Thursday, July 30, 2009

Is Wall Street optimism over reaching rational expectations?

PIMCO's Bill Gross argues that median GDP and capital stock returns have been based on 5% PA whereas the government policy efforts to re-inflate the economy have hidden costs and restraints that will reduce median GDP and capital stock returns to 3% PA. This means a new period of sluggish growth and high unemployment where people will have less disposable income.

I have argued in the past that we risk a period of prolonged sluggish growth with high levels of public debt that become a permanent drag on the US economy. The major ideological battle of the new Obama administration is over ultimate control of the US economy between government and the private sector. President Obama is committed to government control as the superior solution. I believe that these policies will result in a poorer country than Americans have been accustomed in the past with lower competitiveness in global markets.

The stimulus plan is based largely on government programs. Efforts to promote 'Cap and Trade' policies and universal Health Care represent the transfer of an increasing share of the US economy to the US government. Already a large share of the banking industry and the US auto industry has been transferred to the government. The FED has a vastly expanded balance sheet.

All these programs are rife with hidden costs and restraints. Further the expansion of US sovereign debt has been substantial. There are rising risks in currency devaluation and higher interest rate exposure. Little has been done to address the problems of over-leveraging . There is no additional resources to assist the underlying goods and services economy.

As Mr. Gross puts it:

"Investment conclusions? A 3% nominal GDP “new normal” means lower profit growth, permanently higher unemployment, capped consumer spending growth rates and an increasing involvement of the government sector, which substantially changes the character of the American capitalistic model. High risk bonds, commercial real estate, and even lower quality municipal bonds may suffer more than cyclical defaults if not government supported. Stock P/Es will rest at lower historical norms, and higher stock prices will ultimately depend on tangible earnings growth in the form of increased dividends, not green shoots hope. An investor should remember that a journey to 3% nominal GDP means default/haircuts for assets on the upper end of the risk spectrum, as well as extremely low yielding returns for government and government-guaranteed assets at the bottom end.

A corollary of this is that the US financial sector is far larger than warranted and needs considerable downsizing.

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