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  by Dennis M.
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Past Commentaries

Current Commentary, Review and Outlook
April 21, 2010

To my Clients, Friends & Observers:

The market is a discounting mechanism, present-valuing cash flows 12 to 18 months in the future. To date the S&P 500 Index is up almost 7% for the year and I’m not sure it’s seeing what I’m seeing 12 months ahead. You can’t fight the tape but events occurring within the next 6 to 12 months are more likely to make this market 10% cheaper.

A team of economists from Roger Bootle’s excellent Capital Economics group were in Boston last week to present their view of the U.S. economy in 2010 and beyond. It is a view that is not dire but not enthusiastically sanguine either. In brief, the outlook for U.S. consumption, which is most of GDP, is not good. Recent signs of life in retail stores are overwhelmed by high unemployment, weak income, tighter credit, higher savings, low confidence and falling asset prices, i.e. housing. Some other salient points:

  • Continuing, possibly accelerating, deflation, evidenced by the above and also by huge spare capacity and declining purchasing power. Unit labor costs have declined 5% in the last 12 months. Core inflation is less than 1%. The greater risk to our economic health is deflation as in Japan for the last 20 years, or in the U.S. during the Great Depression.

  • Possibility of a double dip in U.S. economic recovery. They usually are small and short, a year or so. The longest in U.S. history was 4 years in the Depression. Factors contributing to another decline include another relapse in housing, the fiscal stimulus ending this year, and a Fed that must tighten and raise rates at some point.

  • Currently there is a 9 month supply of housing, down from 11, but the tax credit that encouraged buying expires this month. Foreclosures are picking up steam and supply is again increasing. By year-end there may be 10 million foreclosed homes on the market, a 22 month supply.

  • Mortgage rates are increasing and applications are decreasing. This is stifling the recovery and increasing bank losses. Residential mortgages and mortgage backed securities (MBS) are 30% of bank loans. Commercial real estate and commercial MBS are 17% of bank loans. A double-dip in housing suggests further price declines of 5%, reducing GDP by .3% to .4% this year and next - not be enough to cause another bank crisis but another reason the recovery will disappoint and deflation could accelerate.

  • Globally, the advanced economies represent 70% of GDP and emerging economies 30%. It takes a 2% increase in GDP from emerging economies to offset each 1% decline of the advanced economies. Predictions are for growth less than 1% in the Eurozone in 2010 and ’11, less than 3% for the U.S. and Japan, each, in 2010 and less than 1% in ’11, and approximately 8% from emerging Asia this year and more than 6% next.

  • China GDP growth will be 12% this year with headline inflation of 3%; core inflation (ex food and energy) less than ½%. China real estate values have skyrocketed but there is no bubble. Luxury residential values are up 15% year over year, office prices up 9%, but lower residential up less than 1%. Nominal incomes are up 15% so as yet there is no inflation threat.

  • The yuan, considered to be 20% to 30% undervalued, will likely strengthen 3% before year-end, doing nothing to rebalance the global economy. China’s commodity imports will not accelerate. China’s sources are in place. The case for commodity price inflation is overstated; when acceleration is exhausted, price levels for commodities level and stabilize. They are bearish on commodities ($60 oil, $900 gold), bullish on the dollar ($1.20/Euro), Asia and U.S. Treasuries (10-year Tsy yield 3% next year).

  • They offer 3 scenarios for U.S.- China relations: 1) China does enough with the yuan and boosts domestic demand enough to satisfy U.S.; 2) The U.S. starts imposing trade sanctions so China accelerates reform and tensions ease, or; 3) a full blown trade war.

(I will add a fourth scenario: China and the U.S. continue negotiating, agreements are reached with much fanfare and nothing is done. The U.S. doesn’t have to accept yuan at 6.82. The U.S. can insist on any exchange rate suitable for trade. That the U.S. chooses to export jobs for cheap goods makes all other rhetoric nothing more than cheap political posturing).

  • The problem with Greece is bad arithmetic; they lie about their budgets. There is no relief in sight for Greece without aggressive fiscal tightening and a prolonged recession. Greece may leave the EMU or Germany may leave the EMU, in which case the EMU splits into two areas.


The European Monetary Union (EMU) has its problems with Greece. Fixing the problem is going to hurt. The pain is inevitable. Either Germany experiences the financial pain of bailing out the Greeks or the Greeks suffer a prolonged period of recession, frugality and reduced public services. Either case results in social unrest of some degree. The sooner it is addressed the sooner it is resolved.

The U.S. has several Greece’s of its own to deal with. In today’s news, California will borrow over $8 billion in the bond market to fund further unemployment benefits. Understand, the borrower is functionally incapable of repaying and the economic prospects for increased employment actually look weaker into 2011. Who will lend? Muni investors looking for tax relief. And when the bonds default who will lend to California then? I suppose the federal government, which has already begun to crowd out the municipal bond market with “Build America Bonds.” The last embers of state sovereignty may be dying.

