Posted by Shyam Moondra
Over the past ten days, the S&P 500 index has declined by 11%, wiping out close to $2 trillion worth of wealth. This big decline over a rather short period has been reported as the largest since 1978 when economy was heading towards recession with double-digit inflation and interest rates. Of course, at the present time, we are just coming out of recession and inflation and interest rates are nowhere near the early 1980's levels. In addition, corporate profits are currently running at record levels with their balance sheets in pristine condition. Therefore, it would seem that the market decline over the last few days was perhaps a knee-jerk reaction to the ugliness of the Congressional debate over the issue of extending the federal debt-limit. Investors are fearful of the toxic environment in the Congress because it breeds uncertainty and it leads to loss of confidence in the government's ability to deal with the tough issues of budget deficit and national debt.
After the unprecedented financial crisis of 2008-2009, which was precipitated by the crash in housing market, the Fed slashed interest rates to near zero and pumped liquidity into the markets. Also, the Obama Administration asked for and received funding from the Congress to implement a big stimulus program consisting of temporary income tax relief and increased spending on infrastructure. Those efforts were successful in stabilizing the financial institutions, helping economy turn around, creating jobs, and giving a big boost to the flagging stock market that made a dramatic u-turn and recovered most of the losses of 2008. However, lately, there are signs that the economy is losing steam and some fear that we may be headed into a double-dip recession.
Negatives in the economy:
· The ugly spectacle of debt-limit debate in the Congress and the partial FAA shutdown because of the political reasons have led to business leaders' lack of confidence in the government's ability to handle major problems. The extremism of the Republican Party incited by their Tea Party comrades has hurt the overall economy. The latest opinion poll shows that 84% of Americans disapprove the way the members of Congress are doing their jobs, which is the worst rating ever. In particular, Republicans and Tea Party members received very high negative ratings.
· Recent major regulatory reforms for financial institutions and health care have contributed to uncertainty as to how those reforms would affect the corporate costs and profitability. Although the new reforms are being phased-in over time, some of the aspects of these reforms are being delayed because Republicans are holding up the funding for the implementation of parts of the reforms that they don't like. These tactics have created uncertainty and many businesses are overwhelmed with the implementation issues and unsure about what would be their eventual costs.
· On-again and off-again approach to the European debt situation has negatively affected the U.S. markets. The conflicting viewpoints within the EU community have delayed the resolution of these problems in a convincing manner. Since the U.S. financial institutions are directly or indirectly affected by all this, it has proven to be a big negative for the U.S. stock markets.
· Since the financial crisis of 2008, most governments, local, state, and federal, are tightening their belts to reduce their budget deficits. Many other countries are doing the same. In the near-term, these cutbacks in government spending around the world are negatively affecting consumer spending and thus making it harder to keep the recovery going.
Positives in the economy:
· Corporate profits are at record levels, exceeding the pre-financial crisis levels of 2007. The corporations hoard $2 trillion cash and their balance sheets have never looked so strong. However, because of the uncertainty and lack of confidence in the political arena, the corporations are holding back and not aggressively investing in capital projects.
· The consumers have done a good job in managing their household budgets. They have reduced their debt and they have been saving more. However, chronic high unemployment rate has been making them reluctant to start freely spending again.
· The declining government spending may be a negative in the near-term; however, it will be a big positive for the future because this will help keep interest rates low going forward.
· In spite of the recovery from the recession of 2008-2009, inflation and interest rates continue to be low which is ideal for continued economic growth.
. The stock market valuation is below normal. The trailing PE ratio for S&P 500 is less than 13 and forward PE is under 12. That's hardly the level that would trigger a huge sell-off like the one we are seeing now. The investors are gripped with fear and they are dumping their shares out of panic.
· The Fed has been very accommodating on monetary policy and they may be ready with QE3 in response to the market crash over the last two weeks.
· The U.S. companies are doing a very good job in exporting goods and services to other countries. In fact, the export sector is one of the strongest performers in our economy right now.
What needs to happen?
· The acrimonious political environment in Washington, DC must end to inspire confidence. The businesses need to be sure that the government officials can behave like adults and make rational decisions.
· The government needs to have another look at health care and financial regulations to bring more clarity and do away with the parts that are proving to be too onerous on businesses. Republicans and Democrats need to resolve their differences on how to move the implementation forward and remove uncertainty that's hanging over the employers, small and large.
· In light of a sharp decline in the stock market in recent days and sluggishness in economy, the Fed should immediately begin a QE3 program to provide more liquidity.
· The Obama administration and the Congress need to work cooperatively to come up with ideas for creating jobs such as targeted tax reductions, new trade agreements that will help the U.S. businesses export more of their goods and services to other countries, training the labor force for high-tech high-paying jobs, etc.
· The government needs to keep working at the budget deficit and debt problems, using a balanced approach. We need to increase taxes on the rich, close the corporate tax loopholes, and reduce wasteful government spending over time. We also need to look at entitlement reforms to preserve those programs for the long-term. The deficit problem can't be fixed overnight; excessive spending cuts at a time when economy is still struggling would be unhelpful. However, we do need a credible plan to eventually balance the budget and retire some of the national debt.
· The state and federal governments should extract procedural reforms from banks on how the foreclosures are handled, but they should not insist on huge monetary penalties. The financial institutions are not yet on sound footing, so the governments should be careful and not push the banks towards another financial crisis.
