Abe Lincoln Print E-mail

"America will never be destroyed from the outside. If we falter and lose our freedoms, it will be because we destroyed ourselves."

Abe Lincoln

There is not an American alive today that has a personal recollection of the United States as anything but the world’s dominant economic power. Nature’s blessings allowed us to develop a global empire that strived to expand the influence of market economies and encourage the spread of democratic values and human rights. This has been our manifest destiny and our gift to the world.

Even in our darkest hours America displayed the capability to rise from the depths of the “Great Depression” to help lead the world in defeating tyranny. It has proven difficult for us to perceive of America as anything other than perpetually omnipotent as it is all we have known. But America is learning a lesson that has confronted every empire throughout history; limits exist for even the most powerful. The promise of America’s fortune has always seemed boundless, but today we are facing the fact that America has made promises it cannot keep and funded those promises with debt that saps our financial strength.

The cost of entitlement programs, corporate welfare, bank bailouts and untenable defense spending conflict with our collective desire for small, un-intrusive government, low tax rates and free market capitalism. Globalization has hastened the trend toward an unsustainable and widening gap between the wealthiest and struggling Americans. Federal reserve policy that includes “exceptionally low interest rates” for “an extended period” and “quantitative easing” have combined to promote speculation and commodity inflation. These policies have helped wealthy investors lever up portfolios to cash in on liquidity driven gains while draining precious disposable income from those least able to cope with rising food and transportation costs.

America has traded jobs for transient profits. It is a trade off with many negative consequences. High unemployment and stagnant wages contribute to weak consumption and the housing market’s unrelenting decline. Foreclosures are adding to a supply glut destined to grow. We fear a deflationary spiral that further depresses prices as savvy buyers put off purchases in anticipation of additional declines.

In the competitive global economy education will largely determine a worker’s future success and earnings power. Our Asian competitors are increasing expenditures to produce more engineers, scientists and mathematicians. Our public education system has many shortcomings that must be addressed. Better teachers and better student performance have to be a priority in today’s world. The cost of a college degree is escalating beyond reach for many, taking the “American Dream” along for the ride. Will America choose to find a solution to its global challenges and fiscal trauma in shared commitment and sacrifice or threaten the social contract between capital and labor and thus the fabric of our nation?

In our search for solutions we must avoid fracturing into splintered interest groups. In a democratic country we are obliged to recognize that misguided policies emanating from both sides of the aisle have contributed to the mess we are in. As we Americans reflect on our past and consider our future we must accept the changes and challenges global capitalism presents to our way of life. And we need to take collective responsibility for the decline of our profligate society now bumping up against the reality of finite resources.  



The IMF's Stealth Message



It has been our goal to draw your attention to the rise of China and other emerging economies in our more recent writings. In our view nothing will impact the American position in the global economy and financial system more. And as many have begun to realize, the global economy has had a direct and important effect on local economies and budgets.

Just a decade ago the US economy was three times the size of China ’s using the metric of “purchasing power parity”. (PPP measures what people earn and spend in real terms in their domestic economies) The IMF, using the same metric predicts that the Chinese economy will surpass the US economy by 2016. During this time frame the US economy is forecast to grow from a current $15.2 trillion to $18.8 trillion with China advancing from $11.2 trillion to $19 trillion. The IMF report was posted on its website with little fanfare in early April. It is the rate of change for China ’s economy that is most startling and grabs our attention. Certainly there is ample room for financial mishap in emerging economies and China has the most potential to suffer a setback. Banking and real estate have been bubbling with valuation and credit issues. China must transform government directed capitalism that rewards party loyalty and political connections to a more just and verdant model before it chokes on social unrest and pollution. But with trillions in foreign currency reserves there is room for China to stumble and recover more quickly than competitor nations with huge debts and current account (trade) deficits.

Because China pegs its currency to the US dollar and depresses its value through market intervention (manipulation) it is enjoying a powerful trade advantage that comes with some pretty large inflationary risks and potential for asset bubbles. The flip side of that coin bears watching for America as global leader. When using present currency exchange rates to compare GDP numbers of the economic giants China ’s artificially depressed renminbi understates the value of the nation’s industrial output. For many economists and analysts this GDP comparison pushes the day of reckoning off well into the 2020s and beyond. A rising renminbi will serve China ’s interests when its domestic consumer class begins to replace the riskier debt driven demand of American consumers. A more accurate measure of the comparative strength of the super powers will then materialize.


Punctuated Equilibrium


We steal the term “punctuated equilibrium” from the world of geology. Simply put the idea says that the geology of the earth exists in a state of relative calm (equilibrium) that is punctuated by disruptive events. The Japanese crises born of earth quake, tsunami and subsequent nuclear disaster represent an example of devastating geologic punctuation and its aftermath.

We are one year removed from our quarterly commentary entitled “Against The Gods” in which we questioned man’s ability to control market risk through the use of advanced mathematics and derivatives. Market meltdowns around the globe reminded us that our ability to predict and control risk is sorely limited. And if we heed the lessons of the Fukushima nuclear disaster we have to acknowledge similar issues with industrial technology. Our fault lies in our inability to accept the existence of tail risks and to ignore the consequences of their occurrence. For many it is in our nature to be optimistic, to build our homes on a river bank and put the 100 year flood out of our minds. For others true risk analysis is derailed by the promise of financial gain.

