Reflections
January 2011 Issue 127
Reflections®
About this Newsletter Reflections is a monthly publication written by John Gilbert, CIO, GR–NEAM. Each issue focuses on current capital markets and investment topics. Our clients find it somewhat unique from many investment publications typically received.
For More Information For more information please contact
Hypothesis Testing The U.S. economy will probably do better in 2011 than we expected. This does not change what we believe to be the inevitable crucible facing American financial largesse, but the reckoning is postponed. The tax measures agreed upon in Washington in recent weeks make it likely that consumption will improve. But the cost makes a deeply troubled fiscal situation worse, and as such it is an exchange of longterm pain for immediate gratification. Unfortunately that would appear to be the American way.
one of our Marketing professionals: Marie Callahan [email protected] Mike Gilotti [email protected]
General Re–New England Asset Management, Inc.® Pond View Corporate Center 76 Batterson Park Road Farmington, CT 06032 Tel. 860 676 8722 www.grneam.com
We were rather amazed at the abuse President Obama received from members of his own party for the tax deal, for in agreeing to the Republican obsession with an estate tax, he won concessions that favor those at the lower end of the income spectrum that were large. A one-third reduction in the Social Security tax paid by employees is a direct increase in disposable income, and the refundable nature of certain tax credits means that recipients will not only pay no tax, but will receive payments from the government for the excess of the credit over their tax liability. Both measures benefit middle and lower income people the most. Social Security taxes are capped at pay of just over $100,000 and are thus regressive, so that a reduction benefits lesser incomes by a greater proportion. The credits phase out above certain income levels. People of middle and lower incomes spend more as a percent of their disposable income, so it is likely that consumption spending will be better than it otherwise would have been.
The cost is significant. The Congressional Budget Office estimates that the bill will increase the federal deficit by $374 billion in fiscal 2011 and $423 billion the following year relative to previous legislation. The largest pieces are the tax cut extensions, but the payroll tax reduction alone will cost the government $112 billion over the two years, and obviously a reduction in Social Security taxes is the last thing the U.S. needs in the long term with a growing retired population. The upward revision of the federal deficit estimates will likely produce a deficit estimate of 9.5% of GDP. That will add well over $1 trillion per year to the federal debt. The excuse that the U.S. fiscal dilemma is a result of economic weakness looks thinner with the passage of time and tax bills like this one. The great risk is that eventually the rest of world, and the financial markets in particular, notice. Since the 2008 financial crisis, we have focused upon the indebtedness of the household sector. It was there that the excessive borrowing occurred over the previous decade, and it was on the balance sheets of households that residential real estate deflation did its damage. As government has substituted its borrowing for that of wounded households, however, the danger of excessive debt is shifting to the federal government itself. The debt burden of the federal government may be defined narrowly as the face value of its outstanding bonds and bills. That number at the end of the third quarter of 2010 was $9.1 trillion, or about 62% of GDP. However, experience has shown that the liabilities of the financial sector—meaning banks, primarily—are not separable from those of the government, since banks are at the center of the financial system and are the mechanism by which monetary policy is transmitted to the economy. We have written before about the peculiar and difficult relationship between government and banks (“Two Difficult People Do Not Make a Good Marriage,” Reflections, December 2009). In the fractional reserve banking systems in use for hundreds of years, banks’ leveraging of their capital to produce a competitive return on that capital is the engine of credit creation. It is also a perpetual source of potential insolvency, and is thus a Faustian bargain. When banks become insolvent, those whose liabilities are large enough to destabilize the financial system are in one way or another rescued by governments. So one way of thinking about the contingent liability of government is that financial sector liabilities are in a sense subordinated government debt. They behave as subordinated debt typically does, yielding a premium over government bonds. Most of the time this premium appears to be a free lunch, since the financial institutions do not require rescue. If we consider financial sector liabilities in this way, we can
2
GR–NEAM
consider government and financial sector debt together relative to GDP: Chart 1. U.S. Government Plus Financial Debt to GDP 180% 160% 140% 120% 100% 80% 60% 40% 20% 0% 1952
1962
1972
1982
1992
2002
Sources: Federal Reserve Flow of Funds and GR–NEAM Analytics
It has been shown that GDP growth slows materially when government debt exceeds 90% of GDP. Government debt was defined narrowly and conventionally for this purpose. At 62% of GDP and rising, the U.S. remains below that threshold, but it is in sight as shown in Chart 2. Chart 2. U.S. Federal Debt to GDP 70% 60% 50% 40% 30% 20% 10% 0% 1952
1962
1972
1982
1992
2002
Sources: Federal Reserve Flow of Funds and GR–NEAM Analytics
The contingent nature of government’s liability for those of the financial system means that government liabilities are understated, using the typical convention in Chart 2. It is only when a crisis causes government to come to the rescue of one or more financial institutions that the government balance sheet is in a sense marked to its true level. Thus during what we refer to as financial peacetime, when economic growth is positive and credit is expanding, the government’s contingent liability is growing but unmeasured. When financial wartime breaks out, as it did in 2008, the size of the government’s true liability becomes apparent. Two years later, that process is still underway. The U.S. government is trying to attenuate the effects of a shrinking financial system by borrowing rather furiously. In Chart 3, we disaggregate the two components shown in Chart 1.
