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April 9, 2012
Q&A on the USA, with a watchful eye on the risk of giant man-eating plants; Spain
Our view for 2012 was that economic and equity market conditions in the US and Asia ex-Japan would be better than in
Europe. So far, that view is on track. Spain in particular is in difficult shape (see page 5); its banks and government
may have to borrow 1.5 trillion Euros over the next 12 months while in recession. Both the ECB and EU will need to
keep the spigot open to prevent Spain from becoming a bigger problem. This week, some Q&A on the US recovery,
flows into bonds and stocks, profits and P/E multiples, municipal bonds, and the long-term US fiscal situation.
The Fed appears to be saying that no additional monetary easing is needed unless the economy worsens further. Are there any
signs that the US recovery is becoming self-reinforcing?
Durable goods consumption, equipment & software spending, vehicle sales, bank loans to companies, manufacturing payrolls
(even after Friday’s disappointing report) and housing stats (building permits, multifamily housing starts) have improved over
the last few months. While delinquency rates are in better shape (credit card delinquencies are back to 2007 levels), household
credit growth is still weak. However, homebuilders are seeing stronger demand, and nationwide remodeling continues to rise.
We see opportunities in retailing and building products companies that may benefit from a continuation in these trends.
Publicly-held builders reporting stronger demand
Percentchange, YoY in latest fiscal quarter
40%
New Backlog
30%
Orders of Orders
Residential remodeling index
Number of homes, millions, 3-month moving average
3.3
3.1
20%
10%
0%
2.9
2.7
2.5
-10%
Lennar KB Home Toll Hovnanian DR Horton NVR Pultegroup
Source: Corporate Reports. Empirical Research Partners.
2.3
2001 2003 2005 2007 2009 2011
Source: BuildFax. Empirical Research Partners.
Has the data really been that good? I heard better US economic data has a lot to do with the weather.
Parts of the US experienced the warmest March in recorded history. Measured from December to February, the winter was the
4 th warmest on record. I don’t think there are reliable models to estimate the impact of demand being pulled forward, so we will
have to see how consumer spending, housing and payrolls behave in the months ahead. As our Chief Economist Michael
Vaknin reminds me, other distortions come from the “catch-up” effect from Japan’s tsunami. As shown below, some
strength in auto sales came from pent-up demand for Japanese cars, a process which now seems complete.
US auto sales in the wake of Fukushima
MoM change in SAAR auto sales, millions of units
1.0
0.5
0.0
-0.5
Japan
-1.0
US+Other
-1.5
Jan-11 Apr-11 Jul-11 Oct-11 Jan-12
Source: BEA/Wards, DB, J.P. Morgan Private Bank. Box indicates impact
of Japanese earthquake.
It looks like pent-up demand for Japanese cars has
caught up, SAAR million units
10
3
2009 2010 2011 2012
Source: DB, J.P. Morgan Private Bank. Shadings indicate Cash for
Clunkers and Japanese earthquake, respectively.
So where does that leave the US payroll and growth picture?
The weakness in the payroll report was almost entirely concentrated in retailing. Net of distortions and seasonal adjustments, it
looks like payroll growth is running at 150-175k per month, and GDP growth is running at a 2.25% trend pace, both below prior
recoveries. While 2.25% is a barn-burner compared to Europe, it only corresponds to a modest improvement in employment.
That’s why 2013 US fiscal policy is so important: this is not a recovery that can withstand much tighter fiscal conditions.
9
8
7
6
5
4
U.S. and other
Japan
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April 9, 2012
Q&A on the USA, with a watchful eye on the risk of giant man-eating plants; Spain
So, how tight is US fiscal policy supposed to get next year?
Very, if you look at what is supposed to happen according to current law. In the chart, we show the annual change in the budget
deficit over the last 25 years. The impact of all provisions scheduled to expire and kick in during 2013 would be very large. But
if Congress and the President elect to extend current tax rates, retain lower payroll tax rates and extended jobless benefits, etc,
the adjustment would not be as big, and only reflect expiration of Recovery Act provisions, the recently passed Budget Control
Act, and some other smaller provisions. There are of course plenty of permutations in between.
Wide range of outcomes for 2013 austerity
Change in cyclically-adjusted federal deficit, % of potential GDP
5
Fiscal stimulus
4
3
2
1
0
-1
-2
2013
scenario
estimates
Congress
punts
-3
Current
Fiscal drag
-4
law
1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013
Source: CBO, IMF, Goldman Sachs, J.P. Morgan Private Bank.
