Archive for March, 2009

The Deflation / Inflation Balancing Act

Kurt Brouwer March 30th, 2009

The Current Climate: The current climate is characterized primarily by fear of further losses. Investors are worried, jumpy and prone to dash for the exits. Investing in the stock market has been a losing proposition for the past 18 months. And, in fact, it has been a very poor decade or more for stocks. Cash is king and the rate on personal savings is climbing (see A Bigger Mountain of Cash).

Though stocks have been hard hit, other assets have been struggling as well. Real estate prices peaked a few years ago and have been falling steadily, with some areas experiencing declines of 40% or more. Real estate sales volume has perked up a bit, but this rebound has been driven largely by sales of foreclosed properties.

Other than U.S. Treasury bonds, the bond market struggled last year, although it is beginning to bounce back a bit as the fears of financial contagion ease a bit. In other words, we have seen falling prices for most assets that we might hold, from stocks to real estate to bonds.

The Congressional Budget Office made this statement in the summary section of its recent report on the President’s Budget [emphasis added]:

…For the next two years, CBO anticipates that economic output will average about 7 percent below its potential-the output that would be produced if the economy’s resources were fully employed. That shortfall is comparable with the one that occurred during the recession of 1981 and 1982 and will persist for significantly longer-making the current recession the most severe since World War II. In CBO’s forecast, the unemployment rate peaks at 9.4 percent in late 2009 and early 2010 and remains above 7.0 percent through the end of 2011. With a large and sustained output gap, inflation is expected to be very low during the next several years…

The government is fighting hard to stave off further deflation of asset prices. However, this extraordinary effort to fight off deflation is likely to lead to higher inflation in the future.

The CBO estimates that inflation will be very low for ‘the next several years’ due to the output gap mentioned in the quotation above. That is, if global GDP is 7% below potential then there should not be a lot of pressure on pricing until the output gap is closed. All things being equal, I think that premise would be correct. However, just as economic output is falling, so is global capacity.

Factories are laying off workers and, in some cases, shutting down. Airlines are mothballing jets. Due to low energy prices, oil exploration is slowing. And so on. So, when the recovery does begin, the supply of goods and services will be curtailed for quite some time and that may lead to a faster uptake on prices than the CBO estimates.

This column from the Financial Times adds to this point [emphasis added]:

…The British economist Peter Warburton of Economic Perspectives raises fresh doubts about the output gap in an intriguing new paper (“Making the Case for an Early Return of Inflation”). Mr Warburton argues the expansion of global trade over the past couple of decades exerted downward pressure on inflation. During the boom years, the global supply chain was tuned to perfection, he says. The credit crisis, however, has fractured this supply chain; companies have gone bust, working capital has been hard to come by, and inventories have been run down. As a result, the productive capacity of the global economy has shrunk and the world has become more inflation prone. “An aggressive stimulus package to aggregate demand,” writes Mr Warburton, “which seeks to restore the status quo ante will encounter inflationary tendencies at lower levels of activity than before”.

This point is a good one in that our economic capacity to produce goods and services is falling and likely to fall further. Also, the extraordinary amount of debt our government is incurring, plus the high levels of government spending and other factors are likely to lead to higher demand from a weakened supply chain. We believe inflation will be the inevitable result.

And, that leads us to a discussion of the environment we expect to be in when this deflationary period ends:

The New Climate: As the financial panic subsides, we believe the future state of the financial markets will be very different from the current one. For a while, the two views - Current Climate or New Climate - will exist side by side, but, gradually, we believe the new climate will take form.

Here are four points that emphasize the new fiscal reality in Washington:

  • The Congressional Budget Office estimates the budget deficit for fiscal year 2009 will be $1.75 trillion.
  • CBO estimates that the budget deficit for fiscal year 2010 will be $1.1 trillion
  • Future deficits will approximate $1 trillion per year for the foreseeable future.
  • Government debt levels will double as a percentage of overall economic activity.

