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 that the sky is falling. We aim to draw attention to a 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, sent a strong message. The public is very angry and “Wall Street” is very much a target. The meaningless term, “Wall Street” has become shorthand for everything business related that the public wants to see punished, taxed and regulated. The recent hearings on AIG and the discussions surrounding the re-nomination of Ben Bernanke underscore the anger. Harder, harsher rhetoric out of the beltway may become harder, harsher regulation in 2010. The Volcker inspired suggested resuscitation of the operational spirit of Glass-Steagall (The Banking Act of 1933) could be the opening round of a heavyweight bout.
The only thing Republicans and Democrats always agree on is the need to be reelected and the value of critiquing whomever the public likes least. This suggests that angry pontificating may become legislative action in the lead up to 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 necessitates the terming out-maturity extension- of trillions across 2010. This will add pressure to the markets as longer term US government securities will encounter rising inflation expectations. As interest rates drift upward, the rates on mortgages and consumer credit will also rise.
Greece, Spain, Ireland and The UK are all similarly staring at large structural deficits and mediocre prospects to grow their way out. Last year’s bonanza of desire for corporate credit will also likely face some upward rate pressure. The 2009 ease of raising low interest money, for developed nation sovereigns and corporations, is very unlikely to be repeated across 2010. This is worth factoring into your understanding of what is to come. Present offering and pricing data indicate that this is not happening.
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, 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, we don’t see a strong and sustained rebound in hiring.
Debt service burdens will continue to be a structural economic issue in 2010 and beyond. The high levels of unemployment and the significant debt burdens in many households will constrain spending growth and result in significant further delinquency and default on consumer credit and housing debt. The eye of the storm has moved from sub-prime to prime. Our situation has evolved 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 end. The go-go boom years are not coming back.
Emerging market strength has been the order of the day for 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 violent correction of 2008-early 2009 made this painfully evident. 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 can not 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. Once again, decoupling fantasy will eventually be punished.
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 in Social Security, Medicare, Medicaid, Defense, Homeland Security, and Veterans Affairs. At the present time, further detail is not available.
We know this means that we will only nibble- perhaps painfully for some- around the edges of a huge deficit problem. 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 the role of the state.
We see this as possible in the near term and are deeply concerned about this 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. We are not in a rush and remain concerned with some valuations.
Disclosure: No positions