Market Comment Q4 2009

Brave New World

How optimistic should we be for 2010? Government deficits in the U.S., Europe, and Japan will remain extremely high as percentages of GDP. Unemployment in all these countries will remain in double-digit percentages. Banking systems in all these countries will continue to labor under the weight of bad loans made during the halcyon earlier years of this decade.

Yet stock markets experienced gratifying rebounds in 2009, ending the year on high notes. Consensus forecasts call for renewed GDP growth across the board – though the gains in Japan and Europe are likely to be smaller than in the U.S. The rebound in corporate profits is exceeding expectations, and managements are forecasting further strong rebound in the new year. U.S. exports have been rising for most of 2009. Early estimates show growth in holiday retail sales of 3.6% (excluding autos and gas). The makings of economic recovery are at hand both despite and because of ongoing systemic travails.

Government actions have helped some. Will they in the future? The first Federal government actions in response to the subprime-borne financial crisis were direct interventions: the forced merger of Bear Stearns (but not Lehman Brothers!), the conservatorships of Fannie Mae and Freddie Mac, the seizure of Washington Mutual, and the injection of $85 billion into AIG – all this in hopes of improving market stability. Results were mixed: The orderly takeovers of major players in the crisis prevented market meltdown but did not restore confidence enough to re-ignite trading in the categories of derivative securities that caused the problem. Counterparty risk – the fear that a trading partner would not be able to pay up – remained high.

Next came TARP. This was originally a mechanism through which the Treasury would buy toxic mortgage assets from banks to clear their balance sheets of the debris. If these assets no longer infected banks, then counterparty risk would presumably shrink, and markets would heal themselves. Sorting out how to price these troubled assets proved to be too difficult, however, and the program soon evolved into the Capital Purchase Program through which Treasury bought preferred stock in banks in order to shore up their capital. This program extended beyond the too-big-to-fail group of banks that were the locus of the crisis. Banks across the country were offered the opportunity to accept Federal investment, and many did. The new preferred shares carried a dividend rate of 5%. Banks that were not troubled at all could often view that rate as a reasonable funding source if their local markets offered attractive lending opportunities.

Completely outside the original intent, this program was extended beyond traditional banks to include AIG, other insurance companies, and entities such as American Express. Even the auto companies received investment through this program. Of the $205 billion paid out to financial institutions through December 9,2009, only $147 billion went to entities whose demise might have had noteworthy reverberations in the economy at large. Much of the rest went to smaller banks whose health matters only to their local communities, not the financial system. For example, $1.8 million went to Monadnock Bancorp in Peterborough, New Hampshire, and $1.5 million went to Saigon Bank in Westminster, California.

How’s it going? The original authorization for TARP was $700 billion. As of September 30, Treasury has announced commitments for $637 billion but only $454 billion has been expended. At that date there had been $72 billion in repayments so that $318 billion, or 45% was still available for distribution.

The purpose of investing in banks was to improve their capital positions so that their balance sheets would continue to pass regulatory muster and they could comfortably extend additional credit to worthy borrowers. That last part has not worked very well. Commercial loans through domestic banks have declined in three of the past four quarters.

The American Recovery and Reinvestment Act of 2009. The next chapter was a fiscal policy response to the deepening recession. A total of $787 billion was appropriated for ‘shovel ready’ projects around the country. Through December 11, 2009, $245 billion, 31% of the authorization, had been put to work.

And on and on. Myriad other programs were initiated over 2008-09 to shore up the financial system and to promote the return of economic growth. Tax credits to first time homebuyers and cash for clunkers are the most visible to consumers. The biggest program was actually TALF, a loan program managed by the New York Fed aimed at providing liquidity through loans against troubled assets. A number of schemes involved extending guarantees on borrowings by financial entities and on liabilities assumed in mergers. A program guaranteeing the value of money market fund holdings has been closed at a profit to the Treasury from insurance premiums paid. This program did prevent massive money market fund withdrawals.

