Government Debt, Budgetary Deficits and the Equity Markets

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by Graham Tench and Denis L'Heureux

As is often the case when discussing the economy, this is a good news, bad news story.  For example the U.S. economy grew at a somewhat sluggish rate of 1.3% per annum in the second quarter of this year, hampered in part by Japanese supply disruptions.  This represents an increase from the 0.4% growth in the first quarter.  While these numbers do have plus signs in front of them, they are far from inspiring and have prompted concerns about whether the U.S. economy is stalling out. 

The Canadian economy has been moving forward quietly and modestly.  Of course what goes on in the U.S. is of great importance to Canada.

The political machinations surrounding the negotiations over raising the federal debt ceiling and deficit cuts in the U.S. have undoubtedly raised the economic anxiety level throughout America.  The uncertainty created by the unnecessary debt ceiling crisis may well have caused businesses and individual consumers to put off decision making.  This will almost certainly lead to more mushy looking economic data for the month of July and likely into August.  With several European economies struggling to come to terms with their own government debt problems, tensions are high.  Media reports are taking on a particularly negative tone.  Talk of a double dip recession abounds  — just like it did in early 2010.  There are reasons to believe the U.S. economy will avoid recession again in 2011.

  •   It is relatively normal for the economy to take a brief pause a couple of years into a growth cycle.
  • The U.S. inventory to sales ratio is near a record low, suggesting that goods are actually in short supply on the shelves.  This also suggests that the situation is ripe for another inventory rebuilding cycle like the one that gave the 4th quarter of 2010 a significant boost.
  • Large U.S. businesses have accumulated record levels of cash (about $1 trillion).  With interest rates near zero, there is a need to productively invest much of this money.
  • U.S. consumers have boosted their saving rate to over 5% and have paid off $150 billion (about 6% of the total) of instalment credit since mid-2008.  Although there are 5% fewer jobs in the U.S. today compared to the January 2008 peak in employment, the aggregate wage bill is now a little over 1% above the 2008 peak.  These factors combine to give consumers considerable spending power.  Since they have not been increasing their spending much this year, there is likely pent-up demand.  Recent weakness in the price of gasoline will also leave consumers with more money to spend on other things.
  • Despite the myriad of reasons not to hire anyone during July, the U.S. economy actually added 117,000 jobs in July, which was more than expected.  The employment figures for May and June were revised upwards from those originally reported.
  • Commercial & industrial loans in the U.S. are up 10% year over year.  They only resumed growth in 2011 and are still below historical levels.  This indicates that banks are finally warming up to the idea of funding business expansion.

Nonetheless there are a number of challenges to continued economic growth.  The greatest of these is the effect on consumer and business confidence of all the media noise about the debt ceiling, a possible recession, southern European economic woes and the European debt domino dilemma.  With confidence still fragile due to the slow pace of economic and job growth, this too is a concern.

Even though there are 3 to 4 million job vacancies in the USA, the weak housing market is restricting labour mobility.  Many workers are reluctant to, or can't afford to, sell their homes at a loss in order to move to where the jobs are.  This is helping to keep unemployment a bit higher, and consumer confidence lower, than might otherwise be the case.  More importantly, businesses have been waiting for clear indications that economic growth is sustainable before taking on permanent workers.

In a normal economic recovery from a recession there is a significant contribution to growth provided by a pick-up in housing construction.  The U.S. housing market is still in decline as the backlog of foreclosed properties continues to overhang the real estate market.  Furthermore, 25% of outstanding mortgages exceed the current market value of the property in question.  These factors combine to provide little likelihood of a meaningful economic contribution from residential construction before 2013.  Even though home ownership in the USA is more affordable than anytime in nearly a generation, potential buyers seem content to keep paying more to rent until they can see a stabilization in housing prices.  There are a lot of other potential home buyers who do not currently qualify for a mortgage under tighter bank lending practices.

