September 2011 Real Investment What will it take to get the economy back on track? "Experience allows you to recognize a mistake when you make it again.." -- Franklin P. Jones   UDGING FROM THE STOCK market you might think there was some sort of dramatic fundamental change in the late summer After approaching the 2011 high in July, stocks plunged 15 - 20% at their lows in August. What could cause such a turnaround? Actually, the only thing that changed was share prices. Chart 1 QUARTER TO QUARTER GDP GROWTH Source: U.S. Department of Commerce GDP is still growing, but barely so. Evidence was mounting for months that the U.S. recovery was slowing if not completely stalled. The first quarter showed a dramatic drop-off in growth from the fourth quarter of 2010 and current indicators suggested the slow-down was continuing in the second quarter. The latest reading of the second quarter GDP growth came in at a weaker than expected 1.0%. Couple that with the first quarter's dismal number and you have 0.8% growth in the first half of the year. The European credit crisis accelerated in August, but it's been around for quite some time and is likely to stay a while longer. Now rather than one country at a time, sovereign debt has become shaky in several at a time, putting additional strain on the European Central Bank. The U.S. debt problems have been around for a long time, too, but the recent skirmish in Congress put them in a bright spotlight. As long as spineless politicians continue to avoid tackling the real problems (Social Security and Medicare) while continuing t add more (Obamacare), there will be no real resolution. That would require actual reductions in entitlement spending, something that's highly unlikely in an election year.   Losing Interest In the meantime, investors looking to protect their portfolios aren't left with a lot of options. Cash, money markets, and Treasury Bills are the usual safe havens but recently panicked investors have turned to them in droves. As a result, short-term rates are virtually zero. At their lowest points in August, short-term Treasury Bill yields were negative -- meaning investors were paying Uncle Sam to hold their money. Long-term rates are hardly better, with the 10-year Treasury Note hovering just above 2% and its 30-year counterpart only a little over a point higher. On the bright side, this is a once in a lifetime opportunity for companies to issue corporate debt with long term yields at levels generally reserved for short-term debt. Early in August Union Pacific was able to sell 30-year BBB rated bonds (one notch above junk) with a coupon of 4.75% -- the lowest for that grade ever. While this is great for corporate borrowers and may eventually help spark the economy (more on that in a minute), such low yields offer little opportunity for investors. Chart 2 10-YEAR U.S. TREASURY NOTE YIELD Even a 2% yield on 10-year government debt hasn't been enough to jump start the economy. This situation is likely to persist for at least the near-term and quite possibly well into 2012 as well. Domestic interest rates were already on the decline even before the Great Debt Ceiling Debate got underway. Ironically, this is what the Federal Reserve sought through the second quantitative easing (QE2) whose goal was to keep interest rates low so businesses would have an easier time borrowing, investing, and jump starting the economy. Unfortunately, all it accomplished was weakening the dollar and driving up the cost of commodities such as oil, gold, and agricultural products that are priced in greenbacks. Although the Fed has recently left the door open for yet a third round of quantitative easing, the Fed Chairman appeared to close it in late August. Speaking at the Fed retreat in Wyoming, he signaled the Fed was willing to stand by to see if either the economy could finally right itself or if Congress and the President could craft a fiscal solution. After the Great Debt Ceiling Debate, few hold out much hope for any fiscal solution. Another untargeted, pork-barrel spending policy would do just as little as its $800 billion predecessor in stimulating the economy. It would, however, also like its predecessor, add even more to the mounting national debt. A return to sustainable growth will only occur when businesses again invest in both human and physical capital. Individual investment in the stock market and yes, even real estate, also need to return. As the past two years so clearly demonstrated, no artificial stimulus -- whether monetary or fiscal -- can make any of this happen.   Inflating Growth Throughout all this, one factor whose absence has been heartily welcomed is inflation. For years economists believed the base level of headline (not core) inflation was about 4%. After the past decade, the average appears to be at least a full percentage point lower. Currently annual inflation is bumping along at roughly 2%, the low end of the Fed's preferred range. Aside from healthcare's entitlement-infused inflation, commodities (e.g. energy and farm products) are the chief remaining pockets today. The latter are driven by the Fed's easy money policy rendering them somewhat controllable. Which brings us to the path back to growth. There are three policies that can help fend off another recession. Two could easily happen; and happen in the near future. The third, unfortunately, is considerably more doubtful. Although the Fed has already lowered short-term interest rates about as far as possible, and has already had two bouts of quantitative easing, it still has two tools at its disposal should it want to ease even further. It may already be invoking the first: Avoiding additional quantitative easing. Over the past few weeks, Fed governors (and the Fed Chairman himself) have suggested they are closely watching the economic situation. Many Fed-watcher take this to mean they stand ready to launch QE3 if needed. That's fine, but on the other hand, none of the speakers have said they would push for it or even endorse it. This is the best option currently available to them. By allowing the market to believe they would step in and come to the rescue should the bottom fall out, they're providing the reassurance necessary to allow investors and businesses to confidently come back to the market. By not actually engaging in another round of quantitative easing, they're allowing the dollar to regain its footing and commodities to fall back toward fair value. Every penny decline in food and energy costs is like a much-needed tax break for consumers enabling them to either shore up their personal finances or spend back into the economy. Increased consumer confidence and spending as well as strong business investment are the fundamental underpinnings of sustainable economic growth. The Fed also has a second, relatively new tool, at its disposal. Several years ago, the Congress granted the Fed the power to pay interest to banks for reserves held on deposit at the Fed. Currently that rate is 0.25% which doesn't sound like much, but at least it's better than negative rates on Treasury Bills and it's just as safe. Ever since the credit crisis of 2007-2008, banks have been working to rebuild their balance sheets, some more successfully than others. Those that are accumulating excess reserves are often simply parking them with the Fed for that guaranteed quarter of a percent rather than risking them on less certain loans. Uncertainty regarding proposed new tougher banking regulations also serves as a compelling incentive to seek the safety of the Fed's 0.25%. However, if the Fed lowered the rate credited to reserves, that would diminish this incentive and quite possibly return some of this cash to the economy. Mr. Bernanke has often suggested this, in reverse, would be an effective tool to remove excess liquidity when the economy heats up, but it remains to be seen how much additional incentive can be provided on the easing side when deposits at the Fed remain high for a 0.25% yield.   The Real Wildcard Which bring us to the third tool to get the economy back on the right path: A coherent fiscal policy. Congress holds this key, and that's the scary part. As we saw so clearly demonstrated this past summer during the Great Debt Ceiling Debate, our leaders are unwilling to make decisions for the long-term good of the country. Instead they'd rather focus on the short-term (getting re-elected in 2012) and that's what makes fiscal policy such a wildcard. To be sure, in the broad scheme of things the current economic slowdown is ultimately a short-term problem, but it's a short-term problem in need of a long-term solution. Another untargeted pork-barrel spending spree like the one fobbed off as the failed stimulus package two years ago is simply not the solution. The national debt is a long-term issue which will continue to weigh on future growth, long after the autumn 2011 economy is just a memory. Long-term entitlement and tax reform is what's really needed and even in the short-term, just its promise would go a long way to averting a double-dip recession. Chart 3 U.S. UNEMPLOYMENT RATE Source: Bureau of Labor Statistics Economic growth, not artificial stimulus, is the solution to the high unemployment rate. But these are precisely the tough issues the President and Congress choose to ignore. The implications of this abdication of responsibility are clear. Even though first and second quarter earnings surprised to the upside, the economy continued to slow. It didn't matter that the quality of earnings have also been steadily improving with profits now coming from actual revenues rather than cost savings from layoffs. Unemployment will remain high until businesses can again feel safe to invest which, of course, requires a long-term solution. Without a coherent long-term fiscal policy businesses are understandably afraid to invest and are holding cash rather that using it for growth. They're afraid of the cost of upcoming mandates from Obamacare and the tax increases being pushed by the left. Ironically, they're afraid the sluggish economy -- resulting at least partially form their own reluctance to invest -- will lead to another recession and choke off their profits. Fiscal policies that lower or flatten corporate tax rates (as President Obama's own commission recommended last December) would be just what the doctor ordered to boost business investment. These investments don't pay off overnight but instead take 5 to 10 years or even longer. Short-term incentives are long gone before most business investments are even projected to be profitable. It's not rational to to expect long-term payoffs if future expenses from taxes and mandates are completely unpredictable.   The Real Things Investment from both businesses and individuals is what's needed to get the economy back on track. We're talking real investment here, not simply a code word for "spending" as those on the left are wont to do. Contrary to appearances, businesses are eager to grow as illustrated by those coming to the market with long-term bonds. They'd like to expand on the equity side, too, but that won't happen until Congress and the Fed step forward with some consistent long-term plans. Despite the August dip, stocks have held up remarkably well. All sectors -- with the possible exception of the battered Financials -- have demonstrated a striking ability to bounce back. This leaves some opportunities for adventuresome investors willing to look past the daily headlines. Many stocks -- particularly those of the larger dividend-paying companies -- are not only much cheaper than they were in July, they're actually to the point where they offer real value. That's what real investing is all about. The underlying fundamentals that drove the first two quarters' surprising earnings are still in place. In fact, they can even improve if Congress and the Fed show signs of taking the course outlined above. Wall Street is dependent on leadership -- real leadership, not just a few eloquent speeches, from Washington. With real leadership can come real investment and real recovery. E-mail your comments. Search this site! Just enter you key word or words:   Get current quotes or follow your own custom portfolio, courtesy of E-Line Financials:   Search:TickerName Company DataQuickQuote     Homepage Return to Top