Kee Points with Jim Kee, Ph.D.

Pretty good news across the board last week like strong industrial production numbers in the U.S., driven primarily by motor vehicles and machinery. And the U.S. housing market continues to show recovery. Housing starts for single-family houses rose, as did existing home sales and single-family home prices. And Chinese growth, while slowing in the fourth quarter, was nevertheless stronger then expected at 8.9 percent, causing a rally in the Chinese stock market. Fourth quarter preliminary GDP will be released this Thursday. The consensus is for 3% growth, which follows 1.8% in the third quarter. The plausible low estimate that I have seen is closer to 2%, but the majority of outlier forecasts are expecting fourth quarter GDP to come in on the highside, or 3% plus.

 

Here's what I think about all of this: Most U.S. expansions are led by housing and autos, also known as "consumer durables." But both housing and autos have been on their backs during the current expansion. Fortunately, export growth and business investment spending have been stronger than normal, and these two categories have helped to off-set the housing and auto sectors. Now with China (and hence exports) slowing and the 100% expensing of capital purchases (and hence business investment) expiring (dropping down to 50%), these two drivers of growth could weaken. Fortunately, it appears that the auto and housing sectors are finally bottoming and starting to turn up. You can see why that's so important.

 

In Europe sentiment seems to be improving, as interest rates are down there (a good sign). There is still debate regarding Greece's debt and the terms of an orderly restructuring, meaning a debt swap in which current debt holders get new bonds worth less (the so called "haircut"). This "debt swap" and new fiscal program (with spending reform) must be in place before Greece is allocated funding from a second rescue package led by the IMF. So Greece is still a question mark for investors. But for the rest of Europe, the overall response to December's long-term refinancing operation (LTRO), which allows banks to borrow from the European Central Bank on favorable terms, has been more positive than many investors and economists expected. For example, the yield on Italian two-year debt is 3.9%, down from a peak of 7.8% in late November (WSJ). Let's hope that continues!

 

Ratings agencies: One story that's getting more play in the press these days, and rightly so, is the historical evolution of credit rating agencies or Nationally Recognized Statistical Rating Organizations (NRSROs) like Fitch, Moody's, and Standard & Poor's. The origins go back to the 1800s as companies emerged to provide detailed analysis of the risks associated with railroad bonds (Jefferies). The business model that evolved was one in which these companies made their money by selling books and subscriptions to investors who were interested in investing in various companies and loaning them money (buying their bonds). By the 1970s the development of things like photocopiers made it hard to protect the proprietary information of these ratings firms. This is a situation that economists call "non-exclusion" or difficulty excluding non-payers from a good or service (the classic example being national defense). As a consequence, a significant change in the business model of these companies occurred, essentially going from an investor fee-based model towards an issuer fee-based model. Jefferies analyst David Zervos deems this a "game changer" in that, with the issuers of the securities being rated paying the bills, "the agencies had a new master – issuer revenues." Zervosí conclusion is that this is really what created the era of mis-rated securitized products which ultimately produced "one of the greatest misallocation of resources in financially history." Perhaps overstated, but I think there's something to it.

 

The most interesting thing I saw last week: Princeton economist and former Federal Reserve vice Chairman Alan Blinder had an intriguing article in the Wall Street Journal last week entitled, "Four Deficit Myths and a Frightening Fact." Few economists would agree with all of Blinder's points, but I think they would agree on his main point; namely, that America's real debt and deficit problem will come in the 2020s and 2030s and beyond, and will be driven by Medicare and Medicaid spending. In Blinder's words, "we don't have a generalized overspending problem for the long run. We have a humongous health care problem." Again, the first part of that statement is open for debate, but not the second: health care entitlement reform is what will drive budget politics in the future.

 

Finally, please join us for our Corpus Christi Market Update & Outlook this Friday January 27th at the Corpus Christi Town Club at 11:30am. Please rsvp to Josie Dorris/jdorris@stmmltd.com or 210-824-8916.