From the CBO report referenced above, we see this estimate of future deficits and increases in national debt:

…The cumulative deficit from 2010 to 2019 under the President’s proposals would total $9.3 trillion, compared with a cumulative deficit of $4.4 trillion projected under the current-law assumptions embodied in CBO’s baseline. Debt held by the public would rise, from 41 percent of GDP in 2008 to 57 percent in 2009 and then to 82 percent of GDP by 2019 (compared with 56 percent of GDP in that year under baseline assumptions)…

The government is incurring debt and ‘printing’ new money at a faster rate than we have seen since World War II. One likely result of this will be budget deficits and pressure for higher taxes - income taxes, corporate taxes, gas taxes and sales taxes. Assuming we have higher tax rates, this will have a negative impact, as it always has, on future economic growth.

This chart from the Washington Post illustrates what we have in store when it comes to Federal budget deficits.The right side of the following chart compares the CBO’s projection for future budget deficits with the White House projections. The left side shows the deficits for previous years, many of which seemed very high at the time. Now, they seem pretty modest by comparison.


Source: Washington Post

An excellent post from the Foundry blog illustrates that this deficit debacle has been a bipartisan project:

After a recession of this severity and duration, we would normally see a strong and vibrant economic recovery. However, that may not happen this time for several reasons. First, once the economy recovers, inflation will rear its head and the Federal Reserve will have to pull back from its extreme position of injecting liquidity into the financial system. When it does, the economic upturn will slow. Also, the ballooning budget deficits will eventually take a toll and government funding for new and existing programs will eventually slow down.

Real estate construction will probably remain at current low levels for a while as the inventory of unsold homes, empty offices and vacant storefronts slowly gets worked down. Therefore, growth in employment from construction will be slow.

The economic recovery overseas will likely lag that of the United States, so our economy will be trying to grow without much help from our major trading partners.

So, we do see an economic recovery on the horizon. However, it will probably not be a robust recovery, but a more moderate one.

The Transition: We believe the financial markets are forward-looking, reflecting the state of the economy many months out. The Current Climate is one of doom, gloom and deflation. Companies are going under, loans are being called, prices for a broad range of assets are weak. However, eventually, the current climate will run its course.

Assuming governmental policy makers make positive progress in cleaning up the banking mess and getting the credit markets functioning again, we believe both the fixed income and equity markets could stage strong rallies over the next two years. As that recovery happens, we will begin the transition into the New Climate, which will be very different from the Current Climate.

The New Climate: The new climate will feature higher inflation and higher long-term interest rates. We believe portfolios will have to evolve over the course of the next year or two to be responsive to this new environment. Bonds, especially those with fixed rates and longer maturities, have done poorly in past inflations. Treasury Inflation Protected Securities are one solution. Equities have historically been good inflation hedges. Other opportunities that should benefit from rising inflation would be energy and commodity-related investments.

One complicating factor is the strength of the U.S. dollar, which rebounded quite nicely as energy prices fell last year. Also, the dollar benefited from the global flight to quality, which primarily involved the purchase of Treasury securities.

However, recent actions such as the announcement of enormous U.S. Treasury purchases have reignited fears that our government is going too far. As such, we have to evaluate future pressures on the dollar when and if inflation comes back.

As we can see from this chart, inflation expectations have already rebounded a bit from the extremely low levels we saw a few months ago. This chart shows the yield on 10-year Treasury bonds minus the yield on 10-year Treasury Inflation Protected securities:

Source: St. Louis Federal Reserve, U.S. Treasury, Capital Spectator

Last year, in response to the challenging credit conditions, yields on U.S. Treasury bonds fell dramatically. As a result, the implied inflation rate (Treasury bond yield minus TIPS yield) fell precipitously. It has climbed back up a ways to about 1.5%, but it is still far from the rate of early last year.

This has been a very challenging period and the current climate — characterized by low inflation, falling asset prices and weak economic output — is not yet behind us. This climate poses its main risk in falling prices for assets of all types.

However, we also see new challenges - such as higher inflation - on the horizon. Facing up to those potential challenges will require a new strategy for the new climate that appears to be ‘baked in’ to the economic and financial solutions our government is pursuing.

For more on these topics:

Taxing Your Charity

Kurt Brouwer March 26th, 2009

In this piece, the eminent Harvard economist, Martin Feldstein, points to a tax increase proposal that would not only increase taxes, but would also deprive charitable organizations of critical donations at the very time they are needed.

