Now on to Europe and Cyprus where we see many parallels.  Cypriot banks, though achieving high marks in the ECB stress tests, were reliant on the ELA loans to finance themselves. They were not able to issue debt in the market and there are very few senior bondholders to stick with the restructuring bill.  Thus the troika came up with what it thought was an elegant solution: a cash for equity swap with depositors. The Troika would tax depositors now in exchange for bank warrants and equity later if deposits were left in each respective institution. It was treated in the US press as a confiscatory tax but in continental Europe, and amongst Italians and Spaniards in particular the move was considered fair.  After all, depositors in Cypriot banks, especially the 40% that were foreign depositors received high interest rates and low taxes for years.   Those foreigners that set up businesses in Cyprus were avoiding taxes in their home countries, some legally, some illegally.

There was an almost schadenfreude-like glee from the core of Europe, the tax evaders were now seeing the inevitable outcome from their folly (Cypriot banks payed high interest rates but built on subsidized ELA financing) yet when it came time to vote on the measure in Cyprus’ parliament, it was an impossible sell.  This was no surprise to those watching the twitterverse where there was a large amount of skepticism and a great concern for contagion and pending collapse of the Eurozone as we know it.  Two caught our attention,  “will the Cyprus experience be seen as a test run for what it is like to leave the euro?[1]” and “protesters tear down German flag from German embassy in Cyprus.[2]”

Enter the Russian element. The reason Cyprus is considered different from the core is not just because of its outsized banking sector in proportion to its economy (8 times); after all, Iceland and Ireland had large banking sectors too.  It is because Cyprus was a haven for Russian deposits due to a tax treaty with Russia going back to the early 90s when Glasnost and Perestroika were sowing the seeds of reform. Much of the early money leaving Russia was linked to organized crime or ill-gotten gains. Some of the deposits were from asset managers wanting to avoid capital gains tax in Russia. Some of the deposits were from Russian entrepreneurs who knew they had a better chance of success with a lower tax regime. But many of the deposits were perceived by the Europeans as dirty, or shall we say, clean, newly laundered money.  The amount of money passing between Cypriot and Russian financial institutions was exceedingly large for the absolute size of Russian deposits in the system, indicating there was a money laundering aspect to much of the Russian banking in Cyprus.  Without going into all of the details, (some can be found on this link to the OECD http://www.oecd.org/ctp/42497950.pdf) the point is that the perception amongst the core Europeans, and the Germans especially and the SPD in particular is that Cyprus was a haven for dodgy Russian money. This was not something German taxpayers would support and with upcoming German elections in September, what the German taxpayer will and will not support is critical. It is important to keep this in mind should another country need assistance before the end of September.

So, while we can see that Cyprus has many one-off characteristics, it is part of a larger set of problems and it comes after Ireland and Greece and possibly before Spain, Italy, Slovakia or Hungary.  Europe has yet to answer the question how does the Eurozone handle mismanaged balance sheets without destroying prospects for economic growth? The Greek pseudo-default last year shines light on the delicate balance that has yet to be achieved by European officials. On one hand, it would have been a viable option for Greece to have exited the Euro, devalue its currency, and inflate its way out of its debt problem. On the other hand, had the Grexit occurred, it would have impacted many German banks and it would have cost the German taxpayer more in the end.  Not so with Cyprus, or so the current logic goes.

Cyprus is not only smaller than Greece, but by many orders of magnitude. The Î5.8bn that the bank tax would cover is a mere 0.06% of the annual EU GDP. But Cyprus does not owe money to the core. Core institutions do not have much known exposure to its banks. Core institutions do not have significant two-way transactions with Cyprus. The perception is it is only Russia that has two-way transactions with Cyprus.

Against this backdrop the unthinkable has come to pass. The ECB issued an ultimatum, ‘come up with the EUR 5.8bn or we will cut you off from ELA funding’.  If this happens Cypriot banks will cease to have sufficient capital and the country will likely leave the Eurozone. The depositors who balked at a cash for equity swap (9.9% for accounts greater than EUR100,000 and 6.7% for smaller accounts) could well suffer the fate of the Lehman creditors if the ECB cuts them off. Those with deposits above the EUR100,00 insurable level will be locked in a five-year plus battle to recover their assets and they will receive maybe  40 or 50 cents on the dollar, – far worse fate than the tax scheme.  Yet one can understand why the parliament voted down the scheme. In its original conception it was not nearly progressive enough. It punished ordinary Cypriots too much and it had more than a whiff of German imperialism.

This brings us back to our Lehman analogy. Lehman was considered too small and not systemic enough to cause problems and given Fuld’s recalcitrance, it made sense to make an example of Lehman. The CEO had not made friends of his fellow CEOs on Wall Street nor with those at the Fed or in DC.  He was not quite as disliked as Russia is by Europeans, but he was similarly distrusted.  We all know the Lehman failure proved chaotic in its aftermath.  We also know that its failure has not solved the perception that certain banks or institutions are too big to fail. In fact, at the same time Lehman was allowed to fail, AIG was given assistance.

Might a similar trajectory be seen in Europe? Allowing Bank of Cyprus and Laiki Bank to fail would surely cause a deep economic contraction in Cyprus. For those with deposits under EUR100,000 they will presumably receive the deposit insurance. For those with deposits greater than EUR100,000 it would mean heavy losses for Cypriots and foreign depositors alike. The tide will go out and we will see who else is swimming naked. Economic and financial market chaos may well ensue in Europe. It may be a Core EZ bank or financial institution or it may be in a country such as Slovakia or Hungary and then we will get the real test if this is a one-off or not.

Cyprus is not the straw that will break the camel’s back, just like Lehman was not the end of Too Big to Fail. The real test will be the next bank or sovereign event. Europe does not have a pan-European mechanism to deal with bank failure and this was brought into stark relief with the Cyprus problem. Brussels recognized the need for one last summer, but like all things in Europe resolution was moving at a glacial pace. Yet without such a mechanism capital will not equalize between countries and economic union will be hampered, possibly even put in jeopardy.  The real test of the European project will come when a Spanish or Italian or possibly a Slovak or Hungarian institution or set of institutions requires assistance. Then we will see if the German taxpayer believes the full European Union is worth saving.

