The party is over. The major factors facing the economy and the market that we have been discussing in past comments (please see archives) are coming to a head as the reality of a post-credit crisis economy becomes more and more apparent in the period ahead. The massive monetary and economic stimulus that saved us from another great depression and led to the current weak economic recovery is now creating more problems than solutions and there is no way out that does not involve some economic pain.
Virtually all of the problems facing the economy today are a result of the massive increase in household debt over the last few decades, particularly the last two. For years we have staved off the problems by keeping interest rates near zero for extended periods of time and using fiscal and monetary policies to pump up housing. Consumers are overburdened with record debt loads at a time when income is stagnant and house values are dropping. As a result the government has substituted government debt for private debt in the hopes of getting the economy to grow on a self-sustained basis. The problem is that increasing the federal debt much more places the nation in great jeopardy, and we are rapidly reaching the breaking point.
At the risk of oversimplification, modern economies need rising amounts of credit (debt) to grow, and we are faced with the problem of reducing debt instead. At best, this means slow growth for years to come interspersed with more frequent recessions. At worst, it means outright collapse into another great depression.
Currently the federal government is facing a deficit of $1.6 trillion while the states have a shortfall of about $125 billion. What's more, the nonpartisan Congressional Budget Office (CBO) forecasts major budget deficits for years to come if nothing is done. According to CBO calculations, entitlement spending and interest on the debt alone will equal all of the federal revenue by 2025. Obviously, that leaves nothing for anything else.
The conclusion is that the government deficit has to be reduced in a major way. Unfortunately, that's a problem too. The Republican-controlled House of Representatives has recently passed a resolution reducing spending $61 billion over the last seven months of the current fiscal year, a pro-rated annual drop of about $100 billion from the 15% of the budget that doesn't include entitlements or defense. While that's only small part of the total deficit, a Goldman Sachs economist has concluded that even that reduction would reduce 2nd and 3rd quarter GDP by 1.5%-to-2.0% annualized. In addition Moody's Analytics Chief Economist Mark Zandi says that the resolution would cost 700,000 jobs by the end of 2012 and reduce GDP by 0.5% this year and 0.2% next.
So there you have it. We can continue spending and do nothing and go over the cliff, or we can balance the budget and endure a period of slow growth (if we're lucky) with a resulting reduced living standard for a long time to come. And we didn't even touch upon the problem of how, at the same time, we maintain our infrastructure and raise our currently inadequate educational system.
In sum, there is no easy way out of the dilemma. If there were, someone would have come up with a solution by now. The stock market dropped sharply today even during the period that oil prices were dropping. China announced a big trade deficit and fears emerged that a slowdown in China would drag down the global economy. Moody's dropped their rating on Spanish debt, bringing attention back to Europe's sovereign debt problems that have been papered over. Investors are also becoming worried (and rightly so) about the imminent ending of QE2. All of this is related to the domestic and global debt problems and the unintended side effects of attempting to deal with them.
The S&P 500 has cracked down through both its upward trendline and 50-day moving average for the first time since early September with particular damage to the technology, commodity and momentum stocks that that led the upward charge. In our view this will prove to be a significant turning point and the trend will now be to the downside despite the usual attempts to rally