Today, the  non-partisan Congressional Budget Office (CBO),  published a report estimating that government stimulus raised real GDP (Gross Domestic Product) by anywhere from 1.7% to up to 4.5% in the second quarter of 2010.   The report is 20 pages long, but is worth a look.  Reuters put out a piece this afternoon that summarizes the report.

A revised Q2 GDP number will be released this coming Friday.  The consensus from economists polled by Reuters is that the economy grew in Q2 at a rate of 1.4%.  Piecing together this number with the CBO’s estimate of the stimulus’s impact leads to the uncomfortable realization that without government stimulus, the US economy contracted in the second quarter, pointing to evidence of a dreaded “double dip recession.”

While this outcome has surprised many market commentators (particularly those in the bullish camp), for almost a year now we have been skeptical that the US economy would come roaring out of our worst recession since the Great Depression, despite the injection of hundreds of billions of dollars in government stimulus.

In our 10 Themes for ’10 we published in January, our #6 theme was the following:

A cold year for growth: We expect the US economy will see almost negligible growth in 2010.  Margins will continue to contract for US businesses and profit growth will remain slim. The expiration of stimulus programs and slim prospects for their renewal in a mid-term election year will reduce aggregate demand.  Cost cutting and efficiency measures will continue to be necessary to offset top-line deterioration.

We believe the impact of the combined credit, real-estate and stock market crisis of 2007-2009 will take years to resolve.  Typically, recovery from such crises has impacted growth rates for 5-10 years as households rebuild savings. Unfavorable demographic trends (such as in Japan), can push growth even further into the future.

In our Q1 quarterly letter, published in April, we wrote the following:

Withdrawal of Economic Stimulus. The other major theme we expect to impact our economy over the rest of the year is the withdrawal of extraordinary fiscal and monetary stimulus programs put in place during the crisis. Various measures by the Fed, European and Asian central banks to provide liquidity support to banks and markets will be withdrawn over the course of the next several months.  Numerous stimulus programs across the world will also be removed over the course of this year, including bank loan fueled infrastructure spending in China.  As the global economy has these crutches removed, we will watch with great interest to see how severe the damage to core private enterprise has been.  We will also keenly track developments in trade agreements since various countries have enacted or are considering trade barriers and currency related moves to protect key industries and exporters.

As evidenced by the CBO report, it appears the damage to private enterprise has been fairly severe and far reaching.  Now that the crutch of government stimulus has been removed (with little likelihood of another round on the immediate horizon), our economy does not appear to be the picture of great health that some market commentators would have us believe.

It is not simply that the numbers are bigger, and they are — our USD 1.4 Trillion deficit (the amount the government spends over the amount it collects in taxes) is larger than the GDP of all except a handful of nations. Part of the problem is that the US has been funding two wars without raising additional revenue.  In fact, tax rates were reduced in the early 2000s, and the cost of the wars was taken off the official budget and funded through emergency spending bills.  The US has also spent a great deal over the past two years to stabilize the financial system and broader economy.

But a larger problem looms in the years to come as record numbers of American workers (the baby-boom generation) retire and begin to draw on the Social Security and Medicare benefits they have been promised.  The cost of the benefits has never been fully funded, largely because it has always been in a politician’s self-interest to promise benefits and defer the costs.  In a similar way, special interest groups including health care providers, insurers and drug companies have  followed their own self-interest and grown a health-care system that delivers the most expensive care in the world, with mediocre results.

Earlier this week, the Congressional Budget Office published a report on the Federal Budget and The Risk of a Fiscal Crisis which contains a litany of alarming statistics.  The bare facts are that the US government spends more on programs for its citizens than it charges them in the form to taxes.  It has been doing this for decades, and financing the spending with debt, except for a brief period of surplus in the 90s.  This debt now totals USD 13 Trillion and it can only be repaid through tax revenues.  Either income and other tax rates go up, or spending comes down.

The problems seems so intractable, the political views so entrenched, and the distrust so pervasive, that it is difficult to know where to begin.  David Stockman’s Op-Ed in the NYTimes earlier this week makes an excellent start and is well worth the read.  He has also been making the rounds on TV, and there is an excellent interview on Bloomberg well worth watching:

We agree with Mr. Stockman that bringing the US deficit, and by extension the debt, under control will require increasing revenue and controlling spending.  We also agree that the problem has been nurtured and grown under both political parties, and in fact the Republicans may have more to answer for than the Democrats since they have presented a policy of revenue/tax reduction without bringing spending under control.

