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An Economy in Drag

February 11, 2013

The central theme in recent months has been that current relative valuations of stocks and bonds could only be justified by an imminent financial crisis.
-David Kelly, chief global strategist, JP Morgan

“Fiscal Drag” should be the topic of the week as American investors get their first look at the impact of this year’s tax increases on consumer spending and the President’s State of the Union Address lays out the battle lines for the debate on the Sequester, now scheduled to take effect in less than three weeks.  Meanwhile, markets will also have an opportunity to contemplate the effectiveness of macro-economic policies in Europe and Japan.

In the U.S., Wednesday’s report on Business Inventories should help solidify expectations that the originally reported -0.1% GDP growth number for 2012Q4 will be revised upwards.  Friday’s New York Fed’s Empire State Survey should see some improvement if regional surveys begin to reflect more positive national numbers.  Unemployment Claims will be watched, as usual, for any hint of labor market improvement.

However, the most important economic report will be Wednesday’s report on January Retail Sales.  The pressure on American consumers in January was undeniable – the increase in the payroll tax in particular should have hurt spending on basic goods and services such as groceries, clothing, fast-food sales, and gasoline.  Moreover, spending on bigger-ticket items could have been restrained by the later-than-usual start to the income-tax refund season – courtesy of the last-minute budget deal.  However, early evidence on the fiscal drag, from monthly chain-store and vehicle sales does not look particularly ominous, and a higher-than-consensus reading on January retailing overall might convince markets that the economy can weather the first bout of fiscal drag.     

The other big domestic event this week will be the President’s State of the Union Address.  While the President has a broad agenda, including gun control and immigration reform, financial markets will be most focused on how serious either the Administration or Congress is in trying to avoid the Sequester.  Last week’s report from the CBO recognized that the Federal Government is making some short-term fiscal progress – with the deficit falling (under current law) from 7.0% of GDP last fiscal year to a projected 5.3% this year, 3.8% next year and 2.5% of GDP by fiscal 2015.  However, this forecast also assumes very slow economic growth this year, as layoffs and program cutbacks due to the Sequester amplify the economic impact of the earlier tax hikes. 

Moreover, the Sequester, by applying equal dollar cuts to spending beyond this fiscal year has a diminished impact in restraining deficits in the out years where, under current law, the fiscal condition deteriorates again.  Both sides in Washington realize that the only way to change the long-term trajectory on deficits is to make significant changes in entitlement programs.  Unfortunately, with Democrats holding out for some further tax increases as part of the price of any entitlement cuts, there is an increasing risk that the Sequester will come into force, at least temporarily.

Elsewhere this week, G7 and G20 meetings will likely involve contentious discussions on the use of currency devaluations as an economic stimulus tool, with a particular focus on the Yen’s recent sharp decline.  Obviously, all governments and central banks trying to achieve a low currency amounts to a zero sum game and rhetoric bemoaning the use of the strategy could impede the Yen’s slide.  Europe, meanwhile, will get a report card on the success of its attempts to restart economic growth with a very dismal -0.4% quarterly growth in Euro Zone GDP expected to be reported on Thursday for 2012Q4.  Despite a positive agreement last week on Ireland’s bank debt, there are few signs that Europe will relax its austerity approach to deficit reduction – an approach that has yielded little success so far.

The central theme in recent months has been that current relative valuations of stocks and bonds could only be justified by an imminent financial crisis.  Despite ineffective and sometimes counterproductive global monetary and fiscal policies this theme remains intact and, provided the global economy can continue to recover slowly, markets may continue to turn a blind eye to the incompetence of its doctors.