On the Economy, Europe & the Super Committee

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
November 22, 2011

IN THIS ISSUE:

1. GDP & the National Debt Both Above $15 Trillion

2. Credit Suisse: Handicapping Recessions in Advance

3. Fitch Warns: US Banks at Risk from European Debt

4. The Super Committee Failed – Surprise, Surprise!

5. What I’m Thankful For

Introduction

Since mid-summer, I have focused a lot of attention on the European debt crisis which is showing no signs of improving. Italian bond yields traded above 7% last week, and Spain’s 10-year bond yield has skyrocketed from 5% in October to near 6.7% last week. This happened despite continued aggressive bond buying by the European Central Bank.

Last Thursday, Fitch Ratings warned that US banks face a “serious risk” that their creditworthiness will deteriorate if Europe’s debt crisis deepens and spreads beyond the five most-troubled nations. Fitch said that the six largest US banks have at least $50 billion at risk in the so-called PIIGS nations in Europe – Portugal, Ireland, Italy, Greece and Spain. The details are included below.

But before we get to that, we turn our attention today to the latest report on the US economy. This morning, the Commerce Department released its second estimate of 3Q GDP which came in lower than expected at 2.0% (annual rate), down from the previous estimate of 2.5%. Total GDP topped $15 trillion in the 2Q of this year for the first time ever. Unfortunately, our national debt also topped $15 trillion for the first time ever this year.

Next, we look at the latest finding from Credit Suisse regarding the outlook for a new recession in the US. Credit Suisse has a longstanding model that forecasts the odds for a recession in the next six months. Fortunately the model is predicting that there is only a 24% chance we will enter a recession over the next six months. That’s a significant improvement since September.

Finally, we revisit the so-called debt “Super Committee” which failed to produce a plan to reduce government spending by $1.2 trillion over the next decade. Surprise, surprise!

GDP & the National Debt Both Above $15 Trillion

Fears that the economy had slipped into a new recession during the summer were quieted in the last week of October when the Commerce Department reported that 3Q GDP rose at an annual rate of 2.5%, almost twice the 2Q rate of 1.3%. However, this morning, the Commerce Dept. revised the 3Q estimate down to 2.0% which was below pre-report expectations.

In the details of today’s GDP report, the Commerce Dept. reported that while consumer spending remained firm in the 3Q, private inventory investment and state and local spending were weaker than expected. Total GDP for all of 2011 is expected to be apprx. $15.2 trillion.

Alarmingly, our national debt also topped $15 trillion last week for the first time ever. According to the Treasury Department, our national debt now stands at $15.03 trillion, which includes $10.31 in debt held by the public and $4.72 trillion in intergovernmental debt outstanding. Here’s a link to the US Debt Clock in real time (very interesting):

http://www.usdebtclock.org/

We all remember the debt ceiling crisis which played out in July and August. What you may not recall is that the debt ceiling limit passed in August was $14.29 trillion. We have now blown through that number by almost one trillion dollars. Makes you wonder what all the fuss was about, doesn’t it? Get ready for yet another debt ceiling debacle starting on December 16 when Congress must once again raise the statutory debt limit.

Credit Suisse: Handicapping Recessions in Advance

Credit Suisse is one of the largest private and investment banking firms in the world. Credit Suisse Group is a world-leading financial services company, advising clients in all aspects of finance, around the world. Years ago, economists at Credit Suisse developed a proprietary model for forecasting recessions in advance, which has been quite successful.

The model incorporates eight separate indicators that help signal recession: “real” factors, including employment, housing permits, consumer expectations, etc.; and financial factors, including the stock market, the interest rate on federal funds, etc. The model is used to forecast economic trends in dozens of countries including the US.

The model has scored impressively. Before all seven of the past seven recessions, it began to flash “red,” signaling a better than 50% probability of recession within the following six months. Actual lead times ran between four and seven months. For example, before the Great Recession of 2008-09, the red flash began in August 2007, five months before the recession started. The 1981-82 recession, which struck just 13 months after the 1980 recession ended, was the one true double dip. The ‘81-82 second dip was first anticipated by the model six months before it started.

Regarding “false positives,” the model cried wolf only once: for a three-month period in 1984, coinciding with the Continental Illinois banking crisis. But for a model tested monthly over more than 40 years – beginning with years leading up to the 1970 recession – a single three-month lapse is also impressive. So what’s it saying now about the US economy?

