James Saft is a Reuters columnist. The opinions expressed are his own.
HUNTSVILLE, Ala. — If history is any guide, we will soon see a deal to lift the debt ceiling, followed by yet another cockamamie relief rally.
Don’t buy it; even if we get past the debt ceiling, and even if the U.S. can avoid a ratings downgrade, the situation facing U.S. assets is still grave. Firstly, cutting the deficit is a process, one with multiple opportunities over time for disruptive market events, but moreover one whose ultimate outcome, at best, is going to hurt corporate profits and suppress economic growth.
And even putting aside the impact of falling government spending, recent data shows a cooling manufacturing economy, consumers who are not consuming and a dangerously weak housing market.
While it’s possible that Aug. 2 arrives with no agreement to raise the debt ceiling and begin cutting the deficit, that outcome is a form of ritual suicide that both Democrats and Republicans will probably collectively choose to avoid. That’s good — a default would be horrific — but a deal won’t change the terribly weak fundamentals now facing the U.S., and U.S. corporations in specific.
David Levy, of the Jerome Levy Forecasting Center, maintains that a $1 trillion widening of the federal deficit between between 2007 and 2009 was responsible, nearly single-handedly, for slowing and eventually reversing the economy’s decline. Take that away, and away it will be taken, and corporations have precious little to make up the shortfall.
“The already depressed and sluggish economy will be hard pressed to avoid a profits decline even if there were no deficit reduction,” Levy wrote in a note to clients.
“Present government baseline projections already include sharp tightening over the course of the next year and a half. That, in this economy, is a recipe for recession.
“Washington, Wall Street, and Main Street do not understand that the economy’s wealth-creation process is broken because there are already too many assets, carried at unrealistically high values, and paid for with too much debt. Trying to fix the economy by cutting the federal injections of profits will backfire, create misery and aggravate the balance sheet problems.
The critical point is the mismatch between assets, their carrying values and the notional value of the debt underlying them. Even if you don’t believe that can be cured through the issuing of more federal debt, it is easy to see the impact that cutting the debt will have. Profits will fall, and the clean balance sheets of so many corporations will not avail, because the busted balance sheets of consumers and the government will be unable to generate enough activity to justify current share valuations.
COOLING ECONOMY
Remember too that the U.S. is in the midst of a soft patch. The Federal Reserve’s Beige Book survey, released on Wednesday, showed economic conditions deteriorating in about half of the country, with weakness tied particularly to housing and manufacturing. Manufacturing has been one of the few relatively bright spots in an anemic recovery; should it falter, the U.S. will likely find itself in another recession by mid-2012.
Consumers are hunkering down, whether by putting off purchases of food and diapers in the days before pay and government assistance checks arrive or by putting off discretionary big ticket buys. Corning cut its outlook for the glass market on Wednesday, sending its shares and those of its rivals into a tailspin.
“What you are seeing is the major TV brands like Sony, Samsung, LG are all reducing their forecasts of what will be sold at retail,” Corning finance chief Jim Flaws told Reuters.
Consumers, Flaws said, are putting their money into items other than TV sets or “perhaps just not spending … at all.” As for housing, there are more than six million homes either in mortgage delinquency or outright foreclosure. Those homes are going to take an enormous amount of time to clear the market, dragging down valuations and comparisons all the while, making mortgages tougher to get. In some parts of the country there really is very little real estate activity outside of the distressed sector. Don’t look for construction to pick up the slack, then.
The focus now is on what divides Republicans and Democrats what or whom to tax, what or whom to cut, who to blame. These differences are important, but the bigger picture is that there is consensus to cut, that the U.S. should enter an era of governmental austerity. That probably won’t change until after the beginning of the recession it will help to cause.
Austerity may be foolish, or it may be inevitable. This is open to debate. What is not debatable is that budget cuts will be terrible for corporate profits, and even with today’s fat profits, will expose current valuations as rich.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)
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