President Obama has put forth a proposal that would really harm non-profit groups by reducing the amount that certain taxpayers could deduct for charitable gifts [emphasis added]:

An Anti-Charity Tax, At the Worst Possible Time (Washington Post, March 25, 2020, Martin Feldstein)

President Obama’s proposal to limit the tax deductibility of charitable contributions would effectively transfer more than $7 billion a year from the nation’s charitable institutions to the federal government…

In effect, the change would be a tax on the charities, reducing their receipts by a dollar for every dollar of extra revenue the government collects. It is hard to imagine a rationale for taxing schools, hospitals, medical research budgets and arts organizations in this way. I suspect that the administration officials who drafted this proposal did not understand that it would have this perverse effect.

The proposed tax change would apply to married couples with incomes of more than $250,000 (and single people with incomes greater than $200,000). Under current law, such couples can deduct the value of their charitable gifts from their taxable income. While no one makes a charitable contribution to get a tax deduction, the deductibility of charitable gifts reduces the cost of giving and therefore increases the amount that individuals give.

Raising taxes on anyone during a severe recession is a bad policy decision. Second, raising taxes in such a way that it adversely affects those who want to — and can — donate to needy charities is doubly pernicious.

Just imagine a $7 billion hit to the annual budgets of charitable organizations around the country and roll that forward over time and you can start to see how significant this would be. More money for the government and less for charities is not a good idea in my opinion.

… By 2011, the year in which the Obama administration proposes to start the new tax rule, the projected decrease in giving would surpass $7 billion. With the endowments of charitable institutions sharply reduced by the fall in stock prices, this loss of gifts would make an already bad situation worse.

Many tax features of the Obama budget should be changed to stimulate the near-term recovery of demand and to strengthen long-term incentives for productivity and growth. But the proposed tax on charitable gifts hits at the foundation of our pluralistic society. The administration should recognize its mistake and withdraw this proposal.

I would hope that charitable organizations are quietly making the point to the administration that this is a very bad idea.

Update: Here is an excerpt from a post by Dave Switzer, Assistant Professor of Economics at St. Cloud State University from his blog:

…Office of Management and Budget Director Peter Orszag actually said this yesterday: ”Contained in the recovery act, there’s $100 million to support nonprofits and charities as we get through this period of economic difficulty,” he said. $100 million. That’s what they’ll get to compensate them for any reduction in private charitable contributions.

Is he serious? He’s actually saying that people who currently contribute $83 billion to charity annually would not reduce their charitable contributions by more than $100 million? That would be a .12% decrease. Do you think that wealthy people will cut their contributions by only .12% when their tax break is cut by 20%?

I have to agree with the good professor. Those who donate do so out of charitable impulses. Nonetheless, they still have a certain amount of money with which they can part. Therefore, reducing the tax deduction for donations means that the taxpayer will have to pay more to the government. The obvious corollary of that higher tax payment is that many of the people affected by this will not be able to give as much.

Healthcare Innovations in the U.S.

Kurt Brouwer March 25th, 2009

Much has been made of the high cost of health insurance and the many other issues and problems associated with healthcare in the U.S. Frequently, our system is compared unfavorably to nationalized insurance and healthcare programs in Europe or Canada.

No one would suggest that our system is without faults, but I think it is fair to say that we seldom focus on its successes too. Clearly, when it comes to medical technology, the U.S. is the world’s leader. That is true with regard to new pharmaceuticals as well.

However, there is another real success story to which we can point — effectiveness of medical treatments for cancer. It turns out that the U.S. medical system is far more successful than other industrialized countries when it comes to treating cancer. For example, the U.S. has the highest survival rate in the world for breast cancer.

The National Center for Policy Analysis has an interesting report out called, 10 Surprising Facts About American Healthcare.

This chart was in the report and it makes a very important point that the U.S. is a major source of healthcare innovations.

Source: National Center for Policy Analysis

This report was authored by Scott Atlas, M.D., a professor at Stanford University Medical Center and a senior fellow at the Hoover Institution. In the report, Dr. Atlas lays out a number of surprising — and in some cases — counterintuitive facts about healthcare outcomes in the U.S. versus those in other developed countries.

