Federal spending drops sharply in the US, leading to a budget surplus for June 2013



Recently, economist Scott Grannis published a post on his Calafia Beach Pundit blog entitled "Budget outlook improves dramatically."   In his post, he notes that:

especially in the last 12 months, there has been a dramatic improvement in the federal budget outlook.  Revenues have grown at double-digit rates of late, while spending has slumped.  As a result, the budget deficit has plunged, both in nominal terms and relative to GDP.  Almost two-thirds of the decline in the burden of the deficit since 2009 has come from the spending side, and that is good news since it leaves more room for the private sector -- the source of most productivity gains -- to expand.

His post contains some important charts which track the federal budget in terms of revenues (chiefly from taxes) and spending.  The charts show that while spending still exceeds receipts, the gap has narrowed significantly due to some recent spending cuts (including the government "sequester").  Other charts on his post show that federal spending has fallen as a percentage of GDP, from over 25% to 21.4%.  

The specific breakout of government spending outlays can be found in the US Treasury Department's most-recent Monthly Treasury Statement (MTS) which shows data through the end of June 2013.  The charts above, from the June MTS, show federal receipts in the top chart and federal outlays in the bottom chart.  While the outlays were generally higher than the receipts in most of the past twenty months, in June spending took a sharp turn lower and receipts took a sharp turn higher, leading to a surplus of $116.5 billion for the month.  Scott Grannis notes that the total spending for the twelve months ending this past June dropped 6% over the previous year -- "by far the biggest one-year decline in the past 43 years."

Brian Wesbury, another economist whose analysis like that of Scott Grannis we believe to be valuable, has commented on the June surplus in a recent piece entitled "Deficit?  What Deficit?"  There, he breaks down some of the components of the June spending drop (including some that are not really spending cuts but that the Treasury counts as spending cuts anyway), and notes that the overall federal budget deficit will probably drop to about 4% of GDP this year, down from over 10% in 2009.  Note that the deficit is the difference between spending and revenues -- that number is down to about 4% of GDP.  In contrast, spending by itself is a larger number than the deficit number -- that number is down to 21.4% of GDP.  It's important to keep those two different measurements straight, if you're not used to looking at these kinds of budget numbers.

We believe this development is actually very positive, and one that is not very well known by the general public or the investing community (Scott Grannis calls it the "most under-appreciated news that I am aware of today").  While there are of course aspects of the situation that could be much better, the fact that spending as a percentage of GDP has come down from over 25% in 2009 is very encouraging, since at that time it looked as though spending might continue to head towards an even higher percentage of GDP rather than coming down.  

It is also encouraging that the US economy (which drives tax revenues for the US government) has continued to grow, even if at a rate that is slower than we would like to see.  Brian Wesbury calls it a "plow-horse economy," as opposed to a race-horse economy.  At least it is still plodding forward.

In an environment in which many people are very nervous about the economy and in which positive economic news is not always widely reported in the media, we believe this development is extremely important and one of which investors should be aware.  

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Investment Climate July 2013: Have Interest Rates Bottomed?

We recently published our quarterly Investment Climate for the end of June, 2013.  It is entitled "Have Interest Rates Bottomed?"

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"A high-entropy, bull-in-the-china-shop distortion"



Here's a link to a recent article by John Tamny of Forbes entitled "All eyes are on the Federal Reserve, and that's the problem."  We believe it should be required reading for anyone who either chooses to invest in market securities or is in any way impacted by the monetary policy of the United States central bank (which is to say, just about everyone).

In the article, Mr. Tamny puts forward the thesis that "the Fed’s machinations have served as a massive barrier to a true bull market."  We agree with this assessment.

In fact, we have been saying pretty much the same thing for years.  We recommend a quick trip down memory lane to the following posts on this subject:

• "The Fed's oversteering and the wreckage of the past decade," July 23, 2009. 

• "Caution: Fed oversteering ahead," August 13, 2009.

• "Why do we want the Fed to steer the economy?"  September 01, 2010.

• "Likelihood of Fed oversteering increases," January 25, 2011.

• "The end of QE2," March 29, 2011.

