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Stocks fell on Friday as continuing economic reports reinforce that the U.S. economy is growing at a slower pace.
While I was away Stanley Druckenmiller, a very successful and legendary hedge fund manager, wrote an Op-Ed piece in the Wall Street Journal suggesting that a short duration technical default on our debt, which might result if Congress failed to raise the debt ceiling, might prove constructive if it shook Congress into action to develop a serious program to rein in our debt and deficits. The article was highly controversial. Needless to say, quite a few conservative investors rallied around the notion on the thesis that a serious spark that ignited action to reduce future deficits would more than overcome any short term damage created by a default that lasted less than a week. Remember, we are in May, one of those vacuum periods where there is little information. When those periods occur each quarter, the risk that analysts and commentators will take some relatively naïve thesis and go overboard with it is heightened.
So let me make it simple. We aren’t talking about horseshoes here. There is no such thing as a little default or a technical default. You either default on your debt, meaning you no longer make timely payment of principal and interest, or you don’t. There is no in-between. Once the notion of default is activated, no one can assure investors anywhere that the default will be fixed in a matter of hours or days. Even if you could give such assurances, what happens the next time?
If the U.S. defaulted on its debt, there would almost certainly be an immediate and sharp reaction in the bond and currency markets. Look as what Greece has to pay to borrow. Sure, we aren’t Greece but, so far, Greece is paying its interest and principal.
Many pretty smart guys, from Treasury Secretary Geithner to JPMorganChase CEO Jaime Dimon have properly noted that default would be a disaster and they aren’t prepared to take the chance. So what are the options available for Secretary Geithner if Congress simply refuses to raise the debt ceiling?
Actually, he has plenty of options. Right now government spending is roughly 24% of GDP. It should be closer to 18-21% but that’s a topic for another day. Revenues are running close to 15% of GDP. The 9% gap is the deficit. If Congress refuses to raise the debt ceiling, quite simply it means Treasury would have to cut spending down to 15% of GDP effective immediately. Ron Paul and Michelle Bachmann would love that! But even they might not love the way Geithner would have to get there in the short run. Obviously, he would have to make very drastic short term spending cuts. Checks to soldiers would be cut or deferred. That isn’t likely to sit well with many folks. The same would be true for Social Security. Elected officials know that seniors tend to vote. Medicare payments would also be cut back severely. Remember, we are talking 9% of GDP. That’s hundreds of billions of dollars in cuts literally overnight.
In the 2008-2009 recession, GDP fell by a little over 4% in real terms annualized. If the debt ceiling weren’t raised and Geithner had to make the type of cuts I mentioned, the hit to GDP before counting any multiplier effect, would be twice as severe if we presume Congress simply can’t agree to raise the debt ceiling. If the cuts only lasted a few days, the impact wouldn’t be all that substantial. But Congress moves slowly. If the cuts lasted a few weeks or a month, the pain would hit pretty fast.
The bond market seems to understand this. Clearly, with the price of Treasuries up substantially over the past month, few seriously expect the U.S. to default over the near term. If there was even a 5% chance, rates would be rising, not falling. The decline in rates may reflect the current deceleration in economic growth but it also may include a small chance that Mr. Geithner will have to take draconian steps to avoid default. An economy that slips back into recession would almost certainly lead to lower rates.
In the end, I think it is highly likely that all sides will find an acceptable temporary compromise simply because the alternatives are too severe. Are the Tea Party favorites in Congress willing to set the country back into severe recession or withhold soldiers’ pay simply to press a point? They might say so on the Sunday talk shows but I doubt they can cobble together anything approaching a majority to back up the rhetoric. The most likely outcome is that the administration will accept a few billion dollars in additional short term spending cuts together with a semi-nebulous agreement to cut the budget by some very big multi-trillion number over the next decade. Rest assured such an agreement won’t have teeth and will only leader to more conversation, not action. Until proven otherwise, this is a Congress that only acts after a crisis, not before.
Let me now switch gears and talk about Gap Stores. This was a legendary growth company but has fallen upon difficult times in recent years. Too many Gap stores and not enough new pizzazz. Last week, Gap reported quarterly earnings pretty close to target but its shares got pounded after it issued rather sobering guidance. Everything suddenly seems headed in the wrong direction. Sales appear to be decelerating just as commodity costs are rising. Although commodity prices have been rising for months, the impact on many companies has been deferred by hedging and the time lag between raw material price increases and the time it takes for that commodity (e.g. cotton) to work its way through into cost of goods sold. I don’t have any direct interest Gap but my rhetoric question is whether Gap is the canary in the coal mine?