What direction is the Congress heading, and what did Larry Summers and Brad DeLong have to say about this recently?
Political outcomes this fall will affect what Congress does, but I get the sense that they will punt fiscal adjustments into the
future if they can, and impose austerity of no more than 1% of GDP in 2013. If so, Congress can point to a March 2012 paper
by Summers and DeLong as justification. The bottom line from the paper: don’t tighten fiscal policy when interest rates are
near zero. The authors assert that (a) additional government spending can ease the long-term budget constraint in conditions
similar to today’s, and (b) tightening policy now would risk permanent loss of human capital, lower labor productivity growth
and lower trend growth. They have held these views for a while; the paper appears designed to convince others.
Advocates for more fiscal and monetary stimulus often point to the charts below. Rising Federal debt has not resulted in higher
interest rates, so why not keep borrowing more? As for the Fed, balance sheet expansion prevented deflation and hasn’t resulted
in an inflationary surge (core inflation measured over 3 months just came in below 2%), so why not keep doing it? Aren’t
these charts amazing?
Rising Federal debt? No problem for Treasury markets
Percent of GDP
Yield, percent, 90 day moving average
80%
75%
70%
65%
60%
55%
50%
45%
40%
35%
Debt to GDP
10-year
Treasury yield
4.8%
4.3%
3.8%
3.3%
2.8%
2.3%
30%
1.8%
Sep-04 Feb-06 Jun-07 Nov-08 Mar-10 Aug-11 Dec-12
Source: CBO, Bloomberg. Assumes CBO Alternative Case for estimates.
Rising Fed balance sheet? No problem for inflation
Percent of GDP
Percent change, YoY
20%
4.0%
6%
0.5%
2004 2005 2006 2007 2008 2009 2010 2011 2012
They are amazing, but no one knows how long they can be sustained. Even Summers and DeLong concede that “even if it is
granted that the stimulus can be both timely and temporary, the question of how large it can be while preserving these attributes
remains for future research”. If one of these trends could not be sustained, my guess is that it would be fiscal constraints rather
than monetary ones. While it’s great to see rising Federal debt not adversely affecting Treasury markets, the chart on the left
reminds me of The Day of the Triffids.
18%
16%
14%
12%
10%
8%
Policies set to expire or take
effect under current law
Sequester Automatic Cuts
(Discretionary Spending)
Sequester Automatic Cuts
(Mandatory Spending)
Bush Tax Cuts ($250k+
Incomes, Estate Tax)
Balance sheet
Core CPI
Source: Federal Reserve Board ,Bureau of Labor Statistics .
Fiscal Drag (%
of 2013 PGDP)
-0.4%
-0.1%
-0.3%
Bush Tax Cuts (Middle Income) -0.9%
Alternative Minimum Tax -0.8%
Payroll Tax Cut -0.6%
Emergency Unemployment
Compensation
-0.2%
Affordable Care Act -0.2%
Source: CBO, Goldman Sachs.
3.5%
3.0%
2.5%
2.0%
1.5%
1.0%
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April 9, 2012
Q&A on the USA, with a watchful eye on the risk of giant man-eating plants; Spain
What is The Day of the Triffids?
It’s a 1951 science fiction novel. There’s a meteor shower, and most people go outside to look at it. The next morning,
everyone who looked at the meteor shower ends up blind, and Earth is taken over by giant man-eating venomous plants. The
point: some amazing events which look benign have unforeseen consequences. Will a pact of going for growth pay the
freight of higher Federal debt in the long run? Hard to say; there are not a lot of examples to draw from. Economic theories and
their associated debt bubbles don’t always work out as planned 1 . After WWII, the US also faced a debt ratio of 80% of GDP.
Austerity was not the answer back then; government receipts and outlays as a % of GDP did not change much during the 1950’s,
and net debt was flat. So how did US debt/GDP fall from 80% to 46% in just ten years? Robust annualized real growth of
more than 4.0%, and 2.0% inflation. However, unique economic conditions and productivity gains of the 1950’s (e.g., interstate
highway, rebuilding of Europe and Japan) may not be repeated, and the country was not headed into an entitlement time bomb.
If the US does not experience a growth/productivity boom, the burden of higher debt could last for a generation or more. A progrowth
Administration would probably help, but the difficulty lay in defining exactly what that means.
