02 Dec 2011 A Silver Lining?

It’s been a busy week in the world of finance. As you have no doubt heard, no thanks is due to the Congressional ‘super-committee’ in their failure to agree on cuts to the nation’s swelling deficit. Fitch, the last of the big three credit-rating agencies lowered the US credit outlook to negative making the probability of a downgrade from AAA greater than 50%. Retailers and investors popped Champaign corks on the news of Black Friday’s $11.4 billion record sales. US unemployment fell to 8.6% on the strength of 278,000 new hires and 315,000 Americans leaving the workforce. Manufacturing, housing, and construction data show improvement while American and European political leaders do not. 

The dysfunction that pervades Congress was this week formally recognized by Fitch when the credit rating agency finally recognized that “declining confidence that timely fiscal measures necessary to place US public finances on a sustainable path will be forthcoming.” Fitch has not lowered its AAA rating on US debt, but placing them on negative credit watch suggests better than a 50% chance it will happen in the coming two years. In its own comments earlier, S&P which has already lowered its rating on US debt from AAA to AA+ said that a further downgrade was not necessary at this time because the committee’s inaction will trigger $1.2 trillion in automatic spending cuts. President Obama has promised to veto any bills from Congress that would undo the automatic cuts.

In response to the missed opportunity by the super-committee, David Riley, Fitch’s head of sovereign ratings in London, said yesterday in a telephone interview with the WSJ “the scale of any subsequent budget cuts are probably going to have to be larger than they otherwise would have been and certainly implemented in faster manner.” U.S. federal debt held by the public will exceed 90% of gross domestic product by the end of the decade, while interest on the debt will require more than 20% of tax revenue, Fitch said. Gross debt, including local and state governments, will climb to 110% of GDP during that span, a level that “would no longer be consistent with the U.S. retaining its ‘AAA’ status,” the firm said.

On Monday, Equity investors were able to turn their attention away from US and European debt crises toward the more pleasant Black Friday and Thanksgiving weekend sales records. US shoppers spent a record $52.4 billion during Thanksgiving weekend in stores and online, representing a 16% increase over last year. Consumer confidence also surged this month with improvement centered in employment. The Conference Board’s confidence measure jumped more than 15 points to 56.0 from 40.9 in October. Econoday says the November reading is the best reading since the debt-ceiling debacle and cut of the US credit rating in August.

In that consumer represent 70% of the US economy, that’s great news. But hold on a minute. Bloomberg’s Caroline Baum points out the emptiness in the hope that the consumer alone will revive our economy. She says “the wealth of nations comes not from what we spend but from what we sow: what we set aside to be invested in productive capacity.” If we don’t invest in tomorrow, there will be no money to spend tomorrow. Merriam-Webster defines consumption as “the utilization of economic goods in the satisfaction of wants … resulting chiefly in their destruction, deterioration, or transformation.” “’Destruction’ should be a tip-off that whatever it is, it isn’t wealth.” This writer thoroughly agrees.

Baum includes the Federal Reserve as complicit in the problem. By holding its benchmark interest rate so close to zero and pledging to keep it there at least through mid-2013, consumers are not getting paid to save. In fact, when inflation is factored in, they are getting a negative rate. So they spend. High real rates (interest less inflation) induce consumers to forgo current spending and save. She says that “households have been deleveraging for three years in an attempt to repair their balance sheets. Yet many economists and policy makers advocate more borrowing and spending as a cure for what ails the economy, and cheer as mall rats infest stores in the middle of the night.” She adds that “it should be obvious that the US suffers from an extreme case of short-term thinking, and it underpins decisions on everything from tax-and-spend policy to monetary policy.”

A lot of economic data was released this week and the vast majority of it was indicative of recovery, albeit modest. The number that will get the most press and make the Administration the happiest is that headline unemployment declined from 95 to 8.6%. Unfortunately, it does not indicate a robust job creating economy. Non-farm payrolls increased by 120,000 in November, 80,000 in October, 158,000 in September and 104,000 in August. The results are anemic by historical recovery standards and much of the improvement in unemployment is due to a smaller denominator; 315,000 people left the job market discouraged.

