DOW 12,000+ and Deficit $1.5 Trillion – an uneven score at best

On the same day that the DOW Industrials traded above 12,000 for the first time in more than two years (1/26/2011), the Congressional Budget Office released its estimate for the 2011 Federal Budget Deficit: $1.5 trillion… and counting.  There’s an irony in this that ought not to be ignored.  There will also be a price to pay.

In President Obama’s State of the Union speech he discussed the need to cut spending while at the same time make investments with federal resources.  President Obama and his economic advisory team’s actions have evidenced in recent years that they clearly adhere to the Keynesian economic concept of a multiplier; suggesting that spending on the part of the government will create more output than it consumes.  Without going into too much detail regarding Keynesian economics, lets simply note that Keynes proffered a theory wherein governments may spend their way out of high unemployment problems and lack of consumer demand as the millions spent are expected to create jobs; the wages of which are recycled through the economy via consumer spending, etc.  Though some prefer not to recognize the validity of Keynes’s multiplier effect, it’s readily observable and like it or not, Keynes was right; he didn’t afford himself the luxury of having to consider the long term costs of such a plan.

Some argue that with real interest rates hovering just above 0%, such spending, even with borrowed money, has little long-term adverse impact.  Add on the possibility that these debts may be repaid with inflated dollars makes the scenario yet less irksome for others.  On top of that, many dismiss the debt issue by suggesting that since we’re not financing this debt ourselves, as we’re letting the Chinese and others loan it to us, it matters yet less.  These are all good thoughts, but wrought with error nonetheless.

I should note here that I admire the work of John Maynard Keynes, his 1936 General Theory of Employment, Interest and Money is masterful and insightful, and as he predicted, it sparked a revolution in economics.  What I find most interesting is how the foundation from which Keynes and his concepts rose.  While discussing the underpinnings of his economic philosophies, Keynes offered the following:

The political problem of mankind is to combine three things; economic efficiency, social justice, and individual liberty.  The first needs criticism, precaution, and technical knowledge; the second, an unselfish and enthusiastic spirit, which loves the ordinary man; the third, tolerance, breadth, appreciation of the excellences of variety and independence, which prefers, above everything, to give unhindered opportunity to the exceptional and the aspiring.  The second ingredient is the best possession of the great party of the proletariat.  But the first and the third require qualities of a party which, by its traditions and ancient sympathies, has been the home of economic individualism and social liberty. (From the collected works of John Maynard Keynes; Macmillan 1971-89, page 311)

Far from reflecting the rigidity of marginalist or neoclassical economics, such thinking appears to accept a blend of pragmatism and idealism – a combination that’s often difficult to maintain.  For good or ill, it’s difficult for me to find fault with his observations; in fact, I find myself connecting to them on many levels, but in the end, reason must win out and popular or not, Keynesian or otherwise, adding hundreds of billions of dollars onto an already out of control debt burden smacks of irresponsibility.  The long-term costs Keynes was unable to address are sometimes just too great to reasonably bear.

In the early days of his administration, President Clinton became one of the first national leaders to describe federal spending as investment.  Though we later came to understand what he meant by the term, that such expenditures were to be directed towards infrastructure and other potentially meaningful projects, the economic climate, both domestic and global, was altogether different than that which we’re experiencing today.  In the end, spending is spending, and while staring at a $1.5 trillion federal budget deficit, it’s hard to understand how seemingly responsible political leaders can advocate more of the same when we’re clearly mired with a debt burden unimaginable only a few years ago.

The Republican victories of last November could easily be erased if the newly elected House of Representatives supports anything short of iron-fisted wallet tightening.  The trick is, how to decrease spending while protecting those in need and maintaining important infrastructure; how to differentiate productive expenditures from those that may be wasteful; or how to tell a generation of baby boomers on the verge of retirement that they may have to put off for another year or three or five, that which they’ve planned for over the last thirty plus years.  It becomes a difficult task, but it is the type of challenge that requires leadership to address and through which leaders are formed and identified.

To add to the irony of higher market levels and deficit announcements, 2,500 of the world’s wealthiest met in Davos, Switzerland during the same week to address a variety of issues ranging from those referenced above to how to ease nearly a billion Chinese and Indian workers into the market.  Ease is such a difficult term to use when speaking about a workforce roughly three times the size of the entire population of the United States, but it’s equally apt.  China and India’s leadership are attempting to balance the needs of their poverty class with real concerns over inflation, infrastructure development, and environmental issues.   Additionally, China is striving to keep the Yuan as closely pegged to the dollar as possible, while experiencing widely different rates of domestic growth; a strategy that has proven disastrous for other polities that have attempted to maintain similar currency policies.  They’re not to be envied and anyone truly aware of the enormity of what they’re dealing with is anxious to see how such a policy plays itself out.

I do, however, find it fascinating to see how they dance around the issues of global competitiveness when there simply isn’t any music playing.  The world is wise to pay attention and consider a future with a stronger China and India filled with resource-hungry consumers demanding higher wages and brighter futures.

With the DOW above 12,000

With 4^th Quarter 2010 GDP coming in at 3.5%, we now have 6 back-to-back quarters of positive GDP growth and with each successive quarter, market makers and industry insiders become increasingly confident; to the point that their confidence may finally be making its way to consumers.  The Consumer Confidence Board recently reported a 7.3 point increase in consumer and 12 point improvement in CEO confidence for January.  As these are the groups that control spending, investment and hiring, the upward shift is significant, especially in the midst of a cold, wet winter.

The market’s resurgence since it bottomed out at just above 6,500 in April 2009 has been built on this growth in confidence, a return to reason and a string of impressive quarterly earnings reports from publically held corporations.  Some suggest that a continuation of strong corporate earnings is less likely in future quarters as unemployment continues to hover near 10%, and they’re right.   Others point to the ease of showing growing earnings after a period of GDP declines, and they’re right.  Yet others contend that the US consumer, having shifted from a net savings rate of less than 2% to one of nearly 7% makes it difficult for demand to maintain levels supportive of ongoing earnings growth, and they’re right.  But each of these voices have been heard before, while the markets have continued to improve on the strength of increased earnings.  The consumer confidence element is critical as it’s consumer spending that drives increases in revenues and motivates corporate investment.  It’s also consumer participation in equity markets that can fuel additional stock market gains necessary to reach new market highs.

Some analysts and asset managers are now calling for the DOW to break 14,000 by the end of 2011.  A lofty goal by any measure for a market that has already retraced it movement back to the 12,000 level, but doable if the right sequence of economic, political and market events materialize.  Though it’s hard to see how such optimism can be maintained in the face of a $1.5 trillion deficit and the need to one day account for our excesses.

And that becomes the challenge; how to balance the reality of current and future debt levels with optimism for the future.  It’s a challenge with which our domestic market is familiar and one that requires hope (however audacious it may be), optimism and clarity.

A Personal Update

Readers of Signature Update may have noticed that it’s been a few months since we’ve published a new issue or offered commentary on economic and market events.  It’s certainly not because there haven’t been any events in our economy worthy of attention, rather, many of you know that I’ve been engaged in a doctoral program in economics at the University of Utah that has kept me more encumbered than I had supposed it might.  Between assisting in the operations of Signature Management LLC, fulfilling academic responsibilities, and striving to be a worthwhile husband and father, it’s been just shy of overwhelming.  However, there’s too much going on in the market and economy to keep quite much longer.

With that said, I thought I’d take the time to comment on an issue of particular import in today’s marketplace and national agenda:  the renewed debate over healthcare legislation.

