( This is part 3 of a 3 part series. Click here for part 1)
Another result of the zero interest rate world was the earlier investor rush to junk securities in their zeal for higher yields. That drove the spread between junk bonds and Treasuries from its 20 percentage point peak in December 2008 almost back to the previous low in June 2007. As in earlier boom times, investor zeal made refinancing sub-investment-grade securities easy, so defaults in the first half of 2011, at 0.2%, were near record lows. Refinancing money was so readily available that defaulting on junk securities took real skill.
But the August agonizing reappraisal of financial markets has hit junk hard. Retail investors, who poured $2.8 billion into junk mutual funds in July and $43.8 billion between March 2009 and February 2011, yanked out $4.6 billion in the first three weeks of August. That forced junk mutual funds to sell securities.
With this rapid reversal, it’s not surprising that the junk issuers raised only $1.2 billion in August, down 93% from July’s $18.2 billion and the lowest since the market dried up in December 2008.
Low and zero interest rates have also influence investors’ views of the values of stocks. The theory says that lower interest reduces the discounting rate that converts future earnings into current stock values and thereby raises their present worth. Also, lower interest rates are supposed to raise price earnings ratios by making stocks cheaper relative to bonds.
In any event, stock bulls and many equity analysts believe that corporate profits growth has been so robust that even considerable economic weakness will not depress stock prices significantly from current levels. And, as usual, equity analysts see robust company earnings for 2012, with a gain of 14.4% for this year’s estimate for S&P 500 operating earnings. Those numbers put the S&P 500 currently selling at 10.3 times next year’s earnings – reasonably cheap relative to the 19.0 average P/E.
But only two quarters of 2011 earnings are recorded so far, and estimates for the second half may prove to be far too rosy, jeopardizing analysts’ forecasts.
Interest rates close to zero and all the related issues are relatively new in the U.S.and Europe, but they’ve been around in Japanfor two decades. So, many wonder if the U.S.is headed for a Japanstyle deflationary depression.
There are a number of similarities that suggest that Americais entering a comparable long period of economic malaise. The recent slow growth in the U.S.economy with real GDP gains of 0.4% in the first quarter and 1.0% in the second looks absolutely like Japan. Furthermore, the prospects of substantial fiscal restraint in the U.S.to curb the federal deficit is reminiscent of tightening actions in Japanin the mid 1990s. Their economy was growing modestly, but deficit and debt wary policymakers in 1997 cut government spending and raised the national sales tax to 5%. Instant recession was the result.
Big government deficits in recent years are another similarly between these two countries and the U.S.net federal debt to GDP ratio is headed for the Japanese level. Japan’s gross government debt last year was 226% of GDP, far and away the largest ratio of any G-7 country.
Japan, in reaction to chronic economic weakness, has spent gobs of money in recent years, much of it politically motivated but economically questionable, like paving river beds in rural areas and building bridges to nowhere. Is that distinctly different than the U.S. 2009 $814 billion stimulus package that was supposed to finance infrastructure projects?
A key reason for the 2009 and 2010 U.S.fiscal stimulus and continuing deficit spending in Japanis because aggressive conventional monetary ease did not revive either economy. Zero interest doesn’t help when banks don’t want to lend and creditworthy borrowers don’t want to borrow. Both central banks found themselves in classic liquidity traps, so both resorted to quantitative ease, without notable success.
So there are many similarities between financial and economic conditions in the U.S.and Japan. But there are considerable differences that make Japans experience in the last two decades questionable as a model for America.
The Japanese are stoic by nature, always looking for the worst outcome while Americans are optimistic, though not as optimistic as Brazilians, but still prone to look on the bright side. Otherwise, why would the Japanese voters stand for two decades of almost no economic growth? Japanese are comfortable with group decision making while Americans revere individual initiative, something the Japanese disdain. “The nail that sticks up will be pounded down”, is a favorite expression there. Perhaps because of this, the government bureaucracy in Japanis much stronger than in the U.S.while elected officials have less control and room for initiative.
Despite little economic growth, Japanese enjoy high living standards. And the Japanese are an extremely homogenous and racially pure population. In a related vein, immigration visas don’t exist in Japan, so there’s nothing in Japanlike the chronic shift of U.S.income to the top quintile. Nothing like the two-tier economic recovery that benefited top tier stockholders in 2009 – 2010, but left the rest struggling with collapsing prices for their homes and high unemployment.
Japanin the post World War II era has been an export led economy. “Export or die,” is the watchword. The result of robust exports and weak imports linked to anemic domestic spending is Japans perennial account surpluses, which along with earlier high saving by households and now by businesses, allow her to finance her huge government deficits internally, with foreigners owning only 5%. As a result, her government bond yields are extremely low.
In contrast, the U.S.is a chronic importer with a chronic account deficit. So foreigners have perennially bought Treasuries with the resulting dollars they earn, and they now own about 50% of them. Treasury note and bond yields are much more controlled by global forces than in Japan. The U.S.is largely an open economy but Japan’s, except for her formidable export sector, is largely closed to the outside world.
Another big difference is the chronic strength in the yen and long time weakness in the dollar, resulting in part from the difference between Japan’s chronic account surplus and America’s chronic deficit.
Nevertheless, governments have intervened in currency markets numerous times, most recently spending $13 billion in early August, to arrest the yen’s climb vs. the greenback. And, of course, a government intervening against its own currency can’t run out of ammunition since it can easily create more of its own currency to sell on the open market. Still, intervention success has been limited, short lived and expensive as even a determined government with unlimited ammo has not been able to overcome the gigantic global currency markets that trade trillions of dollars daily.
We conclude that the differences between the U.S.and Japanare too great to use the Japanese economic experience in the last two decades as a template for the U.S.in coming years.
As we’ve been discussing, near zero interest rates have distorted the financial and economic scene by pushing many investors into risky investments in foreign lands, commodities, junk securities and other investments they may come to regret. But many remain in bank CDs and money market funds for safety despite almost nonexistent returns.
Money market 7 day interest returns in August were a trivial 0.03%, and they would have been negative in many cases if fund managers had not waived their fees. And this condition will likely persist. The federal funds rate target, which rules other short term returns, has been in the 0 to 0.25% range for three years, and the Fed intends to keep it there for two more years, s they have said.
Will Americans be discouraged by low returns and save less, or will they save more to reach lifetime goals? They’ll probably do the latter which is one more reason why the saving rate may jump back to double digits. With the distrust of volatile stocks, shrinking house appreciation that was tapped earlier to fund excessive spending, and the baby boomers desperate need to save for retirement encourages saving for contingencies.
The nonpartisan Congressional Budget Office’s (CBO), new projections which incorporate the reductions in federal spending enacted in August and assume that the Bush tax cuts will expire on schedule, will result in deficits totaling $3.5 trillion over the next decade, down from the $7 trillion forecast in January. The CBO assumes that GDP growth basically catches up from the depressed rates of recent years, rising to 5.0% annual growth in 2015 before dropping back to 2.3% in 2020 and 2021.
Many observers in contrast see slower annual growth of 2.0% throughout the decade. The unemployment rate is assumed by the CBO to drop back to 5.2%, also very optimistic. Faster economic growth propels taxes and thereby restrains the deficit while also reducing the deficit to GDP and debt to GDP ratios. It’s the lower unemployment that eliminates the deficit enhancing pressure to create more jobs that concerns us.
The CBO sees 3 month Treasury bill rates rising gradually to 4.0% over the next decade and 10 year Treasury note yields to 5.3%. These low interest rates in future years will help contain interest paid to GDP ratios for the federal government and therefore also growth in the government deficits and debt.
Trade with a plan.