Just call me Dr. Pangloss; in fact, a few weeks ago someone did just that when I said among other things we would see a Fiscal Bunny Slope, not a Fiscal Cliff.  To be sure, there will be some nail biting days for risk assets while negotiations and posturing continue. Obama may even take a page from the TARP playbook and risk a negative reaction from Wall Street as a negotiating point.  Our analysis estimates that at the end of the day taxes will rise on those in the top income bracket, (dividend interest will stay where it is) and some programs will end or be cut resulting in a $140-160bn combination of tax increases/spending cuts – a Fiscal Bunny Slope compared to the full Fiscal Cliff. This will slow growth in the first half of 2013 to 1.3%-1.8% but it will not be a fall off the cliff. Addressing entitlements spending will slightly reduce economic activity in the near term, but could boost activity longer-term if deficits are gradually reduced and the longer-term entitlement obligations are put on a more sustainable trajectory.

The Fiscal changes that could take place are comprised of automatic spending cuts, repeal of the Bush tax cuts, the end of the payroll tax cut and other miscellaneous items such as new tax hikes linked to the affordable care act and the expiration of extended unemployment benefits. The total combination of increased revenues and reduced expenditure is estimated at $825bn, with $300bn associated with the Bush tax cuts (see table below). Yet despite all of these spending cuts and tax increases the lion’s share of the fiscal burden, that which goes to support the entitlements of Social Security, Medicaid and Medicare, is the real bugbear of the US fiscal situation. Left unchecked these obligations will continue to grow in the coming years, crowding out all other government spending. Boehner’s Dec 3^rd letter to Democrats and the White House proposes $900bn in curbs on entitlement spending yet the White House has not exactly embraced it.  As we discuss in more detail below, touching entitlements is something both parties have trepidation over because cutting these programs is, well, unpopular with both the Tea Party and many Progressives. Economists and business leaders would be relieved if the pending spending cuts and tax increases were reduced in return for a Bowles-Simpson type agreement that dealt with growing entitlement spending. But as we all know, this is easier said than done. So why do I see a Bunny Slope and not a cliff?  There are three main reasons:

1. The stabilizers were put in place to force a compromise on the larger budget issues of tax base, future liabilities and entitlements.  The goal was to force an outcome so unappealing that it would bring about a negotiation so that said outcome could be avoided. 
2. Neither Republicans nor Democrats want a recession.  The OECD just forecast member country growth at 1.4% for 2013. A growth prescription is needed and cyclical fiscal adjustments are a recession prescription. If you are unsure about this please consult the European Recession Manual. Yes, long-term solutions to entitlements are needed, but much of our current budget deficit is cyclical. We need to get growth going which will make it easier to deal with the structural budget problems.
3. President Obama is in a strong negotiating position not just because he won the election but because of points one and two. All the president has to do is let the Bush tax cuts expire in 2013 and then propose a bill that cuts taxes for all but those in the top bracket and it will be up to the Republicans to vote it down. Doing so would be widely unpopular. It is no wonder that we now have key Republicans saying they will consider revenue increases. Obama is playing hardball, because he has the better negotiating position.  Yet Obama would be wise not to completely reject Boehner’s latest proposal which does eliminate many loopholes for upper income earners that would actually make the tax system less cumbersome. Yes it would reduce headline tax rates on the wealthy, but overall income from higher earners who itemize deductions would increase and effective tax rates would rise. 

Thus, in return for increasing the debt levels, deficit/debt hawks put in place measures that are unpalatable to both Democrats and Republicans in the hopes it would force both sides into a so-called Grand Bargain. The week after the election I spent time in Washington DC meeting with key players from both sides of the aisle. I also attended the excellent Guggenheim post mortem election conference.  And just like my take-aways from Glenn Hubbard and Gene Sperling last month, my belief is stronger now than ever, that at the end of the day cooler heads will prevail. A Grand Bargain will be struck that solves our long-term fiscal obligations, perhaps it won’t kick in just yet, but it will be a bargain nonetheless and a Fiscal Bunny Slope to be sure.

When looking at the Fiscal Bunny Slope there are three components to consider, the economic impact, public opinion and the likely outcomes. The first two greatly influence the third.

ECONOMIC IMPACT

The direct loss of income due to tax increases and spending cuts that we outline in the table above have multiplier effects that could cut output by a wide range depending on the multipliers used. The CBO estimates a 1.3% fall in the first half of 2013 if the full fiscal cliff occurs and Strategas Research estimates a more draconian 8% fall in Q1 followed by a 6% fall in Q2.  In either case, if we go over the cliff, there’s no doubt the fall in economic output will result in a recession that would negate much of the deficit savings – as GDP falls so does tax revenue and so does the denominator in the debt to GDP ratio. At the Economic Club of New York the week before last, Fed Chairman Bernanke told the audience there would be a benefit to reaching an agreement saying “A plan for resolving the nation’s longer-term budgetary issues without harming the recovery could help make the new year a very good one for the American economy.” He was talking not just about avoiding recession but about the positive impact avoiding a cliff might have on economic activity. While demand is still weak and disposable income only expanded by 2.1% in real terms in Q3, there are some sectors that are showing signs of life such as construction and oil and gas production. So much in economics is momentum or trend driven; if the previous periods show an increase there is a greater chance the subsequent period will too. Engineering a fiscal bunny slope would cause some slowing of momentum, but the psychological benefit of avoiding the cliff could well offset this. Businesses are indicating they are delaying purchases of equipment as evidenced by the responses to the December ISM survey and the -2.7% fall in capital expenditure in Q3. Lawmakers should also be aware that kicking the can down the road just prolongs the malaise. Doing nothing to solve the question of how we deal with long-term structural issues will keep corporate activity muted.

Public Opinion

According to an October 12, 2012 Pew Research study 64% approve of tax increases on those earning over $250,000 and 58% approve of limiting corporate tax deductions. While not yet a majority approve (only 47%) of doing away with the mortgage interest deduction (as was proposed in Bowles-Simpson), only 44% disapprove of this measure.  The mortgage interest deduction impacts the less than 30% of taxpayers who itemize and who also have mortgages so I suspect this approval number be higher with better education.  On the longer-term issues the outlook is less encouraging. According to Pew there is resistance to making changes in Social Security and Medicare to reduce the debt and deficit: 57% oppose raising the amount Medicare recipients contribute to their health care, while 56% disapprove of gradually raising the Social Security retirement age. As for means testing, 49% approve of reducing Medicare benefits for higher-income seniors while 47% disapprove of such measures.