I hope you enjoy the following issue of Signature Update.

A Future For Obama Care?

Many haven’t been terribly impressed with the Patient Protection and Affordable Care Act (PPACA, aka Obama Care) signed into law by President Obama in March 2010; while others see it as a remarkable piece of legislation.  In fact, it’s likely neither.  As the product of many legislative efforts between two passionate, but opposing political ideologies, the PPACA is cumbersome, burdened by bureaucracy, goes too far in some areas and not far enough in others, and in the end is very expensive while only dealing with some of the pertinent issues.  But with that said, there are some basic considerations that we ought not to ignore.

US citizens and our economy suffer from the inefficiencies of the current state of healthcare, health insurance and the rising costs of both… so much so that we still need to solve some major problems.  In 1993, when then First Lady Hillary Clinton took on healthcare reform, the nation’s policymakers simply couldn’t reach an agreement over what healthcare and health insurance should look like for the 21^st century.  Now, some 18 years later, after the healthcare debate has been put in front of the American people repeatedly, we’re coming to grips with what American healthcare coverage should look like and how it may efficiently and equitably cover the majority of US households.

Over the years, the makeup of the US House and Senate has changed and changed again, and with each successive rotation of legislators, voters have formed a congressional body prepared to tackle an issue that has grown from consuming barely 14% of US GDP in 2000 to almost 17% in 2008, with projections of more than 21% in 2011: remember, that’s a growing share of a growing number as GDP increased from $9.76 trillion in 2000 to $14.6 trillion in 2008.  In virtually every measurable way, healthcare usage and healthcare costs have risen such that there is no longer any debate over whether or not the American system of healthcare is in need of dramatic change.  The only debate is what those changes should be and how they might best be implemented.

The shift in political sentiment evidenced by numerous Republican House and Senate victories in November has now changed, for at least the next two years, the balance of legislative power at the federal level, so much so that the newly installed House of Representatives and more conservative-leaning Senate are seeking an outright repeal of the PPACA.  In addition, the constitutional challenges against the Act have gained momentum and it now appears that the individual mandate, central to the Act’s success, may be stricken.  Whether or not these efforts will prove successful for their supporters remains to be seen, but what is clear is that further change is in the wind and the outcome may be problematic.

Conservatives have offered open disapproval for many of the tenants of the Act, but have focused more narrowly on two issues raised through the healthcare debates: a potential public option and individual mandates.  Both are seen as expanding the role of government and subjecting our citizenry to potential inefficiency and a fearful bureaucratic morass.  While recognizing that a problem exists, they’ve been unsuccessful in gathering support for any proposal that is broad enough to deal with the issues at hand.  Many in this cohort suggest that free-market competition should be allowed to deal with what they see as a market based issue, but objective observation shows that the healthcare market doesn’t conform to competitive market requirements and some level of regulatory intervention is necessary to provide for our nation’s collective health.

Leftward-leaning liberals have advocated a nationalization of the healthcare and health insurance system and many openly support a public option and single payer system.  The PPACA stops short of providing such an option and system, but does include a sought after universal coverage requirement and its functional counterpart, the individual mandate.

Predictably, the two groups continue to be locked in opposition and appear to forget that our nation is a nation of centrists, most of whom simply want a more secure lifestyle without the wrangling of opposing political parties most heavily influenced by their vocal fringes.  What appears to evade those seeking to overturn the Act is that our economy, current and future, as well as our citizenry is in need of a better system for providing and paying for healthcare.  While the PPACA may not be perfect, its imperfection is the predictable product of compromise in a two-party system.  It may also be the one thing keeping a public option or single payer system off the table.

The PPACA’s mandate and universal coverage provisions are interdependent; without the mandate for virtually everyone to be covered by health insurance it becomes unrealistic to require insurers to cover applicants without respect to their health status.   The Act only allows for premium cost differentiation based on age, gender and whether or not the applicant is a smoker.  The only realistic way an insurer can comply is if they can expect to benefit by having a normative mix of applicants, both healthy and less so.   Absent the mandate, a public option becomes almost a certainty in order to cover the less healthy in our society.

The mandate’s possible unconstitutionality hinges on the federal court’s interpretation of the constitution’s commerce clause: is it lawful for the federal government to require the citizenry to purchase a particular good or service?  If it is, then the mandate may stand; otherwise, a problem arises and the universal coverage provision will either drive insurers to financial ruin or force higher premiums; neither of which is preferable.  Without the availability of reasonably priced health insurance, offered by financially viable insurers, the federal government is likely to have little choice but to intercede and offer a public option, almost certainly accompanied by a single payer system.

Additionally, if the mandate is deemed unconstitutional, but the political will to obtain health insurance coverage for all is strong enough, there’s another, perhaps even less advantageous way for the government to do so.  Some legislators have already considered the possibility of having health insurance purchased through state or federal funds and funding the purchase by an increase in taxes.  The argument is that the tax increase would be cash-flow neutral for tax payers as it could be accompanied by an offsetting decrease in insurance premiums paid by individuals or employers.  A counter argument is that tax increases are a slippery slope and that such a plan would likely lead to a single payer system; which competes with tax increases for conservative disdain, but  is highly favored among liberals.

So where does this leave us?  We have an expensive piece of healthcare legislation that was signed into law almost a year ago, meaningful portions of which have already become active.  We have an energized opposition seeking a dismantling of the law and a still-powerful body in support of it.  We have a court system that may one day find parts of the Act unconstitutional, though through a lengthy process that isn’t likely to offer any definitive response until after even more of our healthcare complex has modified its structure to accommodate current regulations.  We have a federal debt problem, exacerbated by recent economic conditions, that doesn’t need added pressure from implementation of the Act’s provisions.  And, we have an electorate in need of relief from the effects of the recent recession and drawn out election year political battles.  Maybe the fearful morass has become inescapable.

Whether the PPACA is repealed through legislative action or is dismantled via the federal courts, the void that might result is almost certain to be filled by future legislative bodies and the manner of fulfillment may be less satisfying to the architects of the Act’s demise than what was provided through the 2010 legislation.  Twenty years ago, when our nation could better afford to solve a systemic problem, the political will to find a solution to the healthcare problem wasn’t enough to move the matter outside of the Whitehouse.  A year ago, the issue was addressed and measures were placed into law in a hopeful attempt to affect a solution, however economically ill timed.  What happens next is certain to disenfranchise some and placate others; hopefully, it will be in the best interests of our citizens.

Record High’s in the Gold Market

With the DOW Industrials closing above the 10,860 level on Friday September 24^th, market observers should once again question the applicability of the phrase “Sell in May and go away”.  For those investors who sold at the beginning of May 2010, when the DOW was above the 11,000 level, current levels marginally serve to support their late-spring decision.  For those who sold later in the month, while the DOW struggled to remain above 10,000, there’s likely a lot of second guessing going on.  Regardless, September is shaping up to be the best September in some 20 years, with a month-to-date return of 9.4%.  While the month isn’t quite over and remembering that October can sometimes prove to be troublesome – my guess is that May sellers will once again be disappointed that they followed an outdated market idiom.

The price of gold breached the $1,300 level Friday without showing any signs of near-term weakness.  Aided by a weakening US dollar and ongoing concerns over federal spending and growing budget deficits, possible tax increases and a decidedly uncertain business climate, it seems obvious that the precious metal has some room to go.  With that said, it’s important to remember that buying at all time highs has never proven to be a winning investment strategy.

