David Rosenberg of Gluskin-Sheff weighs in on what is becoming one of the big, rumbling sub-crises… the state government mess.
(Note that munis are down again today, despite the up day in just about everything else)
Here’s Rosenberg’s note:
“We believe the public sector business will continue to be challenging for at least several quarters,” said Cisco’s CEO John Chambers on a conference call on November 10, 2010.
What is remarkable is how nonchalant the investment community has been to Cisco’s disappointing results and what Mr. Chambers had to say last week. The prevailing view is that the miss was a one-time event and only limited to Cisco. Wrong and wrong.
State and local governments in the U.S. are in a state of disarray and the need to cut spending to close massive fiscal gaps are simply acute. As a result, companies that sell into this part of the economy — the lower levels of government represent 13% of the economy, which is the largest contributor outside of the consumer and double the relative share of capital spending — are extremely vulnerable to cutbacks in sales and squeezed order books. And, it is hardly likely that this problem is limited to Cisco, which proved to be a key bellwether at turning points in the market in both 2000 and 2007.
The fiscal mess at the state and local level will very likely be the front page story in 2011 and the retrenchment in this sector poses the greatest headwind regarding the economic outlook. Chicago, where I am today giving speeches and meeting prospects, has a $20 billion unfunded pension liability. Yesterday’s front page of the WSJ ran with States Offer Washington Lesson in Belt Tightening. The state of Illinois is just behind California in terms of fiscal recklessness — the state just borrowed $4 billion in order to meet a payment to its pension fund (the fund in recent months has been selling assets and the state legislature is now contemplating income tax hikes). Read the article, it’s not just Christie in New Jersey that has taken a knife to sacred cows but so has Mitch Daniels in Indiana who also issued an executive order that terminated collective bargaining rights for civil servants. Spending was sliced and taxes were raised to close the fiscal gaps, and guess what? Governor Daniels has a huge 68% approval rating right now. Tim Pawlenty in Minnesota has also found creative ways to cut costs — though in part offloading the restraint to the cities.
In other words, there is hope. It seems hardly likely that the federal government would guarantee banking sector liabilities and then not backstop the state and local governments because a default in this space is unfathomable — especially from a political standpoint when you consider who owns tax-exempt muni bonds (ahem — the voters). If Europe can find a way to stave off defaults in the periphery, believe me, the same holds true in the case of states and municipalities over here. As an aside, the reason why the EU has to bail out these basket case Club Med countries — there is little choice despite the moral hazard involved — is because the region’s banks have massive exposures. In sum, European banks hold more than $650 billion of Irish bonds alone! So the market here in the U.S. is very likely pricing in default risks, which are risks indeed but will likely not turn into reality. So, the trade here is a barbell between muni bonds at their current attractive yields and a short position on companies whose sales are exposed to the retrenching state and local government sector.
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