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Friday January 4, 2013 - 15:37:29 GMT
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Beware of Market Hysterics (FXA)

Beware of Market Hysterics

 

I consider my views on most things as pretty mainstream – average and not extreme. When it comes to the question of fiscal imbalances I am pretty sure the prior assumptions hold in as much as I am worried about the long-run US fiscal imbalance and the capacity for the country to finance current spending and tax policy.

 

But it is in the financial markets where there is now a consensus extreme view on the deficit and debt (often confused by people who are veteran financial pundits, traders and investors). It reminds me of the post War anti-communist backlash in the US led by Senator Joe McCarthy…McCarthy asserted and most of Congress and the country agreed that communists had infiltrated government at every level, Hollywood, universities and the labor unions. A real hysteria broke out. Communist “witch” hunts were common. Congress turned into the US version of Stalinist show trials with hearing after hearing in committees such as House Un-American Activities Committee (HUAC).

 

Now for sure there were some communists in the US government, Hollywood, educational system and labor unions. But the threat they posed was utterly trumped up – borderline insignificant.

 

Fast-forward to the current environment with Wall Street’s obsession with Congress and the White House where all are engaged in fixing the fiscal ship before it sinks. Wall Street has not come to the fiscal moment on its own but has been driven to it by the political actors in Washington who have determined since 2010 and the success of the Tea Party movement (a backlash to fiscal hole filling in economy where private demand cratered) that fixing the deficit now is not just priority number one but critical to the survival of species as if some drug-resistant influenza is killing millions and threatening the US population (world population) with extinction.

 

Democrats want to “fix” the imbalance with one-to-one spending cuts and tax hikes. Republicans want something closer to five-to-one. Both sides can only “compromise” at the final hour before the country (sequestration, tax hikes) self-destructs – like Jim Jones and his followers in Jonestown, Guyana lining up for cyanide laced Kool-aid.

 

Okay if the fiscal sky really was about to come crashing down on us all as the Wall Street consensus suggests, wouldn’t asset prices and the dollar reflect some of these risks? Wouldn’t volatility reflect some of these risks? Wouldn’t trading volumes reflect some of these risks? I get that the Fed’s QE flow means funding much of the annual deficit at $85bln a month – distortion argument in rates. But we can all agree that if there is rate suppression in one market the distortion correction would show up in equities and or the dollar. And I think that the stock of outstanding US Treasury debt is so vastly larger than what the Fed owns that even with QE rates could go up if the fiscal end of times was nigh based on record deficit and debt levels/growth. Maybe one can argue that gold is one “asset” that is pricing fiscal end-of-times risk. But even this market is not screaming crisis, peaked a year ago and is currently slumping.

 

I tend to think that “fixing” the US fiscal imbalance will at the end of the day involve higher tax rates and much larger sending cuts (reduced social safety net) assuming growth has shifted to a new long-run (slower) sustainable path…1-2.5% range from 3-4% range.

 

But what if the Great Recession recovery is not the long-run potential growth rate? What if the private/public balance sheet adjustment pressures limiting growth are more than offset by some new supply side innovation? Natgas, high tech, medical care innovation (lowering cost)…

 

My point is a higher growth rate is not something we can exclude from long-run deficit and debt adjustment. This is not an argument for doing nothing on the deficit. I think doing something, even big things on the deficit is important in the event that the Reinhart-Rogoff stagnation a la Japan lasts longer than models (R-R) suggest. My issue is the timing, the McCarthy-like hysteria that it is now or never – Mayan-calendar-like.

 

Which brings me to another disconnect on top of the one between fiscal hysterics and asset prices; the disconnect between uncertainty hysterics and the real economy. Don’t get me wrong – the two forms of hysteria are related. Cliff hysteria has been main impulse feeding uncertainty hysteria. Uniformly financial experts, corporate titans and all sorts of economists have asserted that firms were not using record profits, cash balances to invest because of uncertainty over fiscal fix. Well if that were so shouldn’t it show up in things like non-farm payrolls, ISM, auto sales, retail sales, factory orders and industrial production to name a few? Where the hysteria shows up is in sentiment indexes…as it should…public regurgitates what they see and read…TV, newspapers, online. Uncertainty like communists infiltration exists and is problematic…it does (did) get in way of (economic and or political) decision making. But it does not dominate economic decision making…just look at the data.

 

I kind of feel that all the drum beating over the fiscal crisis, served up by dysfunctional Congress, has been some form of primal therapy for Wall Street where to nearly a person the degree of frustration over low volume, low volatility and low returns has skyrocketed. Congress, mainly deservingly so, is an easy target and has served up a modern-day highly unnecessary and overstated equivalent of a communist threat. No amount of primal ranting over Washington dysfunction does anything for the soul or mind if at the end of the day figuring out what drives prices and the economy matters.

 

So what is the moral of the story? Watch what markets do not what they say. Risk assets should do relatively well, not great – need better real economy for that. And fade Mayan fiscal calendars, Chicken Littles, and Senator McCarthys.

 

David Gilmore

FXA

fxa@fxa.com

 

 

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