February 12, 2014

US Economy: Stealth Inflationary Pressures Are Not Yet Priced Into Markets

Posted in Banking, Capital, CBO, Congressional budget office, deflation, Economic Growth, Economy, emerging markets, establishment survey, Europe, Finance, GDP, Inflation, investment advisor, investment banking, investments, job market, labor force, Labor Market, obamacare, payroll tax reductions, Robert Barone, small business, Unemployment at 5:18 PM by Robert Barone

In countries where central banks are printing money, such as the US, UK, eurozone, and Japan, deflation is the fear. On the other hand, inflation is high in countries where central banks have followed more traditional policies, like Brazil (official inflation 5.9%), India (11.5%), Indonesia (8.4%), and Turkey (7.4%). One explanation is the carry trade. Because the central banks of the developed world promised low rates for the long term, the liquidity created by those central banks found its way into the economies of the emerging markets (EM) (read: borrow at low interest rates, invest at high ones). Unfortunately, most of those funds did not find their way into capital investment in those markets, but was instead used for consumption, which has played havoc with EM trade balances. When the demand side (usually measured by GDP) outstrips the supply side (potential GDP), inflation occurs. Now that the bubble in EM countries, caused by excess liquidity in the developed world, is starting to burst — investors no longer believe the carry trade will last much longer — what will become of all of that liquidity?

On February 4, the Congressional Budget Office (CBO), a supposed non-partisan government agency, released a shocking report, “The Budget and Economic Outlook: 2014 to 2024,” projecting that over the next 10 years the Affordable Care Act, commonly referred to as Obamacare, would reduce future employment rolls by more than 2.3 million. Overlooked in that report is the CBO’s projection that “potential” GDP in the US will be much slower over the next 10-year period than it has averaged since 1950; this in an age of innovation where rapid change is considered normal. The CBO says that “changes in people’s economic incentives caused by federal tax and spending policies set in current law are expected to reduce the number of hours worked…” and “that estimate largely reflects changes in labor hours worked owing to the ACA [Affordable Care Act].”

In the US, if the current gap between real GDP and potential GDP closes (and the so-called “slack” in the economy disappears as the CBO projects it will), then, just like in the EMs, any growth on the demand side of GDP above potential GDP, ends up, by definition, as inflation.

There are a many measures that indicate that the economy is much closer to its potential than is generally assumed. One such measure is the fact that, despite record levels of cash flow (used mainly for stock buybacks or dividends), for the past five years, corporations have not reinvested in their plant and equipment. According to David Rosenberg (Gluskin-Sheff), the average age of the capital stock in the US is almost 22 years, an average not seen since 1958. Given the fact that the cost of capital is near an all-time low, there is something holding back such investment. Rosenberg speculates that it is likely found in overregulation and the uncertainty regarding tax policy. An old and aging capital stock implies a much lower growth rate of potential GDP than in the past when the capital stock was younger.

The second issue is the labor force. While the December and January Establishment Survey disappointed the markets (December’s survey reported 75,000 jobs added; January saw a gain of 113,000), nobody is talking about the Household Survey. This is the survey from which the “official” unemployment rate is calculated. While more volatile that the Establishment Survey, the Household Survey showed gains of 143,000 jobs in December and a whopping 638,000 in January. When combined with other surveys (NFIB) which show that 23% of small businesses have at least one open position that they cannot fill (a six-year high according to Rosenberg), and that there is a sustained uptrend in voluntary quits, it would appear that the Establishment Survey is the outlier and that the labor market is quite tight.

If, indeed, the CBO is correct and potential GDP growth will slow over the next 10 years due to Obamacare, a tight labor market in conjunction with old capital stock will only exacerbate that situation. Since the financial crisis, the unemployment rate has fallen from 10.0% in October ’09 to 6.6% in January ’14, a 3.4 percentage point decline. During that period of time, the annual GDP growth rate has been about 2.4%. After the recession of the ’90s, to get the unemployment rate to fall 3.4 percentage points (from 7.8% to 4.4%), it took an annualized GDP growth rate of 3.7%. The lower GDP growth required to reduce the unemployment rate implies that the gap between actual and potential GDP is either small or nonexistent.

