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The U.S. Deficit: A Political Ponzi Scheme?

The “risk on” trade was still firmly in place in February.

With “risk on,” the S&P/TSX gained 4.3% while the Dow and S&P 500 increased 2.8% and 3.2% respectively.  Impressive stuff, given threats of global inflation and political upheaval in the Middle East and North Africa.  (As we are reviewing February, these returns don’t reflect the tragic events currently happening in Japan.  The impact and gravity of that situation will be explored when we conduct our March commentary.)

Strong corporate earnings can certainly take some of the credit.  While profit margins in Q4 declined marginally from Q3, mainly due to higher raw material costs, revenue growth has started to pick up. 

Continued earnings growth is not sustainable without top line growth, so many investors are encouraged by signs that companies have finally been able to increase sales. You can’t cost cut yourself to prosperity forever.

With interest rates remaining at low levels and earnings growth looking more sustainable, why wouldn’t investors continue to buy stocks?

Well, we can think of one. 

The U.S. deficit is on an unsustainable path that could lead to higher interest rates unless deep cuts are made to entitlement spending.

President Obama recently released his 2011 budget with a projected deficit of $1.65-trillion, the largest deficit in U.S. history and, at 10.9%, the largest deficit as a percentage of GDP since WWII. 

The good news is that President Obama is forecasting the deficit will shrink to a miniscule $1.1-trillion in 2012 and a paltry $627-billion by 2017, all of which is estimated to be interest payments.  The White House believes they will be able to shed $1.1 trillion of accumulated deficits over the next 10 years with a combination of spending cuts and increases in revenue. 

The fact that 95% of the deficit reduction would occur after Obama’s term ends in 2013 is purely coincidence. 

Included in the cuts is a five-year freeze on non-defense discretionary spending projected to save in excess of $400-billion.  Too bad this category accounts for a paltry 12% of Federal spending.  Most of the increases in revenue would come from tax increases for the wealthy that would result from the elimination of the Bush tax cuts on upper income taxpayers that are set to expire at the end of 2012. 

Good luck with that one, Mr. President. 

If you couldn’t accomplish this last year when your fellow Democrats controlled Congress, do you think it will get any easier now that the Republicans have taken back control of the House of Representatives?


Even if the White House is able to get the 2017 deficit down to $626-billion (or 3% of GDP), the victory would be a brief one as deficits are projected to begin increasing again as Medicare and Medicaid spending start ramping up with baby boomers entering their prime health care spending years.

Unfortunately, what President Obama’s budget does not cut is spending on entitlement programs such as Medicare and Medicaid or Social Security.  Goldman Sachs projects that even if defense spending is slashed from 4.7% of GDP to 2.8% of GDP by 2012, stimulus spending ends, discretionary spending is frozen, and the Bush tax cuts for the rich are eliminated, the deficit to GDP ratio will still keep increasing. 

Treasury Secretary Timothy Geithner recently acknowledged that spending on benefits, particularly health care, was unsustainable but countered that, “It’s not right to say you have to do those things right now to solve the five-to-ten-year deficit.”  Spoken like a true politician. 

The problem with waiting is the interest the U.S. has to pay on the accumulated Federal Debt is starting to add up.  It is estimated that the U.S. will pay $200-billion in interest this year and $928 billion in ten years unless changes are made to reign in spending. 

By 2014, it is expected interest payments will exceed spending on education, transportation, energy and all other non-defense discretionary spending.  By 2018, it will even exceed Medicare spending.  By 2080, over 10% of the nation’s entire GDP would be allocated to pay interest charges. 

More deficits require issuing more debt, which in turn leads to higher interest payments and additional debt.  Sounds like a Ponzi scheme to us.

Don’t the politicians get it?

Of course they do.  White House budget director Dick Darman was quoted saying, “Sooner or later, the American political system will rise to the responsibility to be serious: to complete the job of fiscal correction.  It may do it in small steps or large; it cannot do it with side steps.”

Unfortunately, the late Mr. Darman wrote this 21 years ago in his introduction to George H.W. Bush’s budget.  Most critics feel President Obama missed an opportunity to show some leadership and tackle the real problem of entitlement spending head on.  As Wyoming Republican Senator Alan Simpson said, “I’m waiting for politicians to get up and say: There’s only one way to do this.  You dig into the big four: Medicare, Medicaid, Social Security and defense.”  

