After a relatively calm and upbeat first quarter, fear and apprehension have come back to the global markets. After a 5% plus return for the S&P 500 in the first quarter following an almost 27% gain in the prior year, the US stock market has come to a halt. The positive assumptions of a V shape recovery, the sustainable profitability of US corporations resulting from severe cost cutting, and the Chinese economy saving the world are all being questioned and reexamined. The massive creation of public debt, injection of capital and accommodative financial, and monetary policies by the G-20 and central bankers have stabilized the global economy from a deep and synchronized recession. Thus far the new mountain of debt has not ignited the much anticipated return of inflation and a corresponding rise in interest rates. One reason is that the newly created public debt substantially replaced the private debt, as individuals and companies continue to deleverage. The world economy is now at a crossroad: begin to take actions to restore the financial health of each economy or continue the flow of public funds to ensure that the fragile global recovery does not result in a double dip, or worse yet, a protracted global deflation.
According to The Long-Term Budget Outlook prepared by the Congressional Budget Office (CBO) which updates The Budget and Economic Outlook: Fiscal Years 2010 to 2020 issued in January this year: “Under current law, the federal budget is on an unsustainable path—meaning that federal debt will continue to grow much faster than the economy over the long run…Keeping deficits and debt from reaching levels that would cause substantial harm to the economy would require increasing revenues significantly as a percentage of gross domestic product (GDP), decreasing projected spending sharply, or some combination of the two.” The Outlook went on to say that “[a]lmost all of the projected growth in federal spending other than interest payments on the debt comes from growth in spending on the three largest entitlement programs— Medicare, Medicaid, and Social Security. By CBO’s estimates, the increase in spending for Medicare and Medicaid as a share of GDP will account for 80 percent of spending increases for the three entitlement programs between now and 2035 and 90 percent of spending growth between now and 2080. Thus, reducing overall government spending relative to what would occur under current fiscal policy would require fundamental changes in the trajectory of federal health spending. Slowing the growth rate of outlays for Medicare and Medicaid is the central long-term challenge for federal fiscal policy.” The CBO concluded by saying that its “long-term budget projections raise fundamental questions about economic sustainability. If outlays grew as projected and revenues did not rise at a corresponding rate, annual deficits would climb and federal debt would grow significantly. Large budget deficits would reduce national saving, leading to more borrowing from abroad and less domestic investment, which in turn would depress income growth in the United States. Over time, the accumulation of debt would seriously harm the economy. Alternatively, if spending grew as projected and taxes were raised in tandem, tax rates would have to reach levels never seen in the United States. High tax rates would slow the growth of the economy, making the spending burden harder to bear. Policymakers could mitigate the economic damage from rapidly rising debt by putting the nation on a sustainable fiscal course, which would require some combination of lower spending and higher revenues than the amounts now projected. Making such changes sooner rather than later would lessen the risks that current fiscal policy poses to the economy.” This week, the Office of Management and Budget predicts the budget deficit will reach a record $1.47 trillion this year. This means that we are borrowing 41 cents of every dollar we spend.
As the politicians prepare for the mid-term election season, there are three topics of concern: jobs, government spending vs. austerity, and double dip recession vs. sustained economic expansion. Regardless if the stimulus comes from further government spending and extending the unsustainable budget deficit or the Federal Reserve further expands its balance sheet, job creation is the single most important factor. According to the June 2010 Employment Situation Report prepared by the Department of Labor’s Bureau of Labor Statistics, the number of long-term unemployed (those jobless for 27 weeks and over) was at 6.8 million. These individuals made up 45.5% of unemployed persons. The number of persons employed part time for economic reasons (sometimes referred to as involuntary part-time workers) was 8.6 million. These individuals were working part-time because their hours had been cut back or because they were unable to find a full-time job. Additionally, 2.6 million people were marginally attached to the labor force, an increase of 415,000 from a year earlier. These individuals were not in the labor force, wanted and were available for work, and had looked for a job sometime in the prior 12 months. They were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey. This means that the total unemployed and under-employed is 18 million.
