My last few posts focused fairly heavily on volatility measures and I thought it wise to shift back to some more current affairs. Rest assured, there will be more on VIX, benchmark/portfolio variance et al. in future posts. Actually, variance optimisation is a significant aspect of my 4!-moments research so there should be some new updates as, and when, these come through. But now, for something completely different:
There’s been some talk regarding the impending US political debate, coming up fairly soon, over the federal government budget and debt ceiling limit. Many political and economic pundits would tend to suggest, with the new Republican congress, an atmosphere of partisan bickering and some 2012 political ambitions coming through early, that we may be in for a potentially history-defining US government gridlock. There is even talk of a possible US default and ensuing calamitous consequences for global markets.
Yield Or Stand Firm?
But are these words of fear really warranted? Is the US, really, in any likelihood of defaulting on its debt that has withstood an impeccable credit record through civil wars, world wars, terrorist attacks, internal political strife, the threat of thermonuclear global Armageddon, global political strife and countless past economic shocks? Oh, okay, so there was that one little boo-boo back in 1933 with a break-out from a gold clause (albeit still met with US Currency) though this isn’t technically possible this time around. And then there was the restructure by Hamilton over assumed State debt in 1790 with the foundation of the US Treasury. Again, though, these were very different circumstances than those faced by the USA today.
Instead, this time around, I would contend that, indeed, we are facing the potential for a fairly momentous gridlock but, interestingly enough, a gridlock that may prove more of a boon than a bane to the US (and global) economy.
1995:The Boombastic Bulls of the 90s
Flashback to 1995, Newt v. Clinton, budget isn’t going through, government freezes. However, aside from the slightly painful music of the time (see: Shaggy, Boombastic), the 90s were one of the most bullish periods of economic growth in living memory. With the government gridlock and budget showdown came the return of unfettered markets, the re-ascendancy of deficit hawks and the potential for significant productivity growth (a full timeline of the events is available here).
Political Freeze and Economic Heat
So what did this government showdown actually yield? Well how about: record market performance, dramatic reductions in government deficits, higher real wages and standards of living, record high productivity and technological upheaval. The world wide web, mobile phones, GPS (open to civilian use under Clinton), world trade and global commerce all really took-off in the latter half of the decade.
Now, things did change post-2000, but still, up until that point things went well (maybe too well) and one could contend that the inability of government to actually really do anything might have actually assisted in this.
The Politics of Agreement v. The Economics of Disagreement
Markets work best when left untouched. Actually, they tend to actively seek de-regulation with a zest that is sometimes difficult to stomach politically. Perhaps it is best to view it this way: in a market there are buyers and sellers, two economic agents with differing opinions over the same transaction and it is the actual existence of this disagreement that leads to the value and mutual benefit of a trade to occur and, by extension, for markets to grow.
In contrast, political action requires consensus, both sides coming to the same view point. Now clearly, if everyone wants to buy (irrational bullishness) or everyone wants to sell (irrational capitulation) then we would all be in a bit of a bind from an economic point of view, even if, politically speaking, it might be a Goldilocks scenario.
So, to a certain extent (of course, it’s a matter of degrees), a political disagreement that is fraught with gridlock and incapable of action provides the perfect setting in which to conduct economic trade. And, with trade, comes surplus, and with surplus, comes wealth…
Back to The Future?
So we now have highly stimulative monetary policies, a set of tax-cut fiscal stimulations in the pipes, and some highly stimulating economic fundamentals but I suppose there is that lingering concern: what about the debt?
Oh, But This Time It’s Different, There’s this Debt and that Will Drag Us Down?
So the naysayers are still spruiking fear: this time it’s different, they say. Yeah, every time someone says (especially in relation to economics/finance) that this time it’s different, do the following: listen intently, politely nod your head, and then put your money into exactly the opposite of what was just said.
But, But, There is a Big Deficit, right?
Yes, true, $1.5 trn. could be added to the national deficit by EOY11 according to the CBO. Yes, it’s a big number, and we should actually get it to drop, not grow. And this is precisely where the government showdown will go towards.
Now imagine that, a government bickering and fighting, perhaps, but determined to reduce the national debt. This doesn’t tend to happen when governments are popular or hold on to full power with debt loads then growing. Now, take a step back and explain exactly why deficit hawks should be a risk to the economy?
But won’t there be a risk of Default?
If a government can withstand wars, floods, blizzards, social changes, political unrest, 250 years of democratic to-and-fro and can withstand this with a AAA rated credit record without a single default (okay, the 1933 gold thing aside) then it can get through to agreeing to a higher debt ceiling.
