Blind Faith

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The Credit Strategist

This essay is excerpted from a recent version of The Credit Strategist (formerly the HCM Market Letter). To obtain the complete issue, you must subscribe directly to this publication; Please go here. The Credit Strategist is on Twitter - @credstrategist

“We live in a technological golden age but in a monetary and fiscal dark age. While physicists discover the so-called God particle, governments print and borrow by the trillions. Science and technology may hurtle forward, but money and banking race backward.
Jim Grant1

 “The further we dug into the way TARP was being administered, the more obvious it became that Treasury applied a consistent double standard…When providing the largest financial institutions with bailout money, Treasury made almost no effort to hold them accountable, and the bounteous terms delivered by the government seemed to border on being corrupt. For those institutions, no effort was spared, with government officials often defending their generosity by kneeling at the altar of the ‘sanctity of contracts.’ Meanwhile, an entire different set of rules applied for homeowners and businesses that were most assuredly small enough to fail.”
Neil Barofsky, Bailout (2012)2

Difficile est saturam non scriber.3

The logic of the financial markets can only be understood as anti-logic. The worse the economy does, the higher the stock market moves on hopes that the Federal Reserve will institute another round of stimulus. The S&P 500 is up 10% for the year while the tech-heavy Nasdaq is enjoying a 13.5% rise despite the high-profile collapse of the social media sector. U.S. investors are hoping and praying that Ben Bernanke and his colleagues will come to their rescue with another round of quantitative easing this week. Their European cousins are holding their breath that Mario Draghi will batter the Bundesbank into agreeing to his plans to repurchase Spanish and Italian bonds and embark on further monetization adventures. The Federal Reserve will announce the results of its meeting on Wednesday, August 1 and the ECB will follow on Thursday, August 2, shortly after this is published.4  We would respectfully advise those anticipating any substantial announcements from these meetings to prepare for disappointment. To the extent they have further cards to play, these central banks are facing political and practical obstacles that will render it very difficult for them to deliver anything more than anodyne words and actions as summer moves into the always dangerous August holiday season. IPhones (we used to say Blackberries) should be kept on alert at the beach through Labor Day.

United States

The second quarter U.S. GDP print of 1.5% seemed too high, and we expect it to be revised downward in the coming months. Unfortunately, for those hoping for QE3, it may have been just high enough to keep the Federal Reserve from acting before the election. Coupled with the Dow Jones Industrial Average hitting 13,000 again and the S&P 500 approaching 1400, 1.5% growth probably doesn’t scream out for urgent Fed action. The stock market may have performed its own intervention, which could then cause it to sell off again in disappointment when the Fed fails to act. If it sells off, hopes for Fed intervention will then start up again. Such a dynamic describes just how nutty stock market psychology has become. In the meantime, the U.S. economy is barely growing, unemployment remains stubbornly high, the presidential candidates continue to talk about nothing, and the rest of us are left banging our heads against the wall wondering how this country is going to get back on a more productive and constructive track. This is how even the allegedly sane are rendered crazy.

I am seeing irrefutable evidence in the dozens of companies that I follow across a wide spectrum of industries that the U.S. economy is slowing. From the manufacturing to the retail and service sectors, corporations are seeing lower demand. They know consumers are worried. The University of Michigan consumer sentiment reading hit 72.3 in July, and the key “expectations” index dropped for the second month in a row to 65.6, the lowest reading of the year. In response, businesses are themselves contributing to slower demand. They are not hiring and are spending very cautiously. They are concerned about the future direction of tax, healthcare and regulatory policy. They do not know what their healthcare and other costs are going to be, although they have every reason to believe they are going to be higher in the future. They are worried about the fiscal cliff, on which they don’t expect to see any action until after the Presidential election, as well as about the outcome of the election itself. Until there is greater clarity on these and other issues, the economy is likely to be stuck in stall speed. In the long run, however, there is little that either Presidential candidate will be able to do to alter the nation’s inexorably negative budgetary, fiscal and monetary trends without radical policy reforms. And neither man has shown any sign of being capability of bringing forth any type of policy proposals that qualify as radical. That would require courage, and courage is in short supply in our political and business circles these days.

The problem is that the longer this slow growth goes on, the more difficult it will be for the economy to emerge from what has been a prolonged period of stasis. Another bout of quantitative easing is unlikely to have much of an effect in view of the fact that interest rates already are at microscopic levels. Economic activity is not being held up by the level of interest rates, it is being delayed by a profound lack of confidence in the future. Faced with the prospect of re-electing a president who believes that the government should be the primary driver of economic growth, or a private equity executive who appears to be too timid to shake anybody up (except the Brits apparently), the natural result is that economic actors lose their motivation to act first and wait for the government to lead. This may not be the intention of Mr. Obama and the Democrats, but it is the necessary consequence of their ideology. It is toxic for the country and for the economy.

The U.S. is in the midst of one of the most interesting earnings seasons in recent memory. More companies are beating on the earnings line than on the revenue line, something we saw in 2009 as the economy entered the balance sheet recession that it is still experiencing.5 But there have been a string of high profile earnings misses as well – MCD, AAPL, SBUX, DOW, AMZN, BSX, UPS. While individual companies are punished when they miss earnings, the overall market seems to shrug off the news. Third quarter earnings are unlikely to be as easy to ignore if economic growth stays on its current course.

Corporations will soon benefitting from a new gift from Congress and the Obama administration. The bill that the president signed on July 6 extending low interest rates on student loans also allows corporations to lower their pension contributions.6  This is being done while S&P 500 companies have a collective pension deficit of $355 billion as of the end of June 2012. The rationale is that corporations need relief in tough times. But if corporate earnings are so great, why do corporations need relief? Corporations should be using their strong corporate profits to bolster their pension funds and protect their employees. This is another example of policy encouraging precisely the wrong behavior at the wrong time. Corporate earnings will soon look better than they should, but investors should not be fooled. Those pension shortfalls are going to have to be filled in the future.

1. Grant’s Interest Rate Observer, July 27, 2012, p. 1.

2. Neil Barofsky, Bailout: An Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street (New York: Free Press, 2012).

3. It is hard not to write satire.

4. The Bank of England also meets on Thursday. No disrespect intended for our British friends, but the impact of any BOE action is likely to be marginal at best.

5. In a balance sheet recession, consumers and businesses limit their spending in order to strengthen their balance sheets. While this is rational behavior for the individual economic actors, their collective behavior leads to slower economic growth. John Maynard Keynes called this the “paradox of thrift.”

6. This is accomplished by allowing corporations to assume that their pension assets are earning a return based on interest rates over the past 25 years rather than over just the last two years when interest rates have been so low. Since this calculation will pretend that they are earning more on these assets, corporations can then contribute less to their plans. Who says Congress can’t get creative when it wants to accomplish something?