In terms of working together the latest Pew Research poll suggests 67% of all voters want Republican leaders to work with Obama and 72% want Obama to work with Republicans. Among Republicans surveyed, 50% want Republicans to stand up to Obama and among Democrats, 42% want Obama to stand up to Republican leaders.  68% of voters say the effect of automatic tax increases and spending cuts will have a major effect on the economy and 62% say that effect will be mostly negative.  So while Obama may have the better negotiating position in terms of an election win and an expiring set of tax cuts that will allow him to play hardball if no compromise is reached before January 1, 2013, such a strategy could actually backfire in terms of popularity and effectiveness. The country want the Democrats to work with Republicans and the majority of the population knows the fiscal cliff will have a major negative effect on the economy.

LIKELY OUTCOMES

So why am I so optimistic?  While there are many things congress does not do well when compared to the best run corporations or other models of efficiency, it does actually work the way it was designed, that is inefficiently. The founding fathers set up a system with checks and balances to limit the government’s powers for which they were prepared to sacrifice effectiveness. Yet time and again, when needed, issues of great import galvanize our legislators into decisive and effective action.  The best action seems to come from a divided government, one where the President is from a different party than the one controlling either the House of Representatives or the Senate.

Voices from the right, such as Glenn Hubbard, Romney’s economic advisor, or Bill Crystal, or even Boehner himself, are all suggesting that the Republicans must consider increased revenue as part of their plan.  A September 2012 survey of NABE economists show that 45% believe the best way to reduce the federal budget deficit is via a combination of spending cuts and revenue increases, while 31% believe it could be done mostly with spending cuts and only 14% believe increased taxes alone would be the best policy.

While much of the wrangling we read about in the press and see on the television is real ideological difference, much is also just posturing. We know that behind the scenes the staffers who work for our elected officials are meeting and hammering out a deal. We know from anecdotal sources such as a recent article in The Hill that K Street (the lobbyists) is unhappy being shut out of the lame duck negotiating sessions.  Yet for those watching this Sunday’s (Dec 2, 2012) morning shows it looks dicey. Obama wants his tax increases on those in the top bracket and it is unfortunate he is not willing to consider a higher effective rate due to the closing of deduction loopholes in return for a lower headline rate. However, if that continues to be the case and we see higher taxes for the wealthy in return for some meaningful cuts to entitlements such as those measures outlined in Boehner’s Dec 3^rd letter, it might be a worthwhile compromise for long-term fiscal health.  It is likely the process will be inelegant. A worst-case scenario has us going briefly over the cliff as a negotiating tactic. However, we don’t believe in a prolonged stalemate and we would see negative market reactions as a buying opportunity. So strap in and get ready it could well be a bumpy ride to the Bunny Slope.

With so many diverse speakers from around the world there was much to learn and plenty of networking to be done.  Nevertheless three main themes emerged from the conference and they suggest that the dismal science may in fact be seeing some bright spots on the horizon.

1. The US and North American Energy picture is a significant game changer for the US economy and geopolitics.  Big changes to the economic landscape such as new oil and gas discoveries take time to be   factored in by historical econometric models like ARIMA models or even the famed RSQE model from the University of Michigan and thus the burgeoning oil and gas industry in the US and North America represents a rather welcome upside surprise to our growth model.

2. Big Data is BIG. It is changing efficiency in energy, industry, and even medicine and health care delivery.

3. The so-called Fiscal Cliff is in fact the Fiscal Bunny Slope.  The political experts that attended the conference as well as the economic advisors to the candidates, Glenn Hubbard and Gene Sperling all believed that a compromise would be reached that would avoid the cliff.

If you are wondering where the dismal is, you will find it mostly in Europe where the situation continues to evolve at an excruciatingly slow pace. There were several presentations on housing, 6 to be exact and none of them forecast a spectacular rebound. Though as we know, where you stand depends greatly on where you sit. If you sit at the bottom of the trough on housing, a small increase from a low base can have a meaningful impact on GDP, a meaningful impact on jobs growth and a meaningful impact on multiplier industries such as home improvement and furniture makers.

North American Oil and Gas

Delving further into the oil and gas picture, John Larson from IHS global insight suggested that the energy sector could add 1.1% to GDP in 2013. If we take average economist forecasts of 2.2% GDP growth and assume that most are not considering including meaningful energy growth this has the potential for a significant upside surprise. When factored in, US GDP growth in 2013 could be as high as 3.3%.

Larson’s other assertions were just as bold and also quite positive for the US economy.

• By 2020, 2mn additional jobs will have been added via direct, indirect & induced employment from the burgeoning energy industry
• The industry will add $200bn to GDP by 2015
• The government will gather $1.5tn in taxes over 15 years with approximately 50% going to the Federal government and the remainder going to local governments.

Edward Morse, global head of Citi’s Oil and Gas team, posited that North America, and the US in particular had some distinct advantages in its oil and gas resources. First, the returns to landowners align incentives of those who wish to drill and exploit the resources with those who own the rights to the resources. In most other countries (Saudi Arabia, Brazil, Venezuela, Indonesia etc.) the resources are all inefficiently exploited and all owned by the State. Secondly, in both the US and Canada, there exist independent risk taking companies that are small and nimble. Small companies can make decisions that large companies such as Exxon or Chevron would take years to make. Thirdly, drillers in North America do not depend on budgets imposed from above, but on private capital markets. These companies can quickly raise money and have the capital to take risks on drilling activities.

The implications of North America’s energy outlook were not only US focused. Mexico had found new oil and gas sources after years of decline at its Cantarell Field. Canada is continuing to grow its proven reserves, pipelines and discoveries.  All this adds up to important Geo-Political as well as economic impacts. Geo-Politically, it means that countries in the Middle East and South America will no longer export to the US.  Their Geo-Political pole will shift to China and Asia. Although, it is certainly possible the US could begin to export more energy to China across the Pacific.  Based on current projections it is feasible that the US could erase its current account deficit by 2022, and thus the dollar would strengthen much more than most economists currently expect over the coming decade.

Big Data

The three words to describe big data are Volume, Velocity and Variety.  The internet is just the beginning of big data’s applications. Scientific and mathematical computations that were both time consuming and prone to error can now be computed in seconds and analyzed in a similarly rapid fashion. Specifically computing ability can now rapidly analyze complex items such as DNA, and sub atomic processes.  We can engage quantum game theory. On an industrial basis we can have intelligent devices, intelligent collaboration and intelligent automation. The implications for growth are enormous and are only beginning to be quantified.

