Investing in a world of austerity
If you are an investor, businessperson or employee, what you care about is outcomes. You want to know what’s likely to happen in the economy and in the markets. That is what this site is all about.
Now obviously, I need to have a keen interest in knowing how policy affects outcomes to know what those outcomes are likely to be. So, in that vein, I present you my opinion on what should be done as well as my analysis as to what likely will be done. On the debt ceiling debate, what is clear to me is that fiscal consolidation has negative short-term consequences for the economy. So when I see US policy makers arguing over where to cut spending and by how much, I know this will be negative for economic growth.
A reader recently commented on my debt ceiling analysis:
Your remarks, especially concerning Mr. Cantor, show that you do not understand the temper of the American times. We’ve had it with this crap. We are not going deeper in debt. We are not accepting higher taxes in any form. It’s that simple. Let the cards fall where they may.
Actually, he is right. That is the mood of many. So I think this reader speaks for a lot of people. That’s what I meant two years ago when I said “Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life” as I reiterated in the recent post on the dénouement of deficit fatigue.
Now intellectually, you can make all sorts of arguments about the US’s being the sovereign issuer of currency or how the government is not like households or how we need to increase aggregate demand or how the government’s deficit is the non-government sector’s surplus. I certainly do. You can make these arguments until the cows come home. It’s not going to work.
I’m just being realistic here. The reality is that people think more about charts and illustrations like this. And what they see is reckless and out of control spending that must be brought to heel. Now, as I mentioned in the deficit fatigue post, “that is certainly why I advised a more aggressive policy response early both on stimulus and recognition of bad debt. A more aggressive response on these two fronts would have dealt with both structural and cyclical causes of recession.” An aggressive response would have been much more effective in holding deficit fatigue at bay. But that is water under the bridge. We’re here now.
What I see says that cuts are coming. What does that mean then for the economy and markets?
- Economy: consumers are tapped out and have a debt overhang that is not being whittled away by housing gains or salary gains, where most people get their wealth and income. Were stimulus to recede that would mean an economy operating at stall speed below 2% growth, vulnerable to any exogenous shock.
- Jobs: The business cycle works in a self-reinforcing way. Therefore, if stall speed were to mean recession, consumers would cut back, businesses would then shed workers, causing income to decline further, causing business to shed more workers. In recessions, this dynamic continues until inventories and bad debts are drawn down and government’s automatic stabilsers and a draw down of savings stabilise demand. A second dip would cause the unemployment rate to rise much higher than it is at present.
- Banks: Another recession would have grave implications for the financial sector because that sector is carrying too many impaired assets at cost. In a downturn, regulatory forbearance cannot hide this as well. These bad debts are crystallized when debtors default. I do not believe extend and pretend in the form of soft-pedaling foreclosures will be effective in preventing a wave of credit writedowns. Because the debt overhang is so high and because consumers will be less creditworthy, credit conditions would reinforce the downward trend of jobs and output. This is negative for bank earnings, and the prospect of bank failures and a loss of capital in bank bonds or bank stocks would increase significantly.
- Stocks: margins and earnings are cyclically high. To my mind that means stock prices would be doubly compressed by a downturn, as P/E ratios drop along with consensus baseline earnings estimates; a downturn would confirm that we are in a period of declining price earnings ratios. This is how all secular bull and bear markets work. The swings are due predominately to changes in price-earnings ratios with decade long swings. Higher dividend-paying, less cyclical, lower-beta stocks outperform in that environment.
- Bonds: In a downturn, demand would drop, which is bond-friendly due to inflation and interest rate expectations. That is bullish for Treasuries (unless they lose risk-free appeal due to default risk). Corporate bond spreads would widen because of credit and default risk. High yield, therefore, would underperform the most. Municipals would be cash-strapped and suffer a huge wave of defaults that could invite Fed purchases to alleviate liquidity concerns. Clearly, an aggressive policy response might change inflation expectations and cause the outlook to change for treasuries. However, if a downturn began sometime in 2012, I would expect low and declining yields until the policy response had any inflationary impact. Remember, reflation would be a global phenomenon so the US would not be the only country trying to reflate its economy and asset prices.
If we see a significant reduction in policy stimulus in the US, along with Europe and China, I anticipate we will see the next downturn by 2012 or 2013 at the latest. Again, this is my baseline case. As I said in March 2008 when the credit crisis was raging, “I expect the likely outcome for the next decade is one of sub-par global growth with short business cycles punctuated by fits of recession”.
On the other hand, austerity-light would be my preferred outcome (more stimulus is not a likely outcome; I assign this lower odds, which makes sense given how the debt ceiling debates have developed). Austerity-light could produce a muddle through scenario, which I am hoping for. That is much more benign for jobs, banks, stocks, and corporate bonds and less benign for Treasuries.