From the March 2012 issue of Investment Advisor • Subscribe!

February 22, 2012

Under Pressure

Unemployment, slow growth, Europe—which valve on the economic pressure cooker will blow first?

The anemic economic recovery has been in the forefront of the news for several years now. Because the economy is so complicated and multifaceted, it’s often difficult to grasp what’s really occurring. Moreover, given all of the noise in this hotly contested political season, the spin machines have only added to the confusion. However, there are some good clues, if you know where to look. For example, why did former Fed Chairman Alan Greenspan say that the yield on the 10-year Treasury is his most important signal? Why hasn’t the massive amount of government stimulus been very stimulating? What role does fear play in the financial markets? Is a U.S. recession still a possibility? Will Greece default? Is Europe already in a recession? When Congress extended employment benefits, did they understand what would happen?

S&P 500 IndexThe ascent of stocks that began in late 2010 continued into 2011 and was bolstered by a tailwind from the Fed’s QE2 program. However, at the end of July, after a group of European bankers met in Paris on July 6 to discuss the Greek debt crisis, the luster of stocks began to fade. In fact, by the time Aug. 1 rolled around, stocks were beginning their decent en route to a very ugly third quarter (see Figure 1, left). Of course, weak job growth in the United States for the previous two months didn’t help the situation.

The bankers who met in Paris were hoping for a “controlled default” in the case of Greece, amid much speculation that a Greek default would trigger a global panic. However Pollyannaish they were—or political, as they were trying to avoid a Lehman-type fallout—many observers, including this author, continue to believe that a Greek default is inevitable.

A few years ago, former Fed Chairman Alan Greenspan commented that if he could only view one piece of data, it would be the yield on the 10-year Treasury. There is a finite amount of money in the world at a given time. Investors seek the best returns for a given level of risk. Then, when fear rises, the velocity of money increases. Also, when fear is on the rise, money seeks a safe haven and flows into the best house in a bad neighborhood, namely, U.S. Treasury bonds. Finally, as money flows into Treasuries (i.e., demand is elevated), its price rises and its yield falls. Thus, in 2011, increased fear led to a 30%-plus return on the long-term government bond.

Fear and Stocks

Volatility and the Stock MarketOne of the most commonly accepted measures of fear is the VIX. The VIX, or Volatility Index, is based on data from the Chicago Board Options Exchange and measures the implied volatility of S&P 500 Index options. Whenever fear rises, put option activity increases; when fear subsides, more call options are purchased. As illustrated in Figure 2, (left), the VIX spiked in mid-2011 and stock volatility increased. Then, in December, the VIX began to fall and volatility abated. The increase in fear in late July and early August was primarily due to the aforementioned events in Europe and the U.S. labor market.

Fear and the Stock MarketReal Gross Domestic ProductWhat role does fear play in stock performance over the long term? To examine this, let’s refer to Figure 3, (left), which compares the St. Louis Fed’s Financial Stress Index (STLFSI) to the S&P 500. The STLFSI uses 18 different weekly data series in three categories: interest rates, yield spreads and other indicators. To even the most casual observer, the near-mirror image is obvious. Although they are not exact opposites, with a correlation of -0.57 over this period, there is a very strong contrary trend.

Recession Reprieve?

Last October, I wrote an article on the possibility of the United States entering a double-dip recession. It included comments from Rich Yamarone, an economist with Bloomberg. His contention was that since WWII, whenever U.S. GDP on a year-over-year basis fell below 2%, a recession ensued. Since U.S. GDP was below this level, he believed that a recession was inevitable before year-end. Although his time line didn’t materialize, the possibility is still quite real. To better understand his position, please refer to Figure 4, (above). This graph begins in January 1950 and plots the percentage change in real GDP from one year prior. The shaded bars are recessions and the red line crosses at the 2% point. In nearly every instance, when year-over-year real GDP fell below 2%, a recession followed. However, there were a couple of instances when it fell below, then rose above, then fell below the 2% line again before the recession occurred. In any event, there is a compelling argument to be made here. Currently, U.S. GDP is below 2%.