10 Surprising Facts About American Healthcare (National Center for Policy Analysis, March 24, 2020, Scott Atlas, M.D.)

Medical care in the United States is derided as miserable compared to health care systems in the rest of the developed world. Economists, government officials, insurers and academics alike are beating the drum for a far larger government rôle in health care. Much of the public assumes their arguments are sound because the calls for change are so ubiquitous and the topic so complex. However, before turning to government as the solution, some unheralded facts about America’s health care system should be considered.

Fact No. 1: Americans have better survival rates than Europeans for common cancers.[1] Breast cancer mortality is 52 percent higher in Germany than in the United States, and 88 percent higher in the United Kingdom. Prostate cancer mortality is 604 percent higher in the U.K. and 457 percent higher in Norway. The mortality rate for colorectal cancer among British men and women is about 40 percent higher.

Fact No. 2: Americans have lower cancer mortality rates than Canadians.[2] Breast cancer mortality is 9 percent higher, prostate cancer is 184 percent higher and colon cancer mortality among men is about 10 percent higher than in the United States.

Fact No. 3: Americans have better access to treatment for chronic diseases than patients in other developed countries.[3] Some 56 percent of Americans who could benefit are taking statins, which reduce cholesterol and protect against heart disease. By comparison, of those patients who could benefit from these drugs, only 36 percent of the Dutch, 29 percent of the Swiss, 26 percent of Germans, 23 percent of Britons and 17 percent of Italians receive them.

We have pointed our some of these concepts before, but it was still surprising to see how much better the outcomes are in the U.S. (see Surviving Cancer — A U.S. Success Story). Having said that, I have no doubt our system could and will be much better in the future.

Fact No. 5: Lower income Americans are in better health than comparable Canadians. Twice as many American seniors with below-median incomes self-report “excellent” health compared to Canadian seniors (11.7 percent versus 5.8 percent). Conversely, white Canadian young adults with below-median incomes are 20 percent more likely than lower income Americans to describe their health as “fair or poor.”[5]

One of the big issues we face is how to better deliver healthcare to lower income Americans. One of the big arguments for proponents of nationalized healthcare or government-controlled healthcare is access for lower income folks. This point — No. 5 — at least suggests that nationalized healthcare has problems in other countries as well when it comes to treating lower income citizens.

Fact No. 7: People in countries with more government control of health care are highly dissatisfied and believe reform is needed. More than 70 percent of German, Canadian, Australian, New Zealand and British adults say their health system needs either “fundamental change” or “complete rebuilding.”[9]

Fact No. 8: Americans are more satisfied with the care they receive than Canadians. When asked about their own health care instead of the “health care system,” more than half of Americans (51.3 percent) are very satisfied with their health care services, compared to only 41.5 percent of Canadians; a lower proportion of Americans are dissatisfied (6.8 percent) than Canadians (8.5 percent).[10]

This point — No. 8 — is also critical. Americans tend to be happy and satisfied with their lives in many different facets even though they express dissatisfaction with broad conditions. For example, in this post from last December (see Americans Are Content With Their Personal Finances), we made a similar point.

In a Quinnipiac poll, only 4% of Americans said they thought the economy was good. But, 56% said their personal financial situation was either excellent or good. That is, Americans thought the economy was bad, but they were still quite happy with their personal financial situation.

In many areas, Americans express dissatisfaction with general conditions, but report high degrees of satisfaction with their own situation.

This pattern is at work in the area of healthcare as well as this piece from NCPA illustrates. Most of us focus on the problems in our system, yet when asked about our own healthcare, 51.3% of Americans report satisfaction. Only, 6.8% report dissatisfaction.

