12 Aug 2011 The Rollercoaster of Uncertainty

Since the slide in equity prices that began July 22^nd, US stocks have lost some $2.8 trillion dollars in value and roughly $4 trillion worldwide. Following yesterday’s rally, the MSCI Total US Market Index is down 13.5% and the blue chip Down Jones index is down 12.1%. Investors slugged it out this week as news gyrated on earnings, interest rates from the Fed, jobs data, and European bond woes. The Dow experienced an unprecedented four-day ride points-wise; down 634, up 429, down 519, and up 423. 

Monday’s woes were focused on European debt woes; specifically Spain and Italy. The ECB bought bonds of these countries for the first time since creating its debt-purchase program 15 months ago according to the WSJ. Italy’s 10-year bond yield fell to around 5.3% from just over 6%. Spain’s fell even further, to 5.15%. But the news did little to slow the declines of stock in Europe and around the globe. According to the WSJ, “Italy and Spain, the region’s third- and fourth-largest economies, have a combined gross domestic product of nearly €2.7 trillion, almost 30% of the euro zone total. Royal Bank of Scotland economists estimate the ECB and Europe’s bailout fund will eventually have to own €850 billion of Spanish and Italian bonds to safeguard those countries.” Estimates are that they bought somewhere between €3.5 billion to €5 billion ($5 to $7.14 billion), a mere drop in the bucket, but enough so far to stem the tide.

The Fed was center stage on Tuesday as they replaced their customary timeframe for maintaining interest rates at near zero from an “extended period” to a crystal clear two more years, through mid-2013. Their use of the word “anticipates,” makes the statement less than a pledge, but it is the first time in recent history the Fed has come right out and given a specific time period. They referenced deterioration in labor market conditions and noted that temporary factors (Japan and weather) appear to account for only some of the recent weakness in economic activity. Three of the twelve governors dissented on the new language as they fear inflation. The markets initially reacted negatively to the Fed’s deteriorating view of the economy but turned 616 points to finish up 429 for the day.

Europe was back under the lights on Wednesday as investors worried that the ECB might be unable to contain its debt crisis and that the economy was faltering. Investors were also worried that Europe’s financial problems would spill into the US. All 10 groups of the S&P 500 Index fell at least 2%. Bank of America and Citigroup each dropped more than 10% as the costs to protect the government debt of Greece, Italy, Spain and France rose. The S&P 500 fell 4.4% percent to close at 1,120.76 and the Dow declined 519.83 points.

Yesterday in rhythmic fashion, the Dow surged 423 points on news of an unexpected drop in jobless claims and better-than-expected corporate earnings gave a glimmer of hope that the economy isn’t slowing as fast as earlier feared on the US debt downgrade and as Europe’s debt crisis widens.

It was also announced yesterday that more executives at S&P 500 companies are buying their stock than any time since the depths of the credit crisis in 2009 after valuations plunged 25% below their five-decade average. Some 66% of insiders at 50 companies bought shares between Aug. 3 and Aug. 9, the most since the five days ended March 9, 2009, when the S&P 500 reached a 12- year low, according to data compiled by Bloomberg.

With the meteoric fall in US Treasury rates these last few days, mortgage rates have benefitted as well. The Wall Street Journal reports that the 30-year fixed-rate mortgage averaged 4.32% for the week ended Thursday is down from 4.39% the previous week and last year’s rate of 4.44%. Rates on 15-year fixed-rate mortgages averaged 3.5%, which is down from last week’s 3.54% and last year’s 3.92%. Five-year Treasury-indexed hybrid adjustable-rate mortgages averaged 3.13%, are down from 3.18% last week and 3.56% a year ago. One-year Treasury-indexed ARM rates averaged 2.89%, are down from 3.02% in the prior week and 3.53% in the prior year.

Is this another 2008?

There were numerous headlines and references this week suggesting the possibility that we might be on the precipice of another 2008. They suggested that the circumstances were eerily similar. Francesco Guerrera of the WSJ made some excellent observations of why this time is significantly different from the 2008 financial crisis that resulted in and from the collapse of Lehman Brothers.

Guerrera says there are three fundamental differences between the financial crisis of three years ago and today.