The problem is that it is a vote loser and no self-respecting politician wants to get tarred with the label of supporting entitlement cuts with an election looming.  Any solution has to be bi-partisan.  As Republican Senator Saxby Chambliss from Georgia says, “The only way we’re going to get this done is for everyone to have skin in the game and everybody to get their ox gored a bit.”  

While the politicians may get it, most Americans don’t.  A recent Wall Street Journal/NBC News poll showed recently less than 25% of Americans supported significant cuts to Social Security or Medicare in order to reduce government deficits.  Republican Speaker of the House John Boehner believes the U.S public “don’t have a clue, [but] once they understand how big the problem is, I think people will be more receptive to what the possible solutions may be.”

So far, Mr. Boehner hasn’t announced what those solutions would be.  Someone needs to show some leadership soon or the bond market will start doing the leading. 


The U.S. Economy

Q4 2010 GDP was revised lower to 2.8% as the State and local government sector contracted 2.4% versus 0.9% reported previously and private consumption grew at a less torrid 4.1% versus 4.4%.  GDP for 2010 in total was also revised down to 2.8%.  Not bad, but hardly robust.

What is starting to look robust, is the manufacturing sector.

The ISM manufacturing index hit its highest level since May 2004 in January with most regional surveys showing equally strong growth.  With a reasonable 2010 in the books, many analysts are starting ratchet up their estimates for 2011 GDP growth. 

A recent Wall Street Journal survey of 51 economists indicated estimates for Q1 2011 GDP growth have increased to 3.6% with Q4 2011 GDP growth predicted to top 3.5% versus 3.3% in the same poll conducted only one month before. 

If they are right, Q4 2011 GDP will expand at its quickest pace since 2003. 



The U.S. added an impressive 192,000 jobs in February and the unemployment rate dropped to 8.9%, its lowest level since April 2009. 

Some of February’s gain was probably the result of activity in January that was delayed due to the harsh winter storms experienced on the east coast.  The U.S. has averaged 136,000 new jobs a month since November, not bad, but still barely enough to keep up with population growth let alone find jobs for the estimated 4.4 million workers who have been out of work for more than a year. 

The decline in the unemployment rate was a pleasant surprise as most expected it to rise to 9.1%.  With the size of the work force estimated to have increased by 60,000, the quality of the decline seems high as well.  8.9% is still a large number, however, and U.S. payrolls are still short 7.5 million workers versus pre-recession levels. 

Also troubling policymakers is the labour force’s participation rate, which is the percentage of adults who have jobs or would like to have jobs.  The participation rate, at 64.2%, has fallen to levels not seen since the mid 1980’s.  In fact, if the pre-recession (December 2007) participation rate of 66% were applied against todays active labour force, the unemployment rate would soar to 11.5%.   


As mentioned above, the manufacturing industry has not only provided strength to GDP growth, but it has also added jobs, 150,000 of them over the past year.  While this pales in comparison to the more than seven million manufacturing jobs lost since the late 1970’s, it does indicate the competitiveness of the U.S. manufacturing sector has improved, which is bad news for other export nations because the U.S. has always been very competitive. 

While the U.S. may have shed manufacturing jobs over the years, manufacturing output has increased every year since 1970, with the exception of recent recession-related decreases in 2001, 2008 and 2009.  In 2009, the U.S.’s manufacturing output was 45% higher than China’s and more than 20% of the world’s total output.  Capital investment in productivity-enhancing technology has enabled the U.S. to continually produce more goods with much less workers. 

It’s similar to what has happened in the agricultural sector over the years.  The U.S. produces more agricultural output today using just 2.6% of its work force than it did 100 years ago using nearly 40% of its work force.

We would like to see some productivity-enhancing technology trim some jobs is in the government sector, which has actually added jobs since December 2007.  

Maybe the government should buy a few new iPads 2’s. 


Inflation continues to creep higher, but is still well below the Federal Reserve’s 2% upper target. 

Higher food and commodity prices have yet to make their way through to consumers, but this may be about to change.  The Federal Reserve’s beige book survey, a summary of economic conditions across the 12 regional districts, recently highlighted that some retailers were planning price increases in the next few months. 

