Adam Matthew Waitzman : Northwestern Mutual - Economic Commentary - March 2009 : Article: Economic Commentary

Economic Commentary - March 2009

Christopher Bremer

Senior Investment Consultant

Overview

On Feb. 17, President Obama signed into law the American Recovery and Reinvestment Act of 2009 (the”act”). The stated purpose of this $787 billion fiscal stimulus package is to preserve and create jobs. It also promotes economic recovery by assisting those most impacted by the recession, aiding state and local governments and providing technological, science, health and infrastructure investments.

Like Lemuel Gulliver, in Jonathan Swift’s “Gulliver’s Travels,” who is seen as many different things to many different people (a giant to the Lilliputians and a dwarf to the Brobdingnags), the act represents a wide array of policy values and perceptions across multiple constituencies, including politicians, economists, market participants and individuals.

Interpretation of the stimulus package is influenced by one’s political, fiscal and social preferences. For some, the act may represent a massive redistribution and populist agenda that provides tax relief for individuals who do not pay taxes, determines private sector pay and advances the “green” agenda. For others, the act answers the call to take urgent action to revitalize the economy, create jobs and enhance financial security for families. No matter how one feels about the act, perhaps many observers agree that the congressional process seemed irrational and not unlike the war between the Lilliputians and the Blefuscudians, waged over the proper way to eat a hard boiled egg.

The approximate allocation of the stimulus bill is as follows: 38 percent for tax cuts, 39 percent for spending, and 23 percent for aid to states, the unemployed and access to health care. (Figure 1.)

The objective of this month’s commentary is not to debate the merits of the stimulus bill, nor the relative value of individual line items in the legislation. Rather, since the stimulus package is now law, market participants want to identify the key provisions, and assess how they will impact the economy.

Stimulus: Counter Measures to Deleveraging

The economy is going though a painful deleveraging process that began with the bursting of the housing bubble and the disclosure of financial banks’ bad assets during the fall of 2007. In order to repair the damage on their balance sheets, financial institutions tried to sell off low quality mortgages and other distressed assets, which led to the sudden and systematic decline in the value of risk assets. (Figure 2.)

The deleveraging process has impacted all phases of the economy, with particular strain on three primary areas: asset deflation, the breakdown of the banking system and deteriorating labor markets. The severe pressures on aggregate demand and the aggressive

policy response to rescue and drive demand higher will have profound implications on the relationship between long-term national debt and gross domestic product (GDP). Below we highlight how provisions in the stimulus package and other policy initiatives, led by the U.S. Treasury, may improve the underlying inputs with regard to the economic areas hardest hit by deleveraging.

Asset Deflation

Housing will remain critical to the economic outlook and, along with the equity market, is probably the most visible and representative indicator of household confidence and the prospect of stimulating consumer demand. Housing starts in January were the lowest on record, driven by a lack of credit, plunging sales of existing homes and the deterioration of the labor markets. A corresponding meltdown in equity prices has further contributed to the severity of the economic stresses caused by the housing bubble and leads directly to consumer retrenchment. (Figure 3.)

Having experienced a 21 percent decline from peak home prices, as indicated by the Case Schiller U.S. Home Price Index (as of Sept. 30, 2008), and a 49 percent drop in equities from the two-year high (as expressed by the S&P 500 Index as of Feb. 18, 2009), many Americans may now commit to saving in the future, which could prolong the recession and depress asset prices further. The inherent conflict is that during recessions, governments want people to spend, not save. Governments then resort to loosening fiscal policy as a way of encouraging the populace to spend.

The stimulus bill provides an $8,000 tax credit for first-time homebuyers. While this tax credit may provide a modest lift to the housing markets, many believe that the current owners are the ones suffering the most from housing-related asset declines. To address the heavy burden of mortgage pressure millions of American families face today, President Obama announced on Feb. 18 a $275 billion program designed to cut mortgage payments for up to 9 million homeowners under financial distress.

Asset deflation for the American consumer is translating into historically low levels of year-over-year retail spending. January retail sales surprised the markets with a positive 1 percent reading, contrary to most forecasts which expected a substantial decline. While this was viewed as a positive sign, a deeper analysis shows that retail spending in January was still 10 percent less than the previous January. Retail spending in nominal dollars is currently at the same level as

October 1995. Personal income, conversely, is still 14 percent higher over this same period. (Figure 4.)

The sharp downturn in personal consumption is contributing to the decline in GDP. Consumption of final goods and services by households accounts for approximately 70 percent of GDP when measured by the expenditures approach. Higher unemployment, frozen credit markets and low consumer confidence all drive GDP lower. The purpose of the stimulus legislation is to offset the decline in private consumptions with government spending.

Together, the $789 billion stimulus plan and the $700 billion Troubled Asset Relief Program (TARP) account for the most ambitious endeavor to advance an ailing economy in U.S. history. A combination of stimulus through programs like unemployment insurance and tax target those in the most immediate need of assistance.