GDP and the Money Supply

U.S. Money Supply and Economic GrowthLet’s turn our attention to one of the key ingredients of economic policy: the money supply. The key is to maintain enough money in the system to foster economic growth. Too much and inflation will occur, and too little will result in a slowdown. Another key is to recognize that the money supply must also keep pace with the growth of the population. If the population grows at a faster pace than the money supply, there would be less capital per individual. To better understand the relationship between the money supply and GDP, please refer to Figure 5, (left). Beginning July 1, 1981, the growth of M2 and GDP has been fairly consistent, with a correlation of 0.95. Upon closer examination, you will notice how GDP was flat to slightly lower during the double-dip recession of the early ‘80s, the recession of 1990 and the post-tech-bubble recession of the early 2000s. Then, in 2008, the economy experienced a very severe contraction, while at the same time, the money supply increased dramatically. This “narrowing” indicates an excess supply of money in the system. In short, the Fed has infused the economy with trillions of dollars. Why then is the economy still struggling? Why hasn’t the Keynesian two-step worked? Where is all this excess money?

Reserve Balances With Federal Reserve BanksYears ago, when the Fed needed to increase the money supply, the Treasury would fire up the printing press. Today, it’s largely electronic as the Treasury can create billions of dollars out of thin air. Once the money is placed on the Fed’s balance sheet, the Fed can transfer it to the 12 regional Fed banks. From there, commercial banks will go to the Fed window to get money to lend. Hence, money flows from the Treasury, to the Fed, to the Federal Reserve banks, to the commercial banks and finally to the consumer. However, if loan demand is weak, the commercial banks have little reason to step up to the Fed window. This is precisely the problem today. So where is this excess capital? As can be seen in Figure 6, (left), much of the excess money sits at the Federal Reserve banks.

The Fed’s position to remedy the problem of low GDP has been to lower rates and increase the money supply. Normally, this is sufficient. However, due to the severity of the recent contraction, a policy of easy money has proven to be insufficient in stimulating economic growth. Why? Before the economy can grow, the consumer, who represents nearly 70% of GDP, must be willing to borrow and banks must be willing to lend. Beginning in the mid ‘90s, under threat of penalty, banks were strong-armed into relaxing their credit standards and lending to lower credit-worthy customers. In hindsight, lender compliance may have yielded a worse result than the penalties would have borne. The desire to expand the housing market to the less credit-worthy is a classic example of an unintended consequence of government regulation, one which resulted in an overheated economy and the biggest housing bubble and subsequent bust in U.S. history.

What will happen to this excess money? If the Fed was to take its eye off the ball and leave this excess money in the system, when consumers finally decide to borrow again, the economy would experience a period of such rapid growth that it would make the Roaring ‘20s look like a depression. Therefore, the Fed is faced with an important challenge. The Fed must manage the process of systematically removing a portion of this excess capital as loan activity increases. According to Mr. Yamarone, the Fed will be able to do this, and I have no reason for doubt. However, if he is wrong, then we would experience above-average inflation. Even so, at the present time the greater threat is deflation, which could lead to QE3.

The Conundrum of Unemployment

Unemployment has been over 7% for 37 months since December 2008. It has been higher than 8% for 35 months and at 8.5% or greater for 32 months. As most are aware, that’s the “official” rate.

The unemployment rate is determined by dividing the number of job seekers by the total work force. Let’s say the total work force was 100 and an additional 10 were looking for work. The unemployment rate would be 10%. Now let’s assume five of the 10 became discouraged and stopped looking. The rate would fall to 5%. This past December, 200,000 jobs were added, but more people dropped out of the hunt and the rate fell. Hence, the real rate is higher than 8.5%.