The aging of the capital stock, lack of new investment, and the tightening labor market indicate that resources are in short supply, which means that there is a strong probability that any semblance of robust economic growth will be accompanied by inflation. Adding to such pressure is the liquidity sloshing around the EM world. If it finds its way home, as appears to be happening, unless much of it goes into new capital formation (which is unlikely given the current regulatory and tax regimes), we are likely to see growing inflationary pressures much sooner than is currently priced into the financial markets.

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Contact Robert Barone or the professionals at UVA (Joshua Barone and Andrea Knapp) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.
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August 2, 2012

Equities: Is a bear market inevitable in this economy?

Posted in debt, Economic Growth, Economy, Europe, Finance, government, investment banking, investments, payroll tax reductions, recession, Stocks, Uncategorized, Unemployment tagged , , , , , , , , , , , , , , , , , at 7:40 PM by Robert Barone

All of the data and the trends in the data indicate that it is possible that a recession might already have begun.

• Job creation has been dismal in the second quarter, with little hope for improvement soon; jobless claims are, once again, on the rise.

• Retail sales have fallen three months in a row; this has never occurred without an ensuing recession. What is of greater concern is that this has occurred while gasoline prices have been falling.

• While market pundits have cheered small gains in housing data, it is clear that housing is still bottom bouncing. Changes in foreclosure laws have caused supply constraints that have made it appear that home prices are rising again.

• Industrial production, the one bright spot in the economy, showed a decline in May before recovering somewhat in June.

• The drought has caused raw food and commodity prices to spike. These will soon translate into higher food and raw input costs. (Is anyone now questioning the wisdom of the congressional mandate to produce increasing quantities of ethanol from corn instead of sugar?)

 • Consumer confidence continues at levels below those seen in past recessions . Much of this is due to uncertainty surrounding fiscal policy and taxes.

• In the June Philadelphia Fed Survey, manufacturers were asked to list reasons for slowing production; 52 percent cited uncertain tax policy and government regulations.

• Real incomes are falling. The downward bias in the inflation numbers produced by the government inflates the reported GDP numbers. It has been my view that, as a result of the biased reporting, the recession never really ended, and real GDP is much lower than reported.

 Equity market up for year

 Nevertheless, despite all of the poor data, the equity markets have held up. At 1,338 (the closing level on July 25), the S&P 500 is still 6.4 percent higher than it was at the beginning of the year. This is strange, given that every other major market in the world is down 20 percent and in bear market territory. Here are a couple of possible explanations:

• The equity markets used to be a leading indicator of the economy. Severe market corrections (20 percent or more) usually meant recession was either imminent or already here. But, with the advent of computerized trading, the market now appears to be more of a coincident indicator. In late 2007, when the last recession began, the market was only off 5 percent from its October peak.

• Europe: There is such financial chaos in Europe that a flight to the dollar is continuing. Because higher quality bond yields are so low, some of the funds have found their way into the U.S. equity markets, thus keeping them buoyed.

Neither of these two reasons should give investors any confidence that U.S. markets can hold up. Besides the poor internal economic data within the U.S., worldwide data have been weak. In addition to the obvious problems in Europe, China is in a much slower growth mode, as is Japan, the rest of Asia, and even the commodity producers like Australia and Canada.

European soap opera
 
Europe is a whole other issue. American markets have benefited from their financial issues, but when panic and contagion show up over there, markets behave poorly over here. We have seen this time and again as the European drama (really a soap opera) has unfolded. It would be far better for the European politicians to come up with an
orderly plan for countries to exit the monetary union than to deny that the union isn’t in any danger of falling apart.

 

Solvable “fiscal cliff”

Finally, the approaching “fiscal cliff” in the U.S. is another wild card that could have a significant impact on capital markets. The good thing about the “fiscal cliff” is that it isn’t an outside force being imposed. The cliff is avoidable and completely under the control of Congress and the president.

With all of this going on, is a bear market inevitable? While I think that the confluence of events (worldwide economic slowdown, slowdown in the U.S., European financial chaos, “fiscal cliff”) make it likely, as I indicated in my last column, the application of “business friendly” policies could prevent it.

Until visibility into policy becomes clearer, investors should continue to be extremely cautious. They should remain liquid.

 Finally, the U.S. economy is so fragile that any external shock, like a financial implosion in Europe, is certain to have negative impacts on U.S. markets. Policy responses to economic slowdown or financial chaos (e.g., printing of money by the European Central Bank or QE3 by the Fed) are likely to have a positive impact on the value of precious metals and commodities. And the ongoing drought will definitely move food and commodity prices upward.

Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value
Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
 
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.

April 9, 2012

Financial armageddon: Should you worry?

Posted in Armageddon, Banking, crises, debt, Economic Growth, Economy, Finance, government, Housing Market, investment advisor, investment banking, investments, IRS, medicare/medicaid, Nevada, payroll tax reductions, recession, social security, taxes tagged , , , , , , , , , , , , , , , , , at 8:37 PM by Robert Barone

You’ve probably seen them in your email, or even on TV — I’m talking about the “approaching financial armageddon” forecasts. People must be responding to them, because they keep on appearing in my email — several per week, and others I know get them too. Should you be concerned?To answer this, we examine data from the six largest categories of Federal expenditures in 2000, 2012, projections for 2016, and their associated compounded annual growth rates (CAGR). Much of this data comes from USdebtclock.org. Caution, the website is not for the faint of heart.Six expense categories (Medicare/Medicaid, social security, income security, federal pensions, interest on debt and defense) account for nearly $3.1 trillion of spending in 2012, represent more than 86 percent of total federal spending and account for 137 percent of taxes collected. These six spending categories are critical when trying to understand the nature and extent of the structural deficit.Growth rates in CAGR show Medicare/Medicaid spending growing to $1,050 billion per year in 2016. The demographics of the U.S. population don’t show us getting younger and baby boomers are just beginning retirement. Social Security will also advance much more quickly than its 5.4 percent growth rate of the past 12 years. All in all, the projection of expenses I’ve shown in the table for 2016 ($3,692 versus $2,265 in 2012) appear quite optimistic. But, let’s go with it.Americans, in general, will tell you they oppose bigger government, at least in the abstract. But in poll after poll, when asked where Congress should make significant cost cuts, almost no specific program eliminations are favored by a majority of Americans. Given this predilection among Americans and assuming that these six categories again account for 86 percent of Federal spending in 2016, then, total Federal spending will be approximately $4.3 trillion.

Some analysts fret about the “fiscal cliff” on Jan. 1, 2013 when the Bush tax cuts are scheduled to expire along with the 2 percent payroll tax reduction for individual social security contributions.

Those analysts put the impact of these at a 3 to 4 percent GDP reduction. When the Bush tax cuts expire, the Federal government theoretically could collect about $300 billion more in taxes if economic activity were otherwise unchanged (a heroic assumption). In addition, the reinstatement of the 2 percent social security tax on individuals will add about $160 billion to tax revenues (again, assuming no decline). The breakout with this story is an estimate of what the deficit would be and its relationship to 2016 GDP. It assumes the Bush tax cuts have been eliminated, the payroll taxes are reinstated, and economic activity is not negatively impacted, so it is likely to understate the deficit. The tax revenue growth rates (left hand column) begin in 2013, after the “fiscal cliff.”

As you can see from the table, reinstatement of the Bush tax cuts and the payroll tax reductions alone do little to solve the issue, as the deficit remains at $1.54 trillion if no further tax increases occur.

 

OUR ‘FISCAL CLIFF’

If Tax CAGR is: Deficit/GDP will be: Deficit will be ($trills):
0% 9.1% $1.54
5% 6.6% $1.12
7% 5.5% $0.93
8% 4.9% $0.83
10% 3.7% $0.63
16% 0.0% $0.00
 
Such a tax regime will clearly keep the economy in a no growth or recessionary mode. If America resists the tax increases, then deficits will balloon, interest rates will rise as the world spurns the dollar, the Fed will continue to print money and purchase the debt that can’t be placed externally, a nasty inflation will likely set in (it has already begun — look at food and energy prices), and we will find ourselves in a Greek type tragedy. The only way out is to significantly cut the growth of Medicare/Medicaid, Social Security, Income Security and Federal Pensions. Which Congress and president will do that?So, should you be concerned about an approaching financial armageddon? Yes.
  

Robert Barone and Joshua Barone are Principals and Investment Advisor Representatives of Universal Value Advisors, LLC, Reno, NV, an SEC Registered Investment Advisor.

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

Universal Value 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 “Firm Brochure”, (Form ADV, Part 2A). A copy of this Brochure may be received by contacting the company at: 9222 Prototype Drive, Reno, NV 89521, Phone (775) 284-7778.

Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value Advisors (UVA), Reno, NV, an SEC Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah
Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.

 Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.