Mr. Stockman was partly responding to an Op-Ed in the Wall Street Journal by Arthur Laffer (another Reagan adviser).  In his piece, Mr. Laffer argues that lower taxes will spur investment and growth, raising revenues in the process, while raising taxes would do the inverse.  We find two aspects of Mr. Laffer’s  argument misleading.  Raising taxes from 33% to 36% is a very different proposition from raising them if they are already at 60% (as they were in the 1980s). Secondly, the top 1% of earners now pay a higher portion of GDP in taxes is because their share of GDP has grown while that of the rest of the population has stagnated. Extreme income inequality ultimately leads to a breakdown in the social contract. It is also important to remember that the Bush tax-cuts were implemented at a time when the US federal budget was running a surplus.  Sunset provisions were incorporated into the cuts because there was a concern that the

However, the political environment is extremely polarized and it is hard for us to imagine reasonable measures being undertaken prior to the mid-term election.  In our view, all legislative action between now and November 6th will be driven by its impact on congressional races.

The flip side of the debate on taxes revenue is the impact on spending and infrastructure.  Paul Krugman writes about this in the NY Times this weekend.

The immediate question is whether the temporary tax cuts enacted in 2000 are to be extended.  These cuts had a sunset provision embedded in them and were enacted at the height of the tech boom, when revenues were inflated and the US was running substantial fiscal surpluses.  Soon after they were passed, the tech-wreck of 2001-2002 and the events of 9/11 shrank US growth and we have seen deficits rise steadily.  The financial crisis and its aftermath have simply exacerbated a problem that was already quite severe.

In our view, the responsible course of action is to let the temporary Bush-era tax cuts expire.  They will result in small increases  to the federal income rates for most taxpayers, and they are a small step towards tackling the larger problem which is explaining to the American populace that the generous benefits they enjoy must be paid for and we may as well start now since we have been incurring the costs for a while.

As for the timing of any further tax increases, we believe they must be delayed. The US economy will experience the withdrawal of extraordinary fiscal stimulus and expansionary monetary policy over the next two years.  Raising taxes simultaneously could well stall or reverse any recovery.  However, there must be some commitment to simplifying the tax code and progress towards a balanced budget.  Ideally, we would like to see Congress debate and pass a tax reform and increase bill which would take effect in a phased manner over a number of years, with a clear goal of paying down the extraordinary debt the US has accumulated.  If the governing classes in the country don’t have the backbone to deliver this unpleasant medicine now, we may be forced to swallow an even worse pill down the road, much like Greece is today.

In his article Banking Needs More Robust Stress Tests Than These, John Kay writes in the Financial Times about the inadequacy of the European Bank stress tests.  He argues that while the language of “stress tests” is borrowed from engineering, the standards being applied are nowhere near as rigorous as those demanded in engineering.  As many banks learned first hand in 2008,  ”industry-standard” stress assumptions can create complacency.  Wimpy standards blessed by primary regulators may be worse.

One of our favorite weekly radio programs/podcasts is This American Life.  The show does not generally cover finance, but does a remarkable job whenever it gets around to covering the topic.  For example, they present a very good explanation of the financial crisis in an episode titled The Giant Pool of Money.  In a recent episode, the team took a look at US state budget deficits through the unique mix of political dysfunction, profligacy and entrenched distrust that characterizes the politics of Albany.  The episode also contained a cautionary tale for states and countries with polarized political landscapes.  In what comes as close to a controlled experiment in economics as one gets, we have the tale of Barbados and Jamaica.  Both countries confronted a ruinous economic landscape in the late 70s.  The nature of their local politics and the level of social cohesion led to small difference in the way they tackled their crises, but these small differences appear to have had an out-sized impact on future growth.   The episode is titled Social Contract, and is worth listening to in its entirety.

and apropos of nothing in particular, we quote The Epicurean Dealmaker:

There are those who style themselves intellectuals—a notably large portion of whom, in my personal experience, happen to be economists—who are deeply suspicious of anecdotal data in general and anecdotes about finance, economics, and the behavior of market participants in particular. This has always struck me as revealing both a superficially shallow skepticism about the primary sense and experience data of others—which, after all, is the most reliable data each of us individually possesses—and a similarly unwarranted credulity about its opposite, broad and impersonal third party datasets.

