Perennial Blog

In February, I highlighted five themes, called “icebergs”, that could have a chilling effect on the global economy: Global Inflation Accelerating, Global Growth Slowing, Jobless Stagflation, U.S. and Municipal Balance Sheets and Real Estate Double Dip. Since then, the stock market as measured by the S&P 500 had remained resilient, despite a backdrop where all five icebergs remain intact.

1. & 2. At this point in the cycle, I’m grouping Global Inflation Accelerating and Global Growth Slowing together, as they are now working hand in hand. In a June 27 report, Pacific Investment Management Co. (Pimco), the world’s largest bond fund manager, argued that the prospects of higher commodity prices and currency shifts will drive global inflation higher in the next few years. Pimco, unlike our Federal Reserve, doesn’t view the recent increases in commodity prices as “transitory.” Their fear is that overall inflation rates could diverge from core rates (which exclude food and energy), while the Fed looks to core rates when focusing on inflation.

As mentioned in February, historically, the best way to combat inflation is to restrict money in circulation by raising key interest rates making, it more expensive to borrow money. Some countries are doing just that.

At the end of July, the Reserve Bank of India signaled that it’s prepared to accept a slower expansion to pull down an inflation rate that could cause a crash in the pace of growth in Asia’s third-largest economy if left unchecked. Economists in the UK expect their first interest-rate hike to come in November after the Bank of England warned that the country faces a toxic combination of slower-than-expected growth and higher inflation. On July 6, China raised interest rates for the third time this year, making it clear that taming inflation remained a top priority, shrugging off their slowing growth. On July 27, Brazilian stocks became the first among the largest emerging economies to fall into a bear market this year as the government adopted new measures to stem currency gains and inflation quickened.

3. Jobless Stagflation

According to the Bureau of Labor Statistics (BLS), in June, the non-farm payroll grew a dismal 18,000. This followed May’s gain of 25,000 (revised down from the initial report of 54,000). Economists had expected the economy to add 110,000 in June and 165,000 in May, approximately 232,000 more than the disappointing reality. The June report also indicated that the unemployment rate remained abnormally high at 9.2 percent. The current employment recession is by far the worst recession since World War II in percentage terms, and second worst in terms of the unemployment rate (only the early ’80s recession with a peak of 10.8 percent was worse).

Consumer confidence fell in June as high inflation and unemployment combined with low wage growth weighed on household spending power. According to Mark Saddleton, head of economic and market analysis at Nationwide: “Consumers are still facing challenging conditions with high inflation, fuel pricing and unemployment weighing down on household budgets and sentiment. Combined with weak wage growth, spending power continues to be eroded and placed under significant pressure, making it difficult for consumers to drive the recovery forward.”

The aforementioned slow or stagnant recovery, coupled with rising inflation in food and commodities, has made it virtually impossible for the producer to pass the higher production costs onto the consumer. This in turn forces the producer to minimize expenses to compensate for the squeezed margins, hurting the ability to hire new employees.

In July, the Fed also released its updated economic projections for 2012, decreasing growth expectations and increasing both unemployment and inflation expectations. The Fed has tried QE1 & QE2 in an attempt to accomplish its dual mandate of price stability and to promote maximum employment. However, it has failed to accomplish the latter. With the recovery muddling along and unemployment near 27-year highs, the Fed’s only answer may be QE3 in the coming months. However, its credibility will be on the line after the lack of results witnessed from QE1 & QE2.

4. U.S. and Municipal Balance Sheets

While most of the country’s attention has been focused on the national debt crisis, at the state and county levels, it may be too late for many to avoid the possibility of a default.

Illinois, which borrowed to make its two most recent annual pension payments, is tied with California as the lowest-rated state in the estimation of Moody’s Investors Service, at A1. As recently as June Illinois was $4 billion behind on its bills to at least 8,000 vendors including businesses, charities and government agencies had been waiting months for the state to pay up. At least 114 companies are due more than $1 million, according to documents from Illinois Comptroller Judy Baar Topinka. While states periodically fall behind in paying Medicaid providers or, in the case of California, rely on bank loans and IOUs, the Illinois backlog has been growing for three years.

More recently, Jefferson County in Alabama faced a possible default on $3.14 billion in sewer bonds. This would classify as the largest municipal bankruptcy in U.S. history. This crisis had dragged for more than three years before finally coming to a head in late July. According to Reuters, the county accumulated this sewer debt over a number of years to fund the development of an EPA-mandated sewer system. Its construction was laced with delays, cost overruns and corruption. The credit rating for this debt started out as AAA in

1997 when it was issued. Currently, creditors made a “very attractive offer” to Alabama’s Jefferson County to settle its $3.14 billion sewer debt and avoid catastrophe.

Debt deal or no deal, now that our federal balance sheet has been put under a microscope, we face the very real possibility of losing our longstanding AAA credit rating. According to Moody’s, if the United States were to lose its AAA rating, at least 7,000 top-rated municipal credits would have their ratings cut. An “automatic” downgrade affecting $130 billion in municipal debt directly linked to the U.S. would occur if the federal level is reduced, Moody’s said. The company rates 15 states at AAA. On July 19, Moody’s placed hundreds of bonds sold by the 15 remaining AAA rated states under review for a possible downgrade. The following day Moody’s placed five of those 15 AAA rated states – Maryland, South Carolina, New Mexico, Tennessee and Virginia – under review for a possible downgrade.

5.  Real Estate Double Dip

Last August, I made the case that we were on the precipice of a double dip in housing. Today, it’s difficult to debate that we have been or currently are experiencing a double dip in real estate values.

Prior to April of this year, the U.S. real estate market, as measured by the Case-Shiller housing index, had fallen eight consecutive months. The housing crisis that began in 2006 has now become worse than the Great Depression. Prices have fallen some 33 percent, greater than the 31 percent fall from the late 1920s to the early 1930s, according to Case-Shiller data. But recently things have changed. The Case-Shiller report released July 26 showed that home prices rose in May, the second month in a row. That same day the Census Bureau showed that new home sales were up from a year ago.

What’s more, recent data shows that the supply of unsold new homes had fallen to just over 6 months. However, continued government intervention such as the recent 12-month extension on the Foreclosure Program for the Unemployed, simply delays the inevitable and adds to what many consider the shadow inventory. While the shadow inventory looms without any definitive number, there is now clearly a light at the end of the tunnel. Especially since the U.S. population continues to grow which will eventually result in more household formation and thus demand.

While it may be premature to go as far as calling a bottom, with home prices dropping more than during the Great Depression and interest rates remaining near all-time lows, it’s starting to look as if the end may be near. However, there are definite obstacles that remain. For one, unemployment remains exceptionally high and wage growth remains considerably subdued, making a property that looks affordable less realistic. Furthermore, the possibility of a downgrade to the U.S.’s AAA credit rating could also retard any recovery in the housing market. As mentioned previously, a downgrade would likely send interest rates higher, which in turn would make borrowing money and home ownership even less affordable.

Conclusion

Newton’s Third Law states that “For every action there is an equal and opposite reaction.” The unprecedented actions taken by the Federal Reserve, coupled with the vast government programs implemented to assist the unemployed and over-leveraged home owners during these difficult economic times, may have helped us avert a second Great Depression; albeit the consequences of those unprecedented actions will be felt for years to come. The end result is anyone’s guess, but early indications are showing that the economy, both domestically and abroad, is beginning to slow and inflation continues to rise.

At the end of July, first-quarter GDP for 2011 was revised from 1.9 to 0.4 percent. For the second quarter analysts had forecasted GDP growth of 1.8 percent, but the numbers released last Friday showed that the U.S. economy grew at a tepid rate of 1.3 percent. According to Sam Stovall, chief investment strategist at Standard & Poor’s, “Whenever we’ve had two successive quarters of year-over-year percent change in GDP that are 2 percent or less, we have either been in recession or ended up falling into recession in less than 12 months. So history is a great guide, it’s never gospel, but it certainly causes concern.”

These five icebergs remain very much intact. To date the market has been able to absorb the impact of facing many of these issues head on. With rumors of a possible QE3 being implemented later on in the year, it remains to be seen whether or not the economy can move past these issues and begin to truly recover without the help of the Federal Reserve and the government, or if history is doomed to repeat itself and we fall back into recession.

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Opinions provided are for information only and are not intended to provide specific advice or recommendations. Indices are unmanaged and cannot be invested into directly. Investing involves risk including possible loss of principal.  International and emerging market investing involves special risks such as currency fluctuation and political instability. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Past performance does not guarantee future results. John Petrick is a Financial Advisor with and Securities offered through LPL Financial, member FINRA/SIPC. His contact: (310)445-2581.