Isn’t it amazing?
1950’s debt reduction was based on growth, not austerity
Net debt Net debt Nominal Real GDP (bn Outlays (% Receipts (%
(% of GDP) (bn) GDP (bn) 1950 USD) of GDP) of GDP)
1950 80% $219 $273 $273 16% 14%
1951 67% $214 $320 $302 14% 16%
1952 62% $215 $349 $322 19% 19%
1953 59% $218 $373 $341 21% 19%
1954 60% $224 $377 $343 19% 19%
1955 57% $227 $396 $354 17% 17%
1956 52% $222 $427 $368 17% 18%
1957 49% $219 $451 $377 17% 18%
1958 49% $226 $460 $377 18% 17%
1959 48% $235 $490 $398 19% 16%
1960 46% $237 $519 $415 18% 18%
Comp. ann'l gr: 0.8% 6.6% 4.3%
Source: OMB, BEA.
Are there debt vs austerity parallels at the state and local level?
Yes and no. At the state and local level, over last decade, more than 1 trillion in unfunded pension and healthcare (OPEB)
related liabilities were recognized (they were accrued over a longer period). Even these “as-reported” estimates, which come
from the states, may be underestimated. A 2011 analysis by the Joint Economic Committee shows that lower portfolio return
assumptions on pension assets sharply increase the magnitude of underfunded pensions (see chart, right) 2 .
As reported unfunded state pension and OPEB liabilities
Billions, USD
1,400
State and local unfunded pension liabilities under
different portfolio return assumptions, Trillions, USD
3.0
1,200
1,000
800
600
400
200
OPEB
Pension
2.5
2.0
1.5
1.0
0.5
0
2001 2003 2005 2007 2009
Source: State Comprehensive Annual Financial Reports.
0.0
8% Return 6% Return 5% Return 4% Return
Source: CBO, Center for Retirement Research.
1 Example: here’s a link to a 2007 article by Austan Goolsbee, former Chairman of the Council of Economic advisors and a member of the
Obama Cabinet. Goolsbee praises the benefits of subprime lending and related affordable housing policies, mocks Congress for holding
hearings on the subject and cites Federal Reserve papers in saying that the “mortgage market has become more perfect, not more
irresponsible”. Some things are only clear in hindsight. http://www.nytimes.com/2007/03/29/business/29scene.html?_r=2
2 This is why under-risked pensions may create huge problems for themselves and their associated state/local governments.
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April 9, 2012
Q&A on the USA, with a watchful eye on the risk of giant man-eating plants; Spain
However, there’s more of an effort at the state/local level to address this issue than at the Federal level. More than 40
states lowered pension benefit liabilities over the last 3 years according to the National Conference of State Legislatures.
Measures taken include raising employee contributions (while lowering employer payments), raising minimum retirement ages,
cutting post-employment healthcare benefits and in some cases, switching to defined contribution from defined benefit plans.
The good news, to paraphrase Mark Twain, is that reports of municipal bonds’ demise have been greatly exaggerated. From
1970 through to the end of 2011, municipal bonds rated by Moody’s experienced a grand total of 71 defaults among 17,700
issuers (11 of which occurred during 2010 and 2011). General obligation bonds accounted for 5 defaults; 29 were related to
housing; 22 for hospitals and healthcare; 3-4 each for education and infrastructure. Utilities and cities registered 2 each, while
counties, special districts, and water & sewer and experienced 1 each. The average recovery for defaulted munis was 65%,
compared to 49% on corporate senior unsecured bonds. Last comment on municipals: while local tax collections are weak due
to the collapse in home prices, state tax collections have been increasing for 7 quarters in a row.
State and local tax revenue
Percent, YoY change of 4-quarter moving average
20%
15%
10%
5%
0%
-5%
Local
-10%
State
-15%
2004 2005 2006 2007 2008 2009 2010 2011
Source: US Census.
US mutual fund flows
Billions, USD
OK, so the US economy is improving, but is still heavily dependent on monetary and fiscal stimulus to grow; and the only belttightening
one can find is at the state and local level. Since 2009, after equities collapsed and bond prices rose, how have many
investors reacted?
By selling more equities and buying a lot more bonds. See chart above (a global version of this chart looks roughly the same).
Have investors been positioning this way since stocks are expensive?