…
Oh, and by the way, while quality has certainly improved since I started in investment banking 20 years ago, it remains true, for example, that the banker who wishes to remain employed will always check the accuracy of third party data against original sources before he incorporates it into his own work product. So much for the reliability of external datasets when real money—as opposed to, let’s say, a research grant—is on the line. Oh snap.

— TED, unpublished remarks

Last week also saw the IPO of the Agricultural Bank of China (ABC), the last of China’s major state-owned banks to go public.  Like all the other state-owned banks, ABC spun-off a package of bad loans prior to going public.  What we’re wondering is whether they’ve also spun-off all the employees who made those bad loans (over 10% of ABC’s USD 828 Bn balance sheet at end 2007).  We’re also wondering it is possible to make USD $110 billion in bad loans in an economy that is growing at a 10% clip.  Fitch Ratings has some ideas.

• NYT: Finding a Good Financial Bill in 2,300 Pages
• FT: Bill Lays out route map for Wall St.
• WSJ: Law Remakes U.S. Financial Landscape

Now that we’ve reached the mid-point of 2010, we thought this would be a good time to look back at our list of Top 10 Themes for 2010 and see how our predictions have fared. We’ve attached this list with an assessment of each of our calls.

Like the recent quarters that have preceded it, the second quarter of 2010 was very eventful.  On April 16^th, the SEC dropped a bombshell when it filed a civil lawsuit against Goldman Sachs charging the firm with fraud over its marketing of a 2007 subprime mortgage product known as ABACUS.  The lawsuit shocked many in the financial services industry as it demonstrated the SEC was getting serious (though many have argued too little too late) about holding the larger firms accountable for questionable business practices that helped accelerate the subprime meltdown.  As a result, Goldman’s reputation has taken a major hit and the firm’s share price has fallen over 30% since the lawsuit was first announced.  The lawsuit helped set the stage for the financial reform bill now working its way through Congress.  And while the White House and Congress have repeatedly denied any knowledge of the SEC’s lawsuit prior to its announcement, the timing of the suit certainly didn’t hurt the bill’s chances of being passed.

On April 20^th, an explosion on the Deep Horizon oil rig in the Gulf of Mexico destroyed the platform, killed 11 workers and ruptured a riser pipe on the ocean floor that continues to leak oil and gas into the Gulf of Mexico as of this writing.  While initial reports downplayed the severity and extent of the leak, the world quickly learned how devastating this disaster would become after several attempts to staunch the flow failed.  The only viable solution now appears to be the two relief wells BP is digging, which are still several weeks from completion.  The spill, which is now the largest ever to originate in US waters, will no doubt have long term environmental and economic consequences for the gulf region.  In the short term, we will likely see the spill become a focal point for the coming energy bill as well as the November mid-term elections.

May 6^th marked the day of the now infamous Flash Crash.  At approximately 2:45 pm, the Dow Jones Industrial Average lost over 700 points in a matter of minutes, only to regain those losses several minutes later.   At one point, the Dow was down 998.5 points, which represented the largest intraday point decline in history and temporarily wiped out over $1 trillion in market value.  The cause of the crash has been vigorously debated, but many agree the central problem was an issue of liquidity (traders willing to buy and sell stock in quantity at the prevailing price).  Today, much of the stock market liquidity is provided by high-frequency traders (HFTs) – computer-driven algorithms used by firms trading at speeds measured in the millionth of a second.  While these HFTs provide liquidity during most normal market conditions, they are not always required to participate in the market (their primary objective is to turn a profit, not to maintain orderly markets). Many critics have suggested that something like the flash crash could occur if a group of these HFTs stop trading simultaneously.  The SEC has since instituted system-wide trading curbs or “circuit breakers” on any S&P 500 stock that rises or falls more than 10% in a five minute period.  It remains to be seen whether or not these measures will prevent another Flash Crash.

