Sep 13, 2010

Investing During a Recession: The Real Impact of the Next Round of Stimulus

By Andrew Mickey, Q1 Publishing

A Japan-style lost decade is imminent.

Last week the financial world learned the current administration’s economic “plan.”

Although stocks rose for the week and bonds showed their first weakness in a long time, the current round of “don’t-call-it-a-stimulus” spending and tax breaks are going to have consequences – bad ones.

As we enter the debate for the third stimulus package in as many years (don’t forget about the $152 billion stimulus form February 2008), there are a lot of details to pay attention too.

This one is going to have a little more politically-friendly packaging, but it’s actually signaling a Japan-style lost decade has already started in the United States. And investors who fail to notice will pay a heavy price. Here’s why.

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Stimulus Spending:

The next economic stimulus package is poised to be just as effective as the last ones.

This one, however, has been packaged up a bit differently. It has a lot more tax cuts. A greater percentage of it is devoted towards infrastructure spending. And there are no promises (i.e. “unemployment will not above 8.5% with this”).

Despite its ineffectiveness though, it will have some consequences.

Here’s a breakdown of the three pillars of it, why they’re likely to fail, and the real consequences.

$50 Billion Infrastructure Investment

Japan provides the perfect example of what increased infrastructure spending will achieve. The country spent more than $6 trillion on various infrastructure projects between 1991 and 2008. All it got was twenty years of economic malaise.

But from an investor’s perspective, we don’t have to look too far to see what any increased infrastructure spending will mean for infrastructure stocks.

Infrastructure stocks were some of the top-performing sectors of the late-2008 “Obama Rally.”

The $60 billion allocated to infrastructure had many investors believing strong growth would surely follow.

At the time, we warned they couldn’t have been more wrong:

I have absolutely no confidence this run in infrastructure stocks can last. In fact, I expect it to end abruptly in the coming weeks and months once reality sets in.

You see, the herd is once again acting irrational…

When you break the numbers down, you can really see how little benefit the publicly traded construction companies will get from the stimulus package. If 90% of $60 billion in infrastructure spending goes to private companies (90% of construction companies are private), only $6 billion worth of contracts will be available to the publicly-traded ones.

That’s not going to amount to much when there are 20 bidders for every project and the heavy construction industry’s net profit of about 4.5% gets squeezed even more.

It didn’t make any sense at all. But that didn’t stop the “buy infrastructure stocks” crowd because it all made sense on an emotional level.

As usual, investors who wanted to go with the crowd paid the price.

For example, Sterling Construction (NASDAQ:STRL) is a company we looked at the time. It is “heavy civil construction company that specializes in the building, reconstruction, and repair of transportation and water infrastructure.”

How well do you think a company that is a veritable pure-play on government infrastructure spending did after $60 billion was earmarked for infrastructure?

Well, shares are down more nearly 40% while the S&P 500 is up 25%.

There’s no reason to expect $50 billion is going to make much of a difference this time either.

Research & Development Tax Credit

The White House estimates the tax credit for R&D spending will increase private sector investment by $200 billion.

The purpose is to help jumpstart the U.S. economy and rescue the U.S. manufacturing base.

It will fail to do either one.

First, managers at big business aren’t thinking, “If we just had a few extra dollars we could do this, this, and this.”

Companies are currently sitting on $3 trillion according to Bloomberg. They’re flush with cash. A tax break encouraged to get them to move future projects up to today is not likely to change that.

As for rescuing U.S. manufacturers, it won’t make a difference either. If for no other reason than the U.S. manufacturing sector does not need rescuing.

Economist Mark J. Perry points out in Manufacturing Death Greatly Exaggerated:

As much as we hear about the “demise of U.S. manufacturing,” how we are a country that “doesn’t produce anything anymore,” and how we have “outsourced our production to China,” the U.S. manufacturing sector is alive and well.

His statement is based on facts.

For example, manufacturing employment levels are held out as a sign of a deteriorating manufacturing economy. More than 19 million people worked in manufacturing in the mid-1970s. Now less than 12 million people do today.

A 37% decline must be pretty bad, right?

In this case, it’s not. The decline has been more than offset by productivity. The average productivity per worker has increased from less than $80,000 per worker to more than $234,000 per worker today (in inflation-adjusted 2000 constant dollars).

Think about it like this. The U.S. makes airplanes and nuclear reactors and China makes steel and iPhones.

Although certainly a bit over-stereotypical, it does provide proof the U.S. manufacturing is alive and well. The “declining” manufacturing sector has actually grown 84% in real terms over the past 35 years.

Simply put, the manufacturing base doesn’t need rescued.

Tax Cut Extension

It increasingly looks like the Bush-era tax cuts are going to be extended.

The tax cuts for the highest earners will likely be phased out (via some political comprise where both sides can say “look, we won”), but some type of extension for the majority of consumers is a near-certainty.

Don’t get me wrong, it’s good. Any time people have more of their earnings to save, invest, pay down debt or spend, it’s always good.

The positive effects, however, will likely be muted according to a very old economic phenomenon known as the Ricardo-Barro Effect.

Investopedia describes the Ricardo-Barro Effect as:

Under the Ricardo-Barro theory, the government is likely to increase taxes in the future in order to repay the money being borrowed to finance a current budget deficit. As a result, households and firms will increase their current level of savings in order to afford to pay higher taxes in the future.

Under Ricardo-Barro Theory any advantages of the extra spending now would be completely negated (Side note: Ricardo and Barro are two great economists – you never hear about them because their research does not support big government spending).

Tax cuts are great for the economy, but they won’t be too helpful without spending cuts.

Economic Window Dressing

In the end, the entire “don’t-call-it-a-stimulus” stimulus package will prove to be marginally effective - if at all.

The U.S. economy is $14 trillion in size and it contains an estimated $50 trillion of accumulated wealth. A few hundred billion dollars borrowed and spent are not going to make much of a difference.

Right now, the U.S. consumer is trying to pay down debt. The government is borrowing and spending as much as it can to offset the decline in debt.

This combination inevitably leads to a long period of sluggish economic growth. Avoid the hype and hope and invest accordingly.

Good investing,

 

Andrew Mickey
Chief Investment Strategist, Q1 Publishing

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