That’s not to say that there won’t be bickering, fighting, whining and chest pumping along the way, but, no, it won’t mean a default none-the-less.
But with deficit reduction, comes reduced government expenditure. Won’t that hit GDP growth?
Yes, and so will excess monetary stimulus, ongoing tax-cuts, ongoing strong corporate earnings and actual economic, as opposed to political, activity. I’m not saying that this is going to be a fun time and that everything is going to be easy. But the current budget showdown is, in my humble opinion, something more to be looked forward to rather than feared.
Okay, so there might be growth but won’t inflation then come in to bite us?
Hmm, yeah, true, inflation isn’t much fun. With the M2 money supply currently double that of the pre-crisis level there certainly seems scope for some uptick there. Indeed, the recent week of commodities news would also seem to support this. Oil is over the $100 hurdle, we’ve had two limit up days on rice and other commodities also appear to be going gangbusters. Recent ISM readings also support the expectation of further inflation with the ISM prices index coming in at a record high (manufacturing at 81.5, non-manufacturing at 72.1) not seen since July 2008.
Though inflation concerns may be warranted; it is still too early to blow the whistle just yet. Indeed, the M2 skyrocket, courtesy of the Fed, is in large part due to the deflation that occurred across the US broader M3 money supply. Remember, that the whole shadow banking system was essentially brought down to its knees with collateral calls coming right left and center. As long as that interlocked economic sub-system is not returned to normal, a lot of the collateral associated with it remains tied-up. This collateral will not be unleashed until underlying asset prices are returned back, or able to absorb up, the price of their carry across the recent crisis.
At the moment, it does not seem as though the current M2 skyrocket will truly lift that locked-out collateral just yet, though admittedly that is partly what it is trying to do (indeed, it is starting to happen in the corporate sector: see Writing Back the Down Up). There is therefore still some potential for ongoing reasonable inflation figures to come through over the coming year.
Wait, so, no inflation?
No, I am not saying no inflation, rather, moderate inflation. I’m not sure whether the new moderate will fit within the old Fed targets per se but nor will it be record core inflation either. Oh, wait, I might have just hinted at something here.
There is a bit of a disconnect occurring over the coming year with core inflation targets diverging from headline inflation measures. Potentially, this might, from a financial perspective, start to bite a few players out there. Duration might widen up considerably and, as previously noted in Inflation and the Curve, I expect more moves occurring at the front-end once the market catches up with the reality of receiving negative real yields. I take comfort that I’m not the only one seeing headline inflation as an ongoing concern here. Bill Gross of Pimco, also seems to share this outlook.
Why Doesn’t 24-Something ever give a Straight Answer? So are markets set to warm up or not?
Well, on the first point, this information is pretty much provided gratis. If you want more straight answers, then ask more straight questions with a related straight-positive bank transfer please. As to the second questions, well, yes, warming up sounds like a good analogy. I would even go as far as say heat up. But, as per the laws of thermodynamics, this heating up might also just be a bit more entropy into the underlying economic fundamentals.
Bond yields will rise, not too hard when we are at negative real yields already. Equity markets will rise, broadly, but potentially so can volatility, which might just normalise the value of any short-term rise. In other words, it won’t be easy coming through and nor will it feel easy.
Rationally Tempered Exhuberance
The recent US unemployment figures reported a recent drop over the headline unemployment rate down to 9%. Certainly a step in the right direction albeit one made on some fairly odd underlying figures (something about a past statistical rejig going on there). Currently, in order to reach a 5% unemployment rate by the end of 2016: the US would need roughly 247k per month in job creation (taking into account a 94k/month labour force growth). Not an impossible task but still a fairly daunting one.
RECENT UPDATE: from the Economist Free Exchange Blog – perhaps 247k per month job creation is already happening…
The BLS helpfully provides “smoothed” data that adjusts for the change in the estimation procedure. By this tally, employment jumped 589,000 between December and January, not by the meagre 117,000 using the unadjusted numbers. The labour force grew by 2,000 instead of shrinking by 504,000. So the unemployment rate fell because more of the unemployed became employed.
As for the current figures, even though 9% sounds better than 9.5%, there still remains the less rosy picture that 16.1% of the population are somewhat without a job (this is the U-6 figure that includes non-labour force members that desire a job). A record low labour participation rate over the current figures certainly isn’t a heart warmer either.
However, this may come as a support for the low core inflation crew. As unemployment and related wage-related pressures should abate back over the broader economic heat. In other words, even though it will be a recovering and growing economy, it won’t feel like a roaring bull market just yet. But, as mentioned earlier, once it starts feeling like that roaring bull market where everyone tells you “This time, I mean, this time, it’s really different!”, well, you’ll know what to do…