Friday, November 9, 2012

What a Second Obama Administration Means for Investors and the Economy

Had I not run out of room, I would have include the word stakeholders in the title, reflecting the mission of these pages, which is to demonstrate how market-related data and economic policy cage-matches ultimately impact us all. Valuations in financial markets, after all, should reflect broad economic prospects …that is when the Fed is not making Herculean efforts to contort asset prices. Rather than add to the pyre of analyses of the recently completed election, we shall instead divine what lies ahead for financial markets and the broader economy within the context of subjects with which we have repeatedly inundated our readers, and for good reason. For these are the issues that the Administration must address in order to catalyze what even top officials admit has been a disappointingly slow recovery. Chief among them is a return to a growth rate sufficient to consistently create jobs, as there is still much ground to make up on that front. Of the 8.4 million jobs lost since just prior to the official onset of the recession, only a little more than half have returned.

If this task was not arduous enough, the Administration must address the January 1st Fiscal Cliff, a growth-sapping combination of tax increases and spending cuts that likely would hurl the country back into recession. And to make it even more of a Maalox moment, these near-term steps must be accomplished in a landscape of consumer (and supposedly government) deleveraging, which robs the economy of the credit-driven fuel prevalent in previous recoveries. Washington must also finally pay heed to the reality that the U.S. economy has to rebalance away from egregious consumption and more towards producing things the rest of the world cannot wait to get their hands on.

War Criminals, Flesh-Eating Zombies and Capitalists

Many of these issues would be simpler to solve with a return to consistent…and ideally above trend, to make up for lost time….growth. A growing economy would create a larger pool for government revenues, making it easier for lawmakers to avoid painful decisions on the right mix of austerity measures, because, as we all know, legislators on both sides do not like making painful decisions. Unfairly or not, the President’s first-term record….as well as his William Jennings Bryanesque campaign rhetoric….is often interpreted as being mildly hostile to business. Should the administration recognize the key role a private sector unencumbered by excessive regulation plays in driving growth, much of the heavy lifting with regard to job creation and rising incomes will be done for it. If, instead, the President confirms that his instincts are to distrust private enterprise, seeing it as a barely tolerable, but necessary, evil, which exists only to execute centralized bureaucratic edicts, and it is government that truly is in the captain’s chair when it comes to guiding the economy, he can look across the Atlantic for a view of what is in store for an over-regulated country with a bloated, and often inefficient, public sector.

 The Major Hurdles

Europe’s real time self-immolation provides evidence of what occurs to countries with low growth and high levels of debt. Despite such a grisly spectacle, Washington continues to punt by ignoring the Bowles-Simpson Commission’s recommendation, failing to reach a grand bargain in 2011, and most recently recklessly allowing the country to veer perilously close to the Fiscal Cliff. The chances of a lame duck congress devising a long-term solution are nil, so likely there will be a Band-Aid placed upon a massive hemorrhage until the next congress is in session.
As seen above, the government deficit as a percentage of GDP is estimated to remain above 4% over the next five years. With interest rates so low (more on that later) the country can finance this imbalance on the cheap. Eventually QE will end and rates will normalize. Should the deficit not be under control by that time, the elevated interest payments will add to an already unattractive debt load. Unlike Europe, the U.S. has the advantage of being home to the world’s reserve currency (the one in which all its debts are denominated) and is the issuer to the putatively safest financial assets on the planet. These facts have allowed policy makers to repeatedly avoid addressing fiscal warning signs as they assume the current reality is immutable. For the short-term, as the Euro burns and China’s growth (and leadership woes) mount, they are likely correct. In the long-run the assumption becomes much riskier. Leading economists, such as Ken Rogoff, have studied at which level of debt is economic growth impacted. The range starts anywhere between 80% and 100% of GDP; the U.S. is currently north of the latter figure. In the sub-2% growth world in which we reside, only a dip of only few basis points puts the country perilously closer to recession.
The key step in avoiding such a scenario is to curtail government spending…..something in which Washington has a pathetic track record. The chart below shows that government’s share of GDP is now above 20%, yet this is before Obama’s eponymous legislative achievement fully kicks in. Should one prescribe to the notion….which we don’t…..that government activity in the economy has a magnifier effect, then a 20%-plus slice of GDP would be swell. With that rationale why not increase it even more to catalyze greater economic growth? That’s the French model. And as we know, the ossified Gallic economy is nothing more than another sickly PIIG, with slightly better public relations and tasty foie gras.
Perhaps the best way to measure the Administration’s efficacy in tackling these issues as events unfold is to map out potential reactions in financial markets, which in turn, will impact everything from the rates on our mortgages, prices at the pump and our 401k statements. 

Fixed Income: A Tilted Table

Rather than rehash last week’s posting on how the Fed has distorted the market for U.S. Treasuries by becoming a major buyer (thus blurring the line between monetary and fiscal policy), let’s just leave it that the country’s balance sheet is structured not unlike those of the irresponsible banks that loaded up on short-term financing in the lead up to the financial crisis. The Treasury’s reliance on funding government through these instruments makes sense as long as the honeymoon (ultra-low rates) lasts. As already stated, should rates increase before authorities have made headway on fiscal adjustments, interest payments will spike, much of which will be funneled to foreign bondholders, and the country’s debt load will climb higher into Hellenic territory. This doomsday scenario, along with Washington’s dysfunction in addressing it, was a key reason cited in the downgrade of the country’s credit rating. Careening off the fiscal cliff or (more likely) kicking the can down the road, could lead to further rating cuts. In the past the U.S. has gotten away with profligacy as its bonds are considered the safest and most liquid instruments around. Although authorities can still bank on this in the short-run, eventually it will change. Even if still on the distant horizon, we can still expect Treasuries to be in for a bumpy ride once the Fed lets its foot off of the QE accelerator. Eventually it must. Otherwise, the institution’s credibility (what’s left of it) will take a hit. With the removal of the Fed’s outsized role in the market, bonds will likely sell off, raising borrowing costs across the economy and causing significant hits to portfolios that have loaded up on fixed income over the past few years. Less credit to fuel growth, a diminished wealth effect to cause investors to skimp on beach trips and dinners out. 

