The Economy Is Too Weak To Reduce QE
In our view the markets have gone too far in pricing in an autumn reduction of the amount of the Fed’s bond-buying program. Investors are assuming that the economy is growing at an accelerated pace, and therefore jumped on Bernanke’s response at a press conference that the Fed could begