Economic Commentary
Daniel Laufenberg, Ph.D.

Numerous economic data series are released between the publication dates of the Laufenberg Economic Quarterly (LEQ). These commentaries are designed to provide insight on the more recent data and their implications for the economic outlook.


Searching for the next debt crisis
(January 13, 2011)

The word "crisis" is overused. It seems that every problem, question or concern instantly become a crisis once the media picks up on it. The European debt "crisis" and the municipal debt “crisis” are the most recent examples. Of course, a few analysts and prognosticators have reputations for anticipating bad news, in large part because they are always predicting bad news. And when they are right less than 10% of the time, they look like heroes. Investors seem to forget or ignore the fact that they were wrong 90% of the time. This attitude by investors is understandable given their bias against downside risk. That being said, when greed drives investment decisions, very few heed the warnings of excess when delivered. But when fear drives investment decisions, very few hear the message of opportunity. Generally, investors want all of the upside, but none of the downside. Most investors are neither that that good nor that lucky.

Sovereign debt crisis

So what are the market implications of the European sovereign debt crisis? I contend that sovereign risk, although worth noting, will not derail the global expansion at the moment. It is too soon for another credit bubble. There still is too much fear among investors for excesses to become problematic for the economy.

Moreover, there are several major differences between today’s European concern and the last sovereign debt crisis of 1997. The prior crisis was in Southeast Asia, led by Thailand, Indonesia, and South Korea. The tipping point for these countries came when they were financing their budget deficits with short-term debt denominated in a currency other than their own. In particular, these Asian countries relied on foreign investors, who would only accept short-term obligations denominated in U.S. dollars. There were two problems with this development—the debt had to be rolled over frequently and the borrowing country needed U.S. dollars to service the debt. As such, default concerns emerged frequently with every roll=over of debt. The cost of servicing the debt rose requiring more dollars, which the Asian countries found more difficult to acquire.

Clearly, European countries have not reached such a point, and as long as the European Union remains intact, they never get there. Just because the European countries share the same currency, does not mean they should share the same credit rating. After all, the various states in the U.S. share the same currency, but not the same credit ratings and as such do not borrow at the same rates.

Nevertheless, investors must not ignore the situation and they should appreciate the tough decisions that must be made to rectify it. If any government refuses to make those decisions, then it most likely will get exactly what it deserves.

People everywhere must heed a basic principle of economics--you cannot have your cake and eat it too (opportunity costs)! Unfortunately, people often forget or ignore this tenet by assuming (or hoping) that someone will provide them with another cake--free. That brings us to another version of the same principle of economics--there is no such thing as a free cake (paraphrasing a bit).

Municipal debt crisis1

The municipal bond market has been advertised as another crisis in waiting. Although concerns had been circulating for several months, it wasn’t until mid-December that municipal debt moved to center stage. On Sunday, December 19, the television program 60 minutes led off with a segment on state and local budgetary issues and the impending credit crisis and payment default on a large portion of the municipal market. Clearly, there is a need for state and local governments to aggressively address both near-term and long-term structural imbalances. However, to suggest that state and local governments will default in the coming year on hundreds of billions of dollars of debt is, in my opinion, irresponsible. State and local governments have a history of addressing and solving financial distressed situations and virtually all States have some statutes providing for local government distress. Unlike a corporation, it is very difficult to liquidate a municipality. Moreover, if a municipality does file bankruptcy, it makes future issuance of debt extremely expensive, if not impossible.

One important difference between municipal debt and corporate debt is the timing of the adverse effect of recessions on revenue. In particular, this adverse effect tends to hit corporate revenue sooner than municipal tax revenue. For the most part, corporate revenue bottomed in 2009, while state and local tax revenue probably hit bottom in 2010. As the economy continues to expand, jobs will increase. More jobs mean even more income growth, which helps boost income tax revenue. Additionally, more jobs also mean the formation of more households and in turn increased demand for housing. Recent reports have indicated that state tax revenues have increased over the last three consecutive quarters continuing the reversal of a downward trend. State tax collections also increased nationwide in the third quarter however, revenues remain significantly below peak levels and are still weak in a number of states. Remember, state and local government finances historically lag the national recovery and this time is no different.

I agree that pressures on state and local government revenues have been severe and that they will continue to be so, particularly as federal support in the stimulus and jobs bills role off. Also, Stonebridge Capital Advisors anticipate continued high profile negative articles in the news regarding the painful cuts being made and the consequences for services and staffing levels. They would expect the rating agencies to increase downgrading of state and local credits as budgets remain under pressure. However, in the end, bankruptcy filings at the state and local level should be extremely limited. According to the most recent studies available, the ten year cumulative default rates for all municipals, including high yield, are 0.09% (Moody’s) and 0.58% (Fitch).

Municipal bond funds have reported over $14 billion of investor redemptions since mid-November, following almost two years of extraordinary inflows into municipal bond funds. Inflows totaled $69 billion in 2009 and $32 billion during the first ten months of 2010. However, other factors also may have added to the collapse of municipal bond prices recently, including the rise in Treasury bond yields, unusually heavy issuance of new municipal bond obligations, the expiration of the Build America Bond program, and the downgrade by Standard & Poor’s of tobacco bonds.

The bottom line is that investors must not ignore the budget problems that governments face, but they also must not throw the baby out with the bath water. Governments at all levels must make some very tough budget and tax decisions. The key is to recognize those governments who have avoided major problems or those governments who are taking the necessary steps to rectify their situation. The debt of these governments may represent an investment opportunity.


1This section relies heavily on analysis provided by Stonebridge Capital Advisors.


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For the current economic forecast, as well as other analysis and commentary, please visit the Stonebridge Capital Advisors website.

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The views expressed here reflect the views of Daniel Laufenberg as of the date referenced. These views may change as economic fundamentals and market conditions change. This commentary is provided as a general source of information only and is not intended to provide investment advice for individual investor circumstances. Past performance does not guarantee future results.

2011 Commentary

Living in interesting times
-- September 8, 2011

A not so pleasant surprise!
-- September 2, 2011

-- August 16, 2011

Debt ceiling politics
-- July 25, 2011

Q2 growth: Another disappointment likely
-- July 14, 2011

Interpreting the ISM manufacturing index and the employment situation report for May
-- June 4, 2011

A slower start to 2011 than anticipated earlier
-- April 14, 2011

Is the dollar's status as the reserve currency at risk?
-- March 21, 2011

More trouble in the Middle East
-- February 26, 2011

Searching for the next debt crisis
-- January 13, 2011

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