December 16, 2010

2011 – Could It Be A Repeat of 2010?

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 5:38 PM by Robert Barone

Many pundits in the business media are signaling that the economy will perform much better in 2011 than it did in 2010.  Here are 9 reasons, forecasts, if you will, why 2011 will look a lot like 2010.

v  U.S. economic growth will remain anemic. There is still a small probability that there will be a double dip in 2011. The recent policy shifts by the Obama Administration to continue the Bush era tax rates and to reduce the social security tax on individuals for a year makes a double dip less probable, albeit this is occurring at the expense of fiscal discipline, something the bond vigilantes clearly do not like.  David Rosenberg, the Gluskin-Sheff economist, has stated several times in his daily blog that he thought 2010 consumption has been buoyed by folks who had stopped paying their mortgages but remained in those homes “rent free”.  Rosenberg has opined that a high percentage of what used to be their mortgage payments likely found their way into consumption.  So, a significant rise in “Strategic Defaults”, as discussed above, will likely have a similar impact in 2011.

But it is because of the job situation that economic activity will continue to be anemic. Job creation is all but non-existent.  The headline monthly jobs report emphasizes the number of jobs created.  That number is estimated by the Bureau of Labor Statistics (BLS) from a survey of large businesses called the “Establishment Survey”.  We’ve all come to realize that, in this economic environment, it is the small businesses that are suffering most.  So the “Establishment Survey” of large business appears to be biased to the upside.  The “Household Survey”, on the other hand, comes from a large sample of U.S. households and is probably a much more accurate gauge of the health of the labor market.  In November, the number of jobs in this survey fell by 173,000 after falling 330,000 in October.  According to BLS, in the 12 months ended in November, the number of employed people in this country rose from 139.132 million to 139.415 million, or by a grand total of 283,000.  Furthermore, we’ve come to look at the BLS data with a jaundiced eye.  According to John Williams of Shadowstats.com, who is an expert in the way BLS measures the data, “the overstatement of the level of payrolls as of November, 2010, is about 610,000 jobs” (see Shadow Government Statistics – Commentary No. 337).  Mr. Williams also indicates that “BLS continues regularly to overestimate growth in payroll employment by roughly 250,000 jobs”  each month due to its biased assumption that in today’s economy, small businesses, which are not in its samples, are actually adding jobs, an assumption that we know is not accurate.

In addition, the policies pursued by all levels of government for the past two decades have finally caught up to small businesses, the major job creator in the U.S.  With reduced income and cash flows, many such businesses can no longer bear the tax, fee and administrative burdens imposed.  In many localities, it is a nightmare to fulfill all of the government imposed requirements, file all of the paperwork, deal with the bureaucracy, and pay the fees just to open a small business.  Then there is the ongoing plague of fees, restrictions and regulations, many of which have arisen because of a few scam artists like Bernie Madoff, or simply because of a failure on the part of the regulators in the first place.  The American people are bearing a great burden in terms of cost for the actions of a very few.  And instead of really fixing the issues with straightforward solutions, every individual and every business is simply taxed or regulated in the name of political correctness.  This applies all the way from airport security to the newest set of Dodd-Frank regulations, to the daily pronouncements of federal and state bureaucracies in the form of ever more burdensome rules.

Big businesses have their own bureaucracy as anyone who has ever tried to call one knows. The internal staff is paid to cope with all of the rules, regulations, and burdens.  With small businesses closing in record numbers, the market penetration of big business is rising.  With small business being choked to death, even in an anemic underlying economy, like that in the U.S. today, big business has been able to prosper.  The overall economic pie in 2011 will be about the same size as it was in 2008 when measured by GDP, but big business’ share of it will have grown significantly.   This view goes a long way toward explaining large cap corporate profitability and rising equity prices along side of high unemployment and overall anemic private sector growth.

 

v  Housing will continue its downward spiral.  In 2011, foreclosures won’t be about those who lost their jobs or just can’t afford the payments anymore.  “Strategic defaults” will mount and accelerate in 2011.  The trend is already beginning.  It is no longer a stigma to walk away from an underwater mortgage, even if you can afford the payments.

 

v  Mortgage ‘Put Backs’ will become a national issue. FNMA and FHLMC purchased tons of low or no doc loans from Wall Street that likely were not entirely “truthful”.  When Congress finally addresses these two bankrupt behemoths, it will be hard to ignore this issue and stick the losses onto the taxpayers, especially after the results of the just past elections.  The large Wall Street institutions, which sold the majority of these “fraudulent” loans to FNMA and FHLMC, are likely to be held responsible.  Remember, it was Wall Street’s greed that led to the housing bubble.  Now that greed is going to come back to haunt them.

 

v  Europe’s debt crisis will intensify. First it was a bailout for Greece; now it is Ireland.  Portugal and Spain appear to be on the bond vigilantes’ radar.  When you hear the prime ministers of these countries publicly proclaim that they do not need a bailout, you know one is imminent.  For the European Union, Portugal can probably be rescued in the same manner as Greece and Ireland.  But Spain is simply too big.  Germany’s prime minister, Angela Merkel, is pushing the idea that by 2013, any government aid will have to be accompanied by a haircut for the bondholders.  If the bond vigilantes attack Spain, which is likely, that idea will have to be moved up to 2011.

 

v  State and local government finances remain in crisis. This is likely to go on for several more years.  Already, these governments are raising taxes on businesses and individuals which can’t be good for job creation.  These governments are large consumers of business products and services.  Last month, John Chambers of Cisco Systems shocked Wall Street by forecasting poor sales for this business segment.  These government entities must lower costs (layoffs) or raise taxes, or both.  All conceivable scenarios for state and local finances imply a much lower level of business activity.  In addition, 2011 will witness a significant increase in the number of local government defaults.

 

v  Debt Concerns will hit the U.S. 2011 could be the beginning of the end of the U.S. dollar as the world’s reserve currency. As I have blogged previously (Wow! That’s a Lot of Debt, TheStreet.com, May 5, 2011, and What Happens to the Cost of U.S. Debt if Interest Rates Rise? Minyanville.com, November 29, 2010), the debt situation in the U.S. is as ugly as some of the European weaklings.  In addition, there is another shoe that has yet to drop, but will when interest rates rise – the cost of the debt. As a result of the almost certain expansion of the deficit due to the tax “compromise” now being considered by the lame duck Congress, there has been a rise in interest rates.  This has happened despite the fact that it has been the Fed’s expressed intent to keep rates low.  Could it be that the bond market is more powerful than the Fed itself?  Could it be that bondholders are getting concerned about the rising deficit and are beginning to demand higher returns?  Could 2011 be the beginning of higher debt costs despite (or perhaps because of) what the Fed does?

 

v  Precious metals likely to continue to rise in value. If U.S. economic growth remains anemic, higher deficits (now a reality given the tax “compromise” the lame duck Congress is now ”enhancing”).  This implies a weaker dollar and a rise in the dollar price of most commodities (including precious metals).  If, on the other hand, U.S. recovery is robust, the world economy will thrive and the prices of most natural resource inputs (including precious metals) will rise due to demand.  But China could be the fly in the ointment.  Rule #9 of Bob Farrell’s, (former Merrill Lynch economist), 10 rules for investors is: “When all the experts and forecasts agree – something else is going to happen”.  So, what can possibly happen?  Answer: A dramatic slowdown in China’s growth.  If that were to occur, demand for natural resources and manufacturing inputs would fall, and, of course, the markets would over react to the downside.  Because of its rapid growth, many view the Chinese centrally planned economy as efficient, much like some viewed Russia’s in the 60s and 70s. But, history hasn’t produced a single centrally planned economy (including that currently in the U.S.) that has worked efficiently.  Lately, there have been many commentators who have pointed out imbalances in China’s economy (empty  buildings, a real estate credit explosion, rapidly rising real estate prices, rapidly rising consumer prices …).  It is inevitable that sooner or later China’s economy will misfire.  Will that be in 2011?  I don’t know – but precious metals investors ought to be cognizant of this risk.