Though I’ve been skeptical of gold’s ability to remain at levels above $1,200 and have taken “Gold Bugs” to task more than once, it’s difficult to ignore what the gold market may be telling us.  The global demand for gold is increasing as a global economic recovery continues, the US dollar continues to weaken against other currencies and US policy makers are likely to accept yet further weakness before structuring monetary policy support in favor of the domestic currency, and investors fearful of federal fiscal policy changes expect long-term inflation to become more meaningful than near-term deflation concerns.  None of these come as a surprise of course, but gold’s movement in contrast to other economic pressures remains curious.

Typically, a weak dollar and increasing gold valuations (in US dollars) signal inflationary pressures on the horizon, and there are certainly some indications of this outside of the precious metals market.  The price of corn and other agricultural commodities are once again on the rise and personal and household incomes have increased (albeit slightly) despite a less than optimal economy.

On the other hand, energy costs have remained relatively stable for many months now, the cost of housing and transportation have continued to decline, and average retail prices have steadily decreased.  Increases in productivity and large scale buying opportunities have aided manufacturing and retail prices on the whole, even though some consumers still find periodic and sometimes surprising price changes at the grocery store.

In recent public statements, Fed Chairman Ben Bernanke has made it clear he remains concerned about deflation and is prepared to take additional aggressive action to keep price levels stable.  In truth, he sees it as the most pressing threat to the economy.  Were it not for the current weak dollar policy and ultra-low interest rates, deflationary pressures may have already become problematic.  The trick central bankers will need to pull off is to tighten monetary policy and strengthen the dollar as deflationary pressures wane and inflation becomes more of concern.

Recovery is a Process and There’s a Long Way to Go

We continue to receive inquiries regarding the strength of the economy, both global and domestic, and questions regarding why there still seems to be economic uncertainty and pain in the face of widely reported economic recovery.  The truth is that the US economy, as well as that of many other foreign countries, has now been in recovery mode for over a year.  But being in recovery is very different than having recovered and this particular recovery will likely drag on longer than anyone might have hoped.

It’s going to be a while before the pain subsides and the marketplace returns to what might be considered normal.  With unemployment remaining close to 10% and the US housing market continuing to struggle, we’re likely to see several additional years of less-than-optimal growth trends.  Even then, it’s unlikely we’ll see the high growth rates of the mid-2000‘s.  The reasons are many of course, but there is one factor beginning to become more readily observable than had been expected.

America is beginning to retire and the baby boom retirees are set to consume investment capital at a much faster rate than employ it.  While the average retiree may only possess less than $200,000 in investment assets, the impact of millions of new retirees drawing from their investment accounts, rather than adding to them, is unmistakable.

Though this shift may not be the central cause of the housing and employment market difficulties, it’s certainly a contributor to prolonging them.

More retirees are turning to lower wage employment for supplemental income and as a means of staying occupied than ever before.  Not only has this had an impact on younger workers seeking employment, it’s made it more difficult for recently unemployed workers to find short-term employment while seeking a more appropriate permanent position.

Many of those who purchased second homes in the last 10 years did so with the intention of retiring in the smaller of the two homes and as then sell the larger.  Though the opportunity sell may not be as strong today as it was when these near-term retirees began to execute their plans, a large percentage choosing to sell what had previously been their primary residence.  For many, this has become preferable to renting the larger home to others or waiting until higher home values are available and selling.   Additionally, most retirees didn’t plan on the expense of supporting two residences, possible even two mortgages, during their retirement years.   This has exaggerated problems in the housing market and aided in keeping prices low and inventories high.

To be certain, the effect of retirees on the investment, employment and housing market may not seem substantial, but in a nation of complex and interdependent markets even small changes form important outcomes.  For those who doubt this, just consider the overall economic impact experienced by a 4% increase in unemployment or how significant it becomes to go from a surplus of 2% to a loss of 1% – it may only be a small move in relative terms, but in many cases it means the difference between winning and losing for households and businesses.

All of this adds to the numerous other factors supportive of a prolonged period of low growth and may cause governments, businesses and households to adjust the way they look at financing operations and where they turn for investments.  We’re already seeing that states are reeling from budget issues at first thought to be temporary and businesses have sought capital-consuming productivity gains over bringing back displaced workers.

Though we’ve eschewed the concept of a “new normal”, it’s important to note that the effect of demographic changes, increased federal debt burdens and impending cost changes due to regulatory, tax and healthcare legislation have adjusted the landscape for businesses, households and governments.

What continues to be impressive is the strength and resiliency of the US consumer and domestic economy as a whole.  Regardless of how daunting issues may appear to some, the bulk of decision makers are prepared to move forward and challenge fear in search of what comes… and that may be the important factor of all.

M&A May Offer Excitement, but Leadership and Consumption Yield Growth

The recent malaise in the US stock market continues to reflect the same pattern of uncertainty discussed in the August 13, 2010 issue of Signature Update.   So much so that it’s becoming increasingly difficult to ascertain if the difficulties in the housing and employment markets are cause or effect for the equity market’s fluctuations in recent weeks.  What is relatively certain is that the markets are looking for leadership, of which there appears to be little on the horizon.

Though the markets are trading well off their late-April/early-May high’s of over 11,000 on the DOW, the markets are currently trading in the same range as late May and have a good chance of once again besting the “sell in May and go away” protagonists who regularly come to the surface in early summer.

It’s true that we can continue to argue that PE ratios make many US stocks look cheap and that there are numerous indicators suggesting we’re dealing with an undervalued market.  There are also credible concerns being raised by knowledgeable market observers and there’s no discounting the impact  9.5%+ unemployment is having at the household consumption level.

On the brighter side, recent M&A (Mergers and Acquisitions) activity has provided excitement; not just because of the upside potential available to shareholders of targeted corporations, but because it signals that some of those with the greatest resources to invest see that there are some real bargains to be had in the current market.   Among those deals sparking the most interest have been the Dell-3Par competitive bid against rival Hewlett Packard, the BHP-Potash hostile takeover bid and the Stryker-Gaymar acquisition announcement; each one offering excitement to an otherwise lackluster market.  In the end, it’s going to take more than M&A activity to give legs to the current market; investors are looking for leadership and sustainable, increased consumer demand – both of which would appear to be in short supply based on current indicators and in light of uncertain economic conditions.  But just how uncertain are they?

Clearly the trajectory of the mid-term 2010 elections has put into question what the fiscal and regulatory environment may look like in 2011-2012.  Few but the most ardent supporters of President Obama are prepared to suggest he’ll succeed in a bid for a second term, but the markets have already discounted for potential, near-term outcomes – higher taxes, higher spending and more regulation courtesy of an increasingly larger federal government.  As the summer winds down and the direction of early-November election outcomes become less vague, the markets appear poised to reward patient investors who stayed the course and resisted the urge to take on a more defensive portfolio.

Targeted Tax Cuts as Fiscal Stimulus

Current economic conditions are testing the wisdom of the Keynesian-style stimulus package delivered by the Obama administration via the US Congress in 2009.  Though the economic strength of TARP investments has become clear, the $787 billion in stimulus plans, now mostly expended, seems less than impressive.

Keynes became the leading proponent of deficit spending as an aid in stabilizing a recessive economy with the 1936 publication of his General Theory of Employment Interest and Money.  While observers of the Great Depression often credit Roosevelt’s support of Keynes’ theories for bringing an end to high unemployment and staggering deflationary pressures, there’s actually much more to it.  What is overlooked by many, though thankfully not by Federal Reserve Chairman Ben Bernanke, is that it was the combination of federal budget deficits and aggressive monetary policy responses that helped turn the country’s economic fate; that and the onset of World War II.

