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 July 2011 The Soft Patchers vs. The Double-Dippers The Economy's Weak, but How Weak is It?
June 2011 has come and gone, and looking back over the past ten months, QE2 was something of a success in all but one count. Interest rates still hover around historic lows. Even in the face of rising food and energy costs, consumer spending was remarkably resilient. Although business spending was restrained by uncertainty arising from the impending costs of Obamacare and its attendant mandates and taxes, business spending was still rather respectable. Stocks went on a nice run, hitting post-financial crisis highs in mid May. Even rising commodity prices weren't totally unexpected given that they're priced in dollars weakened by the Fed's lax monetary policy.
Unfortunately, the only element missing was improvement in the economy itself. After growing at a respectable 3.5% clip in the fourth quarter of 2010, hints started to surface early on that the first quarter would be much less robust. The housing market was still plagued by foreclosures while new home construction and sales declined from already depressed levels. Despite all the Fed's efforts, banks were still reluctant to lend while continuing to nurse along distressed debt on their balance sheets. Nevertheless, many economists were taken by surprise when the first and second estimates of 1st quarter 2011 GDP came in at 1.8%. Even the 0.1% increase in the third estimate still left it well below previous expectations. So now that QE2 has officially ended, what's next for the economy? Several key facts are fairly clear:
In light of all this, we find ourselves at an interesting juncture. The economy is apparently weaker than it appeared earlier this year however, capitalist economists are finally getting their wish: In at least the short-term, the government will finally leave the economy to its own devices. Monetary and fiscal policy should, for the most part, be sidelined.
Gloomy and Gloomier
It's not a question of being negative on the economy, it's a question of degree. Those who are simply gloomy believe the recovery experienced a weak period in Q1 and Q2 of this year. They see the recovery as being temporarily stalled by a speed bump in the road. These are the "Soft Patchers" who believe it's only a matter of time before growth resumes as the recovery regains traction. President Obama and the Fed are officially in this camp although speeches by individual Fed governors occasionally hint otherwise and even the President has indicated his concern about lingering unemployment. The gloomier market watchers see something more sinister afoot. They contend the stock market gains and all the economic optimism from late 2010 were premature. In a sense, all the perceived "improvement" was just a self-fulfilling prophecy with no real fundamentals to sustain it. This became manifest in the 1Q 2011 weak economic reports. After the 2009 pork-barrel "stimulus" bill, cash for clunkers, first-time homebuyer tax credits, and QE1 and 2, the economy is still hobbling along. Without some sort of catalyst -- not necessarily more government meddling -- another recession may be at hand. These are the "Double-Dippers" led by the so-called "bond vigilantes". Normally at this point in the economic cycle, bond investors would be heading for the hills, expecting interest rates to rise and the value of their bonds (which move in the opposite direction of interest rates) to fall. This time, however, they're fighting one another for the chance to buy 10-year Treasury notes yielding less than three percent. One doesn't have to be too old to remember when regular savings accounts offered better yields than that. But now, professional fixed income investors, the so-called "smart money", are willing to lock in three percent for the next ten years. Clearly they see a stagnant if not declining economy over the short to mid-term, and are willing to invest accordingly.
Overreaction Yes, stocks were definitely ahead of themselves when they posted May's highs. Coming off such a weak base, it was understandable they would take off when the rally commenced in 2009. But their trajectory wasn't sustainable with high unemployment, a stale housing market, and lingering non-performing debt still hanging around. At some point it needed to slow down and apparently that sometime was the first and second quarter of 2011. Now, following the late spring correction, stocks are once again closer to fair value, something that should actually excite a true investor. Some of those negative forces from 1Q and 2Q were truly self-imposed. Consumer sentiment declined because of soaring gasoline and food prices. Commodities did have a remarkable run -- one that still persists to some degree. But gold and oil weren't in short supply; instead they fell prey to a combination of speculation and the weak dollar.
Most common commodities are priced in dollars, so as the dollar loses its value relative to other currencies, prices of commodities must rise just to maintain their intrinsic value. Rising prices -- particularly skyrocketing prices -- encourage speculation which drives them even higher. The spike and subsequent blow-off in the silver market is a prime example. This wasn't an case of supply and demand but rather speculation and the weak dollar. These are attributable to speculators and politicians, not an unencumbered economy. And speaking of free economies, the ties to those that aren't also has had a negative impact in the first six months of 2011. The unrest in the Middle East not only drew attention to oil supplies but also led to an undeclared war in Libya. Just as Congress was showing signs of coming to grips with the ramifications of the burgeoning national debt, another expensive military undertaking is now underway with virtually no discussion or debate. The continuing financial crisis in the European Union also set off alarms and not surprisingly, sent foreign investors fleeing to the safety of good old U.S. Treasury securities. That increased demand had at least something to do in keeping U.S. interest rates down. Unemployment is another factor prolonged by politics. Although business has picked up since the depths of the 2008-2009 recession, many businesses -- and least those who haven't joined the thousands getting exemptions -- fear the unknown expense of Obamacare. Not only that, all the blustering about closing "corporate loopholes" and possibly raising corporate taxes (as if businesses and not individuals ultimately paid taxes) has a definite chilling effect on hiring.
Reasons for Optimism Stocks have their own bulls, too -- analysts. Yes, yes, it's true that analysts -- especially sell-side analysts -- always tend to be too bullish, but there's more to it than that. During the late second quarter stock swoon, consensus estimates for S&P 500 operating earnings (also known as earnings before interest and taxes) still forecast a rise of almost 6% in the second quarter and then an additional pick up in the final two quarters of the year (see Chart 2). Even if the estimates are discounted for "over-bullishness" the fact that they've hardly moved down while stocks were sinking can only be a positive sign. As suggested above, the stronger dollar will help contain and possibly even drive down commodity prices. Not only that, it's a lure for foreign investment here in the U.S. That's definitely needed in order to fund the enormous national debt. Any agreement on spending cuts from Washington will also be a definite (although unexpected) plus. Those cash hoards that businesses have been building will eventually make their way back into the economy through capital expansion and investment. While cash can provide a safety net on a balance sheet, businesses also need profits. Idle cash itself is not a profit source. When the clouds lift and business owners get a better sense of what new taxes await from Obamacare and the tax-and-spenders in Congress, they'll be free to look for profits rather than mere safety. That day hasn't arrived yet, but it certainly is closer than it was back in 2009. Of course there's no guarantee that all these bullish events will come to pass. But here's the good news: They all don't have to. It will only take a few to help turn consumer and investor sentiment. The Rough Patchers and Double-Dippers have lowered the collective expectations so far, even a mild improvements will generate positive reactions. That's basically what set off the rally in 2009 when things finally stopped getting worse. Now, they may be poised to actually get better, creating an even better investment opportunity. Search this site! Just enter you key word or words:
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AST AUGUST, THE FED'S QE2 (second round of quantitative easing) set sail on a voyage scheduled to pull into port at the end of June 2011. During the trip, the Fed would essentially buy every Treasury security issued by the U.S. in an effort to replace paper with cash. All of the Fed's purchases went directly into the money supply and were available for banks to lend. The increased money supply was expected to drive down interest rates, the cost of money. With funds so easily available, consumer and business spending was expected to pick up, taking the stock market and the economy along with it.