Some will answer no. Gap’s problems are Gap’s alone, a case of chronic mismanagement. But big problems don’t surface all at once. The weak feel the pain first before it spreads throughout the system. Corporate America has feasted for years on squeezing more and more sales out of fewer employees, cutting inventories to the bone, and deferring expenses. There isn’t any fat left. In fact, in some cases, deferred development expenses are beginning to evidence themselves. Look at Hewlett-Packard which deferred innovation for years and now is paying the price.
As sales per store slow, or even fall as in Gap’s case, profit per store gets squeezed. Margins compress. Now at in high component costs (a fancy way to say higher prices for cotton goods) that can’t be passed on and you get a double whammy; less sales and decreasing profit margins. The impact on profits is quick and nasty as Gap suggested last week.
If you read my letters regularly, you know that I don’t see any sign for of really vibrant sales growth for some time. Yes, there may be some recovery from the current softness caused by one time factors like the Japanese earthquake, spiking gasoline prices and lousy weather, but robust sales need robust employment growth and that isn’t happening any time soon. Furthermore, without another round of quantitative easing, don’t look for the impact to GDP that was felt last year in front of QE2.
Gap’s pain may not spread everywhere. Better run companies can mitigate the damage. Companies that do a lot of business in growth areas overseas or have sexy new products, will weather the storm. But I suspect that Gap won’t prove to be an isolated case. The only question unanswered is how far the disease of margin compression spreads. The longer commodity prices stay elevated and sales remain depressed, the farther the pain will be felt.
Gap is the canary in the coal mine. Pay attention.
Today Jewel is 37. Joan Collins turns 78.
James M. Meyer, CFA 610-260-2220
www.TowersBridgeAdvisors.com
Additional information is available upon request.
# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.
Additional information on companies in this report is available on request. This report is not a complete analysis of every material fact representing company, industry or security mentioned herein. This firm or its officers, stockholders, employees and clients, in the normal course of business, may have or acquire a position including options, if any, in the securities mentioned. This communication shall not be deemed to constitute an offer, or solicitation on our part with respect to the sale or purchase of any securities. The information above has been obtained from sources believed reliable, but is not necessarily complete and is not guaranteed. This report is prepared for general information only. It does not have regard to the specific investment objectives, financial situation or the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized. Opinions are subject to change without notice.
Fed Watch
Market Commentary by James M. Meyer, CFA – May 23, 2011
Stocks fell on Friday as continuing economic reports reinforce that the U.S. economy is growing at a slower pace.
While I was away Stanley Druckenmiller, a very successful and legendary hedge fund manager, wrote an Op-Ed piece in the Wall Street Journal suggesting that a short duration technical default on our debt, which might result if Congress failed to raise the debt ceiling, might prove constructive if it shook Congress into action to develop a serious program to rein in our debt and deficits. The article was highly controversial. Needless to say, quite a few conservative investors rallied around the notion on the thesis that a serious spark that ignited action to reduce future deficits would more than overcome any short term damage created by a default that lasted less than a week. Remember, we are in May, one of those vacuum periods where there is little information. When those periods occur each quarter, the risk that analysts and commentators will take some relatively naïve thesis and go overboard with it is heightened.
So let me make it simple. We aren’t talking about horseshoes here. There is no such thing as a little default or a technical default. You either default on your debt, meaning you no longer make timely payment of principal and interest, or you don’t. There is no in-between. Once the notion of default is activated, no one can assure investors anywhere that the default will be fixed in a matter of hours or days. Even if you could give such assurances, what happens the next time?
If the U.S. defaulted on its debt, there would almost certainly be an immediate and sharp reaction in the bond and currency markets. Look as what Greece has to pay to borrow. Sure, we aren’t Greece but, so far, Greece is paying its interest and principal.
Many pretty smart guys, from Treasury Secretary Geithner to JPMorganChase CEO Jaime Dimon have properly noted that default would be a disaster and they aren’t prepared to take the chance. So what are the options available for Secretary Geithner if Congress simply refuses to raise the debt ceiling?
Actually, he has plenty of options. Right now government spending is roughly 24% of GDP. It should be closer to 18-21% but that’s a topic for another day. Revenues are running close to 15% of GDP. The 9% gap is the deficit. If Congress refuses to raise the debt ceiling, quite simply it means Treasury would have to cut spending down to 15% of GDP effective immediately. Ron Paul and Michelle Bachmann would love that! But even they might not love the way Geithner would have to get there in the short run. Obviously, he would have to make very drastic short term spending cuts. Checks to soldiers would be cut or deferred. That isn’t likely to sit well with many folks. The same would be true for Social Security. Elected officials know that seniors tend to vote. Medicare payments would also be cut back severely. Remember, we are talking 9% of GDP. That’s hundreds of billions of dollars in cuts literally overnight.