Chart 3. Components of Government and Financial Debt 200%
150% 90% Growth Threshold 100%
50%
0% 1952
1962
1972
1982
Government
1992
2002
Financial
Sources: Federal Reserve Flow of Funds and GR–NEAM Analytics
The U.S. is by no means the only country in this situation. The U.K. and the Eurozone also have large deficit problems, but for different reasons. The U.K. has a large banking sector that was hurt by the global financial crisis, and had to rescue major financial institutions. Unlike the U.S., the U.K. has responded with fiscal austerity, the success of which remains to be seen. The Eurozone has an apparently similar problem, with the collapse of the Irish banking system. But the Eurozone issues are quite different since the troubled countries have no currency of their own to devalue. The recent events in the Eurozone are suggestive, however, because the effective nationalization of the Irish banking system meant that the Irish government needed help from its Eurozone partners. Those negotiations included an active debate of the status of holders of Irish bank debt, including senior as well as subordinated bonds. Until the eleventh hour there was a possibility that such debt would be restructured to forfeit some portion of its claim to principal repayment. In the event, the German government gave in and agreed to the rescue without requiring such a sacrifice. The Eurozone stresses are likely to continue and to reach a crescendo in coming months. We do not know if some portion of another country’s bonds will be sacrificed, but we doubt it. The precedent of the Irish deal suggests otherwise. It is the Eurozone banks’ large holdings of Eurozone sovereign debt that may prevent such an outcome, since principal losses could have a severe effect on banks’ capital and potentially trigger the recognition of governments’ contingent liability for the banking system. The circularity of this is ironic at a minimum, and underscores the temporary nature of the current regulatory banking regimes that treat government bonds as riskless investments. Eventually, however, banks’ senior bondholders will forfeit some portion of their principal in the event of insolvency, just as do lenders to industrial firms in distress. The U.S. and U.K., however, have more flexibility. Eurozone countries are effectively borrowing in a foreign currency, with
the apparent exception of Germany, whose superior economic performance is for now supporting the euro’s value. The U.S. and U.K. borrow in their own currencies, and thus can and have devalued the dollar and pound respectively. The fall in the dollar in the second half of 2010 is behind at least some of the better economic performance in the U.S. in recent months. Underlying apparent improvement, however, is the rapid addition of explicit liabilities to the balance sheets of both governments. The budget plans of the U.K. are for aggressive reductions in spending. It remains to be seen how that will work, since the history of countries shrinking their way to health is sparse. Ireland implemented its first fiscal austerity package in October 2008, and the Irish deficit has yet to shrink. The Irish housing sector is in a massive contraction, however, following severe overvaluation a few years ago. The U.K. has as yet no similar housing bust, and a currency to devalue to boot. The U.S., on the other hand, is testing a very different hypothesis. The central idea underlying American financial behavior is that the dollar as the world’s reserve currency enjoys some amount of inelastic demand around the world. Inelastic demand means that people want something so much that they are less sensitive to the price they will pay. Until the last few weeks of 2010 it appeared that the world wanted U.S. government bonds desperately, judging by the decline in yield to just 2.4% on 10-year bonds by early October. In the following weeks bond yields rose rapidly, raising the question of whether the world was finally having enough. We think that it is early to reach such a conclusion, since bond yields around the world rose together, and the rise in the markets’ anticipated inflation rate suggested that the increase in bond yields was in anticipation of better economic growth. The risk is that American behavior turns out to be more hubris than hypothesis. It was not long ago that the credit worthiness of Spain was almost beyond reproach, so Spanish bonds were priced similarly to those of Germany, a perceived bastion of fiscal rectitude. The financial markets then changed their minds, as shown in Chart 4. Chart 4. Perceived Risk: Spanish Government Bond Yields Over Germany 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% 2005