What many forget is that Keynes proffered deficit spending at the federal level without mandating how such deficits might best be employed.  It’s a detail that offers important insight into the state of the US economy today, especially after implementation of the largest stimulus package in history and amidst the most substantial budget deficits our nation has ever experienced.  Arguably, such deficits may provide long-term crippling problems for the US, but there’s more than one way to create a federal budget deficit and the differentiating factor is who ends up in control of how the deficit is to be spent:  tax payers or bureaucrats.

There’s much debate over whether the federal government is the best body to determine how taxpayer monies should be spent.  Sadly, that debate rarely occurs inside of Washington DC.   In fact, such debate is at the heart of the Tea Party movement currently wreaking such havoc for incumbents of both political parties.  Most understand that deficits arise when Congress adopts spending plans in excess of revenue generation (tax collection).  Such spending programs may be similar to President Obama’s stimulus proposals, while others may be needed to support military action, as was the case in the 1940’s.  While few can credibly argue that war time deficits are worth the ultimate cost, many debate whether or not stimulus programs rooted in transfer payments and “infrastructure investments” are ultimately worthwhile.

What about the other deficit-creating stimulus program?  The one where the American people directly impact how monies are spent rather than delegating the task to elected representatives.  We’re talking about tax cuts and though they may be less popular with lower income households, who decides how funds are to be spent is a matter of to whom the cuts are directed, not whether cuts might be popular.

The outcome of supply-side theories promoted by economist Dr. Arthur Laffer during the Reagan era rendered tax cuts a less desirable mechanism for economic stimulus and fiscal conservatives haven’t done a very good job of countering the arguments against them.  The problem lies in the fact that most of the time such tax cuts are discussed the topic is coupled with promises that the increased economic activity the cuts may yield are likely to create more federal tax revenue than the cuts initially cost.  While this is an interesting and enticing possibility, it’s difficult to support through objective observation.

The issue that ought to be addressed is that tax cuts are simply another form of deficit-creating economic stimulus and when viewed through any other lens the picture loses focus.  An important attribute to tax cuts is that they put spending authority into the hands of taxpayers rather than elected officials; a move that’s feared to threaten the political lives of those it might otherwise save.  How likely would it be for Tea Party activists to find credible support had the voters been those empowered to spend nearly $800 billion in stimulus funds authorized by the current congress?   Not very!

The error fiscal conservatives make is in running from Keynesian concepts when economic times indicate monetary policy alone isn’t up to the task of redirecting a recessive economy.  Rather than completely derail possible stimulus plans, the political right would do well to join their counterparts on the other side of the aisle and help frame the debate.  Likewise, progressives hold too tightly to their superiority as it pertains to making spending decisions for the American public.  Were each side to shift their thinking slightly, the outcome may well assure sought after political victories.  More importantly, it’s likely to spark the very increases in consumption needed to thwart unemployment and housing market concerns, while also offering a boost to equity values.

Most opponents of tax cuts forget that it’s the House and Senate that determine to whom such cuts are to be extended and while it’s naïve to think that higher income households wouldn’t stand to gain from such activity, it’s just as erroneous to suppose that cuts can’t be targeted to lower and middle income households that may have been among the hardest hit in the recent recession.

Not to be misunderstood, I’m not advocating extending the federal deficit farther than its current stratospheric level.  However, if additional stimulus activity is deemed warranted by federal policy makers and our elected representatives, either in the current Congress or the next, then a move to put spending authority into the hands of the voters may yield benefits beyond the obvious.  Whether or not Keynes accurately predicted the impact deficit spending might offer a recessive economy isn’t the issue of the moment; how to encourage consumption and capital investment is and there’s nothing like a tax cut – aka stimulus program – to make things happen.

Market Dynamics Revealing Patterns of Confusion

The US equities market had traded in a relatively narrow range for most of the last few weeks following the release of 2^nd quarter earnings reports and leading up to the release of unemployment figures, GDP results, the Federal Reserve Open Market Committee statement and other important economic reports.  That all changed Friday, August 6^th as the market began a series of declines reflecting a pattern not unlike that seen following the release of 1^st Quarter 2010 data.

The pattern appears to be that of investors rewarding those companies with good earnings and revenue growth when reported and then succumbing to overall economic concerns and backing away.  Only to exhibit some level of surprise three months later as the next quarter’s corporate reports show further earnings and revenue increases.  The pattern is also one of a lack of conviction in the markets and is supported by the lighter-than-normal volumes the market has faced for a period of months now.

What this shows is just how concerned the markets are at a possible return to recessive levels of economic activity.  Investors pull back on such concerns, employers refrain from hiring and lenders tighten standards – none of which is supportive of growth and such response, if prolonged, could be the very catalyst that moves the economy back towards negative performance.

All of this was supported in Fed Chairman Bernanke’s recent comments and the FOMC statement released Tuesday, August 10^th.  That the Fed elected to keep it’s balance sheet at it’s current size and intends to reinvest in treasury and mortgage debt as resources come available is an important step in supporting the markets.  It’s also one of the few meaningful options the Fed has at the moment; though there are more aggressive responses the Fed is saving in the event the economy shows greater signs of weakening.

Much of the movement the markets have experienced in recent months has been reflective of these aggregated concerns and seemingly ignores the reality that corporate America is doing better than most casual observers realize.  The growing trade deficit reported August 11th indicates a combination of better-than-expected US retail activity, exchange differences between the US and international trading partners and slower growth in the US and other developed economies.  While these conditions certainly merit attention, they don’t support the 265 point decline in the DOW on Wednesday, nor are they sufficient to signal declining growth patterns.

As discussed in previous issues of Signature Update, the treasury yield curve, still one of the better indicators of future stock market valuation, remains steep enough to support equity value increases of 10-15% in the coming year.  Likewise, current PE ratios remain low enough to support similar market performance, perhaps as early as late 2010.

At the heart of these issues remains a level of investor confusion over future fiscal policy as indicated by the current administration.  Though the mid-term 2010 elections are likely to settle things down enough to clarify taxation, spending and regulatory expectations can reasonably be had for the next several years – all of which has important impact on the employment markets – it remains uncertain as to which direction these are likely to turn.  What is more certain is that the markets and the American people are less satisfied with the current hopes being presented by elected officials and until the picture becomes more clear, the markets are likely to continue to exhibit the back and forth patterns we’re currently observing.

Opening Pandora’s Box

The US District Court for the Northern District of California’s overturning of California’s Proposition 8 on Wednesday, August 4^th reignites an issue that may well lead to a landmark decision by the US Supreme Court.  Though most in support or opposition of the proposition look at the issue as one of gay and lesbian rights, the reality is that it’s an attempt to define marriage for a society in which the political, cultural, economic and religious institutional structures have come to value marriage as an institution.

That Judge Vaughn Walker’s ruling focused on marriage as an institution in support of procreation isn’t surprising in light of how many have come to view this issue, but it is ironic in that it is the one element of marriage the federal government has continued to aggressively support.

Marriages weren’t always common among developing civilizations.  Though there are many scriptural references to marriage to be found in most canonized texts (including the Bible, Torah, Qur’an, and Veda) and thematic folklore (fairy tales) often focusing on marriage and romance, marriage as a formalized function consisting of registration and contract is a more modern invention.  For some, marriage is and will always be a spiritual issue rooted in theology, for others it is simply an issue of contract and for yet others it is a social construct inclusive of spirituality, contract and community.  Without endeavoring to place marriage into any one of these, aka opening Pandora’s Box, an examination of marriage from the state’s point of view may be helpful (in this case state is intended to represent organized government).

