Political and Economic Commentary

Note and partial disclaimer: My political thoughts are not my personal views (politics especially) but how I see the world unfolding based on the past year and historical trends. My personal views often clash with my investing views but as I learned long ago, you should not invest with your emotions but rather invest with conviction based on what is actually happening in the market.

Six months into 2010 and everything is unfolding much as planned. That is not a lack of confidence but rather this unpredictable market is acting as it should act given the economic and political crosscurrents pulling the markets in a volatile and sideways pattern.

The ascent of the ‘Tea Party’ movement should not be surprising as calls for a third party always ring loud in a recession or early recovery when times look bleak. While the Tea Party movement looks to continue its spring primary momentum into the fall elections, I would like to hearken back to a point made at the beginning of the year. A sitting President’s party typically loses approximately 26 House seats and a couple of Senate seats during its first election.

When new President takes over the Oval Office, they feel obligated to push through their mandate for change but run into bureaucratic inertia, which leads to a backlash.

Looking back into history to the early 90’s when the US economy was dealing with the collapse of the Savings & Loan industry, there was a call for a change in politics and we saw the ascent of Ross Perot and his third party. As the economy was struggling along and just beginning to grow again, a Democrat Bill Clinton was elected to the White House and there were calls by the Republican Party for a “Contract with America” leading to sweeping changes in the 1994 midterm elections.

How much of a parallel remains between the current time period and the Bush/Clinton era remains to be seen but I have always felt that the President following Bush would be a one term President as the collapse of the real estate market would take at least a term to clean up similar to the Savings and Loan crisis.

As for the 2012 Presidential Elections, we will start to hear the noise ratchet up as soon as the mid-term elections are complete becoming louder and louder until the Iowa caucus. Remember that as the Iowa caucus approached the early favorites were Hillary Clinton and Rudy Guiliani so a lot can and will change between now and then and it is best to filter out the political noise.

Economically the world is becoming a tale of two areas, strong economic growth in South America and Asia while Europe and the US plod along.

Europe and the US seem to be marching on similar paths. Both are hampered with high budget deficits and weak banking sectors. The difference is that Europe is beginning to sacrifice growth for pain in order to put losses behind them and move forward in the future. The benefit of this policy is a weakened Euro which will help the German growth engine and Europe as a whole.

Weakness in the PIGS is offsetting strong German economic growth. If it were not for the PIGS, Europe would be on a course removing the excess stimulus and setting rates at more normalized levels.

The US on the other hand, stands at a crossroads. In times of recession the government increases spending to soften the blow until business and consumer spending picks up. Unfortunately, when the US entered the most recent recession it was running massive deficits, which led to a myriad of problems. Since the banking and real estate sectors are still in a weakened state stimulus is necessary in order to help the sectors recover. On the other side, massive budget deficits and out of control spending leads to currency debasement and inflation. If the US were to balance the budget right now, the decrease in spending/increase in taxes would be a shock to the economy sending it back into recession. Leaving interest rates low encourages the type of speculation that helped form the real estate bubble. Continuing down the current path is setting the economy up for major problems down the road.

The economic conditions in the US also reminds me of the aftermath of the tech bubble in 2000 where numerous dot coms closed their doors sending equipment into the grey market where it took years for the supply to be digested by the market.

In this case the supply is not routers and desktops but homes and workers as banks finally begin the process of dealing with past due borrowers and foreclosed homes.

For the past two years, the US has gone through a process similar to the five stages of grief where we initially denied that there was a problem and everything was under control. Then we had anger at the banks for making these loans regardless of the failure of people to provide proper loan documentation while chasing quick real estate gains. Banks then tried to negotiate and workout the loans so that borrowers can stay in their homes. Finally, people are throwing up their arms and walking away which leads to acceptance by the banks that they have to face up to the problem loans.

It has always been my belief that the faster we work through the problem loans the quicker credit policy can return to a sense of normality.

For the banking industry, the key to getting out from underneath the banking and mortgage problems is loss recognition. Once losses are recognized, the industry will move forward.

The increase in consolidation in the banking sector is a plus. Healthy banks are acquiring sick banks and excess capital is covering losses similar to the S&L crisis. This is beneficial to the recovery of the overall banking sector. New leaders will emerge and the system will heal.

The US economy will continue to sputter along for some time into the future. When the economy comes out of a recession, there is a restocking of inventories drawn down during the recession.

Once the restocking is complete, the economy will dip as consumer demand is weak due to economic uncertainty and businesses are hesitant to add lost jobs until there is firm evidence that the economy is on a firm footing.

The economic story for the next six months to a year will be the post-restocking phase.

Once businesses are confident about the future you will start to see employment begin to pick up.

An important question surrounds the correct number of unemployed workers. The most recent unemployment report showed a drop in the unemployment rate not due to businesses hiring and unemployed workers returning to the workforce but rather people dropping out of the labor market.
According to the Bureau of Labor Statistics over one million people dropped out of the workforce in the past two months. If accurate, this creates a massive grey market for unemployed workers that will needs to be cleared before we start to see a meaningful recovery much in the way the tech sector needed to clear the grey market from collapsed dot coms and the housing market needs to clear homes in unreported inventories before we can recover.

That said, I would not be an investor in US banking stocks for the reasons stated in my missive at the beginning of the year.

Slow economic growth in the US will help moderate the economic recovery in Canada. Export growth, real estate, and organic growth will be more than enough to keep the economy afloat. Low interest rates will help keep the real estate market moving forward although there may be a small pullback in housing prices as interest rates move back to more normalized levels.

Slow and steady will be the mantra for Canada, putting the country in the sweet spot globally as a strong banking sector helps to support the economy.

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