Financial Jabberwocky – Congress, The Fed Reserve, and Markets
“Beware the Jabberwock, my son! The jaws that bite, the claws that catch! Beware the Jubjub bird, and shun The frumious Bandersnatch!”
From: Through the Looking Glass, and What Alice Found There
Congress:
I never did particularly care for Alice in Wonderland, watching her go down rabbit holes and discover the characters of the White King and Queen, Humpty Dumpty, Cheshire Cat, and the Mad Hatter. But when watching the ongoing budget debates I feel as if the American people are Alice and we are being subjected to a world of budgetary nonsense, spoken in a language that is incomprehensible. The American people know they are being held hostage in a strange place where our Congress orchestrates a Mad Hatter tea party for which the entertainment is kicking the can of debt down the road. The continuous riddles of do we have a revenue problem or do we have a spending problem, can be demonstrated by a Congress in stalemate over whether to cut $32 billion or $61 billion from the current year’s $1.4-trillion-dollar deficit, not to mention our total amount owed of $14.26 trillion. Think about it: if you were my banker and I had a $100 loan and was in trouble and couldn’t pay you back for forty years, would you be concerned as to whether I cut my spending this year by 43 cents or 23 cents? Both amounts are inconsequential when looking at either the total of this year’s deficit or our total indebtedness.
In February, 2010 the President, by executive order, appointed Erskin Bowles and Alan Simpson as co-chairmen of the President’s bipartisan panel to reduce the deficit to 3% of GDP by 2015. The Bowles-Simpson panel consisted of 18 members (seven Republicans, nine Democrats, and the co-chairmen), who by majority voted in favor of five basic recommendations:
1. Enact tough discretionary spending caps and provide $200 billion in illustrative domestic and defense savings by 2015.
2. Pass tax reform that dramatically reduces rates, simplifies the code, broadens the base, and reduces the deficit.
3. Address the “Doc Fix,” not through deficit spending but through savings from payment reforms, cost sharing, and malpractice reform, along with long-term measures to control health-care cost growth.
4. Achieve mandatory savings from farm subsidies and military and civil service retirement.
5. Ensure Social Security solvency for the next 75 years while reducing poverty among seniors.
These goals can be accomplished, but only by cutting discretionary spending and defense spending, reducing health care, means testing Social Security and extending the age of qualification, triaging (rationing) Medicare and Medicaid, and simplifying the tax code (increasing taxes). At this time, Congress and the President are ignoring the Bowles-Simpson recommendations. Why? Why do our leaders continue this journey down the rabbit hole of fiscal irresponsibility, monetizing our debt and devaluing our dollar? The reason, in my opinion, is that nary a Congressman or Senator would be re-elected if they ran on a platform of any the above proposed changes in spending. They need the votes of 90 million Americans who are directly dependent on some form of payment/reimbursement from our government. If you want to really understand the size and scope of our continued deficit spending (scary reading) go to www.kpcb.com and click the tab “USA Inc.” Mary Meeker, the former Morgan Stanley analyst who is now partner with Kleiner Perkins Caufield and Byers, gathered data over the past year and has written a marvelous 277-page assessment of the future debt issues our country will have to face, sooner or later. Over the coming weeks we will see whether our President and Congress can focus on doing what is right for their country, as opposed to their placing priority on their partisan politics and getting re-elected. Let’s hope they do something constructive before Humpty-Dumpty America has a great fall.
The Federal Reserve:
The reason for leading with the deficit commentary and incompetent Congress is that we used to focus our investment analysis on the economy, GDP growth, earnings, valuations, and the risk/reward of the various asset classes when making investments; but now our focus is skewed by deficit issues, the continuous printing of money by our Federal Reserve, and a declining dollar. Since the beginning of 2010 we now monitor at all times the speeches and comments by members of the Federal Reserve. In my opinion, the deficit and monetary policies are one of the key drivers in today’s market. Interest rates are being manipulated in the short-term market, while the excess liquidity being generated is contributing to the decline of the dollar and inflation on a global scale. The consumer inflation we see today is a direct result of Fed monetary policy and the destruction of the dollar. Growth in economic activity is not being created by higher demand, but rather it is the result of trillion-dollar deficits and monetization of the debt by the Federal Reserve. The major question of the hour is, what happens at the end of June when Bernanke’s QE2 is scheduled to dock?