Fact No. 9: Americans have much better access to important new technologies like medical imaging than patients in Canada or the U.K. Maligned as a waste by economists and policymakers naïve to actual medical practice, an overwhelming majority of leading American physicians identified computerized tomography (CT) and magnetic resonance imaging (MRI) as the most important medical innovations for improving patient care during the previous decade.[11] [See the table.] The United States has 34 CT scanners per million Americans, compared to 12 in Canada and eight in Britain. The United States has nearly 27 MRI machines per million compared to about 6 per million in Canada and Britain.[12]

Fact No. 10: Americans are responsible for the vast majority of all health care innovations.[13] The top five U.S. hospitals conduct more clinical trials than all the hospitals in any other single developed country.[14] Since the mid-1970s, the Nobel Prize in medicine or physiology has gone to American residents more often than recipients from all other countries combined.[15] In only five of the past 34 years did a scientist living in America not win or share in the prize. Most important recent medical innovations were developed in the United States.[16] [See the table.]

Conclusion. Despite serious challenges, such as escalating costs and the uninsured, the U.S. health care system compares favorably to those in other developed countries.

I agree with this conclusion. At the same time, I recognize that we need to improve what we are doing and make the system better without stifling the very thing — medical innovation — that has made our lives better and healthier. Who among does not know someone who has a bionic knee or hip? Who does not know of someone who has had a bypass or other heart procedure? What about advances in medicines or dentristy?

This issue of medical innovation is critical because our lives and our healthcare have been very positively impacted by new drugs, new techniques and new technology. Yet, if we are currently doing better in terms of innovation than those in Canada or Norway or Great Britain, why would we want to scrap our system for one that looks very much like theirs?

It is true that there is a cost to innovation. In fact, the availability of these innovations here is one of the leading factors in rising healthcare costs here in the U.S. We could cut costs by cutting out new technologies, but I doubt if many of us would want that. Before we make wholesale changes in our system, we should ask ourselves why innovations are largely developed in the U.S.

This report by Scott Atlas and NCPA is an important one. We need to think deeply about these issues.

Hat tip: The Foundry Blog

Corporate Bonds: Spreading the Wealth

Kurt Brouwer March 24th, 2009

If you want a picture of the credit crisis, you could not do much better than this one.

This chart shows the difference in spreads between corporate bonds with a given credit rating versus U.S. Treasury bonds. The legend on the left side of the chart (y-axis) is denominated in basis points (100 basis points = 1%). The legend on the bottom (x-axis) shows the spread for a given corporate rating (AAA, AA, A …).

Now, the spread is nearly 300 basis points or three percentage points. That is, if a given Treasury yields 2.70% for a 10-year bond, then a 10-year AAA corporate would have a yield of approximately 5.70%. As you can see, a couple of years ago, the spread between a AAA corporate bond and a U.S. Treasury bond was approximately 70 basis points.

That difference is translated into higher borrowing costs for corporations planning to issue new debt. And, for anyone holding corporate debt, the widening spread means the price of the bonds fell. With bonds, as yields go up, prices go down or vice versa.

The spread between Treasuries and lower-rated corporates has widened even further. The lowest rating that qualifies for ‘investment grade’ is BBB. So, BB- or B-rated bonds fall into high yield or junk bond status. For a given B-rated corporate, the yield would be approximately 17%-18% versus a Treasury at 2.70%. Yikes.

Source: ECONOMPIC DATA / Barclays

Back in 2007, we posted on this topic (see High Yield Bonds–Spreads At Historic Low Point). Back then, the spreads between Treasuries and high yield or junk corporate bonds were at a historic low or narrow point, the reverse of the situation today.

This chart below is in a slightly different format than the one above, but it illustrates that, in 2007, the spread between high yield or junk corporates was very narrow. In fact, it was about the same spread as investment grade corporates and Treasuries have today. The high yield spread today, as we saw above, is about five times what it was back in 2007:

Source: Wall Street Journal Online / JP Morgan

Historically, the best time to own junk bonds has been when the spreads were wide and subject to narrowing, which is the case now in my opinion. Over time, as the financial panic recedes, investors will almost certainly begin selling very low-yielding money market funds and Treasury Bills to seek higher yields and this should be good for the corporate bond market overall.

I believe this represents a buying opportunity for anyone who believes the end of the world is not at hand. That is, if you think this recession will end sometime later this year or early next year, then corporate bonds are likely to be fruitful investments.

