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Second Quarter 2011

The U.S. economic recovery is now two years old, and after an uncertain first half should settle into a better level of real GDP growth, which economists now expect going forward to be at 3%. The Japanese tsunami and subsequent nuclear accident impacted the world economy by interrupting the manufacturing supply chain, notably in the automotive sector. As U.S. auto makers are now accessing needed parts from Japan, there should be a “snapback” in manufacturing in the second half. U.S. unemployment still remains persistently high however, and in fact climbed to 9.2% in June, with the private sector adding jobs while federal, state and local governments are shedding them.

The release of 30 million barrels of the U.S. strategic petroleum reserves has brought crude oil significantly off its highs of $114 per barrel, down to $98. This should provide a significant boost to the economy. The Fed’s second stimulus program “QE2” ended on June 30th without incident, which is the first stage in a very long term withdrawal of liquidity from the economy. Another round of overt quantitative easing is highly unlikely at this point, but certain Congressional measures could amount to another important liquidity injection into the economy. In May, ten Republican and Democratic Congressmen sponsored a bill which would lower, for one year, the tax rate on repatriated overseas profits from 35% to 5.25% percent. At present, there are over one trillion dollars held overseas by U.S. corporations, which, if repatriated, may boost jobs through domestic investment.

U.S. companies are doing extremely well in terms of profit growth, due to gains in productivity but at the expense of employment and wages. A recent study from Northeastern University economists indicates that almost all (88%) of gains in national income are going to corporate profits, while wages and salaries have captured only 1% of these gains. While the ethics of this may be debatable, it’s undeniably good for stocks, albeit at the cost of income inequality in the U.S., which is approaching new historic highs. The wealthiest 400 Americans now hold more wealth than the bottom 50% of the population combined, with 25% of the national income going to the top 1% of the population. As agricultural commodity inflation is likely to continue, it is worth contemplating that civil unrest and food riots have impacted nearly 30 countries worldwide since 2008. It is not inconceivable that this phenomenon could occur in the U.S. if real wages continue to decline while unemployment remains stagnant.

The preoccupying risk amongst investors at the moment is the Greek economic crisis and the U.S. budget, which must be resolved by August 2nd. A balanced budget should be worked out by this deadline, as it would not be in the interest of either political party to fall short of an agreement. Greece, on the other hand, remains an intractable problem without a solution and has significant impact globally.

There are similarities between Greece today and Argentina in 2001. Both countries, heavily in debt, experienced declining competitiveness due to wage and price inflation, and tied themselves to other currencies (the Euro for Greece, the US Dollar for Argentina). When Argentina defaulted on its debt, the Argentine Peso ended its US Dollar peg. After a period of civil unrest, Argentina’s powerful agricultural sector became its engine of growth, and with a devalued currency, Argentina enjoyed a decade of rapid expansion. Unfortunately, Greece does not have this option, because the political costs of leaving the Euro are too high.

Greece’s current situation is worse than Argentina’s in 2001. At that time, Argentina’s debt-to-GDP ratio reached 62%; Greece now stands at 143%. Argentina's budget deficit in 2001 was 6.4%, Greece is now at 10.5%. Furthermore, the Greek economy has no earning power, little industry, and is unproductive. The Greek crisis has no solution other than default. Any other measures are simply an attempt to put off the inevitable. The Greek parliament narrowly passed a five year austerity plan as a condition to a bailout package by the EU last week, and stock markets worldwide reacted optimistically. However, the Greek economy shrank by 4.5% last year. Even if Greece were exonerated of any interest payments, budget deficits are still far too high for its moribund economy. Allowing a Greek default would at least provide a measure of control over the process, and reduce any ensuing chaos. U.S. investors should know that Greece represents a risk globally because of the interconnectedness of our banking systems. In addition, a Greek default will lead to a closer examination of other fiscally troubled countries/states, be they Ireland, Portugal, Spain, New Jersey or California.

For the first half of 2011, the Dow rose 7.2%, the S&P 500 increased 5.01%, and the Nasdaq was up 4.5%.

Grant Rogers

Partner

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