 

v  Federal deficit will rise, not fall, in 2011. The actual 2010 deficit exceeded $1.5 trillion.  As a result of the tax “compromise” which is now being debated and “enhanced” in Congress, 2011’s deficit will likely exceed 2010’s.  In a previous blog (What Happens to the Cost of U.S. Debt if Interest Rates Rise? Minyanville.com, November 29, 2010), I indicated that the four major social categories in the federal budget (Medicare/Medicaid, Social Security, Income Security, and Federal Pensions) along with Defense/Wars and Debt interest consume 86% of that budget.  All of these items will have significant upward pressures in 2011 and beyond.  The recent elections will only begin a long process of getting the structural deficits under control, and the success of that is far from a certainty.  The “compromise” reached between the Democrats and Republicans in the lame duck Congress is clearly a budget buster, and that has implications for interest rates (rising) and the dollar (falling).  The bond vigilantes have already reacted as interest rates rose rapidly after the “compromise” announcement.

 

v  The Stock Market will remain range bound. Twelve years ago, the S&P 500 index was right where it is today.  Given the state of the economy, that performance is likely to continue.  While the large multinational corporations may see modest profit growth, much of this will likely be at the expense of small businesses which will continue to suffer from over taxation, over regulation, and rising input costs.  And without jobs and the lack of availability of easy credit, consumption is not likely to be robust.

Just as in 2010, while the economy may do poorly, big business will do just fine.  The stock market will be held back by a lack of job growth, all of the federal, state and local and household debt issues, debt issues in Europe, a continued slump in housing prices, mortgage defaults and “put backs”, and a weakening dollar.  Buoying it will be decent large cap corporate earnings.

Robert Barone, Ph.D.

December 9, 2010

The mention of securities, precious metals or other types of securities in this article should not be considered as an offer to sell or a solicitation to purchase any securities mentioned.  Please consult an Investment Professional on how the purchase or sale of securities can be implemented to meet your particular investment objectives goals.  Investments in precious metals and similar securities or commodities are subject to risks.  It is important to obtain information and understand these risks prior to investing.

 

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

 

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

 

 

December 1, 2010

Wow-II! That’s A Lot of Interest!

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 5:42 PM by Robert Barone

Recent events in Europe have once again focused the markets on the huge overhang of debt in the high debt European economies with Ireland now effectively joining Greece on life support from the EU and IMF.  Can Portugal (Spain) be far behind?  (Most Americans and Germans would have a fit if they knew how much of the IMF commitments were borne by them!)  During that first European debt crisis last spring, I blogged about the level of debt in the U.S. (see “Wow! That’s a Lot of Debt!” at TheStreet.com 5/21/10).  Now, with QE, QE2, and trillion dollar structural deficits as far as the eye can see, I wonder how many people recognize the potential devastating costs of the national debt as deficits continue, especially if interest rates start to rise as many pundits believe is fairly imminent.

This is a blog about the cost of the national debt.  But, to set the table, let’s look at some data.  The national debt currently stands at $13.7 trillion, and, under the most optimistic Congressional Budget Office (CBO) projections for 2015, it is projected at $17.4 trillion (based on 4.9% GDP growth between now and 2015).  More likely, unless economic growth improves dramatically, the debt will rise to $20 trillion, perhaps $22 trillion in the next five years.  The Federal Budget is nearly $3.5 trillion (23.9% of GDP) and CBO projects a Federal Budget of $4.2 trillion (22.8% of GDP) in 2015.  Tax collections for 2010 are expected to be $2.1 trillion, of which $894 billion are from income taxes.  CBO projects total taxes to rise to $3.7 trillion by 2015 (an 11.7% annual growth rate), and for income taxes to rise to $1.9 trillion (16.1% annual growth rate!).  Clearly, such projections occurred prior to the recent elections. Today, for every dollar spent by the Federal Government, nearly $.39 is borrowed.  USDebtClock.org indicates

Six Largest Federal Budget Categories

Budget ($Mill) % of Total Budget
Medicare/Medicaid $787,463 22.6%
Social Security $698,455 20.0%
Defense/War $688,017 19.7%
Income Security* $425,429 12.2%
Interest on Debt $200,340 5.7%
Federal Pensions $196,893 5.6%

* Includes Supplemental Security Income, Earned Income Credits, Unemployment Compensation, Nutrition Assistance, Family Support, Child Nutrition, Foster Care, Making Work Pay.

that the six budget categories shown in the table account for nearly 86% of the Federal Budget.

