The Rebirth of Deficits
In his recent testimony before Congress, Chairman Greenspan was trying to make a commonsensical point about deficits: that they actually do have an impact on interest rates. But then he started talking about accrual accounting…and everyone stopped listening.
What he said, more or less, is that the government will have to pay out a lot of money at some point, and that the long run is indeed catching up to us. In about a decade, said the chairman, this “relative budget tranquility” will come to an end. What will happen then? It seems to us that, at some point – not so far off into the future as many would like to believe – this debt will be inflated away (more than usual, that is).
In fact, even now, higher energy prices are showing up in the indexes, as wholesale prices increased in January at their fastest pace in 13 years. Of course, higher prices for any particular good are not the cause of a general inflation. It is the Fed’s “accommodation” of this increase, through an increase in the money supply, that will lead to a rise in the overall price level.
But energy prices are only one of the factors prompting the Fed’s inflationary policy. Getting back to the effect of government borrowing…to run a deficit, the average person must borrow. But the government can decide to raise taxes. Or even better, as Fed Governor Ben Bernanke reminded us recently, it can make use of a “technology called a printing press”. Wouldn’t you fire up your printing press if you could? We are quite certain the federal government won’t let this handy invention go to waste.
Fed Inflationary Policy: The Indirect Impact of Budget Deficits
Greenspan’s immediate predecessor, Paul Volcker, understood the indirect impact of budget deficits. A few years after squashing the inflation of the late ’70s, Volcker told Congress that “the actual and prospective size of the budget deficit…heightens skepticism about our ability to control the money supply and contain inflation.” Does this mean that the “independent” Federal Reserve is sometimes pressured to monetize the government’s debt (i.e., print money)?
Say it ain’t so, Mr. Volcker!
With the current deficit likely to be just the beginning of a trend, those hardly-working public servants in Washington simply don’t have a lot of good alternatives to printing more money.
The Congressional Budget Office projects that the budget deficit will peak in 2003, and then we’ll be back in surplus-land by 2007. We’ll believe it when we see it. The CBO did include a small caveat with its extraordinarily optimistic scenari “That improving outlook…is bound to the assumption that no policy will change, and as such should be viewed cautiously.” No policy changes allowed? Perhaps the CBO would care to figure the odds of that happening.
Economist Hal Varian, writing in The New York Times, quotes a study co-authored by a Berkeley economist, which uses somewhat more realistic assumptions than those embraced by the CBO (for instance, spending growth that is in line with GDP, the extension of current tax cuts when they expire, a fix for the alternative minimum tax problem and the inclusion of Social Security and Medicare obligations that are bound to explode once the first baby boomers begin to retire in the next few years). As you might imagine, we’re talking real money here. A $1 trillion surplus over the next 10 years morphs into a deficit of $5.4 trillion. Oops!
Fed Inflationary Policy: No Free Lunches
Varian is forced to concede the likely outcome: “Inflation is all too tempting as an ‘easy’ way to avoid the political pain associated with tax increases or budget cuts.” Greasing the inflationary skids may be easy, but we vaguely recall something about the nonexistence of free lunches.
Meanwhile, we are supposed to be marveling at the continued strength of consumer spending. But what will happen when debt burdens and the decline in net worth take another bite out of wallets’ propensity to open themselves? After all, even a nice yearly growth rate in personal income has not been accompanied by a similar increase in spending.
“George Orwell lives on at The [Wall Street] Journal,” observes Northern Trust economist Paul Kasriel, referring to a recent WSJ headline that read: “Consumer Spending Showed Unexpected Strength Last Month.” Yet, as Kasriel points out, overall retail sales were actually down 0.9% in January.
To be fair, stripping out auto sales to get a 1.3% increase, as the Journal did, might be justified due to the sector’s recent volatility. But we have to be careful when we start down that slippery slope – it doesn’t make sense, for example, to strip out energy prices from the CPI when they’ve gone up and stayed up. For perspective, suppose we were to strip out all auto sales and gasoline sales (for which higher prices at the pump boosted the sales figures in January) from the retail data for the past few years. Suddenly, the year-over-year growth in sales wouldn’t look nearly so impressive.
The auto sector’s unusually large impact can also be seen in production data. Industrial output surged in January by 0.7%, the most in six months, and businesses increased inventories for an eighth straight month in December. Auto products had the fastest growth out of all the components, with a 4.4% gain.
Motor vehicle output was also the driving force behind two other monthly gains over the last six months. What will we do after everyone buys his or her third car at 0% financing?