Big Data and the Applications of the Industrial Internet

As Peter Evans from GE pointed out, Economist Robert Solow was famous for noting in 1987 that one could see the computer age everywhere but in the productivity statistics. A lot has changed in 25 years and we wonder what Mr. Solow would say now. We are beginning to see the intelligent collaboration between machines (B2B) as well as between humans and machines as displayed graphically in figure 2 above.  When one considers that there are over 130,000 power plants in the world producing 5200 GW of power annually, there is a lot of headroom for optimization. GE has identified a 1% improvement, or $66bn over a 15 yr period, from efficiency gains derived from Big Data to Gas Turbines.  There are over 4000 hospitals in the US, imagine the headroom for productivity!  The marriage of Big Data and nano technology has given way to graphine strips that can sense one’s physiology and communicate with doctors and hospitals to optimize drug delivery and overall patient care.  Big Data is a topic that has endless applications and we will be writing about it more and more over the coming years.

That the housing market, the nexus of US Economic dislocation, is still quite hobbled is not lost on Washington. In January the Federal Reserve put out a white paper on the housing market which advocated a multipronged approach to clearing bad debts off the books of the GSEs and the banks.  In the President’s State of the Union address he outlined several new measures to help homeowners.  On February 9th, the State Attorney Generals for 49 states (only Oklahoma’s Attorney General did not participate) settled that the five largest mortgage servicers would pay $26bn to make up the difference between the mortgage value and the value of “underwater” homes.  Naturally what happens in housing is linked to the health of the overall economy as housing wealth is a key driver of the consumption function.  But the health of the housing market also impacts other areas such as growth in construction jobs, the auto sector (think pickup trucks), building materials and of course municipal finance and spending.   It is an important economic issue for the Fed and an important political issue for the President, especially in an election year.  For bond investors it is important because what happens in the housing sector will have a disproportionate impact on inflation, rates and credit. Naturally the housing market is itself linked to what happens with employment and the Fed remains focused on getting employment up as well, but the two are intertwined. However, at the moment the refinance market is the main policy factor the Fed has to impact consumer spending and increase the velocity of money.

In order to really “fix” housing, that is to write down the approximately $700bn by which borrowers are underwater on their first lien mortgages and the nearly $400bn they are underwater on (Home Equity Lines of Credit) HELOCs, at least one of the stake holders will have to take a haircut and there are really only three options: banks take the write-down (via foreclosure or debt forgiveness), tax payers pay by allowing Fannie or Freddie to take the write down, or we continue with forbearance hoping that the housing market comes back to life spurred on by the various measures that have been taken/proposed so far. In and of itself, writing down debt is deflationary and it is the Fed’s belief that it is deflationary which provides one of the pillars of support for the current Zero Interest Rate Policy (ZIRP) and the commitment to keep rates low through 2014.

In thinking about 10-year rates, most people are of the view that they are artificially low. I am generally of that view.  But I think it is important to consider the opposite of what seems obvious; to what extent are rates actually just about right? In pondering the situation I reread Irving Fisher the father debt deflation theory; looking at how much housing debt is still to be written down in the US and I am not so sure how many basis points are  artificial. I posit this thought, all the models which suggest we should be at 3.0% rates on the 10-year don’t have a pending debt write-down of $1.3tn as one of their factors.  Of course it is possible that forbearance suddenly begins to “work” but doubt the US government will be that patient. 

As the father of debt-deflation theory, Irving Fisher, wisely observed “Disturbances in these two factors—debt and the purchasing power of the monetary unit—will set up serious disturbances in all, or nearly all, other economic variables. On the other hand, if debt and deflation are absent, other disturbances are powerless to bring on crises comparable in severity to those of 1837, 1873, or 1929-33.” In the case of the housing market, debt and deflation are most certainly present. With house prices falling between 25-33% from the peak depending on what index one uses and with debt reaching historic highs, Fisher’s perfect storm conditions exist. Housing had reached 6% of GDP in the past, but it never fell quite so far so fast because there was never before this much leverage in the housing market. That we are experiencing economic and interest rate market disruptions from the bursting of the housing bubble is not much in dispute either. That the debt overhang in the housing market still has the potential to be deflationary is widely debated inside the Fed and on trading desks around the globe.

In Fisher’s work on debt-deflation he cites nine factors which can work in a variety of combinations that perpetuate vicious circles.  Contraction of deposit currency is one of the factors that the Fed’s QE has averted.  Despite this, a reduction in output, trade and employment and loss of confidence, three other factors, was not averted.  However, due to the Fed’s actions, the ninth and most pernicious factor (disturbances in the interest rate) has been mitigated substantially.  While we have seen “complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest” real 10-year rates are negative at present despite having been quite elevated in 2009 (see graph above). In analyzing the data much of the deflation witnessed over the past five years has been in the real estate sector and while there is still a large debt overhang, the fall in prices appears to have nearly come to an end.  The real question that remains now is whether the current debt overhang that remains in the real estate sector can be cleared quickly and how will the costs borne in this effort impact rates and the real economy.  If we allow a continuation of forbearance this likely means a prolonged period of bouncing off the bottom on prices and a somewhat slower return to normal lending or price appreciation than if the books could be magically be cleared of the $1.3tn of underwater loans. 

Turning to inflation, if we assume that Core CPI continues to rise between 0.15% and 0.20% on a month over month basis until the end of 2014 we will wind up with the chart above. Never before have policy rates been this much below Core CPI for so long.  My first reaction to this graph is, “this is not something we have seen before”, but then very few of us were around between 1929-33 or 1873.  The question about whether or not we get inflation centers in large part on what happens with the remaining $1.3tn of bad debt that has yet to be realized in connection with the housing bubble bursting.  The measures taken so far to assist the housing market have been piecemeal however; they have made a dent in the problem.  If substantial further dents can be made either by enabling (forcing) write-downs or by supporting demand with programs for increased lending, and REO to rent programs, then the debt overhang problem begins to go away and but in the near term, it puts deflationary forces into the mix.  On the other hand (you didn’t think I was a one handed economist did you?) if we get some lift in housing which takes prices up even a modest 2-3% per year, we will still have a huge debt overhang, but we will also have more hope for the forbearance plan which in conjunction with other measures could see us back at a place where housing makes up 4% of GDP sometime after 2020.  When looked at in this light, a 2014 target date seems a bit more reasonable. 

So should rates be at 3.0% now? Probably not. Should they be at 2.0% and are they likely to fluctuate between 1.8 – 2.20% in the near term, it seems to me this is quite likely.  We would need a substantial jump in employment (not out of the question) and a knock on effect in housing to think anything otherwise; at this point, the debt overhang is still just too large to be waved away by a few months of good data. 