Why recite all this? Government support did stave off even worse financial and economic problems than we have suffered. The difficult part for governments lies in knowing when to declare victory and retreat from the extraordinary spending. The worst is behind us. The renewed growth in GDP brings with it a number of welcome statistics: Sales of existing homes have increased in nine of 2009’s first eleven months, rising more than 7% in November to a level 44% above November a year ago. The decline in home prices has improved affordability and enticed buyers. U.S. exports have risen for most of the year, and the trade deficit is scarcely half its level a year ago. While auto sales for the year as a whole are disastrously below their earlier levels, there have been upticks in both October and November. Improvement in auto sales led total retail sales to positive comparisons through November.

Certainly there are parts of the economy that are still worsening. Defaults on commercial real estate borrowings continue to worsen, causing further trouble for banks. There is a reported $180 billion of distressed commercial real estate across the country, a number that might continue to increase well into 2010.

Nonetheless, the preponderance of evidence shows that recovery is underway. It is fortunate that the U.S. economy has returned to positive progress without government having fully spent the authorizations under some of the major programs. The Federal government would do well to focus on deficit control rather than further stimulus.

Deficit spending. The Federal deficit in fiscal 2009 was 10% of GDP, a level exceeded only during World War II. This financial crisis and recession led to significantly lower tax revenues (about 17% lower) at the same time as spending leaped forward (about 18% higher). Given the extent of the recession and the risk that it could have been even worse, this deficit may have been necessary. It is the deficits beyond 2009 that become fearful. The Congressional Budget Office (CBO) projects that under current spending authorizations the deficit will exceed 9% of GDP in 2010, 6% n 2011, and more than 3% per year for the rest of this decade. The average deficit for ten years beginning 2009 would be nearly 5% per year – twice the forty year average.

Then it gets scary. In its August budget update, the CBO says, “Over the long term (beyond the 10-year projection period), the budget remains on an unsustainable path … Continued large deficits and the resulting increases in federal debt over time would reduce long-term economic growth by lowering national savings and investment relative to what would otherwise occur, causing productivity and wage growth to gradually slow.”

There are only two ways to change this outcome: Increase revenues and cut spending. Under current law, which includes the expiration of the Bush-era tax cuts after 2010, the CBO estimates that Federal government revenue will increase 67% from the 2008 base through 2019, but outlays will increase 68% because mandatory programs (Medicare, Medicaid, etc.) are expected to increase 74%. This spending problem has been well-documented for years, but the extreme deficits of the current time have brought it into sharper focus.1 The dynamic U.S. economy has a long history of growing its way out of trouble, but that will be a tall order this time.

Will these deficits accelerate inflation? Inflation is primarily a monetary phenomenon. If growth in money supply is contained, other factors are less important. Over the past twelve months the monetary statistic known as M2 – essentially currency and bank accounts – grew 5%. Since output of goods and services actually fell over that period, theoretically the seeds of inflation have been planted.

As a practical matter, inflation cannot gain a toehold so long as there is excess capacity in global economies. Idle capacity exists around the world because of the slump in GDP in most trading nations.

Employment will rebound slowly. Unemployment is both the most visible measure of slack capacity utilization and the greatest impediment to accelerating growth. Throughout economic history, employment growth has lagged post-recession recoveries. Businesses want to assure themselves that rebounding sale s are sustainable before they incur the expense of additional workers. When unemployment is this high, however, the effect of lower income across the population can create a drag on economic growth, extending the recovery time.

Yet stocks may continue to gain. While stocks in the U.S. rebounded nicely from the depths of last March, their general price level remains well below the 2007 highs. Certainly the recession’s impact on revenue and profits is justification for lower prices. But revenue growth has returned, and the profit rebound is accelerating. Wall Street analysts, nowadays guided by corporate management, are currently forecasting 23% earnings gains 2010 for the companies that make up the S&P 500. This is possible because ramping up the use of idle capacity usually brings strong productivity improvement.

With profit gains anywhere close to these estimates, stock prices are quite attractive. Cash reserves available for investing remain huge, and continuing low interest rates make alternatives less attractive.

Despite the concerns expressed here, the output of most businesses remains vital to global activities of all types. Growth over the next few years may be less than we have experienced after other recessions, but some growth will exist. Owning shares of corporations that cause that growth will continue to be rewarding.

1 At this writing prospective health care legislation has not been finalized, and no impact from it is included.