Fed Inflationary Policy: The Bull Consensus
What actually seems to be happening is an altogether different story. It seems that ordinary people have rediscovered the virtues of saving – not such a terrible thing in our opinion, but a lot of people will get nervous when spending increases don’t show up in the GDP data. Economists are already scrambling to lower their GDP forecasts for the rest of the year, as higher oil prices and temporary “geopolitical” forces prove to be not so temporary after all.
We can hardly blame some analysts for getting excited about improvement in fourth-quarter earnings reports. But the consensus among the bulls [including our own Lynn Carpenter] – which seems to be that, without Iraq, the market would be reaping the rewards from this earnings performance – isn’t quite convincing. “When you look at the aggregate numbers, three things stick in your craw,” says Chuck Hill, director of research for First Call. “The way they slashed first-quarter numbers, the way they slashed second-quarter numbers and [the fact] that pre- announcements are running more negative than normal the last three weeks.”
Fourth-quarter top-line growth for S&P 500 companies that have reported so far hit 4% – better than last year’s minus 4%, but not very awe-inspiring. There is a consistent theme here: Better times may be upon us, but for investors looking at still-high valuations and uncertainty galore, it’s just not good enough.
Businesses are also finding that various costs have been stubbornly rising. Isn’t there supposed to be a whiff of deflation going around? Richard Berner and Shital Patel, of Morgan Stanley, note that corporate America is experiencing a “perfect storm” with regard to cost pressures. While wages, which make up the majority of costs, have remained relatively flat over the last few years, costs have accelerated for health and pension benefits, insurance, worker’s compensation, security services, materials and energy.
Berner and Shital are relatively unperturbed about the impact of rising costs on profits, but they suggest two factors make this non-wage cost acceleration more daunting than the data suggest: First, the cost increases don’t vary with the number of hours worked – that is, they are fixed. And since growth remains weak, the costs are spread over a smaller output, thus pressuring margins. Second, some of the increases in these categories are quite significant. For example, health care insurance premiums for large-cap companies are rising at a 13% rate this year, wholesale energy prices are up 75% from a year ago, and pension contributions, says Berner, will eat up about $20 billion of operating profits in 2003.
Our expert grasp of accounting (profits = revenue minus costs) tells us that a problem could be brewing.
If you throw in looming fiscal trouble at the Federal and State level and an obviously inflationary Fed…the economy – or the stock market, for that matter – doesn’t look like its headed for recovery any time soon.
for The Daily Reckoning
March 7, 2003
Today, we change our investor alert from mauve to fuschia. It is a more dangerous world than it was Wednesday.
Why? Did we come across some inside information? Did our macro-economic computer program begin to whistle in the night?
Nah…we just have a hunch. Stocks fell again yesterday. And it’s Friday. If you had a billion dollars in stocks, would you want to watch the weekend news…knowing that you couldn’t change your positions until Monday? Suppose the war begins?
It’s all very well to believe in ‘stocks for the long haul’. But over the last 3 years, the Dow has lost nearly 40%. In Europe, the losses have been even worse; stock market gains since 1997 have been wiped out. Can you blame investors for getting a little edgy?
Jobless claims rose to their highest level of the year. Consumers have only been able to maintain their spending by mortgaging their houses. The recovery never seems to come.
One thing this market has lacked, so far, is a good panic. Investors have held their positions like good soldiers, getting cut down one by one. But even the Roman legions broke and ran from time to time. And it’s rare in a bear market of such magnitude not to have a little panic from time to time. Maybe today will be the day.
Over to Eric Fry with the market news:
Eric Fry reporting from New York…
– The stock market, evidently, has no weapons of mass destruction. So it must resort to inflicting “death by a thousand swords”. The gruesome and excruciating process continued on Wall Street yesterday as the Dow bled another 100 points to 7,674 – yet another low point for the year. The Nasdaq hemorrhaged about 1% to 1,303. Gold for April delivery gained $3.70 to $356.90 an ounce.
– Warren Buffet made headlines earlier this week when he referred to derivatives as “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”.
– Maybe he’s right. But the many fans of derivatives might call them “defensive weapons”. Both camps have a point…It all depends who’s holding the weapons. But let’s assume that Buffett is right. What should we do about these massively destructive weapons?
– My good friend Michael Martin, a broker with R.F. Lafferty in New York, suggests that we apply the “Bush Doctrine” to the financial realm. “Let’s send ‘weapons inspectors’ into JPM and Citibank to inspect their derivatives books,” Martin suggests. “And then let’s force these renegade financial regimes to ‘disarm’. And if JPM and Citi won’t disarm voluntarily, by golly, we’ll do it for them!” If we don’t do it now, we’ll be in trouble later, right?
