Given that the US consumer accounts for almost 2/3rds of the GDP, the biggest question for 2010 is the consumer’s attitude and spending habits in the face of a 10% unemployment rate. We simply do not see a true economic recovery happening until a) the unemployment rate drops substantially, and/ or b) the huge amounts of debt hanging over the consumer is paid back or destroyed through defaults or bankruptcy. The sooner either of these happen, the better off we will be in the long run. While recent economic readings have begun to show positive signs, with the unemployment rate actually dropping to 10.1% last month, we will have to wait and see if this is the start of a new trend. We will get more clues of the state of the consumer early on in 2010 when retailers report their results on the 2009 holiday season. Early indications, however, point to a consumer that is still dealing with the crash of home values. Survey results released after the Thanksgiving weekend showed that cash was king for holiday shoppers, with only 26% of those who shopped over the weekend saying that they used credit cards for their purchases. A total of 39% of those who shopped said they used cash, while the remaining shoppers used debit cards. When consumers shun credit cards it is a bad sign for retailers because people who buy gifts with a credit card tend to spend anywhere from 20 to 40% more on gifts than those who pay with other methods. With credit card companies increasing rates, continued job losses, boomers heading into retirement scared half to death about a lack of savings and banks reducing credit limits in response to rising defaults, it’s no wonder that consumer attitudes towards debt, borrowing and banks has changed. This change in attitudes is key and something that we don’t feel Mr. Bernanke understands yet. The Fed can print money until they run out of trees, but until the economy begins to show some life, people are simply not going to borrow and spend money they do not have. This huge shift in consumer attitudes regarding credit will contribute to the delay of economic recovery next year and beyond.
The next area where we expect to see major disruptions in 2010 is the municipal bond market. Unfortunately, major states including California, New Jersey, Florida and Oregon, and major cities like New York are facing major fiscal deficits due to bloated pension obligations and have done little so far to ease their respective burdens aside from borrowing more money. 2009 saw investors buying municipal bonds for their attractive yields given their tax exempt status but the risk is clearly not worth the reward. Policymakers need to be cautious that their response to this crisis does not exacerbate the next one as simply borrowing more money to paper over short term issues will only make things worse down the road. And politicians are beginning to take notice as their constituents are voting with their pocketbooks. In New Jersey for example, long time incumbent Democratic Governor Jon Corzine was defeated by Republican challenger Christopher Christie who has consistently said that he is opposed to borrowing more money via bond sales as voters understand that the only way to pay for more borrowing and spending by their respective municipalities would be through higher taxes. Given that there is no realistic way for many municipalities to pay back their debt, we believe that the municipal bond market itself is in a bubble. Ever since the City of Vallejo declared bankruptcy late last year, rumors, some justified and some nonsensical, of other cities and counties that may follow a similar path have been surfacing. If and when cities, municipalities, and counties begin to declare bankruptcy, (which we are expecting) municipal bond yields are going to soar across the board making it that much more difficult for other struggling counties to refinance their debt. The challenge for municipalities in 2010 will be to figure out how to reduce their employee and pension obligations without disrupting city services such as police and sanitary services and this will not be a small task. The deficiencies cannot be put on the backs of taxpayers. While bankruptcy may be the best option for some cities and counties, much of the burden will have to be met by the unions who will have to agree to major concessions.Late last month, the first shot was fired in the sovereign debt market with Dubai telling its creditors that it will default on over $80 billion worth of obligations. Global equity markets quickly sold off on the news and the markets have traded sideways since the announcement. The dollar benefited from the news as investors moved back into safe assets such as US Treasuries. In the case of Dubai, construction and real estate accounted for as much as 25% of the economy creating a massive real estate bubble- think California, Florida etc. The major lesson to take away from Dubai’s default is that market participants know the potential for a serious correction is quite real. Investors and media hypesters alike will begin to realize that calls for Dubai’s neighbors to step in and bail the country out will fall on deaf ears. While Abu Dhabi has recently said that it would bailout Dubai to the tune of $10 billion, this is only a drop in the bucket to the nearly $80 billion worth of debt that Dubai has asked to restructure. There is a simple reason why this problem will not be fixed by a simple cash infusion: the real estate assets purchased by Dubai are now only worth a fraction of what was paid for them during the boom years. For example, the W Hotel in Manhattan, which Dubai paid $282 million for in 2006, was recently sold at auction for $2 million.
As was the case with the sub-prime debt market in the United States, the credit agencies have proved to be extremely slow in downgrading sovereign debt credit ratings. With Dubai, the credit agencies only began to downgrade the nation’s debt AFTER its announcement to restructure payments. The slow response of the credit agencies means that investors will have to do their own homework and pay close attention to credit spreads around the globe. Leading up to Dubai’s default, sovereign credit CDS began to widen dramatically forecasting the event. Looking ahead for 2010 and beyond, it is obvious that we will see more sovereign debt defaults as countries fail to meet their obligations. A few countries whose debt we are paying close attention to in respects to defaults are the ones that have been described with the acronym PIGS- Portugal, Ireland, Greece and Spain. Additionally, we feel that Eastern Europe requires a careful watch and especially Ukraine, which saw a 15.9% drop in 3rd quarter GDP and is already relying on a $16.4 billion loan from the International Monetary Fund to avoid bankruptcy.Readers of this blog know that we believe that we are in the midst of a secular bear market. The next decade is likely to produce less than average growth as we work through the bad choices we’ve made both individually and as a nation. With a 10% unemployment rate (the unofficial rate, including those who have given up looking for a job or who are underemployed, is actually closer to 17%) that in the Fed’s own words will remain elevated for some time, we simply cannot avoid the fact that we are facing major structural problems and will have to make difficult choices in the coming years. As noted above, the entire developed world has huge pension, medical and other obligations that will be nearly impossible to meet, short of a miracle. It’s clear now that the consumer is not going to borrow and spend (and rightfully so) the way they have over the past 15 years. Everyone understands that we are in a serious downturn and need to know the truth rather than have our politicians lie to us daily about promoting a strong dollar policy or economic readings that stretch the truth (to say the least). Politically, President Obama must distance himself from the failed Bush economic policies and team, or he risks losing the majority Democrats now hold in Congress and his own re- election in 2012. Federal Reserve Chairman Bernanke and Treasury Secretary Geithner have failed and need to go. President Obama will no longer be able to blame President Bush for the country’s economic problems as his term moves into its second year. People are fed up with what is seemingly a two tiered system of the haves and have nots and are simply going to vote whichever party is in power out of office out with a pure protest vote. President Obama ran on a platform of change, but within weeks of his Presidency we began to see the same cast of failed characters reemerge and reappointed, and in some cases promoted. We hope that in 2010 we begin to see some real changes from our political leaders that mirror and support the change in consumer attitudes towards debt and credit. It’s time for Washington to work for the people again and not just the bankers who would like us all to become more indebted. Now is the time for our elected officials to become realists and stop putting us into deeper into debt which is only kicking our problems further down the road. The sooner we face up to our problems the better we will be in the long run. It is likely there will be more short term pain, but we will be better off for it. In spite of these problems we are optimists at heart and understand that nothing under the sun is new. The world has gone through periods like this before and we will get through it this time.
Happy Holidays from LRG Capital Group.