In western civilization, before the formation of strong state and religious institutions, marriage was principally the purview of the landed gentry.  It was used to formalize contracts between landowners as they would pass their rights of property from one generation to the next.  The rural working class formed households, of course, and often participated in ceremonial celebrations intended to recognize the union, but marriage as it is known today only became common as the church, acting as proxy for the state, sought to build a more formal societal structure.  As the pre-modern lines between church and state were so commonly blurred, it remains difficult to ascertain which held the greatest influence regarding the formalization of marriages.  What is more clear is that marriage was adopted and subsequently sustained as a means to provide certain social and economic incentives and to motivate specific societal activity.

Absent formalized unions, these early societies found it inefficient and difficult to levy taxes at the household level and to determine the ownership of property.  These issues remain today, but have been joined by other, perhaps equally important considerations.

In modern times, marriage has continued to be a useful institution relative to taxation and property, but it has also become an important tool to incent preferable levels of population growth.  In those societies in which formalized marriages are less common, population growth is observably lower.  While this was less of a concern prior to the efficient use of birth control and more medically safe abortions, it has become a very real concern today.  Birth rates have declined in almost equal proportion to the rise of non-marriage related co-habitation; so much so that much of Europe, the United States and economically developed Asia have become dependant on immigration to maintain desired population levels.

Though the institution of marriage continues to have significant spiritual overtones for those inclined to accept such influences, these aren’t meaningful considerations for governments, while population levels, taxation and property are.

Which bring us back to California’s Proposition 8.  Though it’s unrealistic to suggest that all those on each side of this issue are prepared to separate the emotional or spiritual from the pragmatic when it comes to the institution of marriage, it’s important that policy makers do so; including Supreme Court Justices.  If governments recognize formalized marriages to incent population growth, levy taxes and determine property rights, then policy makers must restrict the debate accordingly.

State and federal governments have consistently supported marriage through tax codes in an effort to offer fiscal incentives for preferred behaviors and outcomes, very similarly to the way employers offer added monetary benefits to motivate performance among employees.  Though it may be unpopular to point this out, married households receive tax breaks to incent birth rates and additional tax breaks are offered to those households raising children.  Similarly, the estates of deceased persons receive tax incentives as assets are passed from parent to child or husband to wife (and vice versa) that aren’t available when assets are passed to others.

Clearly there are those married couples who are unable to bear children and contribute to population needs; these households enjoy the same property and some of the tax benefits as do those able to support population levels, but this lack of ability is less often a choice among married couples and is mourned by most who experience it.  The ratio of married couples who choose not to bring children into the world is insignificant compared to non-married couples who make the same choice.  For the state to extend the same benefits to household unions without any pretense of offering back that which the state seeks to incent is problematic.

Similarly, tax codes exist for businesses that essentially support the same behaviors.  It is the government that allows for the tax deductibility of health care and retirement benefits, offering preferences for married couples under the same conditions as it allows tax benefits to households – as incentives to motivate preferred behaviors and outcomes.  These are economic issues and directly relate to a government’s ability to support a behavior in order to receive a desired outcome.  In this case to support marriage in an effort to maintain needed population levels as well as to efficiently handle issues of property ownership and taxation.

As the institution of marriage is supported by governments for the purpose of maintaining important population levels, tax revenues and the determination of property rights, it’s far too important and potentially counterproductive for state or federal governments to use it for other purposes.  The possible redefinition of marriage from a one man-one woman concept to anything else may open the door for even more far reaching interpretations and applications; some of which may offer disturbing outcomes.  For example, if procreation is no longer a consideration for marriage, then might a redefinition allow someone to marry a close family relation?  If government chooses to alter the definition of marriage and restructure marital property rights and tax considerations, could one choose to be married to more than one person at a time?  To some these may seem like ridiculous expectations, but the point is whether or not our society is prepared to open up what may become a Pandora’s Box.

Marriage has definition for reasons that extend beyond cultural considerations.  Judge Walker’s choice to rule against Proposition 8 based on whether or not the state has the right to support the institution as a tool to promote procreation contradicts hundreds of years of policy.

Already existent on the books of many states is the ability to enter into formalized unions.  Though these may not immediately appear to offer some of the romantic considerations of marriage, that’s more an issue of societal expectation.  As social acceptance of same-sex couples broadens, which acceptance is likely to accelerate in the absence of the current divisive debate, the uniting of these couples will carry greater cultural import to a larger portion of society and those less tangible affects of household formation will become more emotionally appealing.

What remains at issue is whether formalized unions other than marriage ought to carry the same benefits of property as does marriage.  That Walker chose not to address this issue reveals a flaw in the court’s rationale and has aided in opening up the ruling to appeal and potential reversal.

Fifty years ago society was less accepting of racial diversity; thirty years ago the acceptance of females as leaders and decisions makers in the workplace was rare; twenty years ago a legislative consensus couldn’t be reached to offer health insurance to a broader portion of the nation.  That barriers have been broken and social and political support for each of these has become the norm evidences institutional evolution and suggests that adult unions supported by state policy may gain broad based acceptance in the future.  Attempts to force such acceptance via breaking from an institutional definition supported for millennia only risks pushing that acceptance being pushed further into the future.

Controversy over Life Insurance Payouts

When New York Attorney General Andrew Cuomo announced plans to investigate the actions of several major life insurance providers’ policies regarding death benefit payouts on deceased military personnel, it stirred up more than a little controversy for the financial markets.  At issue is how these firms offer payout amounts to beneficiaries and whether or not the insurers stand to profit from funds held on deposit with their institutions.  Also at issue is how badly Cuomo, like Elliott Spitzer before him, wants to be the governor of the State of New York.

It’s irritating to see elected officials like Cuomo use tragedy among military families to gain attention.  While none of us expect these officials to be apologists for the insurance industry, it wouldn’t hurt for them to recognize that there’s little insurers can do that hasn’t passed regulatory scrutiny and disclosure to policy holders or their beneficiaries.

It’s common practice in the life insurance industry to allow beneficiaries to take life insurance payouts in a variety of ways, including lump sum options that can be paid out directly or be left in an interest bearing account with the insurer until the beneficiaries make decisions as to how these funds might best be utilized.

When funds are to be left on deposit, there is typically a “check book” provided the beneficiary so they can access funds as needed and these deposits accrue interest at a stated rate.  Though these aren’t bank accounts (insurance companies are not banks), they act very similarly to money market accounts available though most banks or credit unions – with some important differences that are spelled out in minute detail on documents provided the insured and to those receiving the death benefits.

These details are reviewed by state insurance officials in every state in which the insurance company offers policies and are subject to state and federal regulation on numerous levels.  Like virtually everything in the financial services industry, the internal policies and procedures of these firms regarding investor monies are painstakingly detailed and documented.

In the case of the current controversy, Cuomo and his followers, including some US Senators and House members, have taken issue with the fact that the insurers earn a higher rate of return on deposits than they offer back to depositors.  They’ve also expressed alarm that the “check books” are actually drafts that aren’t immediately exchangeable for cash and are only intended to be used to transfer funds from the insurer to the beneficiary’s bank or credit union accounts.  That these policies and procedures follow regulations imposed on insurers from state and federal agencies appears to be lost on Cuomo and his followers – or perhaps its just politically inconvenient for them to have to accept that the insurers in this case aren’t the evil-doers they might like to make them out to be.