The six categories shown account for nearly $3 trillion of spending and are 140% of total tax collections indicating the nature and extent of the structural deficit.  A few of these six categories have become “sacred cows” with any politician or would be politician attempting to “fix” any of the four “social” categories (Medicare/Medicaid, Social Security, Income Security, and Federal Pensions) subject to vicious political attack.  It also appears that these four are also subject to fierce upward spending pressures as the population ages, the recession continues, and federal employee wages remain significantly above those available in the private sector (and rising!).  As long as the U.S. continues to fight two wars and must defend itself against the war declared on it by the jihadists, upward pressure on the defense budget will continue.  That leaves Interest on the Debt.

The website USTreasuryDirect.gov has a wealth of data concerning the national debt.  As of October 31, the official debt was $13.689 trillion consisting of $8.497 trillion of marketable debt and $5.192 trillion of non-marketable.  Debt held by the public (including foreigners), which consists of most of the marketable debt plus a few minor items (like savings bonds), was $9.07 trillion.

The remainder of this paper investigates what happens to the cost of the debt if interest rates rise?  It isn’t a simple answer because the debt matures issue by issue on widely different dates.  If a maturing issue, for example, has a coupon higher than current market conditions require, the total cost of the debt would fall.  So, changes in interest rates take time to work their way through the debt maze.  To analyze what happens to the cost of the debt, I made the following assumptions: a) the shifts in the yield curve would be parallel shifts; b) a maturing issue would be reissued to its original term (for example, an issue that matures on 11/15/10 that was issued on 11/15/2000 (i.e., a 10 year Note) would be reissued on 11/15/10 at current market interest rates to mature 11/15/20); c) the marketable debt ($8.497 trillion) is a close proxy for the debt held by the public ($9.07 trillion).  While the “cost” of the $13.689 trillion is a number in the $325 billion range on an annual basis, the real cost of the debt is the cost of the portion held by the public because that is the net amount of interest to be paid out; the rest is just intra-governmental transfers.  Some may argue that the budgets of those agencies must reflect the interest that has to be paid, but for this analysis, I have used the “net” debt concept.  The existing marketable debt (Bills, TIPS, Notes, and Bonds) has a weighted average maturity of 4.9 years and a current cost of 2.41%.  The base yield curve used is the yield curve for Treasuries and the yield curve for TIPS on 11/15/10 as shown in the following table:

11/15/10 Yield Curves

Treasuries TIPS
1 month .12%
2 months .13%
3 months .14%
6 months .19%
1 year .29%
2 year .53%
3 year .81%
5 year 1.51% -.06%
7 year 2.16% .34%
10 year 2.92% .87%
20 year 4.01% 1.68%
30 year 4.38% 1.79%

The table below shows the percent change (from current costs) in the cost of the marketable debt in 1, 3, 5 and 10 year periods using parallel shifts in the base yield curve of between 0 and 700 basis points (bps).  As the table shows, the longer the yield curve stays where it is (or goes lower), the better it is for the cost of the existing debt.  For example, under the constant yield curve scenario (0 bps change), because the issues maturing have a higher coupon than newly issued debt, the cost of the existing debt falls.  So, if the 11/15/10 yield curves exist for the next year, the cost of the debt would fall by 5.2%, or approximately $10.6 billion.  And, over 10 years, the annual cost reduction would be quite significant.  Under the parallel shift of 100 basis points scenario, the cost of the existing marketable debt rises 7.3% (approximately $14.9 billion) after 1 year.  Under this scenario, things stabilize and actually improve between the 5 and 10 year marks.  However, as the table shows, as rates rise more than 100 basis points, things deteriorate.  For example, at a 200 basis point rise, 5 years out the cost of the existing debt will have risen 37.4% (approximately $76.5 billion).  So, if the economy begins to experience inflation, or if we simply cannot place the maturing debt without higher coupon yields, the cost of the existing debt becomes a significant issue.  Using the 5 year column, the cost of the existing marketable debt for rises of 300 and 500 basis points is 66.0% ($135.0 billion) and 123.2% ($251.9 billion) respectively.

