goods and services yet. Thus, one firm’s risk-taking enhances profit margins for others, who then invest themselves – and the expansion takes off. Unfortunately, in this cycle, huge government deficits have rebuilt record savings on corporate balance sheets, but businesses remain uninterested in increased investment.
We believe the key to this fortress mentality results from the lack of either carrot or stick. On the carrot side, investment returns are extraordinarily low. In our debt drenched economy we have learned to think of lower interest rates as a driver of economic growth, when in fact it is a decline in borrowing costs relative to investment returns that traditionally widened arbitrage returns and spurred growth. Now, borrowing costs are low because the return on investments one might use other people’s money for are also low. Low returns are the economy’s way of discouraging investment and enhancing consumption to clear excess supply. Politicians don’t get this and continue to offer enhancements like 100% expensing to increase investment – and jobs (votes). Meanwhile, businesses are responding to economic signals by cutting back to their most productive core and focusing on their most profitable existing opportunities. That is they are squeezing the most out of their existing assets rather than adding to the pie. On the stick side, the lack of funding for new competitors has reduced the power of Schumpeterian creative destruction.
Bottom line, already profitable enterprises are more interested in remaining wealthy than in building new wealth. History tells us that this strategy of maintaining the status quo — almost always associated with slow growth – is the norm. It is periods of strong investment, like over the past 200 years, that are the anomaly – and it is the development of efficient financial markets which move money from those that have it to those that have fresh ideas that is the game changer. As Reinhart and Rogoff conclude, even modest financial market problems lead to long grinding recoveries. We are in a once in a lifetime collapse in confidence in financial markets across the developed world.
Adding to the malaise in corporate leadership is the significant uncertainty created by the split in party politics during an election year. A significant part of US business, including medical care, defense, finance, housing, luxury goods retailers and those who rely on state and local government spending find themselves facing a fork in the road on potential policy direction due to the sequester, the potential end to the Bush tax cuts, Obamacare, and the possibility of one party rule. The two month extension of the payroll tax holiday provides only a temporary respite from the political infighting. Perhaps as in 2010, this election’s outcome will be clearer by mid-2012, but right now it is not. Many businesses express their concern about growth by saying they don’t see any demand – but to us that simply means that collectively corporate leaders do not yet have the confidence in policy needed to start an investment cycle that leads to self-sustaining growth.
A Plus from Less Minuses
The biggest benefit to the US economy in 2012 should come from a reduction in the drag due to the ongoing correction in state & local finances. Private sector real GDP actually grew near potential over the past four quarters, up 2.4% in the four quarters ended in September 2011. Over the first half of that period, cutbacks in state & local government spending reduced real GDP growth by 1.4%. That drag diminished to “only” 0.6% over the last two quarters. It may cease to be a drag in 2012. However, one area of concern is an unexpected decline in spending on Medicare and Medicaid transfer payments. Medicaid, which is partially state funded, has seen a 7% drop in payments since June, while Medicare payments rose just 1% over that period. It appears that state restrictions on eligibility and coverage are starting to bite hard on medical expenditures – which are counted as part of personal consumption despite the fact few consumers know what or how much they are buying. Unexpected declines in medical care service payments caused a 0.5% reduction in reported third quarter real GDP growth to a disappointing 1.8% annual rate. Estimates for the quarter had started over 3%. Currently, fourth quarter growth is estimated north of 3%, but with medical transfers still falling we wonder if further corrections may occur. Bottom line, higher taxes and lower transfers may be healing the state & local government sector – but they have reduced real disposable income growth to near zero over the past year. It is safe to say US growth is highly unlikely to reach potential unless disposable income growth rebounds to 2.5% as well.
Same Old, Same Old
It is interesting and disconcerting that we end the year 2011 almost exactly where we started. The stock market and most major currencies are virtually unchanged from a year ago – although they all spent a year of sound and fury signifying nothing. The big movement over the course of 2011 was the plunge in long term interest rates from 3.34% on the ten year note on January 3rd to a low of 1.71% on September 22nd, and closing the year at 1.91 – a slight plus for 2012. Conversely, oil prices are roughly 20% higher at year’s end than at the start of 2011, a modest negative. Fourth quarter growth looks quite robust at over 3%, but then the fourth quarter of 2010 was also initially reported at a 3.2% annual rate before revisions trimmed it to just 2.3%. The ISM manufacturing index has been improving since July, as it did in 2010, but from a level roughly 5 points lower. Unfortunately, ISM readings in the Europe and China are now flashing red meaning a US recovery must stand on its own two feet and perhaps act as a locomotive to world growth. In our view that is a tall order.
Rather, it appears the US economy will rumble along at 2-2.5% growth – basically matching potential. Expected productivity growth in the US is roughly 2.0% and work age population growth is 0.6%. Output per hour generally lags when employment initially ramps up as lower productivity workers are added back. Meanwhile, labor force growth recently has been well below the growth in work age population as participation rates fall in reaction to reduced compensation. Thus, we expect growth between 2-2.5%, which will be non-inflationary and slow to reduce the unemployment rate. A spurt north of 3% may be well received, but any strength it would add to the equity markets would be negated by a stronger dollar, higher interest rates and worst of all – a reduced incentive for politicians to act responsibly exacerbating minor battles like the extension of the payroll tax and the next round on the debt ceiling. While boring on the surface, as we saw in 2011, there is likely to be a great deal of volatility in individual financial markets as active investors respond aggressively to even modest opportunities for positive returns, given the likelihood that aggregate returns will remain low. Meanwhile, passive investors are likely to remain hunkered down accepting any positive return as a blessing and worrying more about return of assets rather than return on assets. We saw it all in 2011, and we may see it again in 2013. It is far more about politics and leadership now – both in the US and around the world – than about economics.
Dear Clients and Friends,
On February 8th, 2012, the Global Interdependence Center, in conjunction with the University of Memphis Fogelman College of Business and Economics, will present a full day conference “Food and Inflation: Truth and Consequences.” McVean Trading is proud to be a sponsor of this event, which features speakers from the Federal Reserve and industry experts from the agricultural community. The conference is followed by an open bar reception and dinner, in conjunction with the Economic Club of Memphis, featuring Dennis Gartman, editor of the Gartman Letter, as the evening’s speaker. Registration to the conference and dinner is open to the public at the Global Interdependence Center website:
A block of rooms at the conference venue, the University of Memphis Holiday Inn, are also available through the GIC website. Registration includes a one year membership in the Global Interdependence Center, which hosts a series of events in the US and abroad on topics of importance to the financial services industry. McVean Trading hopes that many of our clients and friends will take advantage of this exciting and timely opportunity to attend and debate with the experts on the key issues facing the agricultural industry and the economy today.
Looking forward to seeing you soon in our hometown,
McVean Trading & Investments, LLC