MacDonald’s has already warned customers they are considering price increases of 2 to 3% while Kraft has indicated they are going to raise prices, but have not said which products or how much.  Whirlpool is expecting to raise prices 8 to 10% starting April 1 and Hanes has already raised prices but warned that if cotton prices remain at current levels, prices could end up rising a cumulative 30%.   

Of most concern is the global increase in food prices.  The U.N. estimates world food prices rose for the eighth consecutive month in February, increasing 2.2% to reach their highest level since data began being collected in 1990.  Only sugar was down slightly from the previous month, but was still up 16% from last year. 

While much of the increase can be attributed to weather related declines in supply (blame El Nina), higher demand from the emerging markets are also to blame.  A tighter supply/demand balance makes prices more susceptible to large price swings due to poor harvests. 

As the world’s largest agricultural exporter, a lot is riding on the U.S.’s ability to avoid a weather related decline in output themselves.  Scary, since the Midwest is considered to be long overdue for a drought. 


Food prices were not the only thing going up in February.  Oil has also been moving higher. 

Increased demand and turmoil in the Middle East and North Africa has resulted in oil breaking through $100 a barrel.  In late February, oil jumped 10% in only two days, only the seventh time this has happened since 1982.  Birinyi Associates reports that the typical results for the S&P 500 after such a move have been a 9.3% correction. 

Many economists feel oil would need to rise to $120 a barrel before economic growth is seriously threatened, though the risk is increased with food prices simultaneously moving higher.  Combined, food and energy spending account for 12.5% of U.S. disposable income.  Wells Fargo Securities analyst Gina Martin Adams points out that consumer spending drops dramatically once food and energy reaches 13% of disposable income. 

There is no doubt inflation will be moving higher.

However, the real question is whether higher commodity prices will result in a one-time increase or whether they will lead to increased inflationary expectations and, thus, a sustained increase in inflation. 

So far, inflationary expectations remain low.  The Cleveland Federal Reserve, in fact, believes inflationary expectations have steadily declined over the past 20 years such that expectations for the next year are for only an annualized 1.8% increase.  The University of Michigan found consumer expectations for the next year had risen to 3.4%, but expectations for the next 5 to 10 years were stable at a slightly higher 2.9%. 

The hope is that if people don’t expect prices to increase, they won’t. 



Both the University of Michigan and the Conference Board consumer confidence indexes hit 3 year highs in February.  This is very positive for the retail spending.

January retail sales were a little disappointing, most likely due to harsh winter weather.  

February same store sales, however, look quite strong, especially given they were up against tough comparable sales last year.  The second half of the month was stronger and consumers were said to be moving towards buying what they want in addition to what they need.  March retail spending is expected to be negatively impacted by Easter falling in late April this year. 

In another sign the consumer is awakening from their recession induced slumber, the U.S. Transportation Department announced Amercians drove three trillion miles in 2010, the third highest total ever and 0.7% higher than last year.  Most of the gain was attributed to gains in employment as well as increased confidence in the economy. 

It looks like the housing market is double dipping. 

Existing home sales were higher in January, but prices declined on both a month-to-month and year-over-year basis to a nine-year low.  37% of transactions were by distressed sellers and 32% were all-cash deals; double the rates from two years ago.  Cash buyers typically demand a 5% to 10% reduction from the asking price compared to those using a mortgage. 

In a sign that perhaps things can’t get much worse, fewer homeowners fell behind on their mortgages in Q4.  Borrowers who have missed at least one payment declined to 4.3 million, the lowest level since the end of 2008.  Unfortunately, the number of homes in foreclosure remained at peak levels with 4.6% of all mortgages in default.  

One piece of good news regarding the housing market: affordability has returned to pre-housing bubble levels, prompting some to wonder if prices are nearing a bottom. 

Based on a ratio of home prices to annual household income, prices had fallen to 1.6 times at the end of Q3, below the historical average of 1.9 times.  This is well below peak levels of 2.3 times reached in late 2005.  Of course, higher interest rates could negatively impact affordability if they continue to trend higher. 



The trade deficit widened again in December, mainly due to higher energy imports.

Part of the increase in energy imports is due to higher oil prices, but part is also due to higher volumes, which is yet another sign that the economy is recovering.  The trade deficit with China decreased, which should help calm demands for China to re-value their currency, for a while at least.  

