An Era of Debt and Uncertainty - Market Overview

It seems most of the developed world is trapped within the confines of excessive debt and uncertainty. 

Europe is being crushed under loads of debt resulting from years of irresponsible spending – not just in the peripheral countries – but in others such as France.  As a result, millions of people face an uncertain future while their leaders search for a proper course of action and bicker amongst themselves.

Japan is facing deflation and recession, as they grapple with the highest debt load verses GDP in the developed world, an aging and shrinking population, and a political system that has been frozen in uncertainty for the past two decades.

And then there is the U.S., where budget deficits and excessive debt have created both near and long-term uncertainty.  Even though households have already faced the ultimate certainty of excessive debt in the form of the housing bubble and subsequent bust, we as a nation face an uncertain future as our fiscal deficits continue to explode at an unsustainable pace.

Just what have we learned and how far have we come since the housing bubble burst, and since September 15, 2008 when Lehman Brothers fell, the global financial crisis began and the New Reality was thrust upon us?

To answer this question and assess our current situation, we will borrow some of the statements this author has made in past editions of the Market Overview in order to gain a perspective on where we were and where we are now.

Housing: The Boxers - Market Overview, June 30, 2005

“Prime and sub-prime lenders are seeing an explosion in home equity loans.  This has caused banks and lenders to lower their standards in order to become more competitive.”
“…if left unchecked, the combination of excessive/easy credit, high household debt levels and poor lending practices will eventually end in disaster.”

Real Reality - Market Overview, September 30, 2006

“Marginal homeowners, especially those holding exotic mortgages, are facing a day of reckoning.”
“Housing prices will need to fall further in order to come back into sync with reality”

Well, we have already faced our day of reckoning and seem to be coming out on the other side, since the housing market appears to have finished its bottoming-out process and is beginning to show signs of recovery. 

Median sale prices of new homes have stabilized and have actually risen by 5% so far this year (the first rise since 2006), housing starts are up (surging 15% in September), and the sale of existing homes has increased (up 2.1% in October.)  While these developments are positive, current levels are still far below the peak set in early 2007.

However contrary to what was noted in 2005, current lending standards are very high which in turn restricts the availability of credit to potential homebuyers.  This situation has prompted Fed Chairman Ben Bernanke to publicly urge banks and lenders to actually lower their mortgage lending standards and thus extend additional credit to homebuyers.

There is something of an irony here.  On the one hand the Federal Reserve is telling banks to lend more money.  However, at the same time banks are coming under the provisions of what is known as Basel III, which increases the capital requirements of banks (the implementation date of 1/1/13 for Basel III has been postponed.)

In simple English, the Fed is ordering banks to hold substantially higher levels of cash, but then they are asking them to lend more.  Aside from some political motivation, where is the logic behind this requirement and then this request?

Due to the tighter lending standards being imposed by U.S. banks, potential homeowners are turning to the now government entities of Fannie Mae and Freddie Mac, as well as their cousins the FHA (Federal Housing Administration) and Ginnie Mae (Government National Mortgage Association) who are both under the control of HUD (Housing and Urban Development.)  About nine out of every ten new mortgages are currently originated through these four entities.

This raises some very serious questions, especially when it comes to FHA mortgages. 

One of the underlying questions concerning the FHA is related to sub-prime mortgages.  This is due to the fact that even though the private sector sub-prime mess blew up with the housing bubble, the mess was never contained or eliminated.  Instead, it was shifted over to the public sector through the FHA and Ginnie Mae. 

As a result, the FHA has been behaving just like the subprime lenders that helped create our housing bubble.  This has been occurring ever since the government took over - and the U.S. taxpayer provided a bailout for - Fannie and Freddie in 2008.

For example, one troublesome practice at the FHA is that they only require a 3.5% down payment on FHA insured mortgages and require little verification concerning borrowers.  This practice has resulted in massive loan defaults at the FHA while the volume of mortgages on their books has been exploding.

The overall result is that the FHA has completely exhausted their capital reserve that covers outstanding insurance obligations.  In other words, they have gone bust and are broke since they don’t have sufficient funds available to pay current obligations.

On November 16, the FHA announced that their September shortfall was $16.3 billion, meaning that not only will their fees go up, more importantly, they will need a bailout.  As such, they join their cousins Fannie Mae and Freddie Mac that were brought down by poor lending practices that were MANDATED by the U.S. government through HUD and others.  It is déjà vu all over again.

The real loser in this whole mess is the U.S. taxpayer, who is on the hook for guaranteeing about $7 trillion in mortgages generated by the four government mortgage entities.

Debt

Oil Obsession - Market Overview, September 30, 2005

“Basically, the U.S. has become totally dependent upon the surplus capital in the rest of the world in order to support our “debt binge.”  With our deficits exploding going into next year, we will require even more foreign capital in order to support our addiction to debt.”