In addition to the above the highlights, the quarter also saw a further deterioration in the European sovereign debt crisis, a sustained correction in global equity markets and a some less than stellar economic data from China.

But not all the news is bad!

On a personal note, this past quarter also marked the first year anniversary of Washington Square Capital Management (on May 15^th).  This past year has been memorable (to say the least) and we wanted to thank you again for your commitment to work with us – we recognize that none of this would have been possible without you.

Memorial Day Weekend also marked the marriage of Subir to Molly Barker.  There were two weddings: an Episcopal service held on Friday May 28^th in New York City and a Sikh service held in Glen Cove, NY on Sunday May 30^th.

We look forward to speaking with you during our quarterly review.

1. We expect to see the US unemployment rate to peak at 11% in 2010. We may have been a bit aggressive with this call.  While the US job market remains anemic, the unemployment rate now stands at 9.5% (the lowest all year), partly because of workers who have dropped out of the labor force (stopped looking for jobs).  A falling unemployment rate would normally be encouraging news, but private sector job-creation continues to be very slow, despite the record amount of stimulus that has been pumped into the economy. In addition, the most recent jobs data has been disappointing, so the looming threat of a “double-dip” recession remains high and 11% unemployment later in the year is not out of the question.
2. Investors will continue to re-allocate towards less volatile investment classes, like bonds in 2010. This scenario has been playing out as we expected.  According to ICI[1], only $7.82 billion in new money has been invested into equity funds through June 23^rd 2010, while bond funds have seen $154.35 billion of net inflows.  Over the last eight weeks (where we’ve seen equity markets correct), net inflows into stock funds have been -$31.29 billion, while bond funds have seen +$33.98 billion over that same period.  We continue to believe demographic factors in the US and Europe as well as an increasing wariness towards stocks after two major bubbles in 10 years will lead investors to allocate larger portions of their portfolios to fixed income investments with a higher claim on corporate cash-flow than stocks.
3. We expect a number of credit downgrades for developed nations as their persistent deficits come into focus.  The US Dollar will strengthen in any ensuing flight to safety. This prediction has been right.  Since the start of 2010, we’ve seen credit downgrades to Greece, Portugal and Spain, as well as a massive bailout plan for Greece.  The US dollar started 2010 valued at 1.4323 per Euro, but strengthened as the situation in Europe deteriorated.  It reached a level of 1.1875 per Euro on June 6^th and has recently bounced back to the 1.25 range.  We expect continued pressure on the Euro until a workable solution for the sovereign debt crisis has been reached.
4. Interest rates will remain effectively at 0% until the 4^th quarter of 2010, where we will expect to see the Fed raise rates to the 1-2% range. So far this prediction has been accurate.  The Fed has kept the fed funds rate at historically low levels.  It remains to be seen whether or not the Fed opts to raise rates in the 3^rd or 4^th quarters.  While most commentators believe the latest round of economic statistics have made a hike unlikely until 2011, we still believe there’s a good chance the Fed raises rates to the 1-2% level after the mid-term elections in Q4 2010 and then pauses for an extended period.
5. Continuing the trend from 2009, paying down debt will remain the highest priority for US consumers as they attempt to get their financial houses in order. This trend appears to be holding up.  In May, the personal savings rate reached 4%, which is the highest level it has been in 8 months and a far cry from the .8% we saw in April 2008.  Outstanding consumer revolving debt also continues to decline.   The most recent data from the Fed (for April) shows revolving debt at $838 billion, which is down from $866 billion at the start of 2010 and $958 billion at the start of 2009.
6. The US economy will see almost negligible growth for 2010. It’s a bit early for this call since we won’t see this year’s GDP data until 2011.  Current GDP estimates are on track for 3% growth in 2010.  The caveat, of course, is that this has been accomplished with record government stimulus.  If the economy is unable to stand on its own without the crutch of stimulus, it’s entirely possible the second-half will be much weaker.
7. Corporations will increasingly turn to mergers and acquisitions to grow market share. This prediction could go either way.  According to the NY Times, the first half of 2010 has seen $810.3 billion in global mergers and acquisitions.  Through the same period in 2009, this number was $814.6 billion.  However, many of the 2009 deals were a result of government activity in the banking sector, whereas 2010 has seen deals taking place across a range of industries.  A recent Ernst & Young study of more than 800 senior executives across the world showed that 57% of businesses surveyed said they are likely to acquire other companies in the next 12 months.  This number was 33% in the last survey (in November of 2009).  Whether or not these executives follow through on this sentiment remains to be seen.
8. Growth in emerging markets will continue to outpace developed economies.  But this will not be enough to offset the stagnation in developed economies or lead to a robust global recovery. This trend appears to be holding up in 2010.  After a year of gaudy returns, the global equity rally faded in the second quarter.  As of June 30^th, the MSCI emerging markets index was -7.22% year to date, the MSCI EAFE index (which tracks developed markets in Europe, Australasia and the Far East) was -14.72% year to date and the S&P 500 was -7.57%.  We continue to believe equity market returns across the world will be negative in 2010.
9. We believe there is continued risk for a massive correction in China. While we have not yet seen a “massive” correction in China, the Shanghai composite index is now at a 15 month low and is down over 25% through the end of Q2.  We continue to believe equity and real-estate markets in China are over-valued and there is further to fall.
10. In 2010, certain commodities are poised for a sharp sell-off.  Top of our lists for a correction are gold and oil. This call has produced a mixed result.  Gold is up over 13% through the end of Q2 while oil is down over 14% over the same period.  While gold remains a popular investment alternative to faltering currencies (Euro, USD), we believe its big run-up over the past few years puts it firmly into bubble territory.   We believe oil prices will remain depressed until the global economy is back on its feet.