For 2010 in total, the full-year trade deficit with China reached $273-billion as China took over from Canada as the top importer to the U.S.  China is also the third largest export market for the U.S., up from the 18th spot twenty years ago.

The Canadian Economy

There was strong GDP growth in December and Q4 in total, led by record exports of petroleum.

For the year, GDP grew 3.1% in 2010 versus a contraction of 2.5% in 2009.  A huge increase in the Ivey Purchasing Managers Index indicates that the impact of the strong Canadian dollar might be taking a smaller toll on the Canadian manufacturing industry than we initially feared or expected.

Canada generated a less than expected 15,100 jobs in February as the unemployment rate remained unchanged at 7.8%. 

The increase was of poor quality with 38,900 part-time jobs created while a net 23,800 full-time jobs were lost.  More workers were also opting to go out on their own as 25,500 self-employed jobs were added while 20,000 private sector positions were chopped. 

On the bright side, the manufacturing sector added 9,000 positions and has generated 80,000 jobs over the last three months, the highest three-month increase on record.  This is still 8% below pre-recession levels, but pretty good considering the high Canadian dollar.  


Statistics Canada recently revealed Canada’s employment levels have recovered to pre-recession levels faster this past recession than recessions experienced in the early 1980’s and early 1990’s. 

As of October, however, we are still short about 113,000 full-time jobs and 25% of those unemployed have been out of work for at least a year versus only 10% before the recession.  Workers who have part-time positions, but would prefer to be working full time, surged 20% over the past two years. 

If these involuntary part time workers and discouraged workers were included, January’s unemployment rate would have been 10% instead of the reported 7.8%.     

Headline inflation remains over 2%, but core inflation moved a bit lower and is still comfortably lower than the Bank of Canada’s 2% upper threshold. 

C.D. Howe Institute thinks inflation could be even lower than this.  They believe Statistics Canada over estimates inflation by failing to adjust weights in its consumption basket.  They argue consumers typically substitute cheaper products for those that are rising in price. 

While consumers feel inflation is actually higher than reported, this is mainly because people tend to focus on items that they purchase more frequently and happen to be rising in price, like food and energy.  We tend to forget that many items that we purchase less frequently, like electronics and furniture, having been falling in price. 

Given recent moves in food price and crude oil, we would expect to see CPI move higher over the coming months.  Economists estimate food prices will rise 5% to 7% by the end of the year after increasing only 2.1% the past year.  BMO economist Doug Porter recently pointed out that it usually takes nine to twelve months for increases in raw materials to filter down to increases retail prices. 

Low inflationary expectations and slack in the labour market should keep inflation in check after an initial increase due to higher food and energy prices.

Retail sales in December were down a little from December, but are still showing healthy gains versus last year. 

High Canadian household debt levels continue to make news.  A recent report by the Vanier Institute of the Family reports average household debt in Canada has risen to $100,879 with the debt-to-income ratio coming in at a disturbing 150%. 

Canadian households are only saving 4.2% of their income versus 13% in 1990.  Their message to Canadians: “Reduce debt.  Save more.  Spend less.”  TD would agree and highlights that B.C. residents are particularly vulnerable to higher interest rates.  B.C. is the only province where the savings rate is actually negative.  Shame on us.
While home sales and prices continue to moderate off peak levels, the housing market continues to remain strong. 

Over the past year ending in January, BMO believes average Canadian home prices increased 5% and are now 10% higher than before the recession.  Vancouver home prices have rocketed 20% in the last year.  The problem is incomes have not kept pace. 

Luckily low interest rates mean mortgage payments for the typical homeowner only comprise 35% of disposable household income, in line with the 23-year average of 34%.  BMO believes house prices are not setting up for a major correction as long as future price increases are more in line with gains in income.  Or course they are also assuming the Bank of Canada raises rates slowly. 

The average Canadian is not worried about the housing market and believes they have what it take to weather a downturn with the recent RBC Homeownership Study finding 73% of Canadians believe they are well-positioned in the event of a downturn in the housing market.  85% think they have been doing a good job in paying down their mortgage with 90% still confident real estate is a good investment.  

Canada delivered a trade surplus in December for the first time since February of last year, mainly due to higher oil exports.  Again, good news given the strong Canadian dollar.

Overall, a good month for Canada.  We continue to generate new jobs and GDP growth looks to be accelerating.