Mr. Tamny's article is also important for contrasting the excessive Fed focus with what investors should be focusing on: business, and particularly successful and innovative businesses.

He writes:

Rather than judge companies on their individual merits, investors must waste valuable time playing junior Kremlinologist in order to divine the future actions of the second rate economists who populate the Federal Reserve. Investors aren’t doing this because our central bankers have any useful knowledge to impart, but because what should be a low-entropy monetary input has become a high-entropy, bull-in-the-China-shop distortion whose actions must be priced.

Far from a driver of positive economic evolution, a Fed that we all have our eyes on has become an economy-shrinking distraction that forces us to consider the macro over the all-important micro. Instead of focusing all of our attention on commercial ideas not yet hatched but that need investment, on existing companies that simply need new direction, not to mention healthy companies that would grow even larger and healthier if entrusted with more funds, investors must, in the words of George Gilder, spend inordinate amounts of time so that they can “predict the exercise of government power” over predicting which technology highflyer will become the next Apple*, or which corporation is best suited to cure cancer.

This contrast is the most important message in the article.  We believe it goes right to the core of investing, and that investors should keep this message at the forefront of their thinking at all times.

* At the time of publication, the principals of Taylor Frigon Capital Management owned securities issued by Apple (AAPL).

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Municipal bonds

 

In the classic 1988 film Bull Durham, the frustrated manager throws a staged tirade in order to turn his team around, a tirade which includes the immortal lines:

"This is a simple game.  You throw the ball.  You hit the ball.  You catch the ball."

In spite of all the mystique that for some reason surrounds the world of finance (including the numinous world of "high finance"), our opinion is that finance is a simple game as well:

"You invest capital.  You hope to get your original amount back.  You hope to get something in addition to that original amount to compensate you for your trouble and the use of your capital." 

That's it.  Not quite as eloquent as the manager of the Durham Bulls, but simple nonetheless.

If the arrangement is a loan, you hope to get back your principal plus interest.  If the arrangement involves equity in a business, you hope that the value of your equity stake grows enough to return your original investment plus some capital gains.  You may also get dividends.  If the entity asking for the capital is well-connected politically, it might be able to offer you interest that is not subject to taxation.

Other more complex capital structures might involve debt that returns your principal plus interest plus a chance to convert into equity.  There are really no limits to the way the investment can be structured -- theoretically you could craft a deal that would promise to return your principal plus one pizza a month for twenty years, if you really wanted to.

However, if you decide to enter into this business and you want to have any hope of seeing your original amount come back to you, let alone anything extra, you might want to do a little bit of analysis of the entity to whom you are giving your money.  After all, if you walk into a bank and ask them for a million dollars in financing, they won't usually just hand it over to you -- they will typically want to ask you a few questions about your income, your other debts, your credit history, etc.  Investors would be wise to do the same before they get into the business of financing.

That's why at Taylor Frigon Capital Management, when investing capital on behalf of our clients, we exercise extreme caution with regard to investment in municipal bonds.  Not only do we feel that many of them have terrible answers when it comes to their income, other debts, and credit history, but there have also been examples of municipalities being slightly less than forthright in their answers to those questions (in other words, making their answers sound better than the actual situation would suggest is the case).

Recently, the US Securities and Exchange Commission charged two borrowers with securities fraud for allegedly deceiving those considering the loan of capital to them.  Those borrowers were municipalities: Harrisburg, Pennsylvania, and South Miami, Florida.  As municipalities, they borrow money by issuing municipal bonds.  States in the US also borrow money by issuing municipal bonds (when the federal government borrows money, they issue Treasury bills, notes and bonds).

In an article entitled "The Many Ways Cities Cook their Bond Books," Steve Malanga of the Wall Street Journal explains that the SEC has previously charged states with making "material omissions" and "false statements" in their municipal bond documents, including the state of New Jersey in 2010 and the state of Illinois in March of this year.  The article explains that:

With Harrisburg, however, the SEC has gone further and charged the city government with "securities fraud for its misleading public statements when its financial condition was deteriorating and financial information available to municipal bond investors was either incomplete or outdated." The SEC says this is the first time the regulator has "charged a municipality for misleading statements made outside of its securities disclosure documents."

