Donald Fry: Market expert tells a pre-Halloween scary story

By Donald C. Fry

It’s not quite Halloween yet, but Hugh Warns III, senior vice president and director of research for Stifel Nicolaus, has a scary story for anyone who asks where our economy could be going in the next year.

His story goes like this. In the summer of 1937 the U.S. economy was recovering under President Franklin Roosevelt during the final years of the Great Depression. It had gained back most of the 78 percent decline that began in February 1931. “The market had battled all the way back from down 25 percent (in 1936) to just about parity,” Warns says.

Then, two things happened in August 1937. First, Congress raised taxes dramatically. Second, Congress embraced protectionism by raising tariffs on imported goods. “The market fell 40 percent in the subsequent three months,” Warns says.

Where is the U.S. economy now? The stock market is still 20 percent down from its November 2007 all-time high and we’re still hurting. But the market is trending up and has recovered almost all of the 58-percent decline that began in September 2008 – the most precipitous period of decline to the bottom of the current recession.

And what’s potentially looming in Congress today? Tax increases and protectionism.

Tax cuts enacted during the Bush administration are expiring at the end of the year. Also, Congress is making a protectionist move in the form of the Currency Reform for Fair Trade Act. Under the legislation, which has passed the House, the Commerce Department would decide if China has undervalued its currency. Then it could impose tariffs on Chinese goods entering the U.S. “They’ll bump the price of your VCRs by 40 percent,” cautions Warns.

Sound familiar? Then he shows you a chart.

It tracks Dow Jones performance for May 1936 to November 1937 and overlays it with the current market performance track from July 1, 2009 to October 19, 2010. It mimics “almost perfectly” the track leading to the precipice of the 40-percent stock-market decline that occurred between August 1 and November 1, 1937.

“Scary chart,” Warns says.

Yes it is. Admittedly, this chart represents a worst-case scenario in terms of an economic outlook. And Warns himself terms the prospects for a similar double dip in 2010 and 2011 “frightening, but totally avoidable.”

Nevertheless, the chart serves to illustrate what 100 mutual fund and hedge fund CEOs recently told Citigroup when asked what their biggest fear is for the economy. The answer: government – specifically a government policy mistake.

“Investors feared a government policy mistake far more than inflation, terrorism, housing double dip, poor earnings, or any other risks to the economy,” Warns told 350 business executives who attended the Greater Baltimore Committee’s annual Economic Outlook Conference this week.

At that conference, both Warns and Kevin McCreadie, president and chief investment officer of PNC Capital Advisors, noted that the stock market’s rebound from Dow Jones 6,626 in March 2009 and a recent increase in consumer confidence are heartening. But they tempered the good news with some serious cautionary observations.

“People are starting to feel more confident because of the fact the some indicators are returning to pre-crisis levels,” McCreadie said. But holding on to those gains “is going to be difficult,” he added.

Following are some of the issues and challenges cited by Warns and McCreadie that will impact economic growth in the nation and Maryland:

• Business and consumer debt. After an “unbelievable” increase in consumer debt in the first seven years of this decade, debt burden has begun to decrease and savings have rebounded from under 2 percent to 6 percent, said McCreadie. McCreadie and Warns agreed that there is slack demand for loans on both the commercial and the consumer side. The mantra is that “they’re not lending,” but current demand for loans in the four major classes – commercial/industrial, commercial real estate, residential mortgage, and consumer loans – is flat. “It’s not a supply problem. It’s a demand problem,” Warns said. “We’ve got to get off the banks’ back a little bit and give them a chance to recover.”

• Government deficits. Huge deficits being piled up at the national, state and local levels are a major challenge. For example, U.S. federal government debt is 3.5 times the government’s annual revenue – a higher ratio than any European country, even Greece, and more than twice the debt ratios of the United Kingdom, Spain, France or Germany. Also, entitlement programs “are truly at a tipping point” in the next five years and have to be dealt with, said Warns. At the state and local levels, under-funded retirement and retiree health plans present major challenges.

• Employment. While the stock market has rebounded, employment gains remain sluggish, something that experts predict will continue in 2011. Between 130,000 and 150,000 jobs are projected to be created in the next year, said McCreadie, but that is not a pace that will reduce the nation’s unemployment much.

Nationally, many employers are holding off major hiring until they see what government policies develop after the election. Unemployment “is deeper in terms of the number of people laid off, and it is stuck.” Maryland employment and its economy could perform better than most states in 2011 because of the impact of BRAC jobs statewide and cyber security jobs created at Ft. Meade.

• Small business. Small businesses generate between 60 and 70 percent of job growth in the U.S., said McCreadie. But small business owners “are not feeling very good” these days. The biggest issues currently affecting small business are poor sales, taxes, and government regulations and red tape.

Adding to these challenges, animosity toward the business community is at an all-time high, said Warns. He cited “a pretty significant adversarial relationship” emerging between Washington and the business community throughout the U.S.

This gets us back to the topic of government, where one thing is abundantly clear. The relationship between government and business is a key determining factor when it comes to our nation’s economics.

An adversarial relationship with business does not serve government well in either the short run or the long run. A healthy economic environment is one where government and business achieve a healthy balance of interests. And, in a nation or state where the economy and way of life is driven by free enterprise, there are few policy issues that do not impact the business environment one way or the other.

Considering the current health of our economy, it’s imperative that all of the winners at all levels in the upcoming election remember that.

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