The dramatic and extremely sudden deterioration of Greek sovereign credit in the marketplace forced the European Central Bank (ECB) into a rapid about-face.  Germany’s elected representatives blinked and committed to a vast fund to support Mediterranean nations. Very few people expected to see the IMF lead a rescue package for European Monetary Union member-states in their life-times.  Eroding confidence in the ECB and EMU led to a deterioration in the value of the Euro as talk of this currency supplanting the US Dollar as the new global reserve currency did a sharp 180 degree turn and even sober commentators began to talk of a break-up of the European monetary union and the Euro’s death.  Meanwhile, bond-holders have turned their sights on the increasingly precarious state of sovereign balance sheets in most of the developed world.  Shocked by the speed with which Greek bonds lost value, most bond buyers are thinking seriously about sovereign credit risk in the developed world, awakening from a period that lasted two generations during which these risks were largely ignored.  Meanwhile, treasury officials the world over review the results of their bond auctions nervously, wary of any sign of demand slacking.  In many cases, their own central banks are becoming the most reliable buyers or financiers of new debt.

Three months ago, we wrote in an earlier post:

Numerous stimulus programs across the world will also be removed over the course of this year, including bank loan fueled infrastructure spending in China.  As the global economy has these crutches removed, we will watch with great interest to see how severe the damage to core private enterprise has been.

We believe this process has begun and the initial signs do not augur well for the global economy.  We have seen a debate re-kindled recently about whether the withdrawal of stimulus at this juncture is a repeat of “errors” made in the 1930s, when stimulus spending was reduced to control deficits.  However, with aggregate debt levels in the developed world as high as they are, we see few alternatives to a steady reduction of the extraordinary fiscal and monetary measures undertaken to control the crisis.

We also feel it’s necessary to discuss the “Flash Crash” of May 6^th.  In our blog post the next day, we wrote that:

Since US equity market prices are far higher than underlying valuation (according to our measures) we were not surprised by the extent of the drop.  But we were very surprised by the speed at which the drop occurred, as well as the speed of the partial recovery.  It reminded us of the precipitous declines and partial reversals we saw during the height of the credit crisis in 2008 and 2009.   …

Though the US equity markets are receiving most of the attention, they are not the only source of the current volatility. Numerous other markets saw immense turbulence yesterday, including, but not limited to, overnight funding (libor), treasuries and particularly currency markets.  …

The major conclusions we draw from the trading action of the past week is that:

1. Numerous market participants have limited conviction and their default stance is to step aside quickly in a falling market.
2. The Euro-zone crisis will continue to roil markets until it is properly addressed.
3. There are many underlying concerns about commodity prices, Chinese real-estate prices, credit-worthiness, etc. and they can manifest themselves very quickly.

