"Potential Problems for 2011 - Fiscal Woes at States & Rising Commodity Prices"

Sydney M. Williams

Thought of the Day

“Potential Problems for 2011 – Fiscal Woes at States and Rising Commodity Prices”

December 28, 2010

Bruce Hackett, one of my (several) bosses when I worked on Salomon’s equity trading desk in the 1980s, was fond of saying, when confronted with a problem, “my mother never said it would be easy.” Neither did mine, but neither did she warn of the sudden turns and persistent twists investors must undergo as they consider myriad options, pitfalls and opportunities.

There are always reasons to be concerned about markets and, typically, the greater the degree of confidence, the greater the reason to worry. Among those worries are two that keep me awake. The first is the agonizing position in which the states find themselves and the second is the fear of stagflation.

Simply put, the states’ problem, like that facing Washington, is one of largesse – of generously promising more than can be reasonably delivered. Above average returns to financial markets for the two decades ending in 2000 caused actuaries making return assumptions to be far too bullish – to assume that the good times would continue to roll. The four-year rally in the mid 2000s, ending in the fall of 2007, presented a temporary reprieve. The subsequent crash of 2008-2009 only highlighted the problem. There has become, for state pension administrators and politicians, no place to hide.

Steven Malanga, senior fellow at the Manhattan Institute, addressed this problem in the Christmas Eve edition of the Wall Street Journal. He wrote of trickery and quick-fixes that have just fed the spending habit, serving to kick the proverbial can down the road. Arizona has sold its state government buildings, to itself, as no real buyer stepped forward, but allowing them to skirt a provision in their constitution that limits state borrowing. New York State’s comptroller has described their budget as a “fiscal shell game.” Michigan has decreased the amount of money sitting in unclaimed bank accounts from fifteen years to three – thereby providing a one-time boost to its general fund of $200 million. In 2004, Governor Schwarzenegger promised the citizens they could get out of the hole through borrowed money; $10.9 billion in deficit bonds were issued and the state increased spending by a third over the next four years, putting them near bankruptcy today.

All state regulators and politicians should be required to take a remedial course in the morals expressed in Aesop’s Fables. Rereading stories like “The Ant and the Grasshopper” and “The Hare and the Tortoise” would teach them the commonsensical lessons children used to learn by the age of ten. While Governors such as Mitch Daniels of Indiana and Chris Christie of New Jersey appear to have done their homework, one can only conclude that most of the rest, in growing the workforces of their states and promising the world in terms of pensions, were doing nothing more than practicing the ancient art of buying votes.

The possibility of stagflation is my other worry. Washington and the Federal Reserve seem determined to press the message that it is deflation, not inflation, we have to fear. It underlines the determination of the Fed to keep rates low and for Congress and the President to pump money into the economy by increasing federal spending. What it doesn’t explain is that a combination of low interest rates (driving speculation) and increased demand from developing nations have driven commodity prices dramatically higher. The CBOE Index is up 16.3% since September 30. During the same period, oil is up 14.1%, copper up 17.3% and silver up 34.0%. Soft commodities have also been on the rise. Wheat, in the fourth quarter is up 15.4% while corn and soybeans are both up 24.2%. The core rate of inflation as measured in CPI may not rise much, but people cannot live without the essentials. To believe that these commodity price increases will not be reflected in retail food and energy prices next year is to believe the New Hampshire apple farmer who insisted that he was only making one percent on a bushel of apples, which he sold for $2.00 and cost him $1.00.

Stagflation assumes anemic economic growth combined with rising prices. Despite record retail sales this season, with unemployment continuing to hover just under 10% it is hard to imagine that our economy will witness the sort of robust growth typically associated with an economy rebounding from deep recession. Unfortunately, persistent unemployment, which may only become worse because of needed rationalization at the states, will keep labor prices low. Rising commodity prices, and an inability to pass along costs, may also have the residual effect of acting as a “decelerant” on corporate earnings in 2011. The result could be a scenario similar to our experience during the 1970s – a stagnant economy with rising prices.