China’s economy is naturally experiencing the effects of soft growth globally. The government has also been acting to cool inflation and growth in the property market which we believe is now drawing to a close. This weekend China’s vice premier Wang Qishan spoke at a meeting of local government officials and financial executives in Hubei province where he made clear that he is extremely concerned that a global economic recession could last a long time. Chinese financial news outlet Caijing quoted him as saying, “As for our country, which relies highly on external demands, we must see the situation clearly and get our own business done.”

Evaluation of the Chinese economy seems to fall into two camps, hard landing or soft landing, but what if the answer is more stimulus and growth in the near term? Of course this has implications for future landings, ones that we will address, but we do not rule out further stimulus before this happens.  Our thesis that China may begin a round of stimulus in the near term is based on a mix of government confidence and government fear. The government is likely to conclude it has been successful in reigning in inflation and a booming real estate market, giving it the confidence to start stimulating again. It is also watching its exports which have been growing at a slower rate throughout the year, rising by only 16% y/y in October compared with an average increase of 21% over the last decade, including 2009 when exports fell.  Our renewed stimulus thesis is also based on the increasing access the general population now has to media via cell phone text messaging and China’s version of twitter, Sina Weibo.  Even Christine Lagarde, Managing Director of the IMF has joined and her initial post last Monday was reposted 1,400 times. Premier Wang’s comments suggest that the government believes it simply cannot afford the type of reaction it would get if the economy experiences a substantial slowdown in employment.

Exhibit 1:   China PMI (SA, 50+ = Expansion)
Manufacturing Employment (Red),
Manufacturing (Black)

Sources: China Federation of Logistics & Purchasing, NBS/Haver Analytics

Yet a slowdown in employment is just what the data is suggesting.  The reading for the employment component for manufacturing PMI fell below 51 to 49.7 in the October reading.  Meanwhile, the new business component of the non- manufacturing PMI is on the way down, with its latest reading at 52.5. Couple this with an all time low in consumer satisfaction and the government has a reason to be concerned about public discontent.  However, the challenge with any plans to stimulate is that they will largely be credit and fixed asset investment driven.  Unfortunately, while this will assuredly stimulate growth in the near term, it does not set China up for a soft landing in the future but rather it builds on the excessive use of these levers to create greater imbalances in the economy.

The key argument for the China can’t crash camp has been due to the lack of perceived leverage. However, we believe this myth has been debunked, most recently by the government itself. This past summer the National Audit Office did a deep dive on local government debt and the banks which are the conduits for the lending and discovered RMB 10.7tn in liabilities. This essentially means that so-called off balance sheet loans were growing at nearly the same size of official RMB lending that was being recorded on balance sheet.

Exhibit 2:   China Consumer Satisfaction (NSA, 1996=100)

Sources: China National Bureau of Statistics/Haver Analytics

Rapidly growing credit and high inflation caused the central bank to put on the breaks earlier this year and M2 money supply growth has slowed to a 13% y/y rate. Yet we caution that this slowdown doesn’t reflect the rise in off balance sheet lending that is funneled through the savings system via household wealth management products. Further, given the rise in official RMB lending in October 2011 and recent comments by the government about increasing lending to smaller firms and “fine tuning” policy and we would not be surprised to see another surge in fixed asset investment. This surge would not only exacerbate the imbalances in China’s economy, it would increase the overall indebtedness of the system.

Exhibit 3:   China M2 Money Supply (% Chg, YoY, Red, LHS)
China Net Increase in RMB Loans
(3m moving average, 100 mm Yuan, Black, RHS)

Sources: People’s Bank of China/Haver Analytics

It appears that financial markets are beginning to become concerned about the off balance sheet loans, and if not the loans themselves then the lack of transparency they bring to the picture. A late September Credit Sights report notes that the Bank of China’s 5 year USD CDS spread rose to nearly 250bp, reflecting a difference of nearly 130bp over sovereign spreads. While it may not seem like much after the recent increases for European banks, it represents 2 standard deviations away from the 3-year average spread differential.  Add to this that Shang Fulin who recently replaced Liu Mingkang as the chairman of the China Banking Regulatory Commission, told lenders last week to step up debt restructuring and asset sales for local government financing vehicles that are struggling to repay loans and one has to consider that China’s banks may be in for a bumpy road.   Adding to the concern over Chinese banks was the IMF that called for closer oversight as banks increase risks.

The question the markets need to ask themselves is how will Chinese officials handle the near term? Will they respond by allowing greater on-balance sheet lending?  This could give the Chinese and world economy a boost just when it needs it most.  Meanwhile, the US economy has some moderate strength in data across the board, which includes consumption of goods; this is good news for China’s exporters. The ongoing Chimerica relationship of US imports and Chinese purchase of US Treasuries looks to be on reasonably stable footing.

There are two major things that could upset the apple cart in China, a bursting of a debt bubble and a malcontent populous with the ability to organize and communicate to effect government choices. While “fine-tuned” stimulus in the form of loans and other government directed programs will ultimately not be sustainable, it is far preferable to a malcontent populous.  Thus, we believe it means China will continue to be a positive contributor to growth over the next several quarters at least. However, the more that China relies on the crutch of debt fueled growth the less likely the chance that they can avoid a hard landing. We have had plenty of experience over the last two decades with financial gravity and at the end of the day China is no more immune to its force than US home owners or large European governments.

However we see the situation slightly differently. The two main non economic challenges EU leaders face are political and institutional. Merkel and Sarkozy must maintain broad political support as the crisis drags on while they simultaneously work to improve a cumbersome system ill equipped to deal with a crisis in the first place.  European leaders appear to be focused on maintaining political support and are only marginally aware that broader institutional change is needed if the EU is going to withstand this and potential future crises.

Thus, the political challenges to the Euro may actually be larger than the economic ones. There is a reason that most national governments organize around a leader buttressed by institutions that operates with checks and balances but that can also act in a crisis.  Economically Europe could recover if the difficult policy choices were made and if there were suitable institutions in place to bridge the gap between crisis and growth.  But the problem with the economic solutions is that they are all political one way or the other.

Take the July 21^st decision to increase the EFSF.  It was finally approved on Thursday October 13^th by a second vote in the Slovak parliament. Meanwhile events have overtaken the enlargement of the program and now it is universally recognized that Christine Lagarde was correct when she suggested in August that Europe needed a plan to shore up the banks.