While it may be popular to label these insurers as unpatriotic and to suggest that these firms ought not to profit on policies offered to military personnel, it’s also grossly naïve.  Were these firms not able to profit from their insurance related activities, they wouldn’t be in a position to offer the policies to begin with.  This would either leave the government to offer important benefits to the families of service men and women, or to not have these benefits available at all.  Neither of which seems preferable.

It’s unfortunate that some misunderstand the benefits they’ve been offered and how they might access the resources left by those who’ve made the ultimate sacrifice for our country.  At the same time, when an insurance company has outwardly disclosed its policies and procedures to those subject to them and they haven’t been paid attention to or understood, it’s unreasonable to lay the blame at the feet of the insurer.  Unless, of course, those laying the blame are seeking notoriety and hope to find themselves in the limelight of populist attention in the months leading up to an important election – while this may not make it more reasonable, it certainly makes it more understandable.

Austerity or Stimulus; Which Best Serves the US Economy

As the US House and Senate grapple with the reality of an out-of-control federal deficit, uncomfortably high unemployment and what appears to be troublesome mid-term elections, the debate over what will best serve the US economy heats up.  Or at least continues to arise in virtually every serious economic and political conversation.

European and Tea Party leadership are looking for the US to enact spending cuts at the same time the Obama administration is looking to raise taxes.  The US House and Senate continue to assess the congressional will to apply another round of stimulus to the economy while facing pressure from constituents to make budget cuts and help promote jobs.  While these may make for good sound bites, they actually represent difficult issues and may be contradictory to other, more pressing needs as well as plans currently in place.

The hard reality is that the US economy needs jobs and needs a reduced federal deficit; not in three to five years, but now.  To stimulate employment we either need to reduce taxes (which may include maintaining the Bush tax cuts) or execute an expertly designed stimulus program.  The problem with either of these is that they each risk exaggerating the budget deficit – at least in the short run.  Raising taxes or cutting spending may allow for a better deficit picture, but at the risk of jobs.  So what’s an elected official to do?  Or an economist for that matter?

To begin with, policy officials have to remember that it’s not an all or nothing proposition.  A combination of strategic cuts in taxes aimed at stimulating capital investment and retail spending puts resources into the economy with greater efficiency than a politically engineered stimulus program might.  Coupled with spending cuts directed towards those projects that aren’t likely to increase economic growth, no matter how beneficial they might otherwise seem, this stands a real chance of improving federal budget deficits.

This all sounds a lot like Regan-era supply side economics, and it is.  But it only works when congressional representatives are prepared to make potentially unpopular choices, refrain from unnecessary spending increases, and “hunker down”.  Sadly, this may be too much to ask in the face of the coming mid-term elections, as too many House and Senate members need to curry favor with their constituents to remain in office.  Were the economy in a less brittle state, tax increases may be warranted, but it’s not and we’re left to play the hand we’ve been dealt – for now.

This is tantamount to what Fed Chairman Bernanke urged Congress and the White House to do in July 22^nd remarks, as he asked them to avoid raising taxes and maintain current stimulus program plans.  Further statements have been made by Fed officials regarding the efficacy of additional stimulus plans when the existing stimulus program has only released or committed to 62% of the $787 billion authorized.

Though 77% of the stimulus program’s contract, loan and grant provisions have been exercised and 61% of entitlement funds have been released, barely 45% of the tax benefits have been granted.  What this represents is that the majority of the funds to be dispersed under federal and political controls have taken place; while less than half of those funds to be distributed through tax payers have been released.

It’s this sort of activity in the face of potential tax hikes and new stimulus efforts that raise the hackles of tax payers, too many of whom are struggling to find ways to put food on the table and pay their mortgages.  That these issues are being debated in advance of policy action is a win for the US economy.  The discussion will almost certainly remain at the forefront between now and early November when the composition of the next congress will be made known and decision makers will have a few months before feeling the need to focus on their next campaigns.

So Who Just Outsmarted Who – BP or President Obama

• July closed with the largest monthly stock market gain in over a year with the DOW gaining more than 650 points to close the month at 10,466 – a gain of almost 7%.  The upward movement was lead by stronger-than-expected earnings reports coupled with recognition that economic activity for the foreseeable future, though not stellar, ought not to be represent the fearful expectations on which many were focused in May and June.

• BP’s late-July announcement that it will use approximately $10 billion in federal tax credits to fund half of its $20 billion Gulf clean up commitment seems more than a little disingenuous.  It’s hard to believe that Tony Hayward and company didn’t make the commitment without having counted on this resource.  It’s equally as difficult to accept that President Obama and his aides weren’t aware of BP’s plans in the regard.

• Among the wins the Obama administration might well take credit for is the current state of the automobile industry.  Not that the economy has rebounded sufficiently to meaningfully increase sales, but the fact that there are still three major US auto makers from which domestic car buyers can choose isn’t a trivial thing.  Sales are up, margins are improving, and quality and innovation appear to be better than ever – not to mention the fact that the industry that might have cost the US economy upwards of a million jobs in the event of complete failure has added more than 60,000 jobs as it’s risen from the ashes.

There’s Nothing New About Normal

Over the last several months, market watchers and casual observers have begun to talk about a ‘new normal’; suggesting that US households and firms should adjust expectations to fit a new economic expectation and reality.  Though it’s hard to argue that our economic condition of late has been ‘normal’, it’s just as difficult to credibly discover anything new about the current outlook – unless of course you missed the 1950’s through 1980’s.  In truth, the new normal is simply normal.

In the post-WWII era, the US economy has certainly experienced periods of economic growth and low unemployment and interest rates as well as increasing equity, real estate and commodity values.  Likewise, we’ve seen periods of recession, slow growth, high interest and unemployment rates, US dollar value shifts and falling markets.  Like it or not, these are all normal market conditions; they represent an economy responding to fiscal and monetary policy decisions, possible market shocks, demographic changes and opportunity.  These are the trends markets and economies are made of.

The high growth, low interest rate, and high job creation of the 1990’s and 2000’s is what’s less normal, at least for extended periods.  That a high percentage of today’s decision makers have been educated and trained during this period may make current GDP growth expectations of 3-5% seem low or slow job creation in the aftermath of a recession appear weak, when in fact they’re both trends that can be observed numerous times in the last 60 years.

While the crisis-oriented conditions of late 2008 and early 2009 did present an opportunity for an economic reset, they didn’t usher in a new normal.  What they may have done is given the US and global economy a very painful, though possibly necessary means to return to normal after an extended period of obviously unsustainable growth and spending.

“Unusually Uncertain” Isn’t Exactly What We Had in Mind

Wednesday afternoon, Ben Bernanke began two days of semi-annual reporting of monetary policy before Congress.  While the Fed Chairman will certainly use the forum as an opportunity to outline the Fed’s economic expectations for the coming quarters, maybe this time members of congress will actually ask Bernanke about monetary policy issues rather than use him as an expert witness in favor of their favorite partisan points.

The biggest question investors had awaiting Bernanke’s comments was “In an economy in which inflation is below targets and unemployment is high, why isn’t the Fed doing what it can to stimulate economic activity?”  Helicopter Ben answered it and then some; he’s waiting for the right timing and market conditions, and oh… by the way… these are unusually uncertain times.  The market loved that comment to the tune of an over 100 point drop on the DOW and we’re not sure what Bernanke meant.  Anyone paying attention for the last 15 years might have noticed that uncertainty has been a market constant – whether for good or ill.

