Sunday, November 20, 2011

Economic Commentary: Debt super committee, the Euro, and Profit Margins

Investors,

The Debt Super committee, 3 day countdown
When congress agreed to hike the debt ceiling, the legislation included a provision for a "debt super committee." This debt super committee has until November 23rd to find $1.3 trillion in budget cuts. It looks like they will fail. When that happens, lawmakers then have 13 months to pass new legislation to avoid the automatic sweeping spending cuts defined in the debt ceiling hike. It looks like the next election will be a tremendously important referendum on what spending to cut. However the spending cuts and/or tax hikes happen, the effect is deflationary and will directly reduce GDP. If our political leadership manages the process intelligently, it could restore confidence in America's long-term debt situation, but I wouldn't count on it.

The Euro
There is a growing consensus that the only way for the Eurozone to avoid coming unglued in the near future is for the European Central Bank (ECB) to monetize the debt of Italy, Portugal, Spain, and possibly even France. Germany currently opposes this. Most European banks are currently insolvent on a mark to market basis, and situation that is very similar to the US in late 2008 shortly before Lehman collapsed. If the sovereign debt of the weaker EU countries continues to sell off, investors will refuse to lend to European banks (which hold so much of this debt at 40 to 1 leverage on their balance sheets) and they will rapidly collapse. If the ECB monetizes the debt, this should be bearish the Euro. What's tricky for investors is figuring out what will happen to the value of the Euro if the region splinters. If Greece leaves the eurozone, could the euro rally? What about if Portugal left? I wish I knew.

Profit Margins
Corporate profit margins have been remarkably high for the last 3 years and show no sign of falling yet. It puzzles many investors how this can be when unemployment is so high. The answer is government spending. If government spending were constant, then as companies cut costs it would lead to a vicious cycle of lost revenues; after all, one company's costs are another company's sales. However, the government has been picking up the purchasing slack. Companies lay off their employees to reduce costs, but are able to maintain revenue by increasing sales to the US government. As soon the annual fiscal deficit starts shrinking, we'll see corporate profit margins fall.

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