When massive private and public sector debts result in a credit collapse and recession, the efforts to pare down the debt is deflationary. Measures to inflate our way out of the situation are likely to fail as households are attempting to pay down debt and increase savings, rather than start a new round of debt accumulation.
Author: Comstock Partners
As we face another brutal fight over the federal debt ceiling at a time when the economy still remains fragile, the stock market is oddly complacent. Even if the debt ceiling crisis is resolved, the result would be some combination of spending cuts and tax increases that would weaken the economy in 2013. A settlement, however, is far from a done deal as both sides remain far apart and determined to defend their positions. Far worse, if the debt limit is not raised or eliminated, the effect on the economy and markets could be disastrous.
The explosive market rally following the fiscal cliff agreement was based more on what didn’t happen than what did. What didn’t happen was the implementation of automatic tax increases and spending cuts that would have shaved about 5% off GDP and cause a recession. What did happen was an agreement that would still reduce GDP by about 1.5%, an amount that still looms as significant in light of an economy that is only slogging along at a growth rate of about 2%. Even more important is the potential mess that lies ahead. The Treasury Department’s extraordinary measures to extend the debt ceiling runs out at the end of February or the beginning of March. The sequester requiring automatic across-the-board spending cuts of $110 billion for 2013 goes into effect on March 1st. The federal government’s spending authority for the current budget expires on March 27th.
The real takeaway, however, is that the solution to the fiscal cliff problem involves some combination of tax increases and federal spending cuts. To the extent that at least some of it is front-loaded into 2013, which is likely, the result is a tightening in fiscal policy and a headwind to economic growth. While falling off the fiscal cliff amounts to extreme austerity, the probable solution also involves austerity, just less of it.
Like Pavlov’s dog, the market is conditioned to rise whenever investors see the possibility of central bank moves toward ease. This is true whether we are talking about the Fed or the ECB. The problem is that we have been gradually moving to a point where central banks can promise, but can no longer deliver.
We first noticed the first signs that the economy was beginning to soften about three months ago. Now the evidence of a slowdown has become so overwhelming that it is difficult to avoid the conclusion that we are headed for a recession. We cite the following as evidence.
Comstock Partners argues that slowing growth as well as deficit and debt problems in the Eurozone, U.S., China and the emerging nations increases the odds of a deflationary global recession and a renewed down leg in the ongoing secular bear market.
The bullish argument that houses are now generally affordable also does not hold up on closer examination. As we have repeated ad infinitum the average household has too much debt and is in the midst of deleveraging rather than taking on more debt. Furthermore, households, on average, do not have enough cash for a down payment or a high enough credit score to qualify for the more stringent credit standards put into effect following the credit crisis. Neither do they have enough income.
Given a clearly overbought market, the re-emergence of Europe’s sovereign debt problem and the Fed reducing the imminence of QE3, even the bulls concede that a correction is likely. Overall, however, investors remain optimistic, and are looking forward to any correction as a buying opportunity, maintaining that the economy is too strong and the market too cheap to decline very much. As we have written about in recent comments, we do not think the economy is anywhere as strong as many believe. Moreover, we do not accept the conventional wisdom that the market, at current levels is undervalued, a point we want to make in this comment.
A growing number of indicators suggest that the market is running out of steam. Equities have been in a temporary sweet spot where investors have been factoring in a self-sustaining U.S. economic recovery while also anticipating the imminent institution of QE3. This is a contradiction. If the economy were indeed as strong as they say, we wouldn’t need QE3. The fact that market observers eagerly look forward toward the possibility of QE3 is itself an indication that the economy is weaker than they think. We can have one or the other, but we can’t have both.
We received a phone call over the weekend from a close friend and someone who reads our comments religiously. He had a question for us. He wanted to know if we were still in the secular bear market camp or have we thrown in the towel since the economic news has gotten much better and virtually every index is either at or close to new 52 week highs or are fairly close to all time highs. He explained that it looked to him that the European risk has moderated, the China “collapse” has evaporated, the jobs and housing problems of the U.S. have now clearly turned. We responded that we are still in the secular bear market camp and, in fact, are surer than ever that we are close to a significant peak in the market. He responded, “Please, explain yourselves.” This is the logic we used.
For some time we have maintained that the economy, following the severe 2008 credit crisis, would grow at an exceeding slow and uneven pace, and this is the way it is playing out. This is unlike the garden-variety post-war inventory recessions that were mostly short and shallow, and followed by robust rebounds that quickly exceeded prior peaks. The crisis was caused by an extraordinary debt boom that will take many years to work off and create severe headwinds to economic growth. Household debt as a percentage of GDP averaged 55% over the past 60 years, but soared to 99% by 2008. It has now declined to 87% and still has a long way to go before returning to anything near normal.