Fixed Income: Uncertainty = Caution = Slow Growth

Posted by Barry Simson on July 18, 2013

barry_f.jpegAs the third quarter begins, the economy is faced with significant headwinds.  Some of those headwinds are the natural ebb and flow of the economy and some are self induced.  The Federal Reserve (Fed) has recognized these headwinds and has extended “Operation Twist”, where they sell some of the short securities they hold and buy some longer ones helping to keep longer interest rates low.  For anyone with a mortgage with interest rates above 4% to 4.5%, now is the time to refinance.  However, The Fed cannot fix all the economic ills because the level of interest rates is not the issue.  Government policy and uncertainty are the issues.

From a behavioral standpoint, uncertainty seems to be the biggest threat to the economy.  Congress and the administration have both opted to postpone making many choices until year end.  Some are calling this Taxmaggedon and some are calling it the Fiscal Cliff.  Take your choice.  What is certain is that significant spending and tax decisions await.  How big is this cliff?  Some economists are predicting it could reduce GDP by up to 4.5%.  In other words, given our current GDP growth of just under 2%, a 4.5% contraction of GDP would put us back into a recession.  What are the choices Congress has postponed?  Two of the largest are the Bush tax cuts and the payroll (Social Security) tax cuts.  The deficit cap is another one.  There are also a number of spending cuts scheduled to occur this year including some automatic cuts to help control the deficit.

The heart of these choices is a difference in economic philosophy, Keynesian versus Monetarist as they have been expanded.  Keynesians believe that government spending is often the key to economic growth.  Infrastructure rebuilding, increased taxes and austerity will be the key words for this group.    Monetarists began with a belief that stable money supply growth led to better economic outcomes with less inflation than a more active management of the economy by the Fed.  Growth and improved living standards occur when people/corporations have relative stability and so will invest in new ventures.  The key words for monetarists are stable policies, stable and lower taxes, lower government spending and fewer regulations. 

The key disagreement between these two groups is the “multiplier effect”.  Keynesians believe that for each $1 of government spending it creates about $1.5 dollars of economic activity.  As a result, they believe that more government programs are the key to growth.  Higher taxes are not a deterrent to economic activity since the government will be spending those dollars.  Cutting back established government programs will cause economic activity to fall and will be called austerity.  Monetarists argue that the government spending multiplier is actually less than 1.  For each $1 spent by the government, economic activity in the overall economy is curtailed by more than that $1.  This reduction is due to the inefficiency of bureaucracies and the loss of private sector growth due to the higher taxes needed to pay for government spending.  In other words, increased government spending causes less economic activity overall.  Monetarists believe that reducing government programs frees up capital that can be used more efficiently in the private sector which grows the overall size of the economic pie and so will not cause an economic contraction. 

Given the fairly large deficits during the Bush presidency and the huge deficits during the Obama presidency all due to increased government spending, if the Keynesian theory worked and the multiplier effect was greater than 1, the economy ought to be humming along right now.  It is not.      

These differences are why there are so many decisions were left to the end of the year, after the elections.   The members of each school of thought want to get their own way.  Each wishes to avoid a spectacle prior to the elections.  Yet, part of the reason for a slow economy, regardless of whether you are a Keynesian or a Monetarist, is due to uncertainty.  We do not know what our tax rates are going to be.  We do not know what our health care is going to cost.  We do not know if we are going to begin working on our deficits or maintain an unsustainable level of debt.  Banks, who have been painted by some as the bad guys but are vital cogs in our economy, do not know what regulations they will have to operate under and what their costs will be.  The employment picture is uncertain.  Uncertainty breeds caution.  Caution leads to lower economic activity.  So as we look to year end with so many decisions up in the air, we would expect economic activity to continue to be slow or slower.

During the quarter we reached record low rates on the 10 year treasury.  We continue to sit just above those records.   With slow economic growth on the horizon, we do not expect rates to increase outside of their normal volatility.  In fact, we would not be surprised to see new record lows occur during the year.  Some economists are calling for these low rates out to 2015.  For the moment, the U.S. is the least tarnished of the large developed economies and so we are still attractive to foreign capital.  The one exception to the continued low rates will be if we have such a spectacle in Washington that foreigners lose faith in our ability to control our economy.   Then we have a PIIG R US scenario where the market forces discipline by causing our rates to rise.  (As you may recall, a PIIGS R US scenario is when the rest of the world begins to focus on U.S. debt levels, instead of Europe, and begins asking how we are going to control our deficits.) Now that would hurt.