The average and median durations of unemployment are up to 35.2 weeks and 25.5 weeks, respectively, both new highs. The extended absence of these individuals from the labor market reduces their employability, compounding the long-term unemployment problem. Consequently, many unemployed persons will find it difficult to find work even as the labor market improves. As a part of any economic cycle, there is frictional unemployment during an economic slowdown or recession. As the economy recovers, the temporary unemployed are rehired in the same posts or within the same industries. Over the past three decades, the U.S. has seen significant increases in productivity, and much of it is due to advancement in technology. This structural change in the economy is causing fundamental changes to employment. Structural unemployment on the other hand represents a mismatch between demand and supply of labor. The skill set of the unemployed do not match the skills needed by the vacancies as a result of economic and technological change. A case in point is the rapid destruction of the property market and real estate construction industry. The displaced workers in this sector of the economy will not be rehired due to the underlying changes in our economy. During an economic dislocation, hiring patterns alter in response to future demands and not simply due to economic fluctuations. As producers of goods and services respond to global shifts in demand and preferences, their human resource needs also must undergo structural changes in response. This contributes to a jobless recovery as we have witnessed in the last two recessions and continuing in the current recovery. Structural unemployment is a serious challenge with no easy and quick fixes. As such, economists are predicting a persistent high unemployment for many years with significant social, behavioral and economic consequences. OMB’s latest report to the White House predicts an 8.1% unemployment rate in 2012.
Since the beginning of the Great Recession, economists have tried to predict the shape of the recovery. The alphabet soup includes V, L, U, cosine, and W. One of the more worrisome letters is W, which stands for a double dip recession. A double dip recession is loosely defined as a back-to-back recession within a two to three year period. The last recession ended in the second half of 2009 and there is a possibility that the economy can retreat into a recession within the next year. After a strong 5.6% growth in the fourth quarter last year, the gross domestic product during the first quarter 2010 was initially estimated at a positive 3.2% annual rate. At the end of June, the Commerce Department revised the growth rate down to 2.7%. A large part of this revision was due to a downward revision of consumer spending from 3.5% to 3.0%. Earlier this month, U.S.’s trade gap with the rest of the world jumped to an 18-month high in May, reaching $42.27 billion after being just $40.32 billion in April. Many economists revised their economic forecasts for the second quarter from a range of 3.2% – 4.5% to a lowered 2% – 3.5% range. In its annual review of the U.S. economy, the IMF forecasts that the economy will grow 3.3% this year and remain below 3% annual growth over the following five years. The IMF advised the Obama administration to raise taxes and reduce Social Security benefits as ways to contain the U.S. budget deficit and public debt. In Bernanke’s Semiannual Monetary Policy Report to the Congress on July 21, he stated that the U.S. GDP is revised down to a lower level along with a slower recovery for unemployment. After a boost by the supportive monetary and fiscal policies and a robust inventory cycle, the second half of 2010 is likely to grow at a slower pace than the first half with subdued inflation. The current consensus is that there is a low probability (25% most commonly cited) for the U.S. to experience a W shape recovery or double dip recession. We do not support a double-dip scenario and believe that the U.S. economy will continue the current tepid recovery with very little pressure to rekindle inflation.
Everyone agrees that global systemic risks have increased since the Greek debt crisis and the systematic downgrade of sovereign debt among the peripheral European countries started. With the completion of the European bank stress tests this weekend, investors are somewhat comforted by the outcome. China is engineering a soft landing to its economy and signals a slowdown that coincides with the self-induced European austerity. In the short term, investors will continue to climb the wall of worries. After all, there is plenty to be uncertain about in the U.S. and the global economy. We believe that the worst is behind us. Even though the future does not look like the good ole days, the future is better than now. The Pimco coined term – the “New Normal” – represents a world where the developing economies (less affected by the credit crisis with healthier balance sheets) will be in the driver’s seat for the world economy. For the first time, the emerging economies are the creditor nations to the developed economies. How the developing economies make structural changes to fill and maintain the leadership role and the process of the handoff are filled with uncertainties. How the developed world will manage its public debt and implement structural and fundamental changes to its economies and entitlement programs will have significant impact on its recovery and growth prospects.