There's a lot of talk about where the markets are right now with respect to multi-year levels. May 2008 levels refer to market values not seen since the indices fell from late 2007 highs towards the March 2009 lows. The current situation looks more like indices that have been climbing, albeit with considerable volatility from the recent October 2011 lows, and this recent rally is the second attempt to hold or break above levels reached just a few months ago in May.
The Fed will meet this week and the markets and talking heads are acting and talking as if QE3 was a slam dunk. This may minimize the relief rally that might occur on the confirming announcement, but I would not be surprised by a strong selloff if the Fed decides not to open the floodgates in a third round of quantitative easing.
They may decide to wait until after the elections as congress is unlikely to do anything in their next session other than pass a funding bill to keep the government running until the fiscal year ends on September 30th, before they recess to finish up campaign season.
If investors have one eye on our Fed's, the other is certainly on Europe. A ruling in a German court supporting the EU bailout fund has European markets climbing and bond rates falling. Still...despite the enthusiasm, both the EU and the US have a deep hole to dig out of in terms of economic recovery. I'll say more about that later.
Back on this continent, ADP's report earlier last week showing an increase of 201,000 jobs based on a sampling of private sector payrolls had analysts and politicians expecting a strong employment report on Friday. It was not to be. The economy added only 96,000 jobs, which was below analysts' expectations of 125,000. Not to pile on, but June and July numbers were both revised lower by a combined 41,000, and June's numbers had already been revised lower in July.
The unemployment rate fell from 8.3% to 8.1%, thanks to 368,000 dropping out of the labor force. Despite all the talk about how many millions of jobs have been created, we have 4.7 million fewer jobs in this country than we did in December of 2007, and since the population and potential workforce has grown since then, the job deficit is even steeper. If as many people were looking for work now as there were in 2009, the unemployment rate would be above 11%.
A few other disconcerting details are buried further in the report. Temporary hiring fell for the first time since March. This is usually a leading indicator as some temp jobs turn into full-time jobs. A rebound in utilities payrolls of 8,800 was due to the end of a workers' strike that caused the reported loss of 9,000 jobs in July, resulting in a small net loss of 200 utilities jobs.
Hourly earnings fell one cent and have risen only 1.7% over the past twelve months...hardly keeping up with real inflation and rising gas prices. Finally, seasonal adjustments in July skewed the manufacturing payrolls in July as jobs usually lost due to expected automobile plant retooling did not occur. So, those weren't really new jobs, they were just jobs that are usually counted as temporarily lost that were not. This kind of summertime seasonal adjustment makes the 15,000 manufacturing jobs reportedly lost this month even uglier.
There exists a school of thought, with which I strongly disagree that says the US, and all countries should always have debt, and that excessive borrowing and spending is the only solution to economic weakness. Those who subscribe to this philosophy say comparisons to personal, individual debt are invalid because governments are not constrained by life-expectancy. The only time governments have to settle all debts, or default on them, leaving their bondholders holding the bag, is when they shut down for good, and that doesn't happen...often.
As further support for their position they argue many successful major corporations always borrow money and are continuously refinancing that debt depending on changes in interest rates.
I argue a major category mistake in this analysis because major corporations that have this seemingly eternal debt produce something. Their bondholders are "betting" that the companies whose debts they purchase will be able to keep producing and selling goods or services and therefore continue to generate revenues and service their debts.
Government debt is different. What exactly does "the full faith and credit" of a government mean anyway? The government's only source of revenue is taxes. Governments have employees but produce nothing that can be sold. A government with no debt, a surplus or cash reserves could invest in other countries and corporations with the goal of generating income but a government in debt like ours is on the wrong side of this equation.
Further, the argument that excessive and continuous government debt is a good thing only holds water when interest rates are very low. We did the math a month or two ago and showed that an increase in interest rates of only a percent or two would make our government's interest payment the single, largest obligation in the spending plan. At that point, we either borrow more and more money to pay interest or start cutting programs like unemployment, Medicare, Medicaid, and Social Security. The preferred solution of our current elected (and appointed) officials, from both parties, is the former, but how long can that last? Just how much can a government borrow before people quit loaning them more?
Back to the question above about the full faith and credit of the government; when someone buys government bonds, what are they "betting" on? How much you can borrow as an individual or corporation depends on how much you make. The only thing buyers of government debt have to rely on is the taxpaying citizens' ability to continue working and paying taxes in support of government spending.
Our government debt now exceeds our total domestic production by about 5%, and our total, combined private-household, corporate and small-business assets are 77% of our total, unfunded obligations to entitlement programs. With an economy that can't create enough jobs to keep up with population growth, just how much money would you be willing to loan this country...and would you do it at low rates? The US could not qualify for a mortgage based on current income/expense or asset/liability ratios.
How do we get out of this? We can default...just simply stop paying interest on our debt. There are some politicians, advisors and economists out there advocating this course. This is the same attitude that says, walk away from your mortgage if you're upside down, ruin your credit and pay cash for another house in foreclosure whose owner is doing the same thing. Aside from the moral obligation we have to pay our debts, of which they are obviously devoid, the economic decline that would unleash would almost certainly lead to a worldwide depression.
Another exit strategy is massive inflation, which is undesirable for a host of reasons. This solves our debt problem, but not much else. Printing so much money that prices skyrocket hurts consumers, and while we're able to pay off our debts, the dollars with which we do it are worth so little that it hurts our bondholders as well. When our foreign investors are paid off with dollars that don't buy one tenth of what they did when the bonds were purchased, they're going to think twice before supporting the US economy in the future.
Another potential way out, and my personal favorite, is private-sector, job-creating, tax-base-expanding growth, but this is not the way most politicians think. Government stimulus and spending work directly against it, and that holds true in Europe just as it does in the US. The presidential candidates are not talking much about debt and deficits because they know a monster has been created and is now too big to be dealt with in two-year election cycles. Congress and the administration will continue to ignore this as long as you let them. We might present a little illustrative math on this one next month.
Just for some perspective, the US debt surpassed $16 trillion last week. How quickly are we spending money we don't have? It took only 286 days for us to add $1 trillion to our debt, while it took 200 years for us to accumulate our very first trillion! It seems the only thing governments are getting better at is spending.
With respect to your investments, we are looking for opportunities in individual stocks as the indices bump up against resistance, but for now, this remains a trader's market. Long-term, buy-and-hold stocks, even the high dividend payers, are likely to reward those who stay in them to a roller coaster ride between now and whenever the economy really decides to stabilize and start growing again. We will tighten up our exit criteria to protect the gains we've made in this recent rally and look for more volatility ahead as the elections approach.
Higher-income-generating investments like bond funds, REITs and Master Limited Partnerships are holding up well, but that will change quickly if and when interest rates start to rise. In that case, the income will most likely remain stable, but the share prices are likely to fall. We'll be keeping a close eye on our clients' investments in these areas as well.
We'll see what the Fed does for us, or to us, later this week. Please call or reply if you have any questions.