Inflections - Market Overview, February 10, 2010 (In regard to the Greek debt situation)

“of concern from our perspective is that they [Greece] have been operating above the so-called 90% rule, whereby their national debt has been above 90% of their annual output (GDP) for some time.  This is a matter of concern because it is generally accepted that a ratio of 90% or greater reduces overall growth by at least one percent and is a trigger for downgrades on sovereign debt credit ratings.”  

Periods of Disruption - Market Overview, December 4, 2010

“With our own national debt at $13.6 trillion, we have already breached the 90% rule.”
“If our debt rises to $19.6 trillion as projected by 2015, then our debt levels verses our economic output will be above that of Greece today [2010, debt-to-GDP of 120%], or the U.S. in 1946 [all time high of 121%].”  

Not long after these statements were made, the credit rating on U.S. sovereign debt was cut for the first time in history in July of 2011.

Wouldn’t it be great if we had the same national debt we had in 2005 or even where it was just two years ago?  In 2005, our national debt stood at $8 trillion.  Today our debt stands at $16 trillion and is growing at a rate of over $1 trillion per year.  More simply stated, our national debt has doubled in just seven years.

The problem is that we are taking on enormous debt in a slow-growth economy, which has resulted in an outstanding debt balance that is growing much faster than our total economic output. 

For example, our GDP was $12.6 trillion in 2005 verses $13.3 trillion today, representing a 5.6% increase in overall growth over the past seven years.  When this 5.6% increase in growth is compared with the 100% rise in our debt, it can be stated that our national debt has grown eighteen times faster than the growth of our economy over the past seven years.  This is unsustainable.

Currently, our debt-to-GDP ratio is already well over 100% and rising.  If we continue at the current GDP growth rate of around 2%, then we just might hit that ominous goal of 120%; if not by 2015 then shortly thereafter.

In other words, forget the near-term fiscal cliff, it is the ultimate cliff that looms somewhere down the road that should be our greatest concern.

The Economy

The New Reality - Market Overview, September 28, 2008

“Our economy is entering a new era that will be defined by new realities.”

The Seismic Shift - Market Overview, November 28, 2009

“We have often talked about the “New Reality” facing our nation and our economy.  This seismic shift in government, corporate and household behavior involves a multitude of changes including slower long-term growth, higher unemployment, amplified taxation and increased U.S. government intervention and involvement within our economy.” 

Wake-up Call - Market Overview, October 29, 2011

“…if we continue to ignore the consequences of the mistakes made in other parts of the world, then we will face similar consequences.” 

Ditto today.  Nothing has changed within our economy as we remain within the grasp of the New Reality and continue to ignore the consequences of excessive debt and European style socialism.

As to the question of whether we have learned anything as the result of the housing bubble and September 15, 2008, the answer is two-fold.  On the one hand, households for the most part have been trying to de-leverage their balance sheets, even in the face of high unemployment.

Likewise, banks are showing restraint by raising their lending standards and curtailing speculative investment.  It should be noted that some of this curtailment is due to the fact that several major investment banks - such as Goldman Sachs - converted into commercial banks at the end of 2008.  Also, the upcoming “Volcker Rule” regulations regarding proprietary trading will suppress speculation even further and potentially suppress positive investment.

In addition, most major corporations have shown restraint and have solid balance sheets.

On the other hand, the federal government has essentially learned nothing up to this point from either our experience or those of Europe and Japan.  Our debt has taken on an unsustainable upward trajectory, uncertainty over regulations, taxation and healthcare continue to hamper business activity and investment, and our political malaise places a damper on everyone. 

This will continue until there is greater clarity or until circumstances and consequences force us to do otherwise.

Employment

The Paradox - Market Overview, June 15, 2009

“Traditionally, textbook economics considers 4% unemployment to be the floor of the unemployment rate, or what could be regarded as full employment in a growing economy.  Over the past several years, while 4% has been considered the floor, 6% has been considered uncomfortably high and something of a ceiling.  With our slower rate of growth, in the New Reality 6% unemployment will become more of a floor than a ceiling.”

The recent employment report showing employment rising from 7.8% to 7.9% can be viewed in two ways.  One obvious reaction would be to think that the employment picture faded somewhat last month.  

But the numbers need to be put into perspective.  In the first place, the dramatic fall in the unemployment rate from 8.2% to 7.8% a couple of months ago was a statistical aberration, making the validity of current numbers somewhat suspect.

Also, when looking deeper at the numbers the rise in the unemployment rate is actually positive and is an indicator of improved confidence.  This is because some of the people who had been eliminated from the employment numbers are now back looking for work and are included as part of the employable population.  However, it should be noted that when the underemployed and the unemployed who have stopped looking for work are included within the numbers, the actual unemployment rate in the U.S. today is closer to 17%.