Manufacturing in the US continues relatively strong and shows signs of improving. The Chicago Purchasing Managers’ Index jumped to 62.6, far above 50 which indicates monthly growth and well above October’s 58.4. The ISM Manufacturing index also shows orders trending higher. The new orders index was up a very strong 4.3 points to 56.7 indicating strong growth in November. This index was stuck at levels slightly below 50 for several months.

The Fed’s Beige Book released this week largely confirmed the view of most economists that the economy is improving, but gradually. The report said “Overall economic activity increased at a slow to moderate pace since the previous report across all Federal Reserve Districts except St. Louis, which reported a decline in economic activity. District reports indicated that consumer spending rose modestly during the reporting period. Motor vehicle sales increased in a number of Districts, and tourism showed signs of strength. Business service activity was flat to higher since the previous report. Manufacturing activity expanded at a steady pace across most of the country. Overall bank lending increased slightly since the previous report, and home refinancing grew at a more rapid pace.”

There was some welcome improvement in the housing sector this week as well. New home sales rose a solid 1.3% in October. Price pressures continue but are less severe than prior months, according to Econoday. The median price slipped 0.5% in the month to $212,300 but the year-on-year rate turned positive, at plus 4.0% vs. a revised minus 6.5% in the prior month. Supply on the market fell slightly to 6.3 months at the current sales rate vs. September’s revised 6.4 months. The pending home index, which is a measure of contract signings for sales of existing homes, jumped 10.4% in October to 93.3. The gain points to strength in final sales of existing homes for November and December though cancellations, tied to low appraisals that keep buyers from selling their own homes and to restrictions to credit access, have been cutting into the proportion of contracts that make it to closing, says Econoday.

In Europe, political leaders, the ECB and the region’s largest banks are busy putting forth proposals aimed at saving the euro. Tony Blair said in an interview with the Wall Street Journal that the single currency project was politically driven from the beginning, but it is an economic program, and the economics of the project must catch up and meet the politics for it to survive.  A break-up of the euro in any form would be economically “devastating” for the region, Mr. Blair said. The political fallout from a break-up would be harder than the difficult politics needed to reach a deal to save the currency, he added.

Germany vehemently opposes using the European Central Bank as Europe’s lender of last resort, saying that politicians need to establish clear political rules for monetary union and robust, automatic sanctions for violators of the restrictions on debt and deficits. Ms. Merkel and Mr. Sarkozy of France have said that euro-zone countries should allow European review of national budgets, and introduce “more automatic and more severe sanctions” on budget sinners.

“There cannot be a single currency without economic convergence,” Mr. Sarkozy said in his one-hour address yesterday, “Or the euro zone will explode.”

Just as in Europe, US politicians are relying on ‘automatic’ measures to replace cohesive and responsible government which look more and more like a thing of the past. It appears now that automatic spending cuts of $1.2 trillion will go into effect because the elected government of the US cannot effectively budget in the case of Congress or execute in the case of the Administration. Not automatic are several issues the Congress must tackle by year-end. President Obama’s payroll-tax cut and unemployment benefits are both set to expire by 12/31. Additionally, payment adjustments to doctors by Medicare also expire year-end. And there’s that seemingly incessant need to fund the government, which runs out of money on December 16^th.

The economy may be getting better, but it’s becoming increasingly difficult to ignore the big gray cloud on top of the silver lining. Ms. Merkel of Germany emphases that her strategy has always been to use the crisis as an opportunity to achieve long-term change in the European Union. In Europe and in the US long-term solutions will not soon stem the crises we face, but they are vital if we are to escape the crushing weight of the gray cloud of debt. Automatic fixes will not get the job done either. As we consider our votes for Congress and President next year, we would all do well to listen for candidates who champion long-term remedies for our problems, not worthless tonics that leave nothing but the bitter aftertaste of more permanent debt.