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Key Variables in Stopping the Downturn

David Malpass | November 14, 2012
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This piece was originally written for Encima Global.

Our September pieces focused on three crunch points that were pointing to a slowdown and a market top: the U.S. year-end tax increase, likely disappointing news from Europe and overdone expectations regarding Fed and ECB powers (see Sept 29 WSJ Economic Signals Point to a 2013 Recession and Sept 4 piece Slow Growth, More Debt, Market Top.)

  • We disagreed with three core features of the September optimism: 1) the view that Washington would smoothly fix the tax problem after the election; 2) the confidence that the promise of ECB bond buying would induce structural reforms or stop the cash-flow hemorrhage; and 3) the “don’t fight the Fed” mantra.  That might work if the Fed were cutting interest rates, encouraging private sector credit or increasing the M2 money supply, but it’s not.  Instead, the Fed’s asset purchases are contractionary, interfering with the market-based allocation of capital to small and new businesses and discouraging private sector investment.  

Each of the September crunch points is playing out badly so far, with Europe having trouble kicking the can given the immense cost and the Fed redoubling its commitment to contract the economy through a top-down allocation of capital using zero percent rates and large-scale asset purchases for preferred borrowers. 

  • We expect a limited year-end fiscal deal in Washington but don’t think it will do much to improve the U.S. tax code or the growth outlook. Even with a deal, a substantial U.S. tax hike is likely, pushing the U.S. toward even slower growth and a 2013 recession. 
  • The deal will probably allow much more spending, running to hundreds of billions of dollars and hundreds of pages – emergency appropriations for the hurricane, flood insurance recapitalization, a new farm bill, reducing the defense and Medicare sequester and the “doc fix”. 
  • The likely spending increases put a spotlight on the U.S. inability to make spending choices or limit the national debt, while the many remaining tax increases, even in the best-case scenarios of a sizeable deal, drag down growth and asset prices.  We disagree with the view imbedded in the CBO forecasts and many other macro models that the year-end spending increases count more than the tax increases, netting out as fiscal stimulus.  Rather than fiscal stimulus, the likely combination is contractionary, adding to the downward pressure from Fed policies.   

This morning’s retail sales data showed core sales excluding autos and gasoline were down 0.3% in the month of October.  Year over year retail sales ex autos and gas grew only 2.9%, not much above the 2% year-over-year inflation rate, indicating an economy in deep stagnation.  The payroll tax rate is scheduled to rise 2% on January 1, subtracting from already weak take-home pay. 

  • The NFIB Small business optimism index came in at 93.1 for October.  That was up a little from the 92.8 in September, but leaves the level below previous recessions. 
  • Auto sales slowed to 14.2 million in October from 14.9 million in September, held down by Hurricane Sandy. 
  • There’s anecdotal evidence that the hurricane-related weakness in home sales deepened in November due to the pre- and post-election uncertainty about taxes and the economic outlook and continuing problems in the jumbo mortgage market. 
  • Japan’s real GDP shrank 3.5% in the third quarter.
  • China’s GDP slowed to 7.4% year over year in the third quarter.  We think China’s economy is stabilizing, but faster growth will wait for more monetary and credit stimulus or a pickup in the global economy.
  • As expected, Europe’s fiscal deficits have been substantially wider than expectations, a side-effect of deepening recessions.  We think Europe will manage to extend Greece’s funding, but the techniques being used are weakening Europe and the ECB (which is providing most of the funding by discounting relatively worthless Greek treasury bills at par.)

Key Variables (research downloadable here)

  • President Obama’s vision for encouraging private sector growth will matter a lot in stopping the downturn. His appearances Friday and today have been anti-growth, and the market has traded down steadily since he described his growth plan on Fridayafternoon. 
  • Of critical importance is a path to tax reform.  We think this is more important that the details of the lameduck deal. 
  • Looking into 2013, one of the key variables is whether the U.S. can develop a budget or a system to restrain spending and allocate it constructively. 
  • In China, we expect monetary and credit stimulus in coming months, one of the few positives in the global outlook. 
  • In Europe, the key variable is whether leaders in the periphery begin a growth-oriented structural reform process. 
  • Market-based indicators remain negative, with equities falling, Treasury yields low and TIPS yields signaling a deep contraction with the 10-year TIP at -0.84% (pre-tax.)  

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