I think the future actions of the Fed will be reactions to stock/bond market directions and our unemployment numbers. Whether the Fed calls the next intervention QE3 or simply disguises it by some other name, the Federal Reserve will not sit idle. I still believe that Bernanke and company are all in at the Keynesian game of Texas Spend ‘Em. A logical course of events would be for the Fed to end QE2 as planned, stop reinvesting the interest it earns from its current $2.7-trillion portfolio over a period of months, eventually remove the “extended period” language sometime in early 2012 and, if inflation continues to be an issue and the dollar continues to decline, then they should begin raising interest rates in mid-2012. However, with asset price stability and unemployment as the fulcrums of Fed Reserve policy, I do not anticipate this as the course of events for the second half of 2011.
My anticipation is that we will hear a ton of rhetoric related to the deficit, with Congress firmly resolving not to pass anything meaningful – they will kick the deficit can again. As a result of Congressional inability to act, the Fed will give all indications of ending QE2 and begin jawboning the markets about reducing their balance sheet; but at the end of the day the magic number will be 8. The President needs 8% or less unemployment for the 2012 elections; public and private pension funds need an 8% return to avoid underfunded liabilities and added pressure to budgets. The balance here for the Fed is to create an environment for positive returns and lower unemployment while not incurring a rising interest rate that would surely sink our country’s budget ship. This will require further market intervention, whether it is called QE3 or Stealth Bernanke. Consider this: our current debt service is approximately $420 billion a year on $14.2 trillion of debt. A mere increase of ½% in the interest cost to the USA would result in an increase of $80 billion of interest expense; not a pleasant thought. If markets progress and a severe correction is avoided, then the Fed will probably end QE2 as planned in June. My guess is that it will not be that simple.
It’s Official:
Ben Bernanke has now made history; he is the first Federal Reserve Chairman to hold a “press conference” since the Fed came into existence in 1913. Congrats to Bernanke for a more open disclosure policy! Too bad the Fed Reserve had to be pursued and sued over a two-year period to produce the documentation on who they loaned money to during the 2008 financial crisis. In the name of disclosure, check out the Federal Reserve’s lending activities:
There are three things that jump out at me from the above chart:
1. The Fed, at its peak lending in December of 2008, had loaned $11.37 trillion to various banking entities.
2. The largest borrowers were non-US financial institutions. Dexia Credit and Depfa Bank are Germany’s equivalent of Fannie Mae and Freddie Mac. If you look at the “AVG” column, you will see that 74% of the average amount loaned by the Federal Reserve was to foreign entities that compete with US banking corporations.
3. Why not let Germany (Dexia and Depfa), Scotland & the UK (Royal Bank of Scotland), France (Societe Generale), and Japan (Norinchukin Bank) take care of their own banks? I didn’t see the central banks of Europe or Japan jumping up to lend our US foreign banking entities money.
The Dollar Trap and the Silent Tax:
The above graph is of the US Dollar Index (USDX), which indicates the general international value of the US dollar from January of 2001 through May 10, 2011. The USDX computes the dollar value by averaging the exchange rates between the $USD and 6 major world currencies. Looking at this chart, any American who is wondering why his/her standard of living is falling could see that the past ten years of trying to fight two wars on foreign soil, increasing spending, bailing out the fat-cat banking system, and having a Federal Reserve that is printing money at an unprecedented pace, have caused a 31% decline in the dollar. Yet Mr. and Mrs. Joe Sixpack have no inkling that the rising costs of gasoline and food are linked to the continued decline in the value of the dollar. This is the insidious nature of an expansive monetary policy and the erosion of purchasing power from a declining dollar; it effectively becomes a “silent tax” on all Americans. The silent tax hits hardest on fixed-income retirees and those who are hourly wage earners living paycheck to paycheck.