Given the information we have, and our view of overall valuations, we caution investors to remain extremely vigilant and maintain a defensive posture.

All three major indices, Dow Jones Industrials, S&P 500 and Nasdaq composite closed out this quarter below the intraday lows reached that day.  The ten-year treasury is now below 3%, and no amount of commentary on US federal and municipal debt-levels appear to impact the decline.  Meanwhile, the Baltic Dry Index has dipped below 2500 again (amidst talk of expanding fleets and falling Chinese imports).  Speaking of China, we see more commentators openly questioning the solvency of Chinese banks and the reasons behind big IPOs.  All of this underpinned by the fact that unemployment and underemployment rates in western countries remain stubbornly high.

Not only is it increasingly difficult to write off the events of May 6^th as a mere technicality, we believe that sudden decline has lead to deep distrust and uncertainty amongst investors.  Investors were already wary of fundamental economic and market conditions, the flash crash gave them reason to cast suspicion on the technical organization of the market.  This coupled with the SEC’s indictment of the premier US Bank, Goldman Sachs on charges of fraud, has fueled suspicion of large player’s motives and methods.  Many individual investors now believe the market is rigged against them, for the benefit of the largest trading firms and their most senior traders.  In our view, it was always thus.   Professional traders, whether they be electronic market-makers or specialists on the trading floor have always enjoyed a privileged position, which is completely appropriate given their role as liquidity providers and their responsibility to maintain orderly markets.  What we find difficult to accept is the extension of these privileges new players, without them being asked to shoulder the same responsibilities.

We do not see many silver linings amidst a climate of mutual suspicion and bad news.

• The immediate issue is that this measure, and its cost, will likely need be voted on by all member-state legislative bodies. There is a good chance it faces stiff opposition in at least one Euro-zone nation, potentially setting the stage for a political standoff reminiscent of the US congress’s initial vote on the TARP plan in September 2008.  The entire process will be controlled by member-states and the EU institutions have been largely bypassed.  The EU leadership has decided they want to sell this deal in 27 member-states simultaneously, with the markets breathing down their neck.  It is hard for us to believe they will find buyers in every member-state’s legislature.  Imagine if TARP had to be voted on by every US state legislature.  The UK government (after last week’s election, we aren’t sure who that is) has already decided it wants no part of the 440 billion euro loan guarantee program, others may follow upon reconsideration.  In any case, we suspect member-state legislators will not be as easy to corral as finance and prime ministers.
• This announcement undermines the fiscal soundness of all European Union countries, especially if austerity measures are still resisted by the member states who are in very weak fiscal positions.  David Roche writes in the FT that “this deal is a form of contagion by official action”.
• The German provincial election in Rhineland this past weekend did not go well for the Christian Democratic Union (CDU).  German voters handed Angela Merkel’s party an effective loss based on her support for a much smaller bail-out of Greece.  We do not believe German voters, or the constitutional court will be pleased about this announcement and the European Central Bank’s plan to purchase member-state debt.

A number of the fundamental issues raised as our generation’s financial crisis runs its course are summarized in an excellent Statfor piece titled The Global Crisis of Legitimacy.

In other news, Moody’s announced they may downgrade Greece to junk-bond status (S&P already has).   The European Central Bank (ECB) has announced they will buy these junk-rated bonds and the prevailing mood in Europe is to blame the rating agencies and banks for the debt woes of profligate member nations.  The ECB’s reputation for monetary stability and responsibility has been deeply compromised by this weekend’s announcement, and we fear it will be impossible to regain in the short-term.

The sovereign credit crisis in Europe is not over yet, and the questions surrounding the Euro have not been laid to rest.

Further reading:

• Europe agrees rescue package
• In a must-read analysis titled It’s not the way to solve Eurozone debt crisis, David Roche writes in the FT: “Initially, markets may be wowed by the size of the package. But the size just means that more debt has been added to a problem that is about too much debt! EU governments and the European Central Bank are now obliged to guarantee or buy the sovereign debt of other members as a solution to the Eurozone’s debt crisis. But the solution to a hangover is not more alcohol.”