Tax credits can be implemented quickly, but the short-term affects will be uncertain, as the beneficiaries of tax relief have a choice to spend, save or pay off debt. Many economists believe that an aggregated decision to save or pay off debt will not provide the intended short-term economic stimulus. A prudent use of tax relief in this manner, however, may be a more welcome long-term use of funds, as an aggregate lack of judicious borrowing and spending seems to be what helped get us into this mess in the first place.

Breakdown of the Banking System

According to the Congressional Budget Office, “In the absence of any changes in fiscal policy, economic activity will contract more sharply in 2009 than it did in 2008, and the economy will grow at only a moderate pace in 2010.” (Figure 5.)

The key to gaining positive economic momentum is to reverse the credit crunch and provide the incentive for credit providers to transact with one another and engage the credit markets. The primary purpose of the stimulus bill is to fill the void between private sector borrowing and spending. Where the Federal Reserve (the Fed) has used monetary policy to help unlock restrictive lending, the stimulus package is designed to implement more traditional measures of increased government spending and tax cuts.

On Feb. 10, Treasury Secretary Timothy Geithner unveiled a new bank rescue plan, the specific details of which are to be revealed at a later date. After this announcement, the markets declined 4.9 percent, which seems to infer that in times of severe economic distress, the only thing the markets dislike more than poor economic data is a seemingly poor attempt at decisive policy action.

The general tenets of the program Geithner laid out appears to have merits – injecting new government capital into the biggest banks, creating a public-private partnership to buy as much as $1 trillion of banks’ bad assets, and starting a credit facility of up to $1 trillion to promote lending to consumers and businesses. While bank recapitalization is necessary to restoring health to the financial services marketplace, investors wanted to know how or whether the worst assets will be removed from banks’ balance sheets and whether some banks may be allowed to fail.

Ultimately, the main purpose of the Treasury’s plan is to enable and trigger banks and other financial institutions to support economic activity, rather than delaying or impeding it. The Treasury has promised about $1 trillion for troubled assets, or about 7 percent of U.S. Gross Domestic Product (GDP). Goldman Sachs, however, estimates that the total value of bad bank assets is $5.7 trillion. The conundrum with this $1 trillion proposal as this commentary goes to press is that it is not yet operational, or if it is, the Treasury is not disclosing the operational details.

Previous global experiences suggest that the longer governments let broken financial systems languish, the higher the probability of a much deeper and longer recession. The potential benefits of fiscal stimulus diminish over time. It is unlikely the fiscal stimulus package would not fix the broken banks, but it may provide support to declining aggregate demand. Where fiscal policy could help to lessen the shock of the recession, other measures of monetary policy, including bank recapitalization and mortgage assistance, could assist in moving the economy forward.

Deteriorating Labor Markets

The current recession has already contributed to the loss of 3.6 million jobs, and according to Standard & Poor’s, another 3 million could be lost this year. The unemployment rate rose 2.7 percent to 7.6 percent from January 2008 to January 2009, and is projected by many economists to reach between 9 percent and 10 percent. The stimulus bill intends to create about 3.5 million jobs, so even if all jobs are created on the front end of the plan, we are still close to current levels of aggregate job losses. (Figure 6.)

Direct spending on social programs carries the benefit of rapid implementation relative to other stimulus provisions. Unemployment insurance, payroll tax relief and food stamps are a few of the bill’s provisions likely to have the quickest impact on helping to slow down or stop the pace of economic decline, as they should help boost consumer demand.

Many of these provisions, however, serve more as economic safety. Much of the act is not focused on stimulus, but rather on new redistribution programs. Extending health care benefits for the unemployed, however meritorious as a social policy, is unlikely to contribute to stimulating long-term economic growth. Taking funds from an individual today or tomorrow to promote another’s well being will not increase aggregate long-term demand.

Spending on infrastructure is designed to bridge the consumer spending void and to create jobs. Because more time is needed to establish and ramp up new programs, the benefits of infrastructure spending are unlikely to materialize until later this year or beyond. The Congressional Budget Office (CBO) estimates that many of the larger projects will take up to five to seven years to complete. Whether states and other recipients of infrastructure funds are equipped to handle rapid development of big ticket spending programs is uncertain at this time.

Likewise, will grants to states be used to stimulate spending, or to refill depleted general accounts?

Impact on Debt and GDP

The U.S. economy declined at an annualized rate of 3.8 percent during the fourth quarter, the most since 1982. While the current financial crisis is unprecedented for most of us, the pace of GDP decline is not. For example, in 1958, GDP declined more than 10 percent annualized, and in the second quarter of 1980, GDP declined by 7.8 percent annualized. (Figure 7.)

For such an immense fiscal policy to be effective, it must be timely, cost-effective and limit the contribution to the long-term budget deficit. Different provisions in the bill spend out at the varying rates. Tax cuts and aid to individuals tend to be front-loaded, while the bulk of infrastructure spending will be back-loaded.

