Comstock Partners, Inc.January 19, 2012
Economy Entering A Period Of High Risk
Although a number of economic indicators have recently improved, the economy is now entering a period of high risk. In their now well-known book, "This Time It's Different", Rogoff and Reinhart showed that once a nation's government debt-to-GDP ratio reached and exceeded 90%, the period ahead was marked by credit crises, exceedingly slow growth and frequent recessions. The latest example, among many, is the experience of Japan in the years following 1989 and continuing until today. As everybody now knows, after going through last year's debt ceiling debate, the U.S. federal government debt/GDP ratio is now about 100%. In addition, as we have written about ad infinitum, the ratio of household debt to both disposable income and GDP is far above historical averages.
Although the book, which came out over two years ago, may have been regarded by some as too theoretical or impractical, so far the economy has essentially followed the slow-growth trajectory anticipated by the two economists. Since the economic trough in 2009, GDP has grown at an average annualized rate of only 2.5%, and at a rate of only 1.5% in the last four reported quarters. Real personal income less transfer payments are still below the previous peak and industrial production has only come back to the level reached in 2005. Employment is still at the same level as in early 2000, while real median income has declined in a recovery for the first time in the post-war period.
In our view, even the mild recovery seen to date is unsustainable. When we look at the numbers, it is difficult to tell where additional growth will come from. Although consumer spending, which accounts for 70% of GDP, picked up from June through November, this was accomplished largely by reducing the household savings rate from 5% to 3.5%, the lowest rate since the economy peaked in 2007. Without even further reductions in this already low rate, there is little in the economic picture to drive spending. Household net worth is down. Real wages and disposable income less transfer payments are not growing. Employee hiring is still tepid. Housing is still in the doldrums with additional home price decreases still likely as a result of the backlog of foreclosures. Note, too, that December retail sales crept up by a paltry 0.1%, indicating that holiday sales were disappointing despite all the hoopla and exaggerated predictions following "black Friday".
Government spending is another key area that is likely to be a drag on GDP. The impartial Congressional Budget Office (CBO) is projecting a 1% decline in federal government spending in 2012 at the same time that states and local governments are also cutting back.
Exports, which have accounted for almost half of the GDP growth since the bottom, are another unpromising area. Even if the European sovereign debt crisis doesn't blow up, (not a sure thing), Europe is, at best, entering a recession and overall global growth is softening. This week the IMF lowered its global growth forecast, saying that prospects have turned bleak as contagion from the European Union is spreading to the rest of the world----and this was their base case. Underlying their base case was a more ominous assessment of what could go wrong in Europe's currently precarious position. Anecdotal data indicates that China, too, is feeling the adverse effects of the global slowdown. Although this is barely reflected in the official numbers, most of those who know China well regard their data as suspect.
U.S. capital spending is also subject to strong headwinds in 2012. Spending last year was boosted by the 100% accelerated depreciation allowance for items installed by year-end. This probably shifted a significant amount of capital spending from 2012 to 2011. Furthermore, in contrast to some economic theories, the empirical data clearly demonstrates that capital spending lags consumer spending by one or two quarters. In other words, capital spending is a response to consumer demand, unless influenced by meaningful tax incentives.
Summing up, we see lower consumer spending growth, declining government spending at all levels, less exports and lower capital spending. That pretty much accounts for the entire GDP. The upshot will be heavy downward revisions in upcoming corporate earnings estimates and a negative shock for those looking at what they regard as an increasingly strong recovery. Under this scenario the current market rally does not have far to go and the downside risks are high.