State of the Union and Risk Landscape - January 2010

 

State of the Union & Risk Landscape

 
Max Wolff
Senior Analyst
The Beryl Consulting Group LLC
 
January 27, 2010
 
We see three looming and under factored risk exposures as we head into The 2010 State of the Union. Markets and market participants seem to be assuming that the next year will be much like the last from a political perspective. We humbly disagree. The size and scope of deficit spending in the US, UK, and Euro Zone are alarmingly large and not clearly sustainable. Corporates and sovereigns can’t continue to be placed at the present depressed interest rates forever. The full weight and measure of distressed debt dislocation is not behind us. The emerging markets flow and fascination is long in the tooth and short on historical and theoretical underpinning. None of this is to say the sky is falling. We aim to draw attention to the rather alarmingly confident sense of indefinite improvement that seems to be evolving into conventional wisdom.
 
2010 Will Be a Very Politically Sensitive Year
 
The Massachusetts Senate election of Scott Brown (R), and sliding poll numbers for the President, seem to be sending a strong message. The public is very angry and “Wall Street” is very much a target of upset. In fact, the meaningless term, “Wall Street” has become shorthand for everything related to business that the public wants to see punished, taxed or regulated. The recent hearings on AIG and the discussions surrounding the re-nomination of Ben Bernanke underscore this anger. Harder, harsher rhetoric out of the beltway may become harder, harsher regulatory adventure in 2010. The Volcker inspired suggestion to resuscitate the operational spirit of Glass-Steagall (The Banking Act of 1933) could be the opening round of a true heavyweight bout. The only thing Republicans and Democrats always agree on is the desire to be reelected and the value of criticizing whomever the public likes least. This suggests that angry pontificating may become legislative action in the lead up to the November Congressional Elections.
 
Sovereign Debt Levels are Very High
 
The recent past and near future are host to truly jaw dropping levels of Federal spending and paltry tax returns. The Congressional Budget Office (CBO) forecasts a $1.3 trillion budget shortfall in 2010, on the heels of a $1.4 trillion budget deficit in 2009. These are budget deficits with 11 zeros in them. We are and have been spending more than $3.5 billion more than we are taking in per day. America will deficit spend more than 9% of her GDP in 2010 having deficit spent almost 10% of GDP in 2009. We are overspending more than at any time since the end of WWII. This spending binge, unlike that one, will not see us emerge as the lone free market superpower astride the globe. The short-term structure of US debt will necessitate the terming out-maturity extension of trillions across 2010. This will add pressure to the markets as longer- term US Government securities will encounter inflation expectations. As interest rates drift upward, the rates on mortgages and consumer credit will also be pushed up.
 
Greece, Spain, Ireland and The UK are all similarly staring at large structural deficits and mediocre prospects to grow their way out of debt. Last year’s bonanza of desire for corporate credit will also likely suffer under upward rate pressure. The  ease of raising low interest money in 2009, for developed nation sovereigns as well as corporations, is very unlikely to be repeated in 2010. This is worth factoring into your understanding of what is to come.
 
 The Worst is Squarely Behind Us
 
The CBO is estimating that the US unemployment rate will average 10.1% in 2010 and over 9% in 2011. If Federal spending is now to be wound down, and these folks have not yet been meaningfully helped, where will the general economic rebound come from? While childcare and eldercare tax credits are a grand idea, these will not move the national needle. Already, the out of work are caring for children and childcare is unaffordable for many. Likewise, even though tax credits for retirement savings make sense tens of millions of Americans are in too poor economic conditions to make retirement savings a priority regardless of tax treatment. In short, we are still missing more than 10 million jobs. While employment numbers will be better in 2010 than 2009, we don’t see a strong and sustained rebound in hiring.
 
US consumer debt service burdens will continue to be a structural economic issue in 2010 and beyond. High levels of unemployment and significant debt burdens in many households will constrain consumer spending growth and result in significant further delinquencies and default on consumer credit and housing debt. The eye of the storm has moved from sub-prime to prime and from free-fall to steady erosion. However, today’s low rates and government programs may well prove more fleeting than consumers’ trouble paying. We are looking for a very mixed year in terms of macroeconomic data. The world is not coming to an end, but the go-go boom years are not coming back.
 
Emerging market strength has been the order of the day for the last 10 years. Massive flows of developed world and local cash into financial investment have driven a long over due revaluation of emerging market assets. This was clearly and dramatically overdone by 2007. The surge back in emerging market valuations and expectations began in February 2009 and has run very far and very fast. The occasional corrections notwithstanding, the emerging markets cannot and will not repeat anything like their 2009 phoenix like rise from the ashes. Remember globalization? We do. In today’s globalized world, weakness from the US, EU and Japan are real and significant issues for emerging markets. The US and EU were responsible for over 55% of World GDP in 2009. Thus, the US and EU contributed more than twice the global GDP of Asia, including Japan and South Korea.
 
The State of the Union
 
The President has signaled that he will seek a 3-year freeze in non-defense discretionary spending. The general increase in prices over time, inflation, means that fixed budgets are in fact time-release budget cuts. There will be no cuts to Social Security, Medicare, Medicaid, Defense, Homeland Security, and Veterans Affairs. At the present time, further detail is not available. At some point in the near future, interest rates will have to be higher and government stimulation, monetary and fiscal, will have to be scaled back. It remains to be seen if the private sector can more than pick up the slack. Robust growth forecasts rely on private activity to replace more than 100% of the reduction in economic activity from scaling back the role of the state. We see this possible in the near term but are deeply concerned about this in the long term. While the most dramatic dislocations may be behind us, there is more to come. We applaud and plan to stay deeply involved with the dramatic rise of leading developing economies.
 
 
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