It is year-end and time to look ahead to where the economy is going. The path has already been largely charted for the coming year. Congress has passed an extension of the Bush tax cuts and also extended unemployment benefits. The budget cost of this de facto tax-stimulus package is estimated at $800 billion, not because of increased spending but because of its implications for reduced tax revenues. At the same time, Congress also kicked the budget decision on funding of the government down the road until February or so, when the new Congress is in place. The implications here are mixed in terms of sector impacts.
Finally, the Fed has reaffirmed its commitment to increase its Treasury holdings by $600 billion. QE2 is Chairman Bernanke’s bet that the credit channel will work. He and Columbia colleague Mark Gertler wrote about it several years ago. Bernanke hopes it will come through and be the policy conduit for increasing economic growth where other channels have failed. The bet – and it is a very big bet – is that at some point banks will stop hoarding excess reserves and begin lending. After which businesses will finally begin hiring.
There are a lot of if’s here, especially since small businesses, according to the National Federation of Independent Business (NFIB), are cautious about their hiring and expansion plans. Additionally, the claims of politicians notwithstanding, small business access to credit is not regarded by NFIB respondents as a major impediment to expansion, and loan demand is low because demand is low.
Small business job creation is the key to overall job growth, not that of large businesses. Historically, large businesses are not engines of job creation, and they are not likely to be swayed by photo ops and one-on-ones with the President to expand employment. Small business employment decisions are being impacted by lack of demand and uncertainty. Uncertainty about regulation. Uncertainty about taxes. Uncertainty about healthcare costs, which now seems on its way to the Supreme Court, just to name a few.
Due to policy lags it will be well into 2011 before we have concrete evidence as to how the fiscal and monetary policies will play out and what the impacts are on job creation. In the meantime, the real economy continues gradually to improve. Consumers are finally beginning to spend, consumer sentiment is slowly improving, new claims for unemployment insurance are somewhat improved, recent surveys of manufacturing have surged, and the trade deficit is improving marginally. All of this is consistent with an economic scenario of modest growth and job creation.
The most recent surveys of economists suggest they have upped their real GDP projections for 2011 to about 4%. This is probably too optimistic and is somewhat higher than the FOMC’s central-tendency projections of from 3% to 3.6% for real growth next year. Unemployment is also projected by the FOMC to improve by about half a percentage point. Note that the FOMC’s projection takes into account the expected impact of the additional $600 billion of quantitative easing.
What does all this mean for job-creation prospects? Here are some facts. According to the Employment Survey, job losses peaked at 8.363 million jobs in December of 2009. This is six months after the official end of the recession. Since then the real economy has grown a little more than 2% on a year-over-year basis and has added a net of about 951 thousand jobs as of November 2010. This job growth is consistent with, but somewhat on the low side, of what one might expect for our economy, based upon history. Our estimates are that a US economy that grows at 2% per year will create, on average, about 1.2 million jobs. For all of 2010, the low-side estimate is about 1 million. Note that we still have a month yet to go, since the data in hand only go through November.
If the economy were to grow next year at the FOMC’s expected rate of from 3% to 3.6%, then we could look for about 2 to 2.5 million more jobs to be created. This translates to about 200 thousand jobs per month, plus or minus about 35K. Because of recent productivity growth and structural shifts in our economy, the lower estimate is probably more likely than the more optimistic scenarios. This would not be enough to bring the unemployment rate down significantly, since the labor force is expected to grow about 180K per month next year.
This rather sobering job-creation prospect has significant implications for politics and economic policy. Politicians and policy makers will be obsessed with jobs, and more so the closer we get to election season. The Iowa caucuses are scheduled for February 2012, but the jockeying will begin next summer. By then perceptions of how well politicians have responded to the need for jobs will be entrenched in voters’ minds. For this coming election, jobs equate to votes, either for hopefuls to get into office or for incumbents to stay there.
Now, I have already suggested that the economic and job outcomes are essentially already baked into the cake. This means that what will actually count is what politicians say, how partisan the environment is, how the parties react in terms of getting the US’s fiscal house in order, and how all of this plays with voters. The present administration’s fate may already be decided, in the sense there is little that can be done to affect significantly the job outcomes. Instead, a second term will depend upon how angry the public remains and how it reacts to what the new Congress does.
What does all this mean for financial markets and investment strategies? It means that uncertainty will be the dominant theme. As economists, we tend to believe that financial markets are efficient, that asset prices reflect all available information, and that risks are appropriately priced. Presently, however, financial markets appear to be dysfunctional. Pricing anomalies abound across markets. This is true in the fixed-income space and for municipal bonds in particular. Is this evidence for us to conclude that markets are no longer working, that people are irrational, or what?
I prefer to think that what we are presently seeing is not irrationality but rather the logical manifestations of uncertainty. The noted economist Frank Knight taught us the difference between risk and uncertainty. Risk means that we know or have reasonably reliable estimates of the probabilities of returns and events occurring, and therefore can make reasoned judgments on how to price those risks.
Uncertainty is when we don’t know or do not have estimates of the probability distributions characterizing risk. Under uncertainty conditions, many investors don’t know how to evaluate their exposures and make what appear to be irrational pricing decisions. Many others simply throw up their hands and exit the marketplace. Such events create opportunities for the savvy investor and bargains if one does one’s homework and can distinguish risk from uncertainty.
As long as the political, fiscal, and monetary policy uncertainties persist, we think market anomalies will persist. The failure to extend the Build America Bonds introduces great uncertainty, for example, into the municipal bond space; and that, combined with concern about the fiscal situation of many municipalities, has caused many uninformed investors either to leave the market or to demand untypically high interest rates for what are actually sound credits. For informed investors, however, such behavior creates opportunities.
Understanding the inherent quality of assets and the ability of obligors to pay is critical to separating risk from uncertainty when devising investment strategies. That is how to capitalize on asset mispricing, preserve capital, lock in returns, and hedge risks. Other commentaries from Cumberland’s portfolio managers will discuss how we approach such a marketplace.