Will The Tea Party Congress Bring Recovery?

by John Browne, Senior Market Strategist at Euro Pacific Capital

While the markets have known for almost three months that the 2010 election delivered the House of Representatives to the tea-infused Republican Party, I did expect a greater reaction on Wall Street to the formalities of the opening sessions of Congress yesterday.

If the Republicans make good on their campaign promises, we will see cuts in government spending and an end to fiscal stimulus. Given that short-term stock market performance is very much dependent on such government assistance, the current rally is hard to fathom. Meanwhile, gold and silver have experienced a counterintuitive correction (although to be honest, pundits are making much more of this 4% pullback than the size of the move merits). Could it be that the markets now believe that fiscal restraint in Washington is the best pathway to growth? Can a leopard really change his spots?

Not likely, I say. Rather, I believe that we are simply seeing some short-term momentum. Speculators tend to buy and sell on momentum, while investors tend to accumulate on dips and sell on fundamental changes.  Anyone with a pragmatic view of Washington must realize that real change is unlikely.

Most new Republican representatives are well-meaning and genuinely wish to honor their election pledges of reducing the massive government spending and regulations that are strangling the US economy. If they hold enthusiastically to their good intentions, austerity likely will hit America as the natural counteraction to the massive and irresponsible asset booms of the late ’90s to mid-aughts. The question is whether these Republicans will stick to the guns when voters feel the pinch. My feeling is that they are more likely to seek political cover.

Given that many European countries opted for austerity in 2010, it is instructive to gauge the current political situation across the Atlantic as a preview of what may confront Washington.

Throughout Europe, strikes and riots have paralyzed major cities. Several major EU member-states, such as Belgium, Italy and France, appear increasingly likely to follow Greece and Ireland into requiring bailouts. Already the Swiss central bank has announced that it will not accept the bonds of Ireland or Greece, now rated as ‘junk,’ as collateral, even for repurchase financing.

Greater and greater pressure is being placed on Germany to bail out the insolvent states. As they do so, it will become more likely that German politicians will abandon their own domestic austerity plans.

In modern politics, it is apparent that the more senior politicians become, the less they appear to exhibit courage and integrity. In England, Prime Ministers Winston Churchill and Margaret Thatcher were notable exceptions. I served under the latter. It was greatly disillusioning to witness how she was ultimately brought down by a majority of her own senior lieutenants at the first sign of political trouble.

As in many areas of human endeavor, including war and commerce, new blood provides enthusiasm, but rarely sets policy. As the new Republican representatives fill the airwaves with strong statements demanding meaningful cuts in government spending and regulation, their leaders are already showing signs of wilting.

I have met Speaker John Boehner and like him. However, his statement of January 5th that he would urge “adult” behavior by his party filled me with misgiving. America needs the enthusiasm of youth, not the caution of the old, in revolutionizing the role of its government. As proof of this point, Representative Paul Ryan, the new House budget chief, admitted on day one that the promised cuts of a paltry $100 billion could now be “substantially less” than $50 billion, or less that 1/3 of one percent of the $14 trillion Treasury debt.

The acid test will be whether Republicans muster the courage required to freeze the Treasury debt limit. Should they fail to hold the line, a green light will be given to the inflationists, and a cut in America’s vital AAA credit rating may be forthcoming.

Should the dollar and the euro move nearer to collapse in tandem, an international financial and economic meltdown will threaten. The resulting devastation of consumer confidence will encourage US and EU politicians to panic and hyper-inflate. At that point, could China, with $2.5 trillion of cash, bailout the economies of America and the EU, valued at a combined $30 trillion?

For now, few are focused on this endgame scenario. The dollar remains relatively firm on the foreign exchange and precious metal prices have fallen back marginally. Long-term investors should use the opportunity to prepare for the long haul.

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