We revisit this idea and couple it with the IMF forecast of a rising China due to the potential for a punctuated disruption of financial market equilibrium not decades but only years from today.

The US has enjoyed the luxury and numerous advantages that accompany printing the world’s reserve currency. The US dollar and debt markets have benefitted from “coin of the realm” status with greater price stability, global liquidity and lower borrowing costs.

As ICM’s lovely and talented portfolio trader has often said, “Nothing trades like a Treasury”. At least for now….

Markets are reasonably efficient in setting prices a large amount of the time. They are most likely to malfunction in the face of paradigm shifts. While we believe a peaceful coexistence between America and China combined with a gradual shift in currency markets is the most likely scenario over the next decade we have learned not to ignore tail risks. Keeping a vigilant eye on the near term geopolitical horizon and America’s budget battles in particular will help investors preserve value and earn competitive returns with moderate risk.


S&P Said What?


On April 18th the credit ratings company S&P lowered its outlook for America ’s “AAA” credit rating to negative. S&P put the odds of an actual downgrade at one in three. S&P calculated that aggregate US debt equaled about 75% of GDP, roughly in line with Germany, France and Britain , all rated “AAA”. Of these three nations all enjoy a stable outlook. Britain was on a negative watch until its coalition government adopted austerity measures. In its rating warning S&P voiced concern that Democrats and Republicans cannot agree on how to reduce the US deficit. In the near term this negative outlook will have little effect on the US ability to borrow. It is interesting how this company, tainted by scandalous “AAA” ratings of cow-pie derivatives, has attempted to put US finances under scrutiny. As seasoned pros know, the favored ratings companies generally make pronouncements with great flourish long after economic fundamentals have become obvious. There is nothing new here.

What is new is that ratings companies like Eagan-Jones and Weiss Ratings, who are not compromised by taking fees from issuers, are taking a hard look at US debt and their assessments are a bit more alarming than S&P. Egan-Jones put the US “AAA” rating on “watch” March 1st placing the odds of a downgrade to “AA+” as greater than 50/50.

Weiss Ratings recently began coverage of the sovereign debt of 47 nations. Their analysis is based upon a nation’s debt burden, deficits/surpluses, international stability, currency reserves, economic health and ability to borrow in the global market. Weiss Ratings ranked the US 33rd of the 47 nations it covers, which translates in the language of Moody’s and S&P at a “BBB” equivalent, five clicks below “AAA”.  In its ratings announcement Weiss wrote that the current “AAA” ratings were “unfair to investors and savers” and added, “An honest rating is also urgently needed to help support the political compromises and collective sacrifices the US must make in order to restore its finances.”

Weiss Ratings placed China number one on its list of 47. 



US Economic Growth Anemic



A recovery should feel better than this. First quarter GDP slowed to 1.8% annual growth rate from 3.1% in the last three months of 2010. Excluding inventory build up and focusing on “final sales” the economy expanded at only .8%, called “statistically indistinguishable from contraction” by John Williams of Shadow Government Statistics.

Strength in capital expenditures actually hurts employment in the early stages of a recovery. Low borrowing costs and tax incentives provide yet another deterrent to hiring as a recent Duke University and CFO Magazine survey shows. 2011 hiring plans at US corporations have been trimmed to an increase of 1.2% from 2% while capital expenditures are anticipated to rise 12%. Job creation in this environment is slow to emerge and wages fail to keep pace with inflation. The private sector showed signs of life with two month totals of 470,000 new jobs for March and April. But the labor market participation rate (the number in the work force divided by the size of the adult civilian population) is a dismal 58%, a 25 year low. Long term “structural unemployment

 is stuck above 6 million, including 45% of all unemployed. Structural unemployment occurs when there is a mismatch between the skills workers possess and those demanded by employers. There is a segment of the structurally unemployed, aged 50 and above that may not regain its footing. The jobs and associated standard of living may not return in their working lifetimes, transforming productive members of society into financial liabilities.

Manufacturing vigor has been the focus of investor optimism and media hype. The truth of the matter is that manufacturing accounts for only about 15% of GDP. The manufacturing sector feeds off of and into the uptick in capital expenditures. For the most part manufacturing is capital (vs. labor) intensive, export driven; producing few net jobs, stagnant wages and reduced benefits.

The housing market has resumed its slide. The Case Schiller Survey of America’s 20 largest cities show 19 in decline and 11 setting new lows for prices. The housing market is within a whisker of a double dip, with prices falling to new lows since 2006.Nearly a quarter of American home owners are under water on their mortgages and over 8% are delinquent. The glut of foreclosures will only grow as 65% or more than 2 million properties remain on the books of financial institutions. It is small wonder that building permits for new houses is at a record low.