2006
2007
2008
2009
2010
Sources: Banco de España, Deutsche Bundesbank, Haver Analytics, GR–NEAM Analytics
Reflections, January 2011
3
The American economy has strengths that Spain does not, and it has a currency to devalue. But consider the following description—a country with a deficit to GDP in the high single digits, a rapidly rising federal debt load, and the continuing effects of a severe real estate contraction that is still impairing the financial system. Is that Spain or the U.S.? The answer, of course, is both. There was a time when Japan’s AAA credit rating was beyond debate. That rating floated downriver several years ago. Debt rating agencies have already suggested that they are looking at the AAA of the U.S. Our view is that there is a rising probability that the next few years produce a financial event that reorders the global financial order. The rising debt loads in developed countries are unsustainable. Whether or not a crisis is required to induce the change that seems logical we do not yet know. But it makes no sense that the U.S. had the largest quota subscription at the International Monetary Fund at 17%. China’s is less than 4%, yet China holds $2.5 trillion in foreign reserves. The financial crisis made clear that government obligations, broadly defined, were far larger than they appeared. Yet they continue to rise. If something cannot go on forever, it won’t. As we do each year, we thank our clients and friends for our relationships.
© 2011 General Re–New England Asset Management, Inc. This report has been prepared from original sources and data we believe to be reliable, but we make no representations as to its accuracy, timeliness or completeness. This report is published solely for information purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy any security. Please consult with your investment professionals, tax advisors or legal counsel as necessary before relying on this material. This is an analytical piece and references to any specific securities are not to be construed as an investment recommendation. From time to time, one or more of GR–NEAM’s clients, and/or the author, may personally hold positions in any of the securities referenced in this piece. REF201101-127
Reflections®
About this Newsletter Reflections is a monthly publication written by John Gilbert, CIO, GR–NEAM. Each issue focuses on current capital markets and investment topics. Our clients find it somewhat unique from many investment publications typically received.
For More Information For more information please contact
Hypothesis Testing The U.S. economy will probably do better in 2011 than we expected. This does not change what we believe to be the inevitable crucible facing American financial largesse, but the reckoning is postponed. The tax measures agreed upon in Washington in recent weeks make it likely that consumption will improve. But the cost makes a deeply troubled fiscal situation worse, and as such it is an exchange of longterm pain for immediate gratification. Unfortunately that would appear to be the American way.
one of our Marketing professionals: Marie Callahan [email protected] Mike Gilotti [email protected]
General Re–New England Asset Management, Inc.® Pond View Corporate Center 76 Batterson Park Road Farmington, CT 06032 Tel. 860 676 8722 www.grneam.com
We were rather amazed at the abuse President Obama received from members of his own party for the tax deal, for in agreeing to the Republican obsession with an estate tax, he won concessions that favor those at the lower end of the income spectrum that were large. A one-third reduction in the Social Security tax paid by employees is a direct increase in disposable income, and the refundable nature of certain tax credits means that recipients will not only pay no tax, but will receive payments from the government for the excess of the credit over their tax liability. Both measures benefit middle and lower income people the most. Social Security taxes are capped at pay of just over $100,000 and are thus regressive, so that a reduction benefits lesser incomes by a greater proportion. The credits phase out above certain income levels. People of middle and lower incomes spend more as a percent of their disposable income, so it is likely that consumption spending will be better than it otherwise would have been.