Under these parameters, the employment assessment from June 2009 still appears valid and should remain valid far into the foreseeable future.

Perception and Uncertainty

Extremes - Market Overview, March 31, 2008

“Financial markets hate uncertainty.”
“Perception, even misplaced perception, often creates reality.  For example, if enough people believe a recession is going to happen, then a recession will happen.  This is a phenomenon we have often referred to as the “Financial Pygmalion Effect,” or self-fulfilling prophecy.”  

Anyone not living in a cave over the past few months has surely heard of the so-called “fiscal cliff,” whereby automatic tax increases and federal spending cuts are set to take place on January 2, 2013.  This has created some uncertainty in relation to our economy going into next year.

Uncertainty and perceptions create volatility within financial markets, both to the upside and to the downside.  This is pretty much what we have seen over the past couple of years as uncertainty and perceptions have created a “risk-on, risk-off” mentality within the stock market. 

Since financial markets hate uncertainty, stock markets fall and cash flows toward safe haven stocks and assets when uncertainty rises.  This is known as “risk-off.”  A good example of this phenomenon would be the uncertainty surrounding the outcome of the EU (European Union) Brussels summit in July 2011, when the Dow Industrials fell from 12,700 to 10,800 in one month.

Conversely, when uncertainty is replaced with the perception of a near-term positive outcome, stock markets rise and cash flows toward higher-risk stocks and assets.  This is known as “risk-on.”  This has been mainly occurring when major announcements are made, such as the QE3 announcement this fall, the various political announcements that have been coming out of Washington, or the numerous ECB and EU announcements coming out of Europe.  As the perceived impact of these announcements wears off, then the markets revert back into “risk-off” mode and cash flows toward safer havens.

Until there is greater clarity regarding issues such as the fiscal cliff, regulation and taxation, Obamacare, and Europe this “risk-on, risk-off” market mentality will continue.

So what creates uncertainty going forward? 

The most obvious near-term uncertainty is the fiscal cliff.  In our opinion, the most probable outcome of this situation will be some sort of “kick-the-can down the road” compromise that will allow policymakers to defer actual decisions until some later point in time.  Naturally, if this does not occur and the fiscal cliff actually does takes place, then we will see a recession and the stock market will fall.

However, our economy appears to be showing signs of improvement and investors should not make current decisions based solely upon the fiscal cliff.  Investors should also focus on other issues, such as: 

Europe

Europe is in recession and will remain so through at least the first half of 2013.  This will affect companies that derive a significant portion of their revenues from Europe.  In addition to the peripheral economies, the countries we will be watching closely will be Germany and France, as it is our current expectation that Germany will experience 0% to 1.2% GDP growth in the current and the next two quarters, and France will encounter a mild recession.  We will also be watching the showdown of European politicians verses the ECB and Central Banks to gauge their progress toward a unified banking system and potential fiscal union.

China

Periods of Disruption - Market Overview, December 4, 2010

“Since China is the 2nd largest economy in the world, any radical slowdown in growth due to their tightened policies would affect the global economy and our markets.  From our current perspective, we think their growth rate will settle in at about 7 to 8%...anything significantly less than that would be a matter of concern.” 

Today, we believe their current 7.6% GDP growth rate represents a bottom and we expect 2013 growth to be in the 7.5% to 8.5% range.  This is very positive from a global growth perspective.  However with that being said, we do not expect a return to the double-digit GDP growth rate that China experienced during the prior twenty years.

Business Uncertainty

U.S. companies are holding record levels of cash, and yet at the same time, capital investment plans are being scaled back at the fastest pace since the recession.  If the uncertainties concerning some of the aforementioned issues are removed, then some of this mountain of cash will flow into capital investment, which in turn, will spur economic growth.

Due to the uncertainties built into the market we have been raising some cash to provide a buffer against volatility.  This is a short-term event and the cash will be re-applied once clarity returns.

We have also raised some cash to put some capital gains into tax year 2012.  This is because there is one thing that is certain in this uncertain world: taxes on capital gains and dividends will be going up next year.  The simple question is…by how much?  No one seems to know for certain.

- David B. Prilliman

 

 

Professional Investment Counsel, Inc.  Principals: Gary M. Borsch (garyborsch@sbcglobal.net) and David B. Prilliman (davepic@sbcglobal.net)

 Copyright 2012, David B. Prilliman.  All rights reserved.  All opinions and estimates included in this report constitute our judgment as of this date and are subject to change without notice.  Although the information in this report has been obtained from sources we believe reliable, they are not necessarily complete and cannot be guaranteed.  This report is for information purposes only.