Summary and Outlook
Elections this year will determine leadership in countries representing 50% of world economic output, including the USA, China, France, Russia, South Korea, and Taiwan. Political regimes in the Middle East are in transition due the “Arab Spring” movement and future leadership in Libya, Syria, and Egypt is uncertain. In North Korea, Kim Jong-un has succeeded his father as leader of communist North Korea.
The USA is experiencing a mild recovery that appears to be gaining traction. Corporate balance sheets are strong and business spending is leading the recovery. Consumers are still deleveraging, yet the savings rate has declined and credit is expanding. The CPI is running at a 3.4% annual rate, and we will be monitoring price data closely for signs of accelerating inflation.
Final resolution of the Euro-zone crisis and China’s ability to engineer a “soft landing” for their economy are events that will have profound implications for the world economy and US corporate earnings in 2012 and beyond.
We expect that 2012 will be a pivotal year!
Economic Growth (Real GDP)
The US economy expanded at an annual rate of 5.7% during the third quarter, led by a 15.7% increase in business spending. Consumer spending increased 1.7%. Businesses allowed inventories to decline during the third quarter and this resulted in a 1.35% subtraction from third quarter growth. The 5.2% growth rate is comprised of real GDP growth of 1.8%, plus an inflation factor (CPI) of 3.9%.
Our federal budget deficit is currently $1.3 trillion and our annual GDP is $15.1 trillion. This translates to a deficit equal to 8.61% of our annual economic output. To make progress reducing our deficit we must either increase our annual GDP growth to a level greater than 8.61%; reduce the deficit by $785 billion (60%), or some combination of the two. Another popular GDP target is the 4% real growth rate proclaimed necessary to create job growth, which combined with the third quarter inflation rate of 3.9% equates to 7.9%. We must pursue policy measures that will stimulate GDP growth and control spending. Both GDP target rates (8.61% and 7.9%) are well above the third quarter growth rate of 5.7% and we clearly favor growth in real GDP to higher price inflation.
During 2011 short term economic indicators improved during the first quarter, deteriorated dramatically second quarter and improved slightly during the final six months. For the year the unemployment rate declined from 9.4% to 8.5% and capacity utilization improved from 76% to 77.8%. The rebound in employment and utilization has been led by manufacturing, which in turn was supported by weakness in the US dollar relative to the Japanese Yen and Chinese Yuan.
Although corporate profit growth has moderated, continued gains in productivity resulted in strong profit growth during 2011, particularly for non-financial companies. Profits for S&P 500 companies will likely end the year up 16% to 18%. During the third quarter financial profits expanded by $9.2 billion and non-financial profits were up $17.9 billion. Unit profit margins expanded as higher prices more than offset increases in labor and overhead costs. Corporate balance sheets are strong and very liquid with more than $2 trillion of cash on the books.
Monetary Policy, Inflation, & Interest Rates
Subsequent to their annual conference at Jackson Hole the Fed initiated operation “Twist” issuing short term bonds and using the proceeds to purchase longer term issues. The increased demand for long term government bonds resulted in a decline in the ten year Treasury bond yield from 3.17% to 1.92%. The stated purpose of Twist was to stimulate housing demand by reducing mortgage loan rates. Mortgage rates have declined and mortgage refinancing has surged, yet the effect on the demand for new housing has been limited.
A voracious appetite for US government bonds continued unabated during the fourth quarter as crisis in Europe, combined with weakness Japan and a slowdown in China resulted in a flight to quality and the yield for the ten year Treasury bond declined further ending the year at 1.88%. With a net foreign debt balance of $3 trillion, the USA is the world’s largest debtor and strong demand for our debt has resulted in lower interest cost. An overlooked benefit of operation Twist is the favorable affect it has had on the interest cost of our longer term government debt.
Slack in our economy and liquidity trapped in our banking system in the form of excess reserves have allowed the Fed to maintain accommodative monetary policy with limited concerns of price inflation. Nevertheless, the annual change in the CPI did increase from 1.1% to 3.4% during 2011 and the Fed’s favorite inflation barometer (core PCE) increased from .8% to 2.2%. This exceeds the range of 1%-2% they have prescribed as a “loose target”. Consumer and commercial lending trends point to expansion in credit, and the savings rate, which peaked at 8% at the height of deleveraging, has declined to approximately 5%. This suggests that new money is working its way into our economy, and the increase in CPI is evidence that this has resulted in higher inflation.
Consumer debt levels remain well above average and the deleveraging process is continuing, albeit at a slower pace. Government debt levels have reached a pinnacle, exceeding the point of diminishing return relative to growth stimulation. Contrary to the consumer and the government, corporate balance sheets are strong and business spending has supported modest GDP growth.
During October President Obama submitted the Korea, Columbia and Panama Trade Agreements negotiated during the Bush administration to congress for approval. In an unheralded demonstration of bi-partisanship the legislation was promptly passed by the House and the Senate. The bi-partisan Debt Super Committee failed to meet their objective of developing initiatives to reduce the size of our federal budget by $1.5 trillion, and legislation extending the 2% cut in employee payroll tax was recently extended for 60 days after a contentious partisan exchange. It is quite obvious that election year politics are now in full swing, and as a result we do not expect approval of material policy legislation for the remainder of 2012. President Obama has made it clear that he will use all powers available to him to legislate from the executive office, bypassing Congress and the Senate during 2012, and we expect a bevy of new regulatory actions.
The Bush tax cuts are scheduled to expire at the end of 2012. Extension of the Bush legislation will be used by both parties as a campaign tool and therefore we expect the cuts will be extended at some point during the year. If it becomes apparent that the Bush cuts will not be extended there will likely be a surge in merger and acquisition activity in 2012 due to the anticipation of higher future tax rates.
