Lack of Governance

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The inability of the American government to a pass a budget bill exemplifies how inefficient and dysfunctional their system of government truly is. And it is unfortunate for us as Canadian’s to sit by and passively watch the demise of our greatest trading partner. Responses to American’s going over this “fiscal cliff” have been twofold. One side, including the views of some analysts and rating agencies are claiming that a nose dive over the cliff leading to 600 billion dollars’ worth of automatic spending cuts and complemented with tax increases for all earners will send the US immediately into recession. Extreme estimates are for GDP to contract by as much as four percent. The other side of the coin views the cliff as over-hyped, for a potential deal to smooth spending cuts and avoid tax increases to a struggling middle class is still possible for early in 2013. Further to this, an entitled president will have the ability to put forth a budget with limited opposition from a defeated Republican congress.

So, despite the warnings from Fitch, Moody’s, and Standard and Poor’s of the imminent danger of plunging over a metaphorical cliff, the real question regarding the American’s approach to putting forth a budget deal and attempting to address how to finance the future liabilities of major entitlement programs like health care and Social Security is, should the impasse of the American government really come as that big of a surprise?

The answer is no.

We do not even have to delve that far back in time to see that a lot of these budget deals or bills involving government financing do not actually occur until the 11th hour. It was as recently as August of 2011 that the Budget Control Act was drawn up to increase the US debt ceiling. And it was August the 2nd, the exact day that non-partisan Congressional Budget Office had earlier estimated the US’s would reach its borrowing limit, that the bill was passed. It is unfortunate that with only the pressure of time there is accomplishment; however, the word accomplishment is over ambitious as America’s solutions to their fiscal problems leave much to be desired.

Debt has been the ongoing issue for a number of years, and unless we are in crises people seem oblivious to the reality of it. It was as recent as October that the IMF, Bank of International Settlements, and the Congressional Budget Office in the US warned of the increasing present value of America’s future liabilities.

Back to budget debates, initially there was a common misconception involving America’s debt ceiling that it was a debate over the size of government. Simply put though, the money had already been spent. The debt limit needed to be increased in order to avoid defaulting on payments already issued by their government. This was not a debate for bigger government; in reality, it was already that big. Same too with what is expected to come to fruition with America’s entitlement programs. Medicare, Medicaid, and Social Security are increasing financial burdens. They were designed to provide support in correspondence with the levels they are currently contributed too.

That is why the American system of government is broken and remains broken. They are unable to decide upon how to finance their country, and in what direction they want to lead it. Until they do, the allocation to real assets like, gold, real estate, or other tangible assets are the only thing that provides protection against the pall of debt casted over the global market place.

Economic Reality is a Drag on Market Optimism

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Stock markets seem to be carrying a false sense of optimism that economic growth is stronger than it actually is. The economic data, however, tells a story that is quite contrary. The US saw 146,000 jobs created in the month of November and Bureau of Labor Statistics claimed that Super storm Sandy had little to no impact. The Canadian economy added a sizeable 59,000 positions in the previous month, and the majority of the gains were full time employment from the private sector, but those numbers are somewhat misleading. The fact of the matter is the numbers that count were actually quite weak. Stock markets have nothing to be optimistic about, and the labor market is just the first place to look for evidence.

To begin with the US, modest estimates are for 90 to 125 thousand jobs to be added on a monthly basis just to keep up with the growth of the labor market. So when, in fact, the US adds 146 thousand, it raises the question around how the unemployment rate really was able to tick down 0.2 percentage points. What gives? For starters, the labor force participation rate is tracking its lowest levels since September of 1981. The number of discourage and underemployed workers will stay at all-time highs until we start to see a change from the US private sector.

The only changes we currently see from the US private sector is preparing for the end of the golden age of tax rates. Quite simply, Americans have been in a fantasy tax land since the Clinton administration of the 1990’s. And the further income tax breaks put in place by George Bush and continued through Barack Obama’s first term have kept them there. The imminent threat that taxes on capital gains and dividends will soon be going up has a number of corporations paying out special dividends allowing investors to take advantage of this year’s current rate.

Despite also being in a golden age of access to credit markets, the US private sector opts to sit idle and await fiscal policy from a non-constructive system of government. As the fiscal cliff attempts to become the most overhyped story in the media, an appeasing solution really presents itself as quite simple: cut entitlements, increase marginal tax rates on higher earners, and allow congress to increase the debt ceiling to continue to pay its bills. Inevitably, we know all three will happen, but not without opposition from the extremes.

To move north, Canada’s job numbers, although looking strong in aggregate, were not indicative of a growing economy. The majority of the gains in the month fell into service sector jobs, and not with the manufacturing and construction sectors, which tend to move in tandem with a strengthening economy. Thus, economic data leads much to be desired and gives a sense that the equity markets seem to be over anticipating what’s to come.

Instead of addressing what to expect as we go into the New Year, I think a more prevalent question is how will the markets finish off 2012, and on what terms will 2013 begin. Markets need more than false sense optimism as a reason to rally. In the US, the economic recovery has dragged on since June of 2009. It’s apparent from the economic data that this recovery is nothing more than mediocre. And as long as it stays this way, the financial markets will be a very uneventful place.