The Credit Suisse model signaled an increasing risk of recession in the US during the summer. The model peaked at a high point of 36% in September – meaning that there was a 36% chance that the economy would go into a recession within the next six months. Since September, the model has eased to only 24% – meaning that there is a better than 75% chance we will not fall into a recession in the next six months.

This is consistent with the latest readings from Blue Chip Economic Indicators (BCEI), a monthly survey of 50 leadings economists and forecasters. Released earlier this month, the BCEI consensus put the odds of a recession in 2012 at only 27.5%, down from a high of 33.4% in September. The November BCEI estimate for GDP growth for all of 2012 is only 2.1%.

While the improvement in the Credit Suisse model and the latest BCEI survey are encouraging, they could certainly be proven wrong if the financial crisis in Europe continues to worsen.

Fitch Warns: US Banks at Risk from European Debt

Last Thursday, Fitch Ratings warned that US banks face a “serious risk” that their creditworthiness will deteriorate if Europe’s debt crisis deepens and spreads beyond the five most-troubled nations. “Unless the euro zone debt crisis is resolved in a timely and orderly manner, the broad credit outlook for the U.S. banking industry could worsen,” the New York-based rating company said in a statement last week.

It went on to say that even as US banks have “manageable” exposure to stressed European markets, “further contagion poses a serious risk. The “exposures” of US lenders to major European banks and the stressed nations of Portugal, Ireland, Italy, Greece and Spain, known as the PIIGS, are smaller than those to some of the continent's larger countries, Fitch said.

The six biggest US banks – JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc., Wells Fargo & Co., Goldman Sachs Group Inc. and Morgan Stanley – had at least $50 billion in risk tied to the PIIGS on September 30, Fitch said. So-called cross-border outstanding loans to France for all these banks, except Wells Fargo, were $188 billion, including $114 billion to French banks. That’s huge!

Europe’s debt crisis has toppled four elected governments, with the last two in Greece and Italy, falling week before last. Italian bond yields remained at about 7% – the threshold that led Greece, Portugal and Ireland to seek bailouts – and shares of French banks, including BNP Paribas SA and Societe Generale SA, dropped amid concern they'll need more capital.

Bottom line: news from Europe continues to worsen, and this will continue to negatively affect the equity markets around the world. This latest report from Fitch Ratings confirms that the largest US banks still have a lot to lose, especially if Italy and/or Spain go down. If Italy and/or Spain go down, France may not be far behind.

The Super Committee Failed – Surprise, Surprise!

No one who reads this E-Letter on a regular basis could be surprised to learn that the Super Committee failed to reach a deal. But before we get into the details, let’s step back to July when we had the debt ceiling crisis. At that time, it was widely agreed that the US needed to cut spending and/or raise revenues (read: tax hikes) by at least $3-4 trillion over the next 10 years to slow down the explosion in our now $15 trillion national debt.

As a way to tackle this problem, President Obama came up with the idea of a so-called “Super Committee” made up of six Republicans and six Democrats. For some reason, he did not include a thirteenth member who was an Independent as a tie-breaker. We can argue why a 13^th member wasn’t added, but one theory some people believe is that Obama didn’t really care if the evenly divided Super Committee would end in a deadlock.

Even though there was broad agreement that we need at least $3-4 trillion in spending cuts or increased revenues over the next 10 years, Obama only charged the Super Committee with finding at least $1.2 trillion in savings over the next decade. And they couldn’t even do that!

The Republicans compromised last week and said they could live with around $300 billion in tax increases made up largely of caps on popular deductions for mortgage interest, charitable giving, etc. for those in the top income tax brackets. They also suggested some modest cuts to entitlement programs. The Democrats on the other hand, wanted the elimination of the Bush tax cuts at the end of 2012 for those in the highest tax brackets, and they refused to accept any cuts to entitlement programs.

To put this in perspective, using President Obama’s budget for fiscal 2012 and projecting out, the CBO estimates that our national debt will rise from $15 trillion today to $24.5 trillion over the next 10 years. The Super Committee was trying to reduce deficits by only $1.2 trillion over this same period of time, or an average of $120 billion per year.

