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In the U.S., the economy continues to expand at a modest rate as consumers continue to save a greater proportion of their incomes. This increased saving by the consumer, however, is being offset by increased borrowing by the government. While the headline’s focus has been on the federal government borrowing, it is state and municipal borrowing that is likely to trigger the next financial panic. Many states and municipalities have made pay and pension promises they simply cannot keep. Meanwhile, companies have been reluctant to hire because, for most of the year, the costs of employing people had been scheduled to go up, particularly for taxes, regulations, and health insurance. Since the November elections, present tax rates have been extended which should help increase employment.
Indeed, since November, employment has increased at a modest rate as employers see a two-year extension of current tax rates. The pressures on state and municipal finances have become visible with demonstrations in capitol buildings and legislators boycotting votes by fleeing to other states. What we’re seeing is just the beginning.
In our quarterly newsletter published in October 2010, (‘Memorandum #96), we stated, “Yes, our pension plans own stocks and bonds. Politically, we still argue about ‘us’ versus ‘them.’ In reality, it is now ‘us’ versus ‘us.’” On the following pages, we’ve updated data that I’ve monitored for over 25 years. Many who want to raise taxes on corporations believe that corporate stocks and bonds are owned by “the rich.” In fact, much of corporate stocks and bonds are owned by pension funds.
In ‘Memorandum #97, we also wrote:
In 2010, the shocks to the markets and the financial system came from Europe. Since the adoption of the euro currency in 1999, a number of countries have taken advantage of low interest rates to spend money well beyond their tax receipts. In 2010, the “chickens came home to roost.” Greece, in the spring, and Ireland, in the fall, required bailouts by other members of the European community. Much of the sovereign (country) debt is held by European commercial banks across the continent, which likely forced these banks to sell other assets. We do know that, recently, markets in Europe, the U.S., and elsewhere declined when the sovereign debt problems came to the fore. Many European countries are adopting budgets that rein in government spending, (much like Canada did in 1995), but it is not yet clear that their citizens will accept the budgets instead of rioting in the streets. So the European crisis is not over.
Since then, Portugal has joined Greece and Ireland on Europe’s “sick list.” Again, the European crisis is not over.
We added:
The swing member of the international community is now China. While China amounts for only 9% of world GDP (Gross Domestic Product), it is over 40% of the GDP of “emerging markets.” After the meltdown of the fourth quarter of 2008, when many governments (including the U.S.) adopted plans for economic stimulus, China stimulated more than others. Much of its stimulus went into useful infrastructure, but a lot also went into real estate of a bubble character. (If you want to see a beautiful ghost town, look up Ordos, China on Google Maps.) Adding stimulus is easy, removing stimulus is tricky; China has now begun removing stimulus.
China continues to remove stimulus and to raise interest rates (five times so far) to keep inflation under control. True to form, the Chinese economy is slowing and Chinese stocks have been declining.
More recently, of course, we’ve witnessed the earthquake and tsunami in Japan and the addition of Libya to the list of revolutions in the Middle East. The catastrophe in Japan will divert their resources from what they might otherwise have done to a focus on reconstruction and may change their mix of energy going forward. The revolutions in the Middle East (while probably necessary if the area is ever to join the list of developing nations), create further uncertainty which is most visible in the price of energy.
Meanwhile, our federal government is spending $3.6 trillion ($3,600,000,000,000) while collecting $2.0 trillion ($2,000,000,000,000) per year in taxes, borrowing the deficit balance of $1.6 trillion ($1,600,000,000,000). When you spread these amounts over roughly 100 million American families, federal spending averages $36,000 per family per year, federal tax receipts average $20,000 per family per year, and the federal deficit now averages $16,000 per family per year. This is the legacy we’re leaving our children and grandchildren. Currently, our politicians are arguing about whether to cut spending by $400 or $600 per family per year.
With all of this going on, some of our clientele have expressed surprise that stock prices have moved up strongly in the past six months. We believe this has been due to several factors:
- Attractive prices six months ago (see ‘Memorandum #96); we believe that prices, in general, are now fair.
- Modest continued growth in the U.S. economy.
- Quantitative easing of $600 billion in purchases by the Federal Reserve (QE2); this is scheduled to end as of 6/30/11.
Our response in the past six months has been to be nearly fully invested in companies with strong balance sheets and strong income streams. With stocks, on average, now appearing fairly priced, we suspect that prices will be even more volatile going forward.
The comments made by Ron Muhlenkamp in this newsletter are opinions and are not intended to be investment advice or a forecast of future events.
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