The Dollar: What the World Thinks of Us

As with the Treasury market, the dollar has been the beneficiary of America’s preeminence in the global economy, functioning as the world’s de-facto reserve currency. This reality explains that despite such QE-induced low yields on U.S. Government instruments, the greenback has surprisingly maintained its value, with the broad-Dollar index being off only 8% against a basket of major currencies since its most recent peak in 2010. While there are no obvious alternatives to the dollar, unless one is a tried and true gold bug, eventually international investors will diversify away from overweight holdings of the U.S. currency. This transition will only be hastened should authorities not address fiscal issues as well as fail to create conditions for robust growth. Some argue that a weak dollar would aid the rebalancing process with consumption being curtailed as the prices of imports rise and U.S. made exports become more competitive in the global marketplace. Possible. But given the relatively small slice of GDP that trade accounts for, along with the price insensitivity of our major, high value-added exports, net/net the small export boost would be more than offset by imported inflation. 

Commodities Super Cycle Meets Domestic Energy Revolution

The main channel through which inflation would rear its ugly head would be raw materials, namely energy products. The question remains whether the Obama Administration will truly embrace the energy revolution occurring in North America, as it began to do during the campaign, or will the EPA continue to erect hurdles for drilling on public lands and perhaps wade into the waters of hydraulic fracturing and place restrictions on that activity. While in the past many have sneered at the concept of energy independence as nothing more than jingoistic campaign rhetoric, new extraction techniques could greatly reduce the country’s reliance on foreign energy sources and in the process bring down the chronic current accounts deficit, much of which is attributable to energy imports. Furthermore the possibility of exporting natural gas via LNG terminals and taking steps to globalize these currently local markets, would further enhance the country’s trade balance and also have the added benefit putting pressure on an increasingly cantankerous Russia (think Syria) by competing directly with one of the Putin Regime’s greatest sources of revenue. 

Then there is the Keystone Pipeline. Without its completion and other such infrastructure projects, the Canadians will happily export their treasure trove of energy to Asia. Relieving the supply bottleneck in the central U.S. would allow crude to flow into global markets, closing the price gap between WTI and BRENT. But rather than resulting in across-the-board higher prices, the global market would find a new (lower) equilibrium. East Coast drivers would likely benefit as experts have shown gasoline prices there have been tracking the more expensive BRENT contract. Capitalizing on domestic hydrocarbon sources (apologies to the Greenies reading this) would boost the economy in multiple ways. Not only would jobs for gulf coast refiners be created, as well for transit construction projects, but more importantly, higher supply helps consumers by lowering prices, thus freeing funds to be spent on other purchases. Think of it is a form of stimulus; only this time, one that works.  Abundant sources of natural gas could also tilt energy-intensive manufacturers into reestablishing a presence in rust-blighted regions, many of which border major fields like the Marcellus Shale. 

What Verdict Will Stocks Render?

Rather than reading too much into the two-day sell-off following the election, or jump into the conversation about current valuation levels, we’ll highlight how a second Obama administration can harness the power of the corporate sector and consequently how share performance can provide a progress report on Washington’s initiatives. Presently companies are timid; this is best illustrated by the $1.76 trillion of cash on their balance sheets as recently reported by S&P. One does not invest in equities to have them deposit your savings into low-yielding short-term instruments. You can do that on your own at the community bank…if it had not gone under in 2009. The whole point of investing in stocks is the expectation that management can consistently identify investments (new markets and products) that will return more than their cost of capital. It is government’s role to create the conditions for corporate leaders to seek out such investments. Presently key sectors such as financial services and energy must navigate a jungle of regulations, which not only jack-up their compliance costs, but more importantly increasingly dictate operational decisions such as what business lines they can enter (or must leave). 

By creating fertile ground for growth, the Administration can serve its own ends by giving business leaders the confidence to deploy idle cash. Likely targets would be capital goods purchases and hiring workers. The former would increase productivity (a key ingredient to long-term growth) and help industrial firms, the latter would address what should be issue numero uno and finally give consumers the confidence to replace items that have their best days behind them. The release of such pent-up demand is all the more important in an economy that for the near term will still have consumption comprise a 70% slice. 

Corporate tax rates brought down to international norms would also improve the competitiveness of U.S. enterprises, as well as would the removal of punitive measures on repatriating foreign earnings. Officials must recognize that, despite the U.S. address, these are truly multinational companies and their goal is to invest where the potential return is the greatest. Increasing America’s attractiveness as a destination for investment will help loosen the needed capital to kick start the sustainable growth that has been elusive over the prior four years. Failure to unleash the ingenuity of the corporate sector will further nudge U.S.-domiciled firms into investing in plants and jobs overseas. In this scenario, investors in sectors with substantial international exposure may do OK. Domestic sectors would not. In both cases, U.S. workers and consumption would likely take yet another hit.


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