The article explains that such fraudulent activity in misleading potential and actual investors is nothing new in the municipal bond market.  It notes that when Stockton, California, filed for bankruptcy, the city's new financial managers found evidence that Stockton had been hiding "significant costs, including the real cost of employee compensation and retirement obligations," and that after San Bernardino, California, filed for bankruptcy, some observers alleged finding evidence that the city "had been filing inaccurate financial records for nearly 16 years."  Just read that last quotation again slowly in order to let it sink in.

All of this is related to the issue that we have called "The question of our time," which is the fact that "retirement obligations" (as in pensions for government employees) and other government benefits (including health insurance programs) have been promised far in excess of what government incomes can sustain, not just in US cities and states but in fact all over the world (Japan and Europe are two other examples recently in the news). 

Those who decide to loan money to a government entity should conduct a thorough examination of such obligations and the income that is supposed to be supporting those obligations, before committing capital.  As the article points out, however, it is always more difficult to do that when the entity asking for the loan is deliberately falsifying their books.

In the end, financing really is a very simple business.  If you intend to offer your capital to some entity, in the expectation of getting it back some day with "something extra" (whether interest payments, dividends, capital gains, or some combination), it would be wise to consider the potential for growth of that entity's incomes and financial obligations.



http://youtu.be/X0ZHQ6GWlSM?t=1m5s

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Rip Van Winkle, revisited

Here's a link to recent commentary entitled "Still Bullish," from one of the most insightful economists we know, Brian Wesbury.

In it, he proposes a mental exercise, asking readers to imagine that they had gone to sleep on October 09, 2007 (when the major US stock indexes were making record highs, but just before they began their decline towards what became one of the deepest and most gut-wrenching bear markets in history), and just woke up this week.  In this exercise, he explains, our modern-day Rip Van Winkle would have slept through 67 and 1/2 months, nearly six years.  

He then asks readers whether, knowing where equities are today and where they were at that time, they would have chosen to buy equities or not before this long nap.  If the answer had been "buy," then even though the economy suffered a violent recession and the markets were ravaged in the interim, Rip would have awakened this week to find the Dow Jones Industrial Average 8.4% higher than when he started his nap back in October of 2007. 

We believe investors should carefully consider the implications of Mr. Wesbury's article, and the data he provides to support his arguments.  In fact, we used the very same Rip Van Winkle analogy in two blog posts in the past, both of which are worth revisiting today:

• "If Rip Van Winkle took a one-year nap before September 14, 2008," published on September 14, 2009.
• "Rip Van Winkle, 2010," published on October 11, 2010.

In those articles, we pointed out that this analogy is helpful, but only to a point.  We obviously do not advocate simply ignoring one's investments under the mistaken belief that things "always turn out for the best."  Many who have not read Washington Irving's actual tale do not realize that his Rip Van Winkle was not exactly a sympathetic character, but instead was one described as having an "insuperable aversion to all kinds of labor," and one who would rather "starve on a penny than work for a pound."

We also don't advocate the idea that investors are best served if they just "own the market" rather than spending energy evaluating individual companies to find superior destinations for investment capital.  While Rip would have been better off had he bought all the companies in the S&P 500 before his nap than if he had left that money in cash, he would have been even better off if he had been able to buy the shares of a smaller number of truly exceptional companies instead.  Note that in the "nap interval" selected by Mr. Wesbury, the thirty-name Dow Jones Industrial Average outperformed the 500-name S&P index by a fairly wide margin.

However, the main point of the Rip Van Winkle exercise is to highlight the fact that for the vast majority of investors, investing in equities must be a long-term decision, appropriate for assets that one can afford to leave invested for many years.  When that is the case, then investors can afford to take the longer view, and avoid over-reacting and potentially causing self-inflicted wounds during the intervening period.  Like the hypothetical investments of Rip Van Winkle in the illustration of Mr. Wesbury or in our blog posts above, the markets can go through all kinds of gyrations in the intervening years, but none of that matters if your investments are worth more in the long run than they would have been worth had you made a different choice.

This is a very important point to keep in mind during times of turmoil.

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