To this end Merkel and Sarkozy are working on a plan to recapitalize the banks. Yet when this will be mobilized and implemented is anyone’s guess.  We know it will be unveiled on or around October 23^rd.  The original meeting of the European Union where the bank rescue plan was set to be unveiled was pushed back due to disagreements between France and Germany. See where we are going with this?  We cannot even say for sure when Europe will unveil a bank rescue fund let alone ratify it in the 17 member parliaments.  Would it take nearly three months to approve as well?  What if there is a second or third Dexia during the 4^th quarter?

In order to leapfrog the 17 member country approval process France is pushing for a mandate expansion of the European Financial Stability Facility (EFSF) which would swiftly and expediently get a fund established right away.  To us this seems like a viable and sensible plan.  Meanwhile there is talk that the German Finance Ministry is planning to revise a national German measure, the Special Fund for Financial Market Stabilization (SOFFIN) that was used in 2008-09 to shore up bank capital for German banks. Great for Germany but not terribly helpful for the EU as a whole.

Of course European leaders should consider a range of options.  But the problem for Europe is that they must decide and they must implement solutions.  Several suggestions put forth so far would have been very helpful economically such as Euro Bonds, but they met such political resistance that the idea has all but dropped from the available policy menu.  Europe must answer the question, what is the ultimate price tag and are the core economies willing to bear the cost? If the answer is yes they must communicate this clearly and swiftly to the markets and their citizens, preferably along with a plan.  Credible moral suasion would go a long way to resolving the funding crisis that most European banks now face. It would certainly go a long way to giving credence to the idea that Europe has the political will to overcome the crisis and fulfill the political and economic mandate its founders had in mind.

Graph: European Sovereign CDS as of October 13, 2011 (Source: Markit)

Exhibit 1:   U.S. CPI Figures (YoY)

Sources: BLS/Haver Analytics

Consumers have cut back on gasoline use since prices started rising in the spring of this year.  But this has only moderated prices slightly. If we look at Brent crude oil prices, they have fluctuated between $97/bl and $127/bl over the past 35 weeks.  At these levels, gasoline purchases comprise greater than 12% of retail sales.  We can see from Exhibit 1 that energy prices are still rising in the double digits. August data also reveals that higher cotton prices are being passed on to consumers with apparel prices rising slightly over 100b basis points in August.  Food prices continue to move higher rising 30 basis points to 4.5%.  The combination of these factors pushed up both headline and core CPI.

Exhibit 2:   Which one of the following worries you the most at this time?

* Lower wages, investment income or benefits
Sources: ASR Consumer Survey

If one looks at the Dallas Fed Trimmed Mean PCE which (profiled in our April 21^st edition of The Week Ahead) one can see a lower rate of price increases when one takes into account substitution; it comes in at a mere 1.6% y/y. So why all the worry? We believe the answer lies with the oil price. During the 2001 recession CPI was higher than it is now, the Core CPI was higher than it is now and the Dallas Fed Trimmed Mean PCE was higher than it is now, but oil prices were below $30/bl. At this time gasoline station sales as a percent of total retail sales was below 9%. That 3% makes a significant difference in how people feel about inflation and the level of consumer confidence.  Thus, all the backlash towards the Fed. The magnitude of easier money on the price of oil is up for debate, that easier money has helped push up the oil price is not. A jobs policy that helped get more natural gas running cars on the road or that gets more West Texas crude to refineries would do much to help not just jobs but consumer confidence as well.

Exhibit 3: 

This begs the question what if oil prices level off? No what if they fall, I am not even suggesting we be that optimistic, merely what if they level off? In exhibit 4 we show the Brent oil price with forecasts in a random walk between a price of $109-$120/bl and the corresponding y/y% change in price.  By February of next year we start to see a flattening out in the y/y price change. This will begin to help consumer confidence if it happens but will it be too late?

Exhibit 4:

Exhibit 1: Stock Price Index (Red, LHS), 10yr Treasury Yield (Constant Maturity, Black, RHS)

Sources: US Treasury/Haver Analytics

US Debt Outlook:

With its latest attempt at ZIRP (Zero Interest Rate Policy) the Fed has basically ensured that US rates will stay low and that the curve will flatten with long end rates coming in.  Our bold new forecast is for the US 30-year Treasury to fall below 2.75% in the next twelve months and for the 10-year to fall below 1.8%. How long rates stay this low depends on how simulative low rates are on the real economy in the US as well as what type of asset price inflation they bring about globally.  Low 10-year rates in late 2008 and the middle of 2010 helped to spur price increases for hard assets such as oil and gold as well as other non-productive assets such as wine and art.  One could also argue they contributed to growth along with fiscal stimulus. Now that there is no fiscal stimulus we wonder if low rates alone will spur any sustainable growth activity.

In an ideal world, banks would take advantage of low interest rates and the steep yield curve to lend.  They could borrow from the Fed at close to zero and lend out at Libor plus.  But as we can see, although the past three years have resulted in a steeper 2s-10s spread; it has gone from 100bp in early ‘08 to over 250bp earlier this year. All the while, corporate lending has declined.  As Albert Einstein once said “In theory, theory and practice are the same, in practice they are not.”  In fact it seems that low interest rates have merely encouraged liquidity in risky assets rather than providing funding for capital investment that will lead to future growth.  Put another way, if money is spent building a new factory or on R&D or on some productive asset it has a much greater chance of creating future growth than if it is used to purchase fine wine or gold.  Even the purchase of stocks has a transitory impact as any number of global or domestic events can reverse the good fortune of the stock market leaving wealth destruction in its wake.  The over 4% drop on Thursday serves as a reminder of this fact.

Exhibit 2: 2s-10s Yield Spread (%, Red, LHS), US Bank Loans Less Mortgages (Billion USD, Black, RHS)

Sources: Federal Reserve, FDIC/Haver Analytics

Of course what we cannot do is measure what would have happened if the Fed had done nothing. We have no counter factual.  Perhaps lending would have fallen further, certainly corporate bond yields are unlikely to have fallen to the levels they have. Corporates that have had access to the capital markets have borrowed there and been able to reduce interest costs and improve cash flow as a result, but will they employ the money for productive use or are they willing to hold cash?  So far it seems they are willing to hold cash.  This reminds us eerily of Japan circa 1997-2003 where repeated insufficient attempts at stimulus and structural adjustment resulted only in high government debt levels, low growth rates, bouts of disinflation and financial repression.