The cost is significant. The Congressional Budget Office estimates that the bill will increase the federal deficit by $374 billion in fiscal 2011 and $423 billion the following year relative to previous legislation. The largest pieces are the tax cut extensions, but the payroll tax reduction alone will cost the government $112 billion over the two years, and obviously a reduction in Social Security taxes is the last thing the U.S. needs in the long term with a growing retired population. The upward revision of the federal deficit estimates will likely produce a deficit estimate of 9.5% of GDP. That will add well over $1 trillion per year to the federal debt. The excuse that the U.S. fiscal dilemma is a result of economic weakness looks thinner with the passage of time and tax bills like this one. The great risk is that eventually the rest of world, and the financial markets in particular, notice. Since the 2008 financial crisis, we have focused upon the indebtedness of the household sector. It was there that the excessive borrowing occurred over the previous decade, and it was on the balance sheets of households that residential real estate deflation did its damage. As government has substituted its borrowing for that of wounded households, however, the danger of excessive debt is shifting to the federal government itself. The debt burden of the federal government may be defined narrowly as the face value of its outstanding bonds and bills. That number at the end of the third quarter of 2010 was $9.1 trillion, or about 62% of GDP. However, experience has shown that the liabilities of the financial sector—meaning banks, primarily—are not separable from those of the government, since banks are at the center of the financial system and are the mechanism by which monetary policy is transmitted to the economy. We have written before about the peculiar and difficult relationship between government and banks (“Two Difficult People Do Not Make a Good Marriage,” Reflections, December 2009). In the fractional reserve banking systems in use for hundreds of years, banks’ leveraging of their capital to produce a competitive return on that capital is the engine of credit creation. It is also a perpetual source of potential insolvency, and is thus a Faustian bargain. When banks become insolvent, those whose liabilities are large enough to destabilize the financial system are in one way or another rescued by governments. So one way of thinking about the contingent liability of government is that financial sector liabilities are in a sense subordinated government debt. They behave as subordinated debt typically does, yielding a premium over government bonds. Most of the time this premium appears to be a free lunch, since the financial institutions do not require rescue. If we consider financial sector liabilities in this way, we can
2
GR–NEAM
consider government and financial sector debt together relative to GDP: Chart 1. U.S. Government Plus Financial Debt to GDP 180% 160% 140% 120% 100% 80% 60% 40% 20% 0% 1952
1962
1972
1982
1992
2002
Sources: Federal Reserve Flow of Funds and GR–NEAM Analytics
It has been shown that GDP growth slows materially when government debt exceeds 90% of GDP. Government debt was defined narrowly and conventionally for this purpose. At 62% of GDP and rising, the U.S. remains below that threshold, but it is in sight as shown in Chart 2. Chart 2. U.S. Federal Debt to GDP 70% 60% 50% 40% 30% 20% 10% 0% 1952
1962
1972
1982
1992
2002
Sources: Federal Reserve Flow of Funds and GR–NEAM Analytics
The contingent nature of government’s liability for those of the financial system means that government liabilities are understated, using the typical convention in Chart 2. It is only when a crisis causes government to come to the rescue of one or more financial institutions that the government balance sheet is in a sense marked to its true level. Thus during what we refer to as financial peacetime, when economic growth is positive and credit is expanding, the government’s contingent liability is growing but unmeasured. When financial wartime breaks out, as it did in 2008, the size of the government’s true liability becomes apparent. Two years later, that process is still underway. The U.S. government is trying to attenuate the effects of a shrinking financial system by borrowing rather furiously. In Chart 3, we disaggregate the two components shown in Chart 1.
