Posted by Shyam Moondra
The stock market is in a downward spiral, again. However, the trading volume is low, indicating lack of conviction. The market is going down not because investors decided to dump the stocks they own but it's more because of lack of liquidity caused by investors' unwillingness to take risk. They are choosing to keep their cash in bank accounts or in Treasury securities earning a meager rate of return. Some are rushing to buy precious metals. On a valuation basis, stocks are very cheap with a forward PE ratio of less than 10.
The U.S. economy is in a logjam with conflicting crosscurrents. The unprecedented financial crisis of 2007-2008, which witnessed the demise or near demise of well-known financial institutions, forced the Obama administration and Federal Reserve Board to take stern actions to provide immense liquidity in the form of a stimulus program, near-zero federal funds rate, and other federal credit facilities. The aggressive moves by the government were effective in stabilizing the financial system. However, the financial institutions became risk-phobic that led them to become overly cautious in lending, especially to small businesses that create many jobs. In fact, the banks acquire funds at very low interest rates and earn a tiny return by investing those funds in the Treasury securities. The banks are content with a small return rather than lend and potentially earn much more but at much higher risk. Lending lubricates the economic engine; however, the current liberal FED rates and credit facilities are in fact inducing the banks to not lend.
Corporations have a record $1.8 trillion cash on their books but they are reluctant to spend on capital projects because they are not sure how the new regulations that the Obama administration pushed through the Congress would affect their profitability. There is always a chance that some of these complex regulations may lead to unintended consequences in an unpredictable way. The uncertainty created by upheaval in the regulatory regime is making them very cautious in making risky bets on adding capacity or hiring more people, beyond what's needed to replenish the depleted inventories.
Consumers are stunned by the rapid decline in their home prices and in the values of their investments. So they have parked their $8 trillion in bank accounts and Treasury securities that provide close to zero return. Also, they have cut down their discretionary spending to save more. The government tax credits to replace old cars or to buy new homes or to make their homes more energy efficient did provide a temporary burst of consumer activity but all these programs have now ended or are coming to an end. The slow pace of improvement in the job outlook is also discouraging the consumers, making them cautious when it comes to making the big-item purchases. Consumers are also not sure how the health care and financial reforms would affect them. They hope these reforms would reduce their costs, but they are not convinced that they would.
The government is in a fix without any good options. With the rampant budget deficit and national debt, the federal government is not in a position to undertake another large stimulus program that could significantly add to the deficit. Also, many analysts are not convinced that huge government expenditures are the most efficient way to create jobs. On the monetary side, the FED has already reduced the interest rates to almost zero and there is not much they can do on that front. They could buy government securities on the open market or troubled assets from banks to increase money supply but that could spark inflation.
After the crash of financial markets in 1979 and 2001, various publications declared investment in equities as dead, forever. But we know that both times markets came back roaring and they set new record highs. This time would be no exception. Here is what the government can do to speed up the economic recovery:
· The FED should start raising interest rates immediately and lift the fed funds rate to at least 2.5% over the next twelve months and wind down all credit facilities they created to deal with the financial meltdown two years ago. Easy money usually fires up the financial markets, home buying, and business and consumer spending, but this time it's not working out that way. The people are fearful of easy money (that's bound to form a bubble), government regulations, and mounting deficit. So the FED might start raising the interest rates now to induce banks to actively lend again rather than park their funds in risk-free Treasury securities.
· The Obama administration should refrain from starting any new major stimulus program. It's not needed; the U.S. economy is resilient and it will bounce back on its own without any external stimulus. The perceived benefits of any new stimulus program are outweighed by the risks posed by higher deficits and national debt.
· The Obama administration should come up with a credible plan to reduce budget deficit and national debt soon. Any delay in proposing this plan would be negative for the financial markets and would push the long-term interest rates higher that would undermine the economic recovery.
. President Obama needs to do a better job in convincing the people that the recent financial and health care reforms would indeed reduce costs and revitalize the economy.