Exhibit 3: 10yr Treasury Yield (%, Red, LHS), Japan 10yr Yield (time-shifted Jan ’97-July’03, %, Black, RHS)

Sources: US Treasury/Bank of Japan/Haver Analytics

We believe that low rates will only help spur growth if households and businesses feel confident enough about the future to borrow. Herein lies the problem. Dysfunction in Washington and a continued mess in Europe plague confidence which hurts  real economic activity. It is likely that if neither the Japanese tsunami nor the Arab Spring occurred the recovery would be on a much stronger track.  These two shocks, to supply chains and oil prices, were enough to derail a fragile recovery.  Now we are left with fiscal austerity and continued loose monetary policy in the US and fiscal austerity and confused monetary policy in Europe.

As to the situation in Europe we see three basic catalysts for a breakup of the Euro. The first is what we have been calling a “bank walk” where money steadily trickles out of a market (Ireland came to the ESFS as a result of a bank walk).  The problem with the bank walk is there is no solution; Europe does not have equivalents of the OCC and FDIC to quietly handle bank failures in order to safeguard the system. We believe the rules implemented in October 2010 and the meager deposit insurance system are insufficient to deal with the current banking crisis. Sensing this inadequacy, the New York Fed is demanding that European banks give it details about access to funds. An article in the Wall Street Journal on Thursday highlighted the dependence of European banks on the Fed’s liquidity measures of the past year; European banks have increased reserve balances twofold to nearly $900bn as of July 13th. Worryingly, that figure has dropped 16% to $758bn as of August 3rd and many suspect that it highlights a need for dollars.  Should a major European bank fail, it would ripple through financial markets globally and it could well mean a smaller Euro-zone.

Our second concern regarding a European catalyst is politics.  Politics will be critical in deciding if Europe can create Euro-Bonds. Politics will be important in deciding if current leaders will be re-elected.  And politics is important in deciding anything regarding Europe’s future.  Recently Finland was able to require collateral for any monies it put up to rescue Greece. Predictably other countries want collateral guarantees as well.  This is one more fly in the ointment but perhaps one that ultimately prevents throwing more good money after bad.  As the German paper Der Spiegel pointed out Thursday “For some time now, the Bavarian conservative party has sought to foment fears about the euro, using a tone not too distant from that of the euroskeptic right-wing populist parties who have recently been gaining ballot-box traction across Europe with their messages.”

Finally, we believe the ECB policy of purchasing European Government bonds is a mistake.  Europe should let Portugal and Greece leave the Euro so they can focus on saving core countries like Spain, Italy and possibly even the French banking system.

Both the Europeans and the Americans should take heed to what Christine Lagarde said in her August 16th op-ed in the Financial Times. To us the core of her article is about being able to grow our way out of the cyclical and structural deficits we now face.  She wisely says “Decisions on future consolidation, tackling the issues that will bring sustained fiscal improvement, create space in the near term for policies that support growth and jobs.”  For the US it is time to consider some sort of public works/infrastructure public-private partnership that will put many back to work.  It is difficult to imagine in the current political environment, but if fashioned correctly it is not altogether impossible.  In Europe we believe that Greece, Ireland and Portugal should no longer be supported. These countries would experience more pain in the short-term from a market based restructuring, but it would save the rest of Europe and would likely cauterize the crisis.  These would each be bold moves, but with equity markets down between 5-7% across Europe and the US in two days time and with economic growth stalled to the point where a new global recession is easily imagined, bold moves are required. The real question is how does the body politic galvanize to make bold choices possible so the economy can get through rehab and begin to thrive again?

The three voting members who dissented, Richard Fisher from the Dallas Fed, Narayana Kocherlakota from the Minneapolis Fed, and Charles I. Plosser from the Philadelphia Fed have telegraphed their concerns over the current accommodative policy stance but this is the first time they have voted against Chairman Bernanke. I noted in my April 15, 2011 piece on the FOMC that these three were likely to be dissenters if monetary policy remained loose or if additional non-standard measures were used.  Even though the district that is covered by the Dallas Federal Reserve Bank (Texas, Northern Louisiana and Southern New Mexico) is relatively strong with Texas boosted by strong oil prices, the Dallas Federal Reserve Manufacturing survey is showing signs of faltering strength.  Meanwhile, the Philly Fed Index has decidedly fallen from its highs.  While, in the 9th district where the Minneapolis Federal Reserve and Narayana Kocherlakota sit, the situation is comparatively pretty good.  Throughout the recession and recovery period the 9th district has benefited from the relatively strong farm economy as well as energy and mining. Likewise, services and manufacturing in the district seem to be doing better than their national peers.  Even with some softening in their districts, the three dissenters are all situated in regions of the U.S. that are experiencing relative strength and inflation pressures.  This gives them reason to believe that the economy is on a more solid trajectory than say, Dennis Lockhart from the Atlanta Fed. Still what we find curious is that price data in most regions is showing signs of moderating.  Current inflation levels will prove to be a false signal come the 4th quarter.

Exhibit 1:   Prices Paid (Diffusion index, SA, %):
Philly Fed Business Outlook (Red)
Dallas Fed Manufacturing Survey (Black)

Sources: Philly Fed, Dallas Fed/Haver Analytics

The Federal Reserve will continue to debate non-standard measures as it said in its statement and we expect the market may get out over its skis in terms of expectations from Jackson Hole. While we do believe continued weakness in the U.S. economy will result in continued non-standard measures, we believe the big guns will be kept in reserve for a meltdown in Europe.  We have long believed that if Europe were to experience significant difficulties it would so rile financial markets and liquidity that the Fed would probably need to step in, even if only to engineer another equity market rally.  It is not uncommon for a so-called perfect storm to develop in financial markets and with the downgrade of the U.S. by S&P, the faltering of Europe’s continued effort at rescuing its periphery, and the spread of the crisis to core countries such as Italy and now even France such a perfect storm seems to be brewing.  The question is what, if anything, will the Fed do about it?

Our view remains that it will require an event in Europe, perhaps an acceleration of the slow moving train wreck we have seen so far.  The difficulty is that a default event in Europe appears to be coinciding with events (both economic and political) in the U.S.  The S&P has gone from 1200 on August 4^th to 1173 on August 11^th, extending a downturn that was already taking place. As I update this piece, the S&P is now back above 1200.   In speaking with our contacts at the Fed and reading the tea leaves in the statement, we get the sense that the Fed will not be able to assuage dissenters unless price pressures ease.  But an easing of price pressures, perhaps the return of disinflation, will certainly follow a write-down of European debt.   So far, the rout in markets has also been accompanied by a fall in oil prices with Brent falling from $127 to $108 per barrel last Friday, a 15% drop.  Normally a fall in oil prices would give a helping hand to economic growth, but with a potential European default on the horizon we fear that the fall in oil price will not be the good news it normally is. Instead we watch and wait for the catalyst that will provide a decisive action in Europe; so far it feels we are waiting for Godot.