1. “The older  one spread from the bottom up. It began among over-optimistic home buyers,  rose through the Wall Street securitization machine, with more than a little help from credit-rating firms, and ended up infecting the global      economy. It was the financial sector’s breakdown that caused the recession. The current predicament, by contrast, is a top-down affair. Governments around the world, unable to stimulate their economies and get their houses in order, have gradually lost the trust of the business and financial communities. That, in turn, has caused a sharp reduction in private sector spending and investing, causing a vicious circle that leads to high unemployment and sluggish growth. Markets and banks, in this case, are victims, not perpetrators.”
2. “Financial  companies and households had feasted on cheap credit in the run-up to  2007-2008. When the bubble burst, the resulting crash diet of deleveraging      caused a massive recessionary shock.This time around, the problem is the opposite. The economic doldrums are prompting companies and individuals to stash their cash away and steer clear of debt, resulting in anemic consumption and investment growth.”
3. “The  final distinction is a direct consequence of the first two. Given its genesis, the 2008 financial catastrophe had a simple, if painful, solution: Governments had to step in to provide liquidity in droves  through low interest rates, bank bailouts and injections of cash into the  economy. The policy didn’t come cheap as governments world-wide poured around $1 trillion into the system. Nor was it fair to the tax-paying citizens who had to pick up the tab for other people’s sins. But it  eventually succeeded in avoiding a global Depression.   Today, such a response isn’t on the menu. The present strains aren’t caused by a lack of liquidity—U.S. companies, for one, are sitting on record cash piles—or too much leverage. Both corporate and personal balance sheets are no longer bloated with debt. The real issue is a chronic lack of confidence by financial actors in one another and their governments’ ability to kick-start economic growth. The peculiar nature of this crisis means that reaching for the weapons used in the last one just won’t work. Even if the central banks were inclined that way, pumping more money into an economy already flush with cash would provide little solace.”

The conclusion is that more money pumped into an economy already awash in too much cash is not going to induce businesses to invest or hire or investors to invest. Short term stimulus measures such as temporary tax breaks and intra-mediate term infrastructure projects have failed to start the engine.

Uncertainty

The issue facing the country at this crucial point is summed up in one word UNCERTAINTY.  Mr. Guerrera hit the nail on the head when he said, “The real issue is a chronic lack of confidence by financial actors in one another and their governments’ ability to kick-start economic growth.”

The upcoming battle of Congress’s ‘Super Committee’ promises to pit Keynesian’s social liberalism (big government) against Milton Friedman’s free market economics. But with a wobbling economy suffering unemployment of 9.1% and confidence dropping, the debate is anything but hypothetical.

Keynesian policies of huge government spending to start the economy simply have not worked. While the government injections of TARP were necessary to avert a complete financial meltdown in 2009, the stimulus measures that followed have been ineffective, expensive, and hugely additive to the national debt. Piling more people into the wagon and forcing fewer to pull it simply is not a recipe for success.

The fiercest arguments will be the right ones; entitlements and taxes. We all hope that that some meaningful reform emerges in both areas, but it is absolutely clear from Republicans that nothing resembling tax increases will be acceptable in the House and perhaps the Senate. Believe it or not, this is less about politics and more about sound commonsense economics than ever.

Higher taxes slow investment and hiring – period. That’s not what you want to do in a recession or near recession. Frequently cited are the examples of tax increases resulting in economic growth during Reagan’s and Clinton’s presidencies. What is not mentioned is that the economies in both circumstances were coiled springs ready to explode and tax increases were certainly not the trigger. Clinton benefitted hugely by his Vice President’s invention of the Internet.

Under President Regan the American economy went from a GDP growth of -0.3% in 1980 to 4.1% in 1988. Unemployment fell from 7.1% in 1980 to 5.5% in 1988. Oil prices per barrel dropped from $60 to $20, stagflation was ended by Fed chair Paul Volker, regulations were reduced, and America’s confidence skyrocketed. These are not the things of tax increase.

According to Wikipedia, “With the Tax Reform Act of 1986, Reagan and Congress sought to broaden the tax base, eliminate many deductions, and reduce rates. In 1983, Democrats Bill Bradley and Dick Gephardt had offered a proposal to clean up/broaden the tax base; in 1984 Reagan had the Treasury Department produce its own plan. The eventual bipartisan 1986 act aimed to be revenue-neutral: while it reduced the top marginal rate, it also partially “cleaned up” the tax base by curbing tax loopholes, preferences, and exceptions, thus raising the effective tax on activities previously specially favored by the code.”

The ‘Super Committee’ would do well to read some history, particularly those of bi-partisan success stories of Regan and other. What would really be nice is if they would take an honest look at what happens to US economies when taxes and regulations are cut. The remedies are not complicated, but they require more political sacrifice of one party than the other. Will it happen? It has before.

Have a nice weekend.