Percent (%) and Dollar Changes (Bill $) in the Cost of Existing Marketable Debt

Under Parallel Shifts in the Yield Curve

Yield Curve Shift 1 Yr 3 Yr 5YR 10YR
0 bps -5.2% 

-$10.6

 -14.3% 

-$29.2

 -19.8% 

-$40.4

 -30.9% 

-$63.2
100 bps 7.3% 

$14.9

 8.1% 

$16.6

 8.8% 

$18.1

 6.5% 

$13.3
200 bps 19.8% 

$45.5

 30.6% 

$62.5

 37.4% 

$76.5

 44.0% 

$90.0
300 bps 32.3% 

$66.0

 53.0% 

$108.4

 66.0% 

$135.0

 81.5% 

$166.6
500 bps 57.3% 

$117.2

 97.9% 

$200.2

 123.2% 

$251.9

 156.4% 

$319.8
700 bps 82.3% 

$168.3

 147.6% 

$291.9

 180.3% 

$368.8

 231.3% 

$473.0

Of course, this does not tell the whole story, as the U.S. continues to run significant budget deficits, and each added dollar of debt results in increased interests costs.  The CBO has projected the national debt at $17.35 trillion in 2015.  That is $3.68 trillion more than now exists.  Given the current deficit estimate of $1.27 trillion for fiscal year 2011 (which began October 1) after $1.56 trillion of red ink in fiscal 2010, and an economy clearly in low gear, the CBO number is clearly optimistic.

In the table below, I show the change in the cost of the marketable debt using the CBO $17.35 trillion of total debt, and adding more realistic $20 and $22 trillion columns (I note that on June 9th, the Treasury projected the 2015 deficit at $19.6 trillion).  Besides the assumptions used in the table for the existing debt, the following assumptions were added to create the estimates for higher levels of debt: a) all of the new debt created is marketable; and b) the term structure of the total marketable debt would not change from what it is currently.  As can be seen from the table, deterioration in the cost of the debt is rapid, even if interest rates rise only slightly.  For example, even at a parallel shift in the yield curve of only 100 basis points, at $20 or $22 trillion of debt, the cost rises 63.8% ($130.5 billion) or 81.2% ($166.0 billion) from current levels.  The cost of the debt, which is currently 5.7% of the Federal Budget, would rise to 11.1% under CBO projections and to 13.4% or 15.1% of the Federal Budget under the $20 trillion and $22 trillion scenarios at the more “normal” interest rate levels represented by the 300 basis point shift row in the table.  While that is daunting, the rest of the table is truly terrifying, especially if the Fed’s QE programs end up putting the U.S. economy into a 1970’s type inflation.

Percent (%) and Dollar Changes (Bill $) in the Cost of 2015 Marketable Debt

Under Parallel Shifts in the Yield Curve

Yield Curve Shift CBO ($17.35 trillion) $20 trillion $22 trillion
0 bps -4.0% 

-$8.1

 7.4% 

$15.1

 16.0% 

$32.7
100 bps 40.8% 

$83.5

 63.8% 

$130.5

 81.2% 

$166.0
200 bps 85.6% 

$175.0

 120.2% 

$245.8

 146.3% 

$299.3
300 bps 130.4% 

$266.6

 176.6% 

$361.2

 211.6% 

$432.6
500 bps 219.9% 

$449.7

 289.4% 

$591.8

 341.9% 

$699.3
700 bps 309.4% 

$632.8

 402.2% 

$822.5

 472.3% 

$965.8

It is a fine line the Congress and Federal Reserve is walking.  Given the structural nature of the deficits and the difficulty of slowing or reversing defense costs or the costs of the “social” categories, even small upward changes in interest rates toward “normality” will exacerbate the deficit and economic growth issues.

Robert N. Barone, Ph.D.

November 29, 2010

The mention of securities or types of securities in this article should not be considered as an offer to sell or a solicitation to purchase any securities mentioned.  Please consult an Investment Professional on how the purchase or sale of securities can be implemented to meet your particular investment objectives goals.

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.