Monday, February 14, 2011

Questions for The Economy

It's been interesting: most of the equity strategists that I have listened to recently seem to focus most of their attention on the bond market.

The vast majority believe that interest rates are moving higher at some point this year. I do not necessarily agree with this, as numerous posts have discussed.

On the other hand, if interest rates do go higher, it will probably be a sign of an improving economy, which would be great news.

Still, I saw several news items over the last couple of days that call into question the durability of the current economic recovery.

First, there was an article in this morning's New York Times describing how home prices have been falling in areas that had been considered "safe". Here's an excerpt:

CoreLogic, a data firm, said last week that American home prices fell 5.5 percent in 2010, back to the recession low of March 2009. New home sales are scraping along the bottom. Mortgage applications are near a 15-year low, boding ill for the rest of the winter.

It has been a long, painful slide. At the peak, a downturn in real estate in Seattle was nearly unthinkable. In September 2006, after prices started falling in many parts of the country but were still increasing here, The Seattle Times noted that the last time prices in the city dropped on a quarterly basis was during the severe recession of 1982.

Two local economists were quoted all but guaranteeing that Seattle was immune “if history is any indication.” A risk index from PMI Mortgage Insurance gave the odds of Seattle prices dropping at a negligible 11 percent.

These days, the mood here is chastened when not downright fatalistic. If a recovery depends on a belief in better times, that seems a long way off.

Those who must sell close their eyes and hope for the best. Those who hope to buy see lower prices but often have lighter wallets, removing any sense of urgency.

Then there's the President's budget proposal for fiscal 2012.

How much of the apparent improvement in the U.S. economy is due to continued government deficit spending is not clear, but this paragraph is not particularly happy reading (I have added emphasis):

For the current fiscal year 2011, which ends Sept. 30, the Obama budget projects a deficit of more than $1.6 trillion, a level equal to nearly 11 percent of the gross domestic product, making it the largest shortfall since the end of World War II. That projection has swelled recently mostly due to the big tax cut deal that Mr. Obama and Congressional Republican leaders agreed to in December to spur the still-fragile economic recovery. It included a payroll tax cut this year for all Americans.

The deficit for fiscal year 2012 is projected to be more than $500 billion less, $1.1 trillion, due largely to the end of some of those tax cuts and of the two-year stimulus package that Mr. Obama signed into law soon after taking office. Economic growth and deficit-reduction measures account for a lesser share of the expected improvement.

In other words, at a time when most economists are revising their growth forecasts higher, and equity strategists are nearly uniformly saying that stocks are poised to take their cue from the economy and move higher, why is their the need for such huge government deficit spending?

And finally there is this: if interest costs are truly set to move higher for our government, how will lawmakers find the funds to meet their obligations? While this may seem like a relatively minor problem today, if the Obama budget future projections are close to reality, interest cost might become more of a topic for discussion:

Feb. 14 (Bloomberg) -- Barack Obama may lose the advantage of low borrowing costs as the U.S. Treasury Department says what it pays to service the national debt is poised to triple amid record budget deficits.

Interest expense will rise to 3.1 percent of gross domestic product by 2016, from 1.3 percent in 2010 with the government forecast to run cumulative deficits of more than $4 trillion through the end of 2015, according to page 23 of a 24-page presentation made to a 13-member committee of bond dealers and investors that meet quarterly with Treasury officials.

While some of the lowest borrowing costs on record have helped the economy recover from its worst financial crisis since the Great Depression, bond yields are now rising as growth resumes. Net interest expense will triple to an all-time high of $554 billion in 2015 from $185 billion in 2010, according to the Obama administration’s adjusted 2011 budget...

The amount of marketable U.S. government debt outstanding has risen to $8.96 trillion from $5.8 trillion at the end of 2008, according to the Treasury Department. Debt-service costs will climb to 82 percent of the $757 billion shortfall projected for 2016 from about 12 percent in last year’s deficit, according to the budget projections....

“If government debt and deficits were actually to grow at the pace envisioned, the economic and financial effects would be severe,” Federal Reserve Chairman Ben S. Bernanke told the House Budget Committee Feb. 9. “Sustained high rates of government borrowing would both drain funds away from private investment and increase our debt to foreigners, with adverse long-run effects on U.S. output, incomes, and standards of living.

Falling housing prices and unsustainably high federal deficit spending - are these the cracks in the ice beneath the better economic figures?