Not only is the stimulus package’s dollar tab one of, if not, the largest of the global economies, it is also the largest relative to the size of the economy. The net cost of stimulus bill and Treasury bank programs combined will proportionally increase the long-term public debt of the United States. (Figure 8.)

According to estimates by the CBO and the Joint Committee on Taxation (JCT), the American Recovery and Reinvestment Act may widen the federal budget deficit by $170 billion in fiscal year 2009, $356 billion in fiscal year 2010, $174 billion in fiscal year 2011, and by a total of $816 billion over the 2009–2019 period (excluding additional interest costs).

Economies can recover from high debt burdens with real growth and fiscal restraint, something with which the U.S. Congress will need to reintroduce itself. Congress will eventually have to consider ways to roll back the massive deficit the act will almost surely generate, or the markets will eventually discount the burden of federal debt and higher long-term interest rates.

What to Watch For

Up until the passage and signing into law of the act, the markets have exhibited a consistent pattern of rallying ahead of the announcement of a stimulus or relief plan, followed by an acute sell-off on uncertainty over the plan’s execution or ability to generate positive economic results. Should this pattern continue through the early stages of implementation, it would signal a vote of no confidence from the markets. On the other hand, a market that can sustain positive momentum through key implementation stages may signal that it is looking ahead toward an eventual economic recovery.

Timeliness of implementation is critical as the economic benefit of the stimulus plan will depend on how quickly government spending can occur. The legislation, however, is back-loaded. According to the CBO, the stimulus package will cost $787 billion and will circulate $185 billion into the economy this year and $399 billion next year. Also, the data used to report on the state of the economy are published with significant lags. Likewise, the implementation of the stimulus plan will occur with lags of varying degrees depending on the type of stimulus.

Interested observers should not be too concerned with improvements in absolute readings of economic data. Rather, focus on the directional trends (i.e., whether the pace of economic declines is moderating) in areas of the economy most likely to be impacted by the front-end provisions of the stimulus package and Treasury plan: corporate spreads versus U.S. Treasuries

(corporate bond spreads represent the difference in the yield companies are required to pay investors relative to a U.S. Treasury bond), initial jobless claims, and ascertaining whether the beneficiaries of tax relief are saving or spending. (Figure 9.)

Economic data published so far during the first quarter has been bad and will likely come in a little worse. However, things are getting worse at a declining rate. While this serves as no comfort to individuals impacted by asset declines or deteriorating labor conditions, it does generally serve to instill a slight degree of optimism in the markets and the possibility of looking ahead instead of through the rearview mirror.

Where Are We Headed?

The paradox is that massive unchecked use of leverage almost certainly got us into this situation, and federal policymakers are trying to stimulate borrowing to get us out.

The fiscal stimulus plan by itself probably cannot mend the economy, but in conjunction with the Fed’s monetary easing and the U.S. Treasury’s bank rescue plan, a more positive economic environment may be within sight. This does not, however, mean an abrupt end to unpleasant economic data or short-term market dislocations.

The most effective fiscal stimulus is temporary, with minimal impact on the long-term federal deficit. Over the long-term, massive deficits result in higher interest rates, which impede the very economic growth prospects the stimulus was designed to boost.

Our view is that a sensible mix of tax cuts, government spending and monetary policy is necessary to have the desired effect of stimulating the economy. By the reaction to Treasury Secretary Geithner’s initial press conference on the new Treasury plan, the markets have clearly signaled a strong desire to see decisive, well articulated policy with consensus support among policy makers. Appetite for risk assets will remain tenuous as long as the outcome of the government’s policy measures is uncertain.

From the perspective of restoring confidence in the economy, we also would have preferred to see strong bipartisan support. It is our opinion that both parties of Congress failed in this regard—the Democrats seemed wrapped up in spending initiatives having nothing to do with stimulus, and Republicans seemed unwilling to cooperate in a time of economic need.

For all its faults and uncertainties, the stimulus bill is likely to provide a boost to quarterly GDP. The question most economists ask is whether the act will promote a “multiplier effect” to GDP. The multiplier effect is essentially a calculation for the increase in real GDP per dollar of spending.

A large fiscal intervention is critical for boosting the economy’s slumping demand, and to the extent that any individual or collective components of the government’s stimulative efforts can help mitigate and turn demand around, the bill represents a positive development for the economy and markets.

Thus, the real measure of success for the stimulus plan will not be in measurable economic benefits of each provision, although such an analysis of the 1,100-plus page bill itself may prove to be a net job creator. The plan will ultimately be judged on whether it contributes to reducing uncertainty and promoting confidence…confidence that we are not headed toward depression, confidence that demand is not collapsing, confidence of business to invest in a new product, confidence of consumers to make that next purchase, and finally and perhaps most importantly, confidence that the paltry yields on U.S. Treasuries represent the riskier option for meeting long-term investment policy and liability objectives.