There are several ways to look at the downgrade of the long-term rating from AAA to AA+. What are the facts, what did the S&P report say?  One can also consider the reasons for the downgrade, and why in this very high stakes game of chicken the government might have actually welcomed a downgrade to send a message to the TEA Party and their steadfast view that revenue-raising measures are taboo. And finally, there is the impact on interest rates, the markets and the real economy.

What did the S&P report say?

You can read the full report here. However, to summarize, the debt-ceiling increase did not achieve the long-term goals S&P had suggested were necessary to avoid a downgrade; S&P specified that spending reductions of $4tn are required over the next 10 years, the package only seeks to obtain $2.4tn.  To us, the key sentence in the report is as follows: “More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.”  Due to wide and seemingly intractable political divisions S&P is skeptical that the Administration and Congress can leverage their agreement last week into a broader accord about fiscal consolidation that stabilizes current US debt dynamics.  We recently heard Carmen Reinhart note that incidents of default are rarely due to unwillingness to pay.  Yet we note that unwillingness to negotiate a credible plan takes the US pretty far down the path of unwillingness to pay.  We agree with S&P’s view that the difficulty in even framing a consensus is all the more problematic with a backdrop of low economic growth and private sector deleveraging.

S&P now assumes that the Bush era tax cuts remain in place. This, combined with the recent legislation, leaves them projecting deficits of 74% of GDP by the end of 2011 to 79% in 2015 and 85% by 2021.  However even these dire projections are rather optimistic because of the assumption of 3.0% GDP growth, which is looking more and more elusive in the face of continued deleveraging.  S&P acknowledges this in talking about the BEA’s GDP revisions and growth in general: “First, the revisions show that the recent recession was deeper than previously assumed, so the GDP this year is lower than previously thought in both nominal and real terms. Consequently, the debt burden is slightly higher. Second, the revised data highlight the sub-par path of the current economic recovery when compared with rebounds that followed previous post-war recessions. We believe the sluggish pace of the current economic recovery could be consistent with the experiences of countries that have had financial crises in which the slow process of debt deleveraging in the private sector leads to a persistent drag on demand. As a result, our downside case scenario assumes relatively modest real trend GDP growth of 2.5% and inflation of near 1.5% annually going forward.”

In a high stakes game of chicken, might some in the government welcome a downgrade?

When compared with other AAA-rated countries with high levels of debt, namely France (83%) and the UK (80%), the difference is the trajectory of fiscal consolidation and the political landscape.  This leads us to our second point. Surely the US is an equal credit risk to France or the UK?  One can credibly argue the US economy is as viable as that of France or the UK, perhaps even more so.  The difference is politics.  One is tempted to blame whichever side one disagrees with. But as my wise colleague Alexander Avtsin says, “the Tea Party is just the messenger.”  The fact is both parties are willing to engage in the game of chicken now playing out, and we did not just arrive here suddenly.  The discontent has been brewing, and the backdrop of a great recession and massive deleveraging are only part of the problem.  The other part of the problem is that many Americans have seen their ability to gain upward mobility truncated in the last five years as housing wealth proved a mirage and retirement needs have grown due to growing life expectancy and health care costs.

There are mutterings in the blogosphere and amongst friends in DC that the administration wanted the downgrade to provide a foil. To say to the Republicans, you want to do this without raising revenues, well here is what that plan looks like.  This seems like a very risky game to me.  In my view, failing to seize on the compromise offered in the Bowles-Simpson fiscal commission was a tragic mistake on the part of the Obama administration. There was real bipartisan compromise and promise in those pages.    Likewise, failing to bring together moderate Democrats and Republicans was a failure of the leadership of both parties.  One potentially positive aspect of the Super Committee of 12 members of Congress (6 Senators, 6 Congressmen – 3 from both parties, sent by each chamber) is that their proposals are immune from filibuster and they require only a simple majority to pass. This is an important technical detail that should help government function a bit better than it has recently.

What will the market reaction be?

Despite calls to end the US dollar as the reserve currency (and it could happen one day) and despite the rise of gold prices and the fall in equities (which we believe has more to do with the economic outlook), we think there is a good chance the near-term response is rather benign.  We take as our example Japan after its downgrade in 1998. Bearing in mind that the US has not nearly the level of private savings nor a current account surplus two things that could change in the next 5-10 years we believe the longer-term market reaction will be similar to what it was when Japan was downgraded.  (We note that in November 1998, it was post Long Term Capital Management, the Fed was cutting aggressively, and Japan was on the verge of recovery. So we do not mean to suggest the next quarter will be similar, but the next several years are very likely to be.)

The US Treasury market is still the home of the risk-off trade.  Further, when one considers who owns US Treasuries (the Fed, foreign institutions, money market funds, and institutional managers) it is difficult to imagine a large selling cohort. Then there is the 13% of treasury holdings by individuals, what do these people do in the face of this news? Here there may be some selling pressure but we doubt it will have more than a 48-hour impact. What we do worry about is the ability to leverage the treasury market to make purchases in so-called riskier assets. Risk-on markets are likely to experience some level of dislocation.   Further, equities must still respond to growth prospects that are looking rather grim.  The unfortunate confluence of a balance sheet recession (presentation by Nomura’s Richard Koo), low consumption rates, reduced confidence that is not helped by a great deal of uncertainty about regulation, taxes, and long-term entitlement commitments does not present a positive backdrop for stocks.  As for the dollar, it is likely to continue its weakening trend, especially versus the Swiss Franc and Japanese Yen. But ultimately, this dollar weakening will be our savior; the US will import less and will be able to manufacture more competitively, and this will help with rebalancing.

The real question is can the US politicians and the electorate that put them in power find a way to compromise and build a stronger, more viable path for the future? Only if “we the people” choose to vote for candidates who can find a common ground and who can put economic prosperity over partisanship, something increasingly difficult to do with our over-gerrymandered congressional districts. The electoral landscape has only reinforced the prevailing modus operandi in Washington that believes compromise is a sign of weakness.  At this point, only the voters can change the minds of those in Washington.  Will the heretofore un-galvanized center step forward and find its voice; is it up to the task?