Chart 3. Components of Government and Financial Debt 200%
150% 90% Growth Threshold 100%
50%
0% 1952
1962
1972
1982
Government
1992
2002
Financial
Sources: Federal Reserve Flow of Funds and GR–NEAM Analytics
The U.S. is by no means the only country in this situation. The U.K. and the Eurozone also have large deficit problems, but for different reasons. The U.K. has a large banking sector that was hurt by the global financial crisis, and had to rescue major financial institutions. Unlike the U.S., the U.K. has responded with fiscal austerity, the success of which remains to be seen. The Eurozone has an apparently similar problem, with the collapse of the Irish banking system. But the Eurozone issues are quite different since the troubled countries have no currency of their own to devalue. The recent events in the Eurozone are suggestive, however, because the effective nationalization of the Irish banking system meant that the Irish government needed help from its Eurozone partners. Those negotiations included an active debate of the status of holders of Irish bank debt, including senior as well as subordinated bonds. Until the eleventh hour there was a possibility that such debt would be restructured to forfeit some portion of its claim to principal repayment. In the event, the German government gave in and agreed to the rescue without requiring such a sacrifice. The Eurozone stresses are likely to continue and to reach a crescendo in coming months. We do not know if some portion of another country’s bonds will be sacrificed, but we doubt it. The precedent of the Irish deal suggests otherwise. It is the Eurozone banks’ large holdings of Eurozone sovereign debt that may prevent such an outcome, since principal losses could have a severe effect on banks’ capital and potentially trigger the recognition of governments’ contingent liability for the banking system. The circularity of this is ironic at a minimum, and underscores the temporary nature of the current regulatory banking regimes that treat government bonds as riskless investments. Eventually, however, banks’ senior bondholders will forfeit some portion of their principal in the event of insolvency, just as do lenders to industrial firms in distress. The U.S. and U.K., however, have more flexibility. Eurozone countries are effectively borrowing in a foreign currency, with
the apparent exception of Germany, whose superior economic performance is for now supporting the euro’s value. The U.S. and U.K. borrow in their own currencies, and thus can and have devalued the dollar and pound respectively. The fall in the dollar in the second half of 2010 is behind at least some of the better economic performance in the U.S. in recent months. Underlying apparent improvement, however, is the rapid addition of explicit liabilities to the balance sheets of both governments. The budget plans of the U.K. are for aggressive reductions in spending. It remains to be seen how that will work, since the history of countries shrinking their way to health is sparse. Ireland implemented its first fiscal austerity package in October 2008, and the Irish deficit has yet to shrink. The Irish housing sector is in a massive contraction, however, following severe overvaluation a few years ago. The U.K. has as yet no similar housing bust, and a currency to devalue to boot. The U.S., on the other hand, is testing a very different hypothesis. The central idea underlying American financial behavior is that the dollar as the world’s reserve currency enjoys some amount of inelastic demand around the world. Inelastic demand means that people want something so much that they are less sensitive to the price they will pay. Until the last few weeks of 2010 it appeared that the world wanted U.S. government bonds desperately, judging by the decline in yield to just 2.4% on 10-year bonds by early October. In the following weeks bond yields rose rapidly, raising the question of whether the world was finally having enough. We think that it is early to reach such a conclusion, since bond yields around the world rose together, and the rise in the markets’ anticipated inflation rate suggested that the increase in bond yields was in anticipation of better economic growth. The risk is that American behavior turns out to be more hubris than hypothesis. It was not long ago that the credit worthiness of Spain was almost beyond reproach, so Spanish bonds were priced similarly to those of Germany, a perceived bastion of fiscal rectitude. The financial markets then changed their minds, as shown in Chart 4. Chart 4. Perceived Risk: Spanish Government Bond Yields Over Germany 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% -0.5% 2005
2006
2007
2008
2009
2010
Sources: Banco de España, Deutsche Bundesbank, Haver Analytics, GR–NEAM Analytics
Reflections, January 2011
3
The American economy has strengths that Spain does not, and it has a currency to devalue. But consider the following description—a country with a deficit to GDP in the high single digits, a rapidly rising federal debt load, and the continuing effects of a severe real estate contraction that is still impairing the financial system. Is that Spain or the U.S.? The answer, of course, is both. There was a time when Japan’s AAA credit rating was beyond debate. That rating floated downriver several years ago. Debt rating agencies have already suggested that they are looking at the AAA of the U.S. Our view is that there is a rising probability that the next few years produce a financial event that reorders the global financial order. The rising debt loads in developed countries are unsustainable. Whether or not a crisis is required to induce the change that seems logical we do not yet know. But it makes no sense that the U.S. had the largest quota subscription at the International Monetary Fund at 17%. China’s is less than 4%, yet China holds $2.5 trillion in foreign reserves. The financial crisis made clear that government obligations, broadly defined, were far larger than they appeared. Yet they continue to rise. If something cannot go on forever, it won’t. As we do each year, we thank our clients and friends for our relationships.
© 2011 General Re–New England Asset Management, Inc. This report has been prepared from original sources and data we believe to be reliable, but we make no representations as to its accuracy, timeliness or completeness. This report is published solely for information purposes and is not to be construed as an offer to sell or the solicitation of an offer to buy any security. Please consult with your investment professionals, tax advisors or legal counsel as necessary before relying on this material. This is an analytical piece and references to any specific securities are not to be construed as an investment recommendation. From time to time, one or more of GR–NEAM’s clients, and/or the author, may personally hold positions in any of the securities referenced in this piece. REF201101-127