Whether you look at investment grade corporates or high yield (junk) corporates, it is critical that you invest in a diversified portfolio because there will be corporate bankruptcies or defaults ahead. That is why, diversified corporate bond mutual funds or exchange traded funds (ETFs) are a suitable vehicle.

Good News/Bad News from the Fed

Kurt Brouwer March 18th, 2009

The Federal Reserve announced today that it is planning to buy up to $300 billion in U.S. Treasury securities and Fannie Mae and Freddie Mac government agency securities. When you hear people say the Fed is printing money, this is it.

When it buys securities, the Fed pays for those securities with new money. Actually, the money is not printed, it’s just digital, but it does represent newly-created money that goes from the Federal Reserve to those folks selling the bonds.

The stock market reacted positively to the news — with the S&P 500 soaring 2% — and that’s the good news. The bond markets reacted positively as well. However, the reason the Fed took this step is the continuing weakness in the economy — the bad news — and this finally induced them to make a move they had been contemplating for several months.

This piece from the Wall Street Journal [registration may be required] gives some background on the decision [emphasis added]:

Fed to buy Treasurys, Expand Balance Sheet (Wall Street Journal, March 18, 2020, Joel Hilsenrath and Brian Blackstone)

The Federal Reserve ramped up its efforts to resuscitate the sagging economy, saying it would purchase up to $300 billion of long-term U.S. Treasury securities in the next few months and hundreds of billions of dollars more in mortgage-backed securities.

By buying long-term government bonds and mortgage-backed securities, officials hope to push up their prices and bring down their yields, and thereby energize the economy. Interest rates on many corporate bonds and consumer loans are benchmarked to U.S. Treasury debt. (Read the Fed’s statement.)

The move was a bold statement of force from the central bank, which during months of internal debate on the issue had been hesitant to begin buying long-term government bonds as the Bank of England recent began to do.

…Prices on U.S. Treasury bonds soared on the news and the yield fell sharply. Yields on 10year treasury notes dropped. Stock prices also rose sharply and the dollar sank.

The Fed’s steps came against a gloomy economic backdrop. “Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending,” the Fed said in a statement after its two-day meeting. “Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment. U.S. exports have slumped as a number of major trading partners have also fallen into recession”

…With rates near zero, the Fed is now essentially printing money to increase the supply of credit in the economy.

The Fed said will buy up to $300 billion in long-term Treasurys over next six months. The purchases of mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac will push the maximum to as $1.25 trillion, up from the previous $750 billion. The Fed also said it would increase the size of its potential purchases of the mortgage giants’ debt to $200 billion from $100 billion.

The Fed’s strategy appears to be to double down on the programs that it thinks work. In addition to commercial paper and money market mutual fund facilities, which appear to have stabilized those sectors, Mr. Bernanke has repeatedly highlighted the decline in mortgage rates in response to the agency and mortgage-backed securities facilities, calling it one of the “green shoots” evident in some markets…

This move was anticipated in part by astute bond managers such as Bill Gross of Pimco Total Return. As this excerpt from a post from January 9, 2020, indicates, the folks at Pimco have correctly anticipated a very large response from the Fed and now it is here:

So CQish (Pacific Investment Management / Investment Outlook, November 2008, Bill Gross)

…There will come a time, however, perhaps over the next few weeks or months, when deleveraging of the private sector is met by the leveraging up of the government sectors: the TARP, CPFF, and MMIFF will inject over a trillion dollars of liquidity into the system over a short period of time. At that point, our nuclear atom will begin to stabilize and it should be safer to move a little distance back out toward the perimeter where yields and potential returns are very attractive. PIMCO would focus on the following:

A continued above-average allocation to agency mortgage-backed securities – now yielding close to 6%…

The Federal Reserve’s Positive Surprise

In my opinion, this big bond buy is a good move by the Fed. The idea the Fed would buy Treasury securities surfaced several months ago, but it has been off and on since then. So, this announcement today caught the markets by surprise.

As we have seen over the past few weeks, with one problem after another, the government has not been able to articulate a clear plan for resolving this economic crisis. The furor over AIG is only the most recent fiasco.

With today’s announcement, Bernanke & Co. made a move that was not only timely, but also big and bold. And, that’s a welcome surprise.

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