During the third quarter, we outlined four possible solutions to the sovereign debt crisis in Europe:
1. European banks will enter a ‘gentleman’s agreement’ to extend their loans into the far future. The banks may get a guarantee of payment from other EU member states in exchange for this rollover.
2. The European Financial Stability Fund will tender offer or purchase ‘distressed near-term debt’ of sovereign member states at a significant discount to par. These discounted bonds can then be redeemed by either reducing or refinancing maturities within five years for distressed nations, buying them significant time to put their fiscal policy on a more sound footing and avoiding any instance of default.
3. Sovereign euro debt will be consolidated into a common ‘Eurobond’ issuance, the principal and interest of which would be guaranteed by all the member states. The issuer would either pay a penalty rate of interest to the consolidating entity to compensate for the guarantee, or would have to meet certain fiscal policy tests to issue Eurobonds.
4. All member states will ratify an amendment to the existing EU treaty that builds a fiscal policy governance mechanism, with meaningful penalties for irresponsible fiscal governance, both in terms of deficit spending and overall debt load. Such an agreement would also have a timetable for full compliance for the PIIGS, which are currently the focus of concern.
It seems that all four options, none of which had been implemented as of early October 2011, are all either in the process of being implemented (#1 through three-year loans from the ECB and #4 through constitutional-level balanced budget amendments now required as part of EU membership), being discussed more seriously (#3), or coming online soon (#2).
In our view, the shift in discussion from Greece to Italy was meaningful, and in a way was good news masked as worse news. By forcing European leaders to focus on Italian problems, the markets have forced Europe to confront the heart of the matter, Italy’s $3 trillion of sovereign debt. Greece has been the focus of attention, but its problems can be handled relatively easily, and the repercussions of any missteps would almost certainly not have been calamitous. Italy, however, is the largest of all the PIIGS and its failure would be catastrophic, with repercussions probably more severe than the 2008 Lehman failure.
By pushing Italy to the forefront of discussion, the markets have signaled to the European leaders that the time for dithering is over, and that they must accelerate their efforts to resolve the crisis. Each and every bond auction in the PIIGS is the focus of intense scrutiny, and there is no longer any room for disappointment, because a failure would induce immediate panic. We believe that, despite the brinksmanship that has been played to arrive at this point, that the European leaders will implement the four points we have outlined above through 2012 and 2013, thereby calming investors and restoring market stability.
We believe that the discussion of a breakup of the euro is overdone, because we believe that the ECB will act to support the credibility of its currency, with or without German support. Furthermore, the ECB by definition has unlimited resources at its disposal and could buy every penny of sovereign debt in the EU if necessary, so speculation against the ECB’s ability to act is in vain, although speculation as to the ECB’s inclination to act is justifiable. We believe that the ECB will be greatly inclined to support the currency and any weak sisters in the EU through bond purchases (#2 above) if the threat of dissolution becomes apparent.
Iraq: The withdrawal of U.S. troops from Iraq was the quiet ending note of a largely successful campaign to remove Saddam Hussein from power. Although the country retains the baggage of its past, and its attendant political instability, Iraq is probably the best example of what democracy will look like in the Arab Middle East as it moves through Egypt and possibly Syria. It would be in the best interests of both the U.S. and global political stability if regime changes move toward the model of a secular democracy, such as Turkey and Iraq, instead of an Islamic.
Syria: Syria could be confronted with regime change as relentless violence has failed to quell the rebellion there. The anti-Assad forces seem to have been emboldened by the ruthless response of Assad’s regime to protests, which included the torture and killings of children, and by the success of Libyan rebels in toppling Gaddafi’s regime.
Iran: Iran has stepped up its threats to close the Hormuz Strait, and many experts predict that oil prices will either stay at $100 per barrel or jump much higher as long as Iran’s rhetoric remains belligerent. However, these threats are the result of sanctions recently imposed on Iran’s central bank, which are having a tremendous impact on the local economy. Some reports have noted that the country’s economy has deteriorated significantly as a result of the most recent sanctions, which have severely limited Iran’s ability to exchange its currency into dollars or other currencies. As a result, prices have increased significantly and it could be only a short period of time before the country experiences another round of violent protests, as it did in 2009 and 2011.
We view high oil prices during a period of significant economic disruption as the result not only of Iran’s threats against vital shipping lanes in the region, but also as a result of a significant drop in Libyan production during their civil war, and the potential for significant unrest in Saudi Arabia. Any instability in Saudi Arabia, the world’s largest oil producer, would significantly increase oil prices.
Overshadowed by events around the world, Cuba has begun taking small, important steps to liberalizing its economy that could set the stage for a significant improvement in their economy. Left virtually alone after the collapse of the U.S.S.R., the economy began to open after Fidel Castro fell ill and left his brother Raul as President. Over the past five years, Cuba has relaxed restrictions on the purchase of household electronics and computers, overhauled the salary structure of state-run companies to reward harder workers, and generally committed itself to Chinese-style economic reforms.
Islamist activists in Nigeria known as Boko Haram (which means Western Education Forbidden) have engaged in multiple widespread acts of violence against Christians in the country in November and December, which could lead to reprisals and instability in the country, which is also an important oil exporter.
Kim Jong-il died in December, leaving the reins of power to his 28-year old third son, Kim Jong-un. It is unclear how the country will navigate the succession, but it seems that North Korea consistently chooses belligerence when faced with uncertainty. This transition is unlikely to be as smooth as when Kim Il-sung died, because Kim Jong-il was 53 when he took over from his father, had many decades of political experience behind him when he became the Supreme Leader, and was the heir apparent for many years before Kim Il-sung’s death. Kim Jong-un has none of these advantages and could be susceptible to the strong voices in North Korea’s military and political circles, of which we know almost nothing.