Not really. Insert a giant martini glass on the chart below from 1998 to 2001 (I hate using simple averages which include
periods when the market had lost its collective mind). The current P/E multiple is in the middle of the ex-bubble range of the
last 25 years. Some bank stocks look interesting, even after accounting for reliance on shrinking loan loss reserves to drive
income, and ongoing regulatory uncertainty. Most US banks are at or close to Basel 3 funding needs, have considerably fewer
capital adequacy questions than their European counterparts, and do not rely on wholesale funding to finance loan portfolios.
1,000
800
600
400
200
0
Bonds
-200
-400
Equities
2007 2008 2009 2010 2011 2012
Source: Investment Company Institute.
S&P 500 ex-bubble price to earnings multiple
Price to next twelve months operating EPS
24x
22x
20x
18x
16x
14x
12x
10x
8x
1985 1988 1991 1994 1997 2000 2003 2006 2009 2012
Source: IBES, Standard & Poor's.
US bank price to book ratio
4.5x
4.0x
Datastream
3.5x
3.0x
2.5x
Morgan Stanley
2.0x
1.5x
1.0x
0.5x
0.0x
1969 1973 1977 1981 1986 1990 1994 1998 2002 2006 2010
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April 9, 2012
Q&A on the USA, with a watchful eye on the risk of giant man-eating plants; Spain
Now that P/E multiples have risen off the bottom, what’s the outlook for P/E multiples and earnings from here?
The return on the S&P this year has been a function of P/E multiples rising (from 11.3x to 12.9x), a big part of which has been
Apple (3% of the S&P index, 15% of S&P’s YTD returns). As shown below, earnings revisions have been negative for 2012,
but analysts are still optimistic about 2013. According to Morgan Stanley, analysts are forecasting the highest percentage of
companies posting 2013 margin expansion since 1970, and by a very wide margin. In our view, it will be difficult for multiples
to rise further unless earnings outperform expectations, particularly if Europe’s structural problems take center stage again.
Revisions to consensus EPS by quarter
Win, Place and Show:
Index, 12/30/2011 = 100
101
The problem of Spain
100
99
4QE +1%
Number of dwellings to population
Non-financial corporate debt to GDP
3QE -1%
Corporate sector debt to cash flow
FY12 -1% Construction sector debt/assets
98
2QE -2% Banking sector branches per 1,000 people
Reliance on foreign capital (Net Int. Inv. Pos.)
97
Real estate as % of household assets
1QE -3% Housing overhang (as per CEPS)
96
Commercial RE exposure % of bank assets
12/30/2011 01/31/2012 02/29/2012 03/28/2012 Encumbered banking system assets, %
Source: FactSet.
World Bank labor rigidity, Europe
The place that worries me the most: Spain. It ranks at or
close to the bottom in a lot of categories (see table), and
its growth outlook is poor. Historically, this kind of
thing has not ended well. Spain has defaulted 13 times
since 1500 AD; it’s probably going to take a lot of
bilateral aid and ECB financing to prevent another one.
Intra-European real effective exchange rate
Shadow economy, % of GDP, OECD
Unemployment rate
Production time per unit
Reliance on ECB to finance sovereign debt
Bank lending to HH/NFC, last 12 months
HH/NFC = households and non-financial corporations
Sources: IMF, OECD, EU, World Bank, CEPS
Michael Cembalest
Chief Investment Officer
Sources
“States of Bankruptcy, Part I: The Coming State Pensions Crisis”, Joint Economic Committee Republicans, Representative
Kevin Brady and Senator Jim DeMint, December 8, 2011
“The Trillion Dollar Gap, Underfunded State Retirement Systems and the Roads to Reform”, Pew Center, February 2010
“Fiscal Policy in a Depressed Economy”, DeLong (Berkeley) and Summers (Harvard), March 20, 2012
Moody’s US Municipal Bond Defaults and Recoveries, 1970-2011
IMF Country Report 11/216. “Spain: Selected Issues”, July 2011
The only country I can
find that's in worse
shape than Spain is:
Greece
Ireland
Portugal
None
None
Ireland, Portugal
None
Ireland
None
Greece
None
Italy
Italy, Greece
None
Italy
None
None
The material contained herein is intended as a general market commentary. Opinions expressed herein are those of Michael Cembalest and may differ from those of other J.P.
Morgan employees and affiliates. This information in no way constitutes J.P. Morgan research and should not be treated as such. Further, the views expressed herein may
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