The Fed Speaks


In the first ever Federal Reserve press conference Chairman Bernanke acknowledged that a faster pace of job growth is “sorely needed” while saying the economy was recovering at a “moderate pace”. Bernanke also said that “Increases in the prices of energy and other commodities have pushed up inflation” and that the fed expects the effects to be transitory”. What he did not say was that the Fed’s confidence in transitory inflation rested upon muted wage gains. In an economy driven by consumers the fed is betting its prospects for a non-inflationary recovery on the back of the weak labor market. While this looks like a good bet today the long term wisdom of this strategy leaves me puzzled.

The fed also vowed to “keep rates exceptionally low for an extended period”, its mantra since 2008. This works well for companies borrowing to purchase technology and machines to reduce labor costs but not so well for investors coughing up hard earned dough for miniscule returns. This effective transfer of wealth and purchasing power can only hurt consumption for those tentatively tethered to a job or living on retirement savings. Pension funds have also taken a beating in this low interest rate environment which exacerbates solvency issues and the ability to honor future obligations.

QE2 or the purchase of $600 billion Treasury securities by the Federal Reserve will continue to completion, ending June 30, 2011. The withdrawal of liquidity from the markets will be gradual.  Reinvestment of principal and income from mortgage securities purchased by the fed at the height of the financial panic will continue to support Treasury prices. These mortgage securities will remain on the fed balance sheet until they can be sold with minimal disruption to the markets.

A great deal of financial maneuvering will occur before the fed actually raises the benchmark fed funds rate. The markets will look for signals of tightening in the previously mentioned actions and ICM will be more than casual observers of the same.

There is an old adage in the hazy world of economics that says “you can’t cure a solvency (debt) crisis with a liquidity solution”. The Fed continues to pump money into the financial system, bolstering stocks and commodities while ignoring the disastrous legacy of cheap money and too much debt. Low interest rates benefit well heeled investors who can lever up through margin accounts. This policy has done scant little to address the structural unemployment problems in America or add to productivity but has done wonders for Wall Street speculators. The increasing concentration of wealth, stagnant wages lost benefits and jobs witnessed the past decade or more has all but discredited “trickle down” economic theory for many economists outside the fed but few within.


What It All Means


The truth of the matter is that I can’t say for sure where we are headed in the near term. The economy grows slowly and many are being left at the station or are being booted off the train as it hurtles toward an unknown destination. The economic issues of our time have become politically charged as our major parties wage an ideological battle in the face of very troubling financial conditions.

For local governments we will step out into traffic to render the following observations.

The economy is recovering slowly for all except those on Wall Street or in the export business. Jobs will dictate local economic conditions. Housing markets will follow wages and employment. Property revaluations are becoming more popular almost as rapidly as public employees are becoming less popular. Property taxes will continue to be depressed and may decline in parts of the nation.


We are contemplating the long term effect of the employment crisis and housing market collapse. In the future will Americans forego the dream of home ownership for the flexibility to pursue job opportunities unencumbered by the financial risk of a mortgage? Will this lead to a real estate market composed of more multi-family dwellings and renters rather than single-family homeowners? And how will this potential change from residential to commercial ownership impact tax revenue? 

Consumption taxes will be hurt by falling real wages (down 2.1% in past 6 months), job losses and higher food and energy costs. Commodity inflation will effect what we call “fleets and streets”. It will be more expensive to maintain fleets of municipal vehicles and the roads they drive on.

And finally, there is a brain drain coming; municipal employees are heading for the exits at an alarming rate. The contentious nature of their relationship with the general public and their respective governor’s coupled with financial incentives to retire may leave local government short handed just as new demands for efficiency and expertise are implemented. Our clients in Wisconsin cannot be surprised that retirement applications jumped 79% in the first quarter of this year compared to last. One third of state and municipal workers across the country with specialized skills or degrees are scheduled for retirement in the next five years. Unless you are one headed for the door it may make sense to plan for this next hurdle.


Markets and Portfolios


Market interest rates climbed through much of the first quarter taking yields on two year Treasury notes up to 82 basis points from just under 60 basis points at the New Year. The increase in rates can be tied to fourth quarter GDP figures above 3% and rising inflation concerns. Yields have since fallen back to 60 basis points on the two year Treasury as of this writing on May 2, 2011. Economic conditions have softened. Inflation concerns remain. The US dollar continues to slide versus the currency of our trading partners. This is good for exporters and commodity speculators but bad for consumers.

Portfolios maintain a defensive posture. Most new additions to portfolios during the first quarter have followed a familiar refrain, quality step up coupon agencies, some short duration Treasuries and corporate floaters where appropriate. Rates will begin to rise when the Federal Reserve signals an end to the extreme stimulation and liquidity of the past three years. That day is drawing near. Phasing out QE2 is the first step in that direction. ICM client portfolios are in good shape for our anticipated economic and market scenario.


America Needs A Wakeup Call


Honest Abe had it right. “A house divided against it self cannot stand.” Partisan politics is the enemy of a sound solution process. That may be the one thing S&P has gotten correct in a very long time.


And, finally, Plato had a lighthearted reminder for us all, “One of the penalties for refusing to participate in politics is that you end up being governed by your inferiors.”