You’re on your own, kids

June 7, 2011

James Saft is a Reuters columnist. The opinions expressed are his own.

First came the realization that U.S. economic growth was fading. Now comes the dawning feeling that no meaningful help is on the way.

There is no sign of significant new stimulative government spending and little chance that the Federal Reserve will be willing, much less able, to follow up with another round of quantitative easing.

As for the global economy, Europe is in its own crisis and that transition to a consumer economy in China is going to take a while.

For investors used to more than a decade of bailouts, this will be a rude shock and will follow the usual pattern of denial through to acceptance.

Government bonds will get yet another boost, as will the U.S. dollar, while equities and other expressions of risk appetite will get pummelled.

Friday’s jobs report brought home just how feeble the U.S. economy is with non-farm payrolls rising by just 54,000 in May, about 100,000 less than is needed to merely keep employment stable. Private sector hiring was disappointing, but so too was government employment, which has been on a long, slow descent.

The data merely confirmed what was already apparent: economic growth began to slow in the first quarter and has slowed further as the year has gone on.

While lots of attention is paid to the things that have changed and are hurting the economy — energy prices and freak weather — the fundamentals driving the economy are really unchanged. Households have too much debt, supported by too little earnings and secured against, in many cases, assets with diminishing value like real estate.

The Pavlovian response among investors has been to figure that a weak economy and weakening markets will bring further government stimulus; after all for many that’s all they have ever known.

This time is going to be different, for good or ill.

“We have shifted in the economy from a rescue phase, which is government-directed, to a phase in which we’ve got to rely on government policies that are trying to leverage the private sector and give incentives to the private sector to be doing the growth,” Austan Goolsbee, the head of White House Council of Economic Advisors said on ABC television.

While Goolsbee may believe this, it wouldn’t matter if he didn’t because the Administration has little choice but to hope the private sector can do something; the public sector will not.

While there are proposals for stimulative measures — like an infrastructure bank — they are either blocked in Congress by Republican opposition, are too small to make a difference, or both.

POLICY STALEMATE

This is the great unaccounted-for cost of the TARP and other rescue plans dating from 2008. They poisoned public opinion against all government stimulus, tying the hands of the current Administration and very likely of future ones.

The debate has moved firmly towards budget cuts, and while those are an ultimate necessity, the market has not quite caught up with their economic implications. It is not just bureaucrats who will be thrown out of jobs, private sector employment and profits will take big hits too.

As for the Federal Reserve, things would have to get a lot worse, as well they may, before they can be expected to weigh in with another round of QE. While “QE2″ fulfilled its aim in driving equity prices up and the dollar down, there is genuine controversy over what the risk/reward trade off actually is.

Federal Reserve vice chair Janet Yellen last week acknowledged that, taken too far, the sort of “reaching for yield” the Fed has engineered can lead to dangerous financial imbalances.

Almost more to the point, even if the Fed wanted to go further with extraordinary measures it faces real political risks and costs if it does. QE2 has been very unpopular in certain quarters. This is partly because of fears of inflation, but also because many Republicans view it as fiscal policy by another name, and its use as a unilateral infringement of Congress’ powers.

Wrong this may be, but it will be increasingly difficult for the Fed to act again as the 2012 election cycle kicks off, raising the bar for further action.

So, how does this play out in financial markets? It is very positive for government bonds, even in the face of the debt ceiling negotiations. The economy is doing poorly and will get little further support. The dollar should do well too, as investors come to realize that there will be no additional (virtual) money printing.

For equities and other risk assets it will be, of course, bad. It will take a while for the new reality to sink in, but when it does look for conditions that are just bad enough to bring consensus on rescues, stimulus and extraordinary measures yet unimagined.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

5 comments

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James, at what point does the dollar-favorable investor psychology change? I mean, Mohamed El-Erian of PIMCO recently compared those holding dollar investments (like Treasuries) to the proverbial frog that is getting boiled alive, albeit slowly.