Examining the ability to pay of the issuers of municipal debt reveals a disturbing picture. Governments at all levels are so far proving absolutely incapable of arresting ever-increasing spending, with or without the resources to fund it. Passage of the federal health care bill is the biggest and most obvious example, the elephant in the room. There is an eerie sensation reminiscent of the sub-prime/derivative/credit default swap/mortgage binge from which we have not even begun to recover, a foreboding of uncontrollable inertia. Even if this won’t be stopped it will end and it can only end badly. In the end, debts will be reconciled and it will be painful. There will be social unrest, poverty, and all the violence that comes with it.

For every TEA party meeting or demonstration there are at least as many or more demonstrations by government employees at every level protesting threats to their budgets. The Greek protestors fighting police with sticks and stones are government employees. Which contract prevails: the contract between the government and the governed or the contract between the government and the government’s employees? Fiorello LaGuardia, the great New York mayor, declared for the former. The power to govern is only by the consent of the governed and “you cannot strike the public,” he said. The only other pol I know who has enforced that principle is Ronald Reagan with the air traffic controllers. It is apparent that government employee unions are universally pandered to by politicians buying votes.

While I’ve gotten very cautious about municipal paper for clients in Connecticut, Massachusetts, and California – all of which have disturbing fiscal problems – there is nothing in public finance at state and local levels to compare with the Commonwealth of Puerto Rico, which municipal bonds are state and federal tax exempt. It’s a perfect case study for the inertia and corruption of intertwined federal and local politics.

The U.S. owned territory of Puerto Rico is an oblong island roughly 35 miles deep by 100 miles wide. It has a population just under 4 million people. The U.S. federal government transfers over $12 billion annually to PR. Puerto Rican citizens pay no federal income taxes. The Commonwealth chronically and deliberately spends more than its revenues, overestimating its revenues and underestimating its expenses. For fiscal 2009 revenues were $7.6 billion although budgeted at $8.5 billion; expenditures, budgeted at $9.5 billion, were actually $10.9 billion. The structural deficit was $3.2 billion, 42% greater than revenues. Note that a portion of the deficit (but never a surplus) was budgeted, I would assume with the presumption that the U.S. Congress will eventually pick up the unpaid bills.

PR hopes to balance its budget by 2013, the result of an additional $5 billion from the American Recovery and Reinvestment Act of 2009 (the $787 billion U.S. “stimulus” package that followed TARP) over the next two years, and “more realistic budgeting.” The “more realistic” budget for 2010 estimates revenues of $7.67 billion and matching expenditures of exactly $7.67 billion.

However there will be “approximately $2 billion of additional transitory expenses for fiscal year 2010 related to the implementation of the expense-reduction plan…and a $500 million projected remaining structural deficit…to be funded with proceeds from bond issues.” This is from the Commonwealth of Puerto Rico Financial Information and Operating Report dated 5/15/09.

So to a reduced, but balanced, budget of $7.67 billion PR will add an additional $2.5 billion (each year for 2 years), for a total of $10.17 billion in 2010, an increase of 7% over the 2009 budget. And despite this, the Commonwealth is committed to borrowing $2 ½ billion more to fund the “expense-reduction plan” and the “remaining structural deficit.” If utilized in 2010 that would bring total money available for political spending to $12.67 billion. What realism.

Puerto Rico has the highest debt per capita of all states and territories, 8 times that of Connecticut, which is 2nd highest. And yet, as above, there are billions more needed to borrow. Unemployment is officially 14%. PR is 3rd behind California and New York in total debt outstanding, $35.19 billion. The largest employer in PR is the government. Government employees receive pensions at retirement and the government’s pension obligations are 78% unfunded. By comparison, 50% funding is the lowest of any state.

Puerto Rico is a society that functions only as well as it receives its transfers from the pockets of the citizens of the United States. At what point does the U.S. say no mas? What obligation does the U.S. have to continue to feed the ridiculous, not to say immoral, budget process above? The question is not rhetorical. With the enormous financial challenges facing the U.S., transfers to Puerto Rico will inevitably be threatened.

Who will bail out the federal government? Nobody will and nobody will care, because it’s not about the economy, or the noble goals of economic freedom and economic justice (equal opportunities). Political power is its own currency and those with the power to control are the very wealthy. What would the end look like? The collapse of the Soviet Union and its ensuing thugocracy? Venezuela or any of the other Latin American countries? Whichever prevails, left or right, it inevitably occurs at the point of a gun. If the political aristocracy has any real concern “for our children” they will get some fiscal responsibility, real soon.

Corruption and moral blindness everywhere

The ethic for compensation in the financial services industry is that remuneration is fairly commensurate with the responsibility for managing money. This is socially beneficial, moral. The ethic for investment banking is the capitalization of industry. That is the social benefit, the moral. Much derivative activity is like sports betting: a secondary game derived from a principal game. When the two intersect the principal game is corrupted.

Irresponsibility and immorality at the highest levels of banking have put the entire global economy out of equilibrium and hurt the capitalization of industry, yet compensations have remained immune. There is no justification for the extent and opacity of derivatives transactions, and particularly credit default swaps.

Kind regards,

Dennis M. O’Connor