If the Committee had been successful in finding $1.2 trillion in savings, that would have only cut the projected deficits by 2.6% of total budget outlays over the next 10 years. Thus, the Super Committee failed to enact what is essentially a drop in the bucket compared to total projected debt. That begs the question: How can we expect Congress to ever make the hard decisions necessary to significantly reduce the deficit?

Without a deal from the Super Committee, automatic spending cuts of $1.2 trillion (the so-called “sequester”) are set to kick in beginning in January 2013, half of which will be defense spending cuts. Of course, there is already talk of new legislation to block the sequester. Surprise, surprise!

Throughout this Super Committee process, President Obama made sure to stay as far away from the Committee as possible. However, just as soon as the Super Committee announced that it had failed to reach an agreement, Obama vowed that he would veto any legislation that would block the automatic spending cuts now scheduled to begin in 2013. Needless to say, this issue is far from settled.

What I’m Thankful For

As we head into the Thanksgiving holiday week each year, I always pause and reflect on the things I am most thankful for, both in my professional career and in my personal life. For many people, it is hard to be genuinely thankful given that there are a lot of problems out there. But not for me as I have more blessings in my life than I can count!

One of the benefits of writing a nationally distributed E-Letter as I do is that I have business relationships spread all across our great country. Sometimes it is easier to express thanks to those that you see and talk to in person than those who are only available via e-mail or telephone. However, I want to take this opportunity to thank all of my clients around the country.

Were it not for those who have entrusted us to manage their investments, there would be no E-Letter. My companies currently have over 1,000 clients representing almost every state in the Union, and many of these individuals have been our clients for over a decade. In many cases, what began as client/advisor relationships have now developed into warm friendships.

Next, I want to express my sincere appreciation to all of you who regularly read my E-Letters. Since its start in September of 2002, my E-Letters now go out to around a half a million people each week. And I especially thank those of you who give me feedback. Your comments and suggestions definitely help me to put out a better E-Letter.

Other long-distance relationships to which we owe a debt of gratitude are our consultants, which include accountants, legal counsel and those that help us evaluate and track money managers. It has become a fact of life that good consultants are necessary for a successful business, and I think ours are among the best in the industry.

The final long-distance relationships I’d like to thank are the professional Advisors we recommend. Since we perform due diligence on each of them, we are well aware of all of the work it takes to formulate and implement a market strategy designed to manage the risks of being in the market.

Next, I would be remiss if I did not extend a hearty “thanks” to my internal staff. Everyone on our staff has been with us for us over a decade, with one exception (and she is very close). They are a very loyal and dedicated bunch that makes their top priority to serve our clients and help me in what I do. They are more like family than employees.

Finally, it is important to never forget to be thankful for your family. My wife, Debi, works in the business and is an important sounding board for every major decision I make. She is also the CFO of the company and handles all of the detailed financial duties that allow me to concentrate on writing and overseeing our investment management business. She does all that and is still my best friend and a great Mom!

I’m also so thankful for my kids. While the media increasingly laments “out of control” young people, my kids are NOT among them. My son and daughter are both in college now, making excellent grades, holding leadership positions in their respective service organizations and attending church regularly. And both are very smart with their money.

On a larger scale, I am thankful to be living in the greatest country on the face of the earth. Sure, we have our problems, especially in light of the current economic and financial challenges and political concerns. Yet there are people around the world who would trade places with us in a heartbeat!

And finally, there continues to be a vocal minority who want to challenge the “One Nation, Under God” concept, which never seems to stop. Yet I don’t think that we should ever forget to thank Him who has blessed our nation so bountifully. No matter what detractors may say, our nation was founded upon Biblical principles, and I think that’s a big reason why America has been so successful and has lasted for so long.

These are just a few things that I am very thankful for this Thanksgiving week. As you are inundated with food, football and Christmas shopping promotions this week, please don’t forget to stop for a minute, bow your head and be thankful for all of the blessings you have received during the year. I certainly am!

Happy Thanksgiving,

Gary D. Halbert

SPECIAL ARTICLES

Why the Super Committee Failed
http://online.wsj.com/article/SB10001424052970204531404577052240098105190.html

Super Committee – Typical Washington Charade
http://washingtonexaminer.com/opinion/editorials/2011/11/only-election-can-break-washingtons-gridlock