UnemploymentWhat’s particularly concerning is the average number of months of those who are unemployed (see Figure 7, left). Notice as the unemployment rate rose, the average number of months that people have been unemployed kept pace. Then, when the rate fell, the average number of months fell. Historically, these have tracked closely. That is until recently. While the unemployment rate has fallen, the duration of unemployment has risen. Why?

For 61 years, from January 1948 through January 2009 (the month before unemployment exceeded 8%), the average duration of unemployment was 13.6 months. From February 2009 through December 2011, it was 32.6 months. In December 2011 alone, the average length of time for the unemployed was three times greater than in the 61-year period mentioned earlier, now standing at 40.8 months. This is due to the extension of unemployment benefits. Is it possible that the extension is a disincentive to job seekers?

European Infection

The top five largest economies in Europe, as measured by GDP, are Germany, France, the United Kingdom, Italy and Spain. From this group, only Germany has a GDP rate greater than 2% and an unemployment rate below 8%. In fact, Spain has the highest unemployment rate at over 20%, followed by Ireland and Portugal. Moreover, Europe’s GDP is less than 2%, which is extremely weak.

We are all aware of the debt and potential contagion in the eurozone. What’s also important to realize is that on March 22, 2012, Greece will have a substantial bond payment due. If they are unable to meet it, global risk will rise and stocks … well, let’s just say you might not want a lot of exposure there.

The United States is the largest single economy at around $15 trillion. However, if you combine all the countries in Europe, their GDP is similar. Currently, Europe is near or perhaps already in recession. As an important trading partner, U.S. economic growth is greatly influenced by Europe’s economy. The emerging market economies derive a great deal of their growth from exports, and with weak demand from Europe and the United States, these economies are slowing. In short, global demand, according to the IMF, will continue to slow.

The Search for Answers

We know unemployment is too high and GDP is too low. To find the solution, let’s conduct a brief experiment. First, to lower the unemployment rate, businesses must hire. Let’s assume you are a business owner; as a business owner, what would need to happen to make you hire? Answer: You would need more business. Let’s assume you are a consumer. What could government do to put more money in your pocket? Answer: Reduce your tax burden. Therefore, the primary focus should not be on business, but on the consumer, since consumer spending is the largest component of GDP.

During the great debt build-up, along with consumers, businesses became over-levered. Since then, businesses have done well to reduce their debts. Although they harbor large cash balances, they have been reluctant to hire due to low consumer demand and uncertainty over recent government regulations. Comparatively, non-financial companies are in a stronger position than financials. Even though financials are much better positioned than they were in 2008, there is still a cloud overhead. What did the government do in the wake of the financial crisis? They added more regulation to financial companies. Instead of penalizing the financial companies, why not prosecute the offenders?

Before the economy can rebound, financial companies must heal because the money supply flows through them. The government has been focusing on banks with Dodd-Frank, but fails to see that any associated expenses will simply be passed on to the consumer.

During the 1907 bankers’ panic, financier J.P. Morgan stepped in, pledging his own money and convincing bankers to do the same. This restored liquidity and confidence to the system. When the stock market crashed in 1929, Morgan had died, and although there was a weak attempt by a few in the private sector to rescue the ailing market, the effort failed. A few years later, FDR took a page out of Keynes’ book and intervened with massive new government programs. During the Great Recession of 2008, when liquidity and confidence dried up, there was little interest from the private sector to step in, and the task fell to the federal government once again. In Europe, a great deal of money has already been allocated to Greece by their stronger neighbors, but that well may be drying up, along with their patience. Without additional support, Greece will default, fear will rise, the contagion will spread to Spain and Portugal, and financial markets will seize up once again, causing stock prices to plummet.

It’s hard to say exactly how this will unfold. However, we know that Europe’s problems will be around for many years. We can also be reasonably sure that politicians will take action based on what’s politically expedient, and the problem will be extended until it can no longer exist.         

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