In the 2008-2009 recession, GDP fell by a little over 4% in real terms annualized. If the debt ceiling weren’t raised and Geithner had to make the type of cuts I mentioned, the hit to GDP before counting any multiplier effect, would be twice as severe if we presume Congress simply can’t agree to raise the debt ceiling. If the cuts only lasted a few days, the impact wouldn’t be all that substantial. But Congress moves slowly. If the cuts lasted a few weeks or a month, the pain would hit pretty fast.
The bond market seems to understand this. Clearly, with the price of Treasuries up substantially over the past month, few seriously expect the U.S. to default over the near term. If there was even a 5% chance, rates would be rising, not falling. The decline in rates may reflect the current deceleration in economic growth but it also may include a small chance that Mr. Geithner will have to take draconian steps to avoid default. An economy that slips back into recession would almost certainly lead to lower rates.
In the end, I think it is highly likely that all sides will find an acceptable temporary compromise simply because the alternatives are too severe. Are the Tea Party favorites in Congress willing to set the country back into severe recession or withhold soldiers’ pay simply to press a point? They might say so on the Sunday talk shows but I doubt they can cobble together anything approaching a majority to back up the rhetoric. The most likely outcome is that the administration will accept a few billion dollars in additional short term spending cuts together with a semi-nebulous agreement to cut the budget by some very big multi-trillion number over the next decade. Rest assured such an agreement won’t have teeth and will only leader to more conversation, not action. Until proven otherwise, this is a Congress that only acts after a crisis, not before.
Let me now switch gears and talk about Gap Stores. This was a legendary growth company but has fallen upon difficult times in recent years. Too many Gap stores and not enough new pizzazz. Last week, Gap reported quarterly earnings pretty close to target but its shares got pounded after it issued rather sobering guidance. Everything suddenly seems headed in the wrong direction. Sales appear to be decelerating just as commodity costs are rising. Although commodity prices have been rising for months, the impact on many companies has been deferred by hedging and the time lag between raw material price increases and the time it takes for that commodity (e.g. cotton) to work its way through into cost of goods sold. I don’t have any direct interest Gap but my rhetoric question is whether Gap is the canary in the coal mine?
Some will answer no. Gap’s problems are Gap’s alone, a case of chronic mismanagement. But big problems don’t surface all at once. The weak feel the pain first before it spreads throughout the system. Corporate America has feasted for years on squeezing more and more sales out of fewer employees, cutting inventories to the bone, and deferring expenses. There isn’t any fat left. In fact, in some cases, deferred development expenses are beginning to evidence themselves. Look at Hewlett-Packard which deferred innovation for years and now is paying the price.
As sales per store slow, or even fall as in Gap’s case, profit per store gets squeezed. Margins compress. Now at in high component costs (a fancy way to say higher prices for cotton goods) that can’t be passed on and you get a double whammy; less sales and decreasing profit margins. The impact on profits is quick and nasty as Gap suggested last week.
If you read my letters regularly, you know that I don’t see any sign for of really vibrant sales growth for some time. Yes, there may be some recovery from the current softness caused by one time factors like the Japanese earthquake, spiking gasoline prices and lousy weather, but robust sales need robust employment growth and that isn’t happening any time soon. Furthermore, without another round of quantitative easing, don’t look for the impact to GDP that was felt last year in front of QE2.
Gap’s pain may not spread everywhere. Better run companies can mitigate the damage. Companies that do a lot of business in growth areas overseas or have sexy new products, will weather the storm. But I suspect that Gap won’t prove to be an isolated case. The only question unanswered is how far the disease of margin compression spreads. The longer commodity prices stay elevated and sales remain depressed, the farther the pain will be felt.
Gap is the canary in the coal mine. Pay attention.
Today Jewel is 37. Joan Collins turns 78.
James M. Meyer, CFA 610-260-2220
www.TowersBridgeAdvisors.com
Additional information is available upon request.
# – This security is owned by the author of this report or accounts under his management at Tower Bridge Advisors.
Additional information on companies in this report is available on request. This report is not a complete analysis of every material fact representing company, industry or security mentioned herein. This firm or its officers, stockholders, employees and clients, in the normal course of business, may have or acquire a position including options, if any, in the securities mentioned. This communication shall not be deemed to constitute an offer, or solicitation on our part with respect to the sale or purchase of any securities. The information above has been obtained from sources believed reliable, but is not necessarily complete and is not guaranteed. This report is prepared for general information only. It does not have regard to the specific investment objectives, financial situation or the particular needs of any specific person who may receive this report. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed in this report and should understand that statements regarding future prospects may not be realized. Opinions are subject to change without notice.
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