Goldman Sachs hedging its bets: Is more economic pain on the way?

Investment bankers – can’t live with ‘em, and can’t live without ‘em.

At least that's how it seems in these tough economic times. We tend to hang on their every word, as if they truly know how big money intends to manipulate financial markets in the foreseeable future. But we also tend to blame these financial powerhouses for creating the worst recession since the Great Depression.

Goldman Sachs, Morgan Stanley and JP Morgan are the evil villains in this plodding screenplay, but, as the world suffers, these guys keep running to the bank with enormous bonuses with rarely any visible intention of correcting prior wrongdoings. They refuse to accept any fault for continually maneuvering the system to their monetary advantage. They do it because they can. They are the center of the global capital formation industry, where money and greed drive the engines of commerce.

As much as we may despise the reality of the present situation, we also respect these financial titans whenever they opine on the potential of future events, especially when they project valuations for stocks, commodities and currencies. When they speak, we listen intently. Up until now, Goldman, the leader of the pack, has been very upbeat on its forecasts for the stock market in 2013, suggesting a stellar second half of the year after the fiscal shenanigans in Washington have run their course.

Analysts at the firm have steadfastly predicted a 1,575 value for the S&P 500 index by the end of 2013. The index presently sits just above 1,500. But, this week Goldman published a graph, which a Washington Post headline described as scary. The chart depicts federal consumption and investment spending over the past 50 years. There are two major dips during the period, followed by a dire prediction over the next three years.

Alec Phillips, a Goldman Sachs economist, wrote, “We lowered our outlook for federal spending, to take into account the increased likelihood that cuts under sequestration take effect. With that built into their baseline, the cuts to federal consumption and investment look deep in the coming years. Sequestration, spending caps, and reduced war spending will together reduce real federal consumption and gross investment by 11 percent over the next two years.”

An 11 percent drop is material by anyone’s standards. The two previous drops followed the end of the Vietnam War in the late 1960s and the end of the Cold War in the early '90s. As these cuts were taking place, the economy was rebounding on both occasions, enough to sustain any significant withdrawal of stimulus from the government sector. Now that the Afghanistan and Iraq wars have almost concluded, sequestration budget cuts will decrease military spending automatically while our economy is still struggling to recover.

Previous federal spending cuts have been back-loaded during the latter half of the following budget decade in order to allow time for the economy to gain steam. The analyst at Goldman is only recognizing that the current situation is decidedly different than the last two dips. The chart also does not take into account the expiration of payroll tax cuts and the rise in tax rates for the wealthy, changes that some predict will add additional drags on economic growth.

Are we putting too much faith in the forecasting ability of Goldman analysts? They do reverse positions from time to time. While maintaining their 2013 projection for the S&P 500 index at 1,575, they had originally stood by a 1,250 forecast for 2012. The index ended the year at 1,426, a 14% error. Goldman also recently shocked gold investors by predicting a $1,200 price per ounce for the precious metal by 2018. It currently sits at $1,667, and a survey of analysts see modest gains in store for the next two years. Goldman is an admitted outlier in these estimates, as well.

While grandiose predictions may eventually garner future bragging rights if you are correct, we do live in an era of globalization. We must be mindful of what officials are doing in other parts of the world and how their actions might impact us down the road. Austerity measures in Europe and other regions have not corrected the current economic conundrum – how do you generate real, sustainable GDP growth under current conditions?

More central bankers are beginning to accept the U.S. approach of weakening the national currency to stimulate exports and domestic growth in the process. Mario Draghi, the European equivalent of Ben Bernanke, noted this reasoning in his comments today. The Euro plunged as a result. The Bank of Japan has recently pursued a path of qualitative easing in concert with the new Abe administration. The Yen has weakened 18 percent versus the greenback in just the past three months. Currency wars appear to be forming on the horizon. Someone, however, has to be the importer of last resort.

Favorable economic data, although modest, suggest that a gradual recovery is still in progress. The deficit shrank in December, and trade data is improving. But the CBO recently noted, “According to CBO’s projections, if all of that fiscal tightening occurs, real (inflation-adjusted) gross domestic product (GDP) will drop by 0.5 percent in 2013, reflecting a decline in the first half of the year and renewed growth at a modest pace later in the year.”

Another disconcerting statistic is that nearly $1 trillion flowed out of equities during the month of January. Do billionaires and hedge fund managers know something that the rest of us do not? President Obama knows that he is not out of the economic woods yet, the reason for his moving to slow down the impacts of sequestered budget cuts. Hopefully, Republicans are reading from the same playbook and will move in a similar fashion. Otherwise, we may all be in store for more economic pain in the near term. Lean Forward!

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