While the Federal government has committed massive amounts to economic stimulus programs, 49 of the 50 states are required to run balanced budgets.  They have had to cut costs and staff through the recession and recovery.  While the private sector has been adding jobs over the past year and a half, state and municipal governments have been cutting staff.  This has been a prime factor in weak job growth in the U.S.  State governments are still cutting jobs, but may be nearing the point where tax revenues are sufficient to allow their employment levels to stabilize.  However, the same cannot be said for municipalities that continue to face declining property tax revenues via sliding real estate values and the abandonment of properties.

The U.S. Budget Deal

The deal cut between the U.S. Senate, House of Representatives and the President to cut deficits by $2.4 trillion over 10 years was constructed of smoke and mirrors but contains an important mechanism, that might just accomplish something.  The agreement can hardly be described as an austerity budget as spending will rise fairly steadily from about $3.7 trillion in 2011 to $5.7 trillion in 2021.  The smallest projected deficit over the coming decade is projected to be $533 billion in 2013.  The deficits over these 11 years are projected by the Congressional Budget Office to total $8.4 trillion.  This is calculated before taking into account whatever long term deficit reductions might result from the new bi-partisan Congressional Committee charged with finding $1.2 trillion of deficit reductions the agreement calls for.  The Committee will be able to look at tax reform proposals put forward by a previous presidential commission and the Congressional “Gang of Six”, as well as other possibilities.  Since the agreement calls for across the board spending cuts that neither Democrats nor Republicans can stomach if the Committee's proposal is rejected, there is a window of opportunity for Congress to do something constructive while also mending its in-the-dumpster public approval rating.

Downgrade of the U.S.'s Credit Rating

Standard & Poors was previously been chastised by the U.S. Government for not applying enough foresight to debt problems emanating from the 2006 real estate bubble.  It was the first rating agency to downgrade the USA's long term debt AAA credit rating to AA+.  It did this when the U.S. Government agreed to $2.4 trillion of deficit reduction over the next 10 years rather than the $4 trillion of budgetary tightening S&P was looking for to maintain the AAA rating.  Sovereign borrowers downgraded from AAA typically find the yield on their bonds rises 0.02% in the following week.  The real concern is about what the spillover effect on borrowing costs may be for other bond issuers in the U.S. and around the world.

European Debt Crisis

There is a crisis of confidence in European governments' behind-the-curve handling of the various European government debt crises.  They have been playing catch-up since the first hint of trouble in Greece.  This has led to a domino effect of rampant, near-self-fulfilling speculation about which other European country will be next to be on the verge of defaulting on their government debt.

The European Central Bank (ECB) has finally done the inevitable and stated its intent to buy up Spanish and Italian government bonds to prevent a run on them.  The ECB seems to now be satisfied with the measures taken by those two governments to place their fiscal houses in order in a timely manner.

The G7 has chimed in, indicating its intent to “take all necessary measures to support financial stability and growth”.  The G20 has expressed a similar mindset.  While this is only talk at the moment, such talk usually presages action.

Market Reaction

It is somewhat ironic that it is the stock markets that take it on the chin when these macro economic issues become the focus of fear in the population at large.  Ironic, because corporations in general are in their best balance sheet shape in generations and are enjoying solid earnings growth while the main problems concern the ability of some governments to make good on their bonds because of persistent failure to balance their budgets.

The S&P500 is now trading at about 13 times earnings, a level that generally represents pretty good value.  Compared to bonds, stocks now present as good relative value as they did at the bottom of the market in March 2009 and during the 2010 sell-off during fears about a double-dip recession.  This calculation is based on the difference in earnings yields on stocks and yield on government bonds.  Both of those previous low watermarks were followed by significant upward movement in the price of stocks.  Most of the market analysts who forecast those previous market recoveries are now predicting the equity markets will enjoy a meaningful rally between here and the end of the year.

We've said it before and we'll surely find the need to say it again, in the long run earnings drive share prices.  In the short run the only things that matter are fear and greed.  As always, the markets will do what they do best – overreact.