“Risk” is relative. If the U.S. and Europe soon descend into a second recession that is uglier than the last one (as is very likely), then real fears over sovereign defaults will rise. Relative to the emerging economies whose finances are massively in-the-black, the dollar and Treasuries will look pretty risky then. In fact, even in the crisis of 2.5 years ago, global investors piled mostly into short-dated Treasuries for a safe haven. I read that as evidence that investors have profoundly serious doubts about the dollar beyond the short term. Those fears are, if anything, worse now, 2.5 years later when the U.S. is on the verge of another recession and crushed by a mountain of debt, with no way out but are strategic weakening of the currency or even a default.

So I think your analysis is quite a bit too simplistic. I think the prognosis for the dollar is awful beyond the very short term, and if the U.S. soon suffers another recession it will be extremely disruptive and will eventually drive investors into non-dollar assets. Their traditional risk assessment psychology is already being incrementally rewritten, though they may not realize it fully yet.

The dollar ceases to be the safe haven when investors finally come to realize the U.S. is already profoundly stuck with two bad choices – weaken the currency strategically, and/or default on some debt. No one believes any longer that the U.S. will succeed in getting its financial house in order. And if the impending deep recession materializes, it will be the last straw that breaks the back of traditional, dollar-favorable risk assessment psychology.

Posted by NukerDoggie | Report as abusive

[...] You’re on your own, kids | James Saft. [...]

…Or, there is another choice – FED does nothing and lets the investors slowly bear the loss. The private markets may lose 30-50% over the next decade, but it is still better than 70% overnight in 2008.

Although, I would say we are facing a generation or two of slow materialization of equity loss – i.e. releasing the steam of the markets…around 25-30 years.

Posted by Ananke | Report as abusive

…Or, there is another choice – FED does nothing and lets the investors slowly bear the loss. The private markets may lose 30-50% over the next decade, but it is still better than 70% overnight in 2008.

Although, I would say we are facing a generation or two of slow materialization of equity loss – i.e. releasing the steam of the markets…around 25-30 years.

Posted by Ananke | Report as abusive

The FED chose the Japan model (albeit a quicker response time) to try and solve the problem of the last recession… why is it so unreasonable to expect that the solution plays out along the same proportional time frame? Given that Japan still has no solution after nearly 25 yrs how is it that America will suddenly come up with the right answers? There are answers, but no political will to implement them… only half-measures from the body politic and push back on those from the wealthy. I think it would take Saudi’s saying ‘we won’t advocate for cheaper oil anymore unless you get your act together’ to really effect chance in America… until then expect at least 10 yrs of Kabuki

Posted by CDN_Rebel | Report as abusive

“For equities and other risk assets it will be, of course, bad. It will take a while for the new reality to sink in, but when it does look for conditions that are just bad enough to bring consensus on rescues, stimulus and extraordinary measures yet unimagined.”

Jim,
Restoring health of the US housing market has lately been mentioned by many analysts as the missing piece in putting together a bona fide recovery.

For over two years there has been a tug of war between the market fundamentalists who would have foreclosures proceed with abandon and those who have various concerns for the social and economic consequences of unlimited foreclosure.

In the next six months as the current foreclosure lull abates, we should probably see a harbinger in some “market-friendly” states of what may await the US economy.

Perhaps then the “consensus on rescues, stimulus and extraordinary measures” you suggest will emerge.

I suggest the following:
Using funding from settlements with servicers, USG sets up a monumental database for the following:
1) clean up toxic housing securities on balance sheets by using data from multiple sources to model individual mortgage performance
2) offer principal reduction to eliminate underwater mortgage balances through a private intermediary to overcome Congressional obstruction. Funds would be QE3 from Fed by purchase of intermediary’s securities. This reduction would be a recourse loan from intermediary, so serious incentives would be offered homeowners to enter this principal reduction program.

This program would result from USG global agreements with servicers and debtholders to give USG proxy to execute modifications and substitution by novation of homeowners and their mortgages so that people could end up in affordable homes and mortgages in localities with jobs while avoiding foreclosure and mitigating credit damage. This proxy would be logical as USG is in effect already guarantor of most mortgages.

Private intermediary and in turn the Fed could accomodate foregiveness of some principal reduction loans resulting from mortgages arising at height of the bubble in 2004-7 as a way of fighting deflation. Perhaps Fed could simply erase this loss on such securities together with corresponding reserve creation. This would literally be “printing money” and a more targetted use of QE3.

Full details available in a paper from rnwelle@attglobal.net

Posted by richwell | Report as abusive