As an aside, one class of workers not being seemingly hurt by the declining dollar are the CEOs of US corporations. According to Executive Paywatch, the average compensation for CEOs in 2010 was $11.4 million, up 23% from the prior year. For the 299 biggest US corporations, total CEO compensation in 2010 was $3.4 billion. That means the average CEO is earning 343 times the average worker’s compensation; this is, in a word, ridiculous.
The silver lining of a cheaper dollar is the increase of US exports and improving profitability of large multinational companies. The downside is that these multinational earnings stay in foreign lands due to the double-taxation standard the US government imposes on earnings of US companies in non-US countries. Should we reform the tax code to a more reasonable corporate tax policy, then you would see companies such as Microsoft, Procter & Gamble, Cisco, Coke, Pepsi, etc. bring those dollars back home for reinvestment in our economy.
Markets:
Our assumptions have changed slightly from our commentary “Driving Without Restrictor Plates” at the end of February:
1. US GDP revised downward from 3% to 2.5% – primarily due to the persistent rise in fuel costs to the US consumer.
2. Fed Reserve action is no change.
3. Still believe any euro crisis in the PIGS countries will be diverted until 2012. Germany is firmly in control.
4. Election cycle is still in place and we do not see a substantial change in government spending.
5. The killing of Osama does not change our position that the Middle East remains the wild card over the next 9-12 months.
6. We will remain biased to commodity-driven companies and assets. I prefer some form of commodity-based currency to a fiat currency, given the propensity of central bankers to (a) keep their currencies low relative to everyone else and (b) continue to monetize their debt by printing more money.
Investor sentiment remains too bullish, which leads us to believe some form of short-term correction may be in the offing. While not becoming a total bear, we will be more defensive heading into the June-August time frame, as no one knows what the Federal Reserve will or will not do. We are in unchartered waters with regard to the deficit and Federal Reserve interventions. My friend John Mauldin has written The End Game (buy the book, if you have not), in which he has accurately assessed that the US has no “good” choices as relates to deficit reduction and getting our country on a sound fiscal footing. In the long term our country faces either painful decisions or excruciatingly painful decisions. But for now, with interest rates being manipulated at these low levels, it is still “Risk On.”
China Note:
The Economist magazine presented ideas on where China could spend part of its $2.8 trillion excess reserves:
1. China could buy all the US farmland (value of $1.87 trillion) and have a trillion left over.
2. China could buy all the world’s monetary gold ($1.43 trillion) and have money still in the bank.
3. China could buy Apple, Microsoft, IBM, and Google for $916 billion.
4. China could buy all the US military equipment for $414 billion.
5. China could buy all of Manhattan for an estimated $287 billion.
And yet what do the Chinese continue to pursue? They are buying mining companies, natural resources rights in places such as Angola, oil and gas fields, and rare earth minerals. China is focused on ensuring its supply chain of natural resources to protect their country. Not a bad investment thought for your portfolio. Own any farmland?
Drum Roll Please… Introducing: Troy Gayle:
I am pleased to introduce Troy Gayle, who has joined our firm as Chief Investment Officer, effective May 1, 2011. Troy will be responsible for day-to-day security analysis, selections, investment operations and team with me regarding our tactical asset-allocation strategy. Troy has previously worked 15 years with Westfield Group, a regional property and casualty insurance company located in Westfield Center, Ohio. He spent the past 11 years at Westfield managing their stock and alternative investment portfolios.
Troy is a veteran of the US Army. He holds a BS in commerce from the University of Virginia and an MBA from Cleveland State University. Troy also holds the Chartered Financial Analyst (CFA) and Chartered Alternative Investment Analyst (CAIA) designations. He is a past board member of the Westfield Insurance Foundation and the Cleveland Association for Business Economics (CABE). Troy, his wife Krissi, and his three daughters will reside in Savannah.
“Some see private enterprise as a predatory target to be shot, others as a cow to be milked, but few are those who see it as a sturdy horse pulling the wagon.” –Winston Churchill
Cliff W. Draughn
President
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