– The stock market “acts poorly”, no question about it. But some parts of the market act less poorly than others. Tech stocks, in particular, have been faring relatively well lately, while the stocks that populate the Dow 30 have been “sucking wind”. Including yesterday’s slide, the Dow has tumbled 8% year-to-date, while, surprisingly, the Nasdaq 100 is unchanged for the year.
– The divergence between the Dow and the Nasdaq 100 probably reflects two unrelated phenomena. First, tech stocks are very popular…with short-sellers, that is. Tech stocks are among the most heavily “shorted” stocks in the market, which, from a contrarian perspective, is a positive sign. More about that in a moment. – Second, blue-chip American companies are under siege – a profit siege. Most of these companies face rapidly rising costs – like health benefits for their labor force – intensifying competition, and slack demand for their products. The result is a wicked profit squeeze. Throw in some substantial, and rapidly increasing, pension liabilities and you’ve got a pretty toxic mix.
– Best case, who would want to own stocks like these? As your co-editor has asserted repeatedly to his colleagues at Apogee Research, the only reason that the Dow Jones Industrial Average still trades at 7,700 instead of 3,700 is the “pedigree” of its 30 components. It’s not easy, emotionally, for most investors to sell a blue-chip name like General Electric or IBM or General Motors.
– However, if we were to subject the Dow stocks to a “blind taste test”, most investors would slap a much lower valuation on them than what they currently possess. Stripped of their famous, All-American logos and examined purely on their investment merit, the Dow stocks would probably be selling for about half their current prices. Instead, these marquis names receive the benefit of the doubt.
– Very few tech stocks enjoy such regal treatment. To the contrary, stocks like Gateway Computer receive little more than disdain. (In the spirit of full disclosure, your co- editor owns the stock in his personal account, purely as a speculation, and he might sell it at anytime…Including today!).
– To be sure, Gateway’s recent history of poor performance deserves scorn, if not ridicule and contempt. (Wednesday, the company held a meeting with analysts and investors, promising to do better. We’ll see.) On the other hand, this “fallen angel” of the tech world is trading well below the value of the net cash on its balance sheet. The stock, which is currently selling for about $2.25, holds more than $3.00 per share in net cash on its books. In other words, a buyer of the stock theoretically receives more than 75 cents per share “for free”, along with the entire company “for free”.
– In theory, that’s a cheap price to pay. But if Gateway’s operations continue to stumble as they have been, even $2.25 would have been too much to pay for them.
– Gateway shares are but one example of the low state to which some tech stocks have fallen, especially when compared to their counterparts in the Dow Jones Industrial Average. Today, most Wall Street analysts despise Gateway just as much as they adored the stock three years ago, when it was selling for more than $80 per share!
– The entire tech sector is receiving similarly brutish treatment. Indeed, short-sellers have been placing increasingly heavy bets in the tech sector. Technology and telecom stocks have become the most heavily “shorted” sector in the stock market. All of which suggests to this market observer that tech stocks are likely to fare BETTER over the coming few months than the rest of the stock market. Of course, “faring better” might simply mean falling less.
Back in Paris…
*** Meanwhile, the day of reckoning approaches. The French, the Germans, Russians…and even the English…say they want nothing to do with Bush’s war. America’s future…its honor…its integrity is on the line, not to mention the lives of thousands of people and billions of dollars.
And now the nation’s democratically elected representatives gather to meet in solemn session, taking up the matters most urgent and most important to the republic’s very soul. The constitution makes it clear that there are some issues so weighty that they can only be shouldered by the joint effort of the peoples’ Congress. War and peace, for example. Now that the administration is proposing to the U.S. a change in military strategy – from one that is intended to defend the country to one that is designed to attack – could any more clear or immediate danger present itself?
Yes, says the distinguished senator from the great state of California – changes to FASB regulations! Months ago, with hardly a moment’s discussion, Congress gave up its constitutional obligation to debate the administration’s war aims, to pass a Declaration of War if that is where its judgment led it, and to raise the troops and money needed to get the job done. With such issues out of the way, congresspersons can get down to their real business – posturing for the lumpenvoters back home and shilling for their constituents’ special pleadings. Thus it was that Sen. Barbara Boxer declared yesterday that “we can’t stand by and let accountants wearing green eye shade decide who is going to get the American Dream”.
No matter that the proposed change by the Financial Accounting Standards Board is none of her business (it is a private organization). And no matter that it has nothing to do with who gets the American Dream, but with how corporations treat stock options on their books.
Thus does history move forward like the theater season…with comedies, tragedies, and gross farces.