U.S. stocks gained ground on a quiet day as there were no economic releases yesterday.  So the market took its cue from the Asian markets, which were all up with some posting 3.5% gains. 

Mid and small cap indices continue to outperform.  The S&P 400 Index (mid cap) made a new high a couple of weeks ago and the Russell 2000 and S&P 600 indices (small caps) are within 3% of their 2007 all-time highs.  As a result valuations are seriously stretched. 

The Shanghai Composite enjoyed it biggest rally since December on Sunday night, fueled by strong trade activity and indications they may not tighten policy as aggressively as previously believed.  The Chinese government re-calibrated their CPI, reducing the weighting of the food component – how convenient.  As a result, their main inflation gauge showed prices rose 4.9% year-over-year, shy of the 5.4% expected. Still, I think the Chinese will have no choice, absent a global event that curtails growth, but to continue to tighten policy, and probably more aggressively over the next few months. 

Energy just killed it again yesterday, up 2.11% as the broad market gained just 0.24%.  Basic material shares also rallied hard, up 1.03%.  The losers were utilities and telecoms. 

Commodity prices continued higher on the whole, led by the energy complex (oil down but gasoline and heating oil up), the metals and wheat.  Wholesale gasoline jumped 2.1% to $2.52/gallon (about $3.10 national average retail); copper rallied 2.0% to a new high (now 13% above the level hit during the summer 2008 commodity-price spike); the price of wheat remains 30% below its high hit in 2008 but on the current trend line would hit a new high by June. 

Market Activity for February 14, 2011

Sector Activity for February 14, 2011

The Budget

Here’s the short description:

So, President Obama unveiled his 2012 federal budget proposal yesterday.  It does nothing but pretend that tax increases will generate big revenue gains, that our interest payments to service the debt will go down (yes, that’s really one of the deficit-reducing measures) and that more fees on business is what our economy needs.  Oh, and then it cuts spending by about $20 billion/year over three years.  But we shouldn’t worry about any of this because we only need to continue raising the debt ceiling.  This is a complete joke, even for a political ploy (let the other side propose all the cuts and then castigate them as a bunch of haters).

That short version is for those who have no desire to read about such things.  But it would be pretty weak on my part to end the topic in such simplistic manner for those concerned that we’ve got a major growth-inhibiting problem on our hands.  To wit:

So we find out in this budget that there is no desire from the White House to return to pre-crisis level spending, which was already stupidly high under GW Bush.  No, what all of that spending was about, the spending that’s nearly doubled the publicly-held debt in just three years, was to set a new baseline.  This new budget cuts nothing in any meaningful percentage terms (less than 1% over the next three fiscal years). 

And here’s a kicker.  Two-thirds of the deficit-reducing measures come from a combination of tax-rate hikes on business and the top-income earners, lower debt service, fee hikes, and finally spending reductions.

Call me crazy, but raising taxes isn’t going to deliver substantial revenue growth for a number of reasons.  The quickest way to understand this is simply to remember how investors lined up to engage in tax-avoiding behavior late 2009 through the summer of 2010, flooding into the muni market when it was believed tax rates were going up.  The same behavior will occur in a multitude of other ways, which is always the case. 

Then we have the complete fantasy that we’ll enjoy lower interest payments over the next several years.  Um, unless Bernanke caps the long-bond at 2.5% (which I’ve mentioned he may very well do before he’s ultimately finished manipulating markets – it’s been done before), I’d bet every penny in my near zero interest-paying bank account that the government’s debt-servicing costs are going up – I know, I’m not sticking my neck out.

Then the budget counts on higher fees on business (that’s going to create jobs), and finally some spending cuts (less than 1% of the current outlays) as the final measures of deficit reduction. 

What I like most about this budget proposal (which has to be good to beat the belief that Washington will enjoy lower interest payments over the next several years) is the estimated $1.1 trillion in supposed deficit reduction over the next 10 years.  Whoa!  Really, 10 years… I’ll continue typing when I stop crying with laughter, or is it despair?   Assuming the projected $1.1 trillion in deficit reduction over the next decade turns out to be remotely accurate, I guess it’s worth reminding everyone that the 2011 fiscal year’s deficit alone is projected to be $1.6 trillion, which follows the $1.2T shortfall in FY2010 and the $1.4T deficit in FY2009.  Consider this reality and you see the joke of $1.1 trillion over 10 years.

In this budget there is no reformation of the entitlement programs, which now account for more than 50% of spending and will easily move above 60% in just the next few years as more baby boomer hit the retirement age.  And once interest rates normalize (which must happen or it means we don’t have a self-sustaining economy), the percentage of spending that’ll be needed just to pay interest on this debt will double to 15-20% of spending.  And just to be an equal-opportunity criticizer, I highly doubt Republicans are going to offer any real reforms either.  Sure, there will be the few people that really care about things, but most are not willing to rock the boat.  Even some Republicans tied the vaunted Tea Party appear unwilling to go there. 

But man, we need to reform these massive budget items bad; you know it’s a sorry situation when I’m talking about deficits – frankly, while I paid attention to the figures, I never worried all that much about the subject prior the last three years.  I’m sure there are people who can’t understand that.  Here’s the explanation:

Despite the punditry nag fest over the past 25 years, the deficits were always manageable.  The average deficit/GDP ratio averaged 2.4% during the 25 years ended 2008 – and total federal debt levels were below 65% of GDP. 

But that was before FY2009 came along.  Now we’re running annual deficits at 10% of GDP, with total debt approaching 100%; due to this sad and disgraceful position, suddenly hitting the prior postwar era’s record high deficit/GDP ratio of 5.6% would be seen as a victory. 

These are deficits levels that justify serious concern and are well too high for growth to absorb.  There will come a time in the near future when the entitlement programs will need to be reformed, but for now we continue to kick the can down the road.  Alas, now is not the time; the longer we wait the harsher it will be.  And all the while, growth will be inhibited as 2-4 percentage points of capital in terms of GDP is sucked from the private sector and businesses remain undesirably hesitant to make decisions and create jobs. 

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Have a great day!

Brent Vondera, Senior Analyst

Phone: 636-449-4900