The Fed has monetary policy tools at its disposal, but with interest rates essentially at 0%, there’s little the Fed can do with rates.  However, the Fed can reinstitute its program to purchase US treasury bonds and mortgage backed securities.  For now, Bernanke believes that the benefits of employing more of its policy tools, including purchasing these instruments, is outweighed by the cost.   The Fed may be holding onto these weapons in the event that the economy needs major assistance to avoid a double dip.

The market turned from a 125+ point loss to a gain of over 75 points Tuesday July 19^th on rumors the Fed may stop paying interest (low that it may be) on bank deposits held at the Fed and then lost ground on Wednesday as a result of top-line sales concerns.

Tuesday’s rumor turned out to be unfounded conjecture, but the market’s willingness to react to such reports reveals the need for concrete action from policy makers to get bank lending back up to levels supportive of economic growth.  Even though the earnings banks can receive through Fed balances are minute, they’re also certain, and at current levels of risk and reward offer a more attractive picture for bankers.  If banks are no longer able to receive gains on Fed deposits, they’ll need to look elsewhere for yield, which should cause them to loosen up lending and seek other investment opportunities.

Likewise, the market decline surrounding Bernanke’s comments Wednesday represented reaction to little more than anticipation at what Bernanke might say next.  As President

Obama promised no more Wall Street bailouts during his signing of the recently passed financial regulatory reform bill, the markets waited for Bernanke.  As important corporate earnings reports were being digested by investors and analysts the market waited for Bernanke.  When Bernanke spoke the market stopped waiting and gave up ground in the face of two more important events: banking reform and the reporting of corporate profits in excess of expectations.

Thursday July 22^nd’s rally of some 200 points on the DOW amounts to the market’s wake-up to what was glossed over the day before – companies are making money and employees are slowly returning to the work force; exactly what we might expect in the 3^rd and 4^th quarters following an extended economic downturn.

A Tale of Two Economies?

Though the US stock market successfully struggled for its seventh straight gain Wednesday, some investors are beginning to look towards the DOW reclaiming the 11,000 point level by Labor Day, while others continue to be concerned about a pull back.  At issue are seemingly contradictory corporate earnings reports versus concerns over how small business are faring in this stage of the nation’s economic recovery.  The scenario is leading some to suggest the US is in the midst of a bifurcated economy – an economy split between a growing big business sector and small businesses struggling to compete.

The equity market’s recent rise comes on the back of impressive earnings reports from tech giant Intel (INTC), metals manufacturer Alcoa (AA), freight transporter CSX (CSX) and others as 2nd Quarter 2010 earnings reports are being released.  Each of the last four days have brought reports of higher than expected revenues and earnings in the face of analysts and investors having recently scaled back expectations.  Though it’s true that some of the best reports are released early in the reporting season, the reports that seem to be moving the markets are coming from firms that make up the backbone of the business market and offer an objective glimpse into the strength of the US economy.

As discussed in the July 8^th issue of Signature Update, recent market levels have reflected discounted equity values have been due for a positive correction.  After months of negative reporting from major media outlets and a string of difficult economic events, investor sentiment had become unrealistically low, creating a buying opportunity in the markets.  Whether the market’s recent rally will extend further will rely largely on how investors compare 2^nd quarter earnings gains with 2^nd half economic expectations.  Much of the story will be told as financial stocks begin reporting July 16th, including GE (GE), Bank of America (BAC), CitiGroup (C),  and State Bancorp (STBC), and as firms offer tech, manufacturing and financial stock offer projections for 2^nd half revenue and profit expectations.

GE’s CEO Jeffrey Immelt offered a glimpse into his firm’s earnings July 13^th as he discussed GE’s Ecomagination campaign; now contributing more than $20 billion to GE’s revenues – up from $5 billion in 2005.  “Green is green” offered Immelt in a presentation that evidenced what may be an important issue facing US businesses: those with access to capital and fresh ideas are posting increasing profits, while those smaller firms that are less able to attract capital are struggling.

At the same time, some investors and the Federal Reserve are exercising caution in the face of a small business report released this week by the National Federation of Independent Businesses (NFIB), reflecting growing pessimism among small business owners.  “Either policymakers have no idea how to help the economy or they are intentionally committing it to unsustainable expenditure growth and deficits so large that there will be no alternative but to raise taxes, a slow suicide for a dynamic economy,” the report stated. “While political leaders trumpet their ideological attempts to remake the economy and save small business, more and more ordinary folks are wondering what in the world are they are thinking.”

Small business owners (those with 100 employees or less) represent the largest portion of the US labor market and have provided the majority of domestic job growth since the late 1970’s.  Among this group’s concern is the apparent lack of credit capital available from banks and venture funding, which capital is critical to business development.  In July 12^th remarks to the Federal Reserve Forum, Fed Chief Ben Bernanke urged lenders to ease credit restrictions for small business, citing decreased lending due to collateral problems, stricter lending standards and diminishing government in.  Bankers fired back claiming that small business loan applications are down commensurate with the decline in lending, suggesting there’s capital to lend to those business owners prepared to ask for it.

Regardless of the cause, the affect of reduced credit capital to America’s employers can be seen in the nation’s unemployment levels; still lingering above 9% with some states, including California, Michigan and Nevada, officially reporting 12-14% levels with unofficial reports averaging 15.8% nationally.  Inc Magazine’s July 2010 issue offers constructive input on Revitalizing the American Dream through entrepreneurial innovation and jobs growth and offers a 14 point, integrated plan to stimulate the US economy.

With the seemingly disparate experiences among large and small businesses, economists and market watchers are weighing in on whether or not small business activity is a lagging indicator representative of the difficult economy we’ve weathered over the last few years or a leading indicator of the nation’s economic future.

The Federal Reserve’s Policy Influence

With unemployment lingering above 9%, retail sales reports reflecting reduced activity among US consumers and the mid-term 2010 elections just over three months out, Washington DC policy makers have encouraged the Federal Reserve to consider the potential cost and benefit of further economic stimulus programs.  The Federal Reserve’s Open Market Committee (FOMC) released its economic forecast on Wednesday and projected slower economic growth for an extended period, including GDP gains of approximately 3% and unemployment expectations of 7-9% for the next 3-5 years.

While short-term interest rates remain effectively at zero, the Fed has limited ammunition with which to affect economic change, but they’re influence is not to be discounted.  The Federal Reserve remains the most objective and credible source for economic policy influence around the world.  Less than a year after other central banks publicly called for a shift away from the US dollar as a global currency, and the Fed’s vocal critics in the US House and Senate sought significant Federal Reserve oversight powers, the Fed has successfully accomplished what it has long been charged to do: maintain relative stability of the US dollar and mitigate inflationary pressures.  Even now, the Fed’s economic policy stance is to keep rates low for an extended period as it uses its monetary policy tools to stave off deflationary pressures without allowing inflation to negatively impact the nation’s economic future.

That the 2^nd half is expected to grow at a slower pace than did the latter part of 2009 and the 1^st half of 2010 doesn’t represent the long-term problem many expect.  It represents expectations of modest GDP growth rather than recessive declines (i.e. no double dip) and though not particularly helpful to the nations unemployed, it does allow for the formation of a firm economic foundation on which future growth can be established.

The most significant threats to growth appear to be the extraordinary budget deficits committed to by the current administration, House and Senate and the tax and regulatory plans these bodies intend to implement.  Were it not for a likely shift in power following the mid-term 2010 elections, the US markets would have reflected yet greater concern over current taxation, spending and reform agendas.  Even still, the possibility of a lame-duck congressional session designed to thwart electoral intent has been considered by Democratic leadership and fortunately was met with active resistance.  So much so that President Obama would almost certainly negate the possibility out of concern that it may come with the proverbial nail in the coffin of his 2012 re-election bid.

Though some may not agree, the US economy is far better off with slow and sustainable growth influenced by a strong Federal Reserve than it is with an economy actively managed by elected officials.  We’ve seen the negative conditions often left in the wake of monetary policy directed via legislation and regulatory imposition, and would rather not have to endure again the calamity that followed.

Get to Know the PCORI

• British Petroleum’s recent sale of gas storage assets likely marks the beginning of what may be a long and drawn out process the firm will explore to raise cash for operations while meeting its $20 billion to the US government.  The market’s positive reaction to the news suggests a greater level of confidence that the firm will survive, though not completely intact.  A word of caution: there’s a lot of BP oil in Gulf Coast waters that may easily extend BP’s liability to many times its current commitment.

• Some investors seeking safety and higher returns are being lured into higher-yielding, long-term corporate debt instruments, treasury bonds, CD’s and fixed annuities as a way to improve returns without realizing the potential risk these instruments may face between the dates of issuance and maturity.  With short-term interest rates near zero, the greatest likelihood is for rates to increase over time and as rates adjust upwards the value of lower rate instruments with years to go before reaching maturity declines.  The affect may be higher yields than offered by other short term instruments at the cost of lower rates of return when market value adjustments (MVA) occur.

• The Patient Protection and Affordable Care Act of 2010 (PPACA – healthcare reform bill) relies on the Patient Centered Outcomes Research Institute (PCORI) to make non-binding healthcare policy recommendations and is expected to maintain political independence and objectivity similar to that which is expected from the Federal Reserve.  This 19 member body, made up of one representative each from the National Institute of Health (NIH) and Agency for Health Research Quality (AHRQ) and 17 independent board members appointed by the Comptroller General of the US, is likely to wield enormous influence in the shaping of health care policy in the US in much the same way the Federal Reserve shapes monetary policy.  Now would be a good time to better understand it and how it may affect our futures.

Earnings and Individual Investors at Odds

With 2^nd Quarter 2010 having drawn to a close, investors are preparing for corporate earnings reports.  Even with adjusted expectations following the BP disaster in the Gulf, the EU’s debt crisis and legislative debates over taxes and financial regulatory reform, analyst expectations for positive earnings reports are high.  Second quarter earnings expectations are reflecting a 35% improvement over the same period last year and modest gains over 1^st Quarter 2010.  Wednesday’s market gains of 274 points on the DOW and 66 points on the S&P 500 reflect the recognition that recent market weakness may have gone too far.

Though the DOW has once again breached the 10,000 point mark, the irony remains that investor sentiment is as low as it’s been since early 2009 and both the S&P and DOW continue to trade at unrealistically low earnings ratios.  At current market levels, the S&P 500 is trading at approximately 12 times earnings, compared to a more typical earnings ratio of 15-16 times earnings.  As investor confidence returns and the markets internalize the current earnings picture, the S&P 500 and DOW could see gains of as much 25%, allowing the indexes to regain their holds on late spring highs.

For months now the US stock markets have reflected economic concerns and given up ground.  So far, the US economy has been spared the contagion of the European markets, we’ve weathered months of a catastrophic oil spill in the Gulf and we’re internalizing the components of healthcare reform.  The mid-term election cycle is preparing a new wave of legislative leadership to take control of the federal budget and attempt to stem the flow of red ink.

But right now little of that seems to have import for households and consumers.  In the face of unemployment rates above 9% and highly publicized fears over the possibility of a “double dip recession” or potential 1970’s style “stagflation”, the individual investor is hunkering down and eschewing risk assets.  However, their real risk is being left behind when markets improve.

These investors appear to have lost sight of the fact that corporations are posting profits and improving their balance sheets.  Though data is hard to come by, it now appears that individual investors are hoarding cash and abandoning their equity positions just as corporations are once again increasing capital spending and committing to longer-term employees.  Sadly, individual investors respond more to fear than virtually any other influence and their response tends to breed more of the same.

Institutional investors and market makers also respond to fear, but typically in the opposite direction.  As consumer concerns heighten, these investors become more willing to take on additional risk rather than run from it.  The result tends to be greater gains for institutions and woes for households and the individual investor.

Think of the Economy Like a Game of Football

I had the opportunity to listen in on a conversation Wednesday morning with Federal Reserve Bank of Dallas President Richard Fisher.  While discussing the possibility of a double-dip recession, Fisher offered an excellent analogy of our current economic climate and explained why he thought additional recessive pressures weren’t likely.

Like many good Texans, Fisher likened the economy to a football game and explained that a year ago we were deep in the opposing team’s end zone.  Thanks to inventory rebuilding, retail sales increases and capital investments in equipment and software we made it up the field.  Now we’re battling through a ground game and we’re still making progress, though forward movement is slow and hard fought.  We’re also facing “random referees” intent on changing the rules in the midst of important plays, but because of the strength of our offense, the depth of our bench, and the leadership of our coaching staff, we’ll make our downs and get the ball into the end zone.

Again, it’s a good analogy and in order to better appreciate what Fisher’s communicating it helps to understand the events he’s referring to.

The inventory rebuilding the economy experienced in late 2009 and early 2010 extended further than most economists expected and contributed to the 5%+ GDP gains we saw for those same periods.  Manufacturing and retail had decreased inventories to near depression levels and the effort required to rebuild them is largely responsible for keeping unemployment from climbing well into double digits.

At the same time, pent up consumer demand outpaced manufacturing gains and extended manufacturing and employment benefits – we’re only now getting back to the point where inventories are at levels consistent with sustainable growth.  Though moderated from prior periods, retail sales continue to show sufficient strength to keep manufacturing levels high enough to maintain current workers and slowly return factory utilization back towards the 80%+ capacity levels necessary for efficient production.

As managers and decision makers worked to increase productivity and reduce operating costs, substantial commitments were made to technology and software.  The affect was to improve the bottom line of corporate customers employing improved technologies as well as those of the manufacturers and suppliers of these products and services.

These improvements have helped move us up the field considerably, but we’re now playing a ground game and running the ball can be hard work.  We’re experiencing modest GDP gains consistent with an economy dealing with the realities of a complex domestic marketplace and global financial pressures.  GDP growth of 3-5%, though not terribly exciting, is sustainable and in time will help absorb excess housing inventory and bring workers back to full employment.

In the mean time we’re contending with “random referees” or legislators and policy makers intent on changing the rules.  Though some changes are needed, the uncertain playing field leaves business managers cautious; they’re conserving cash and keeping the permanent labor force as lean as possible so they can weather possible changes.  This caution isn’t likely to lead to recessive economic conditions, but it does moderate growth and causes this phase of the current recovery to seem lackluster.

It’s that same uncertainty that yields volatility in the equities markets.  Possible tax hikes in 2011, pending financial industry regulatory changes designed to limit profitable banking operations, and concern over the fiscal impact of changing healthcare and insurance initiatives are all weighing heavily on the markets and increasing investor and business concerns.

Though these concerns curtail growth, recent experiences have taught business managers and investors, our offense and bench, to limit the detrimental impact of these influences and find innovative ways to improve productivity and maintain profitability – the very engines of economic growth.  This same determination and ability to innovate has led the economy through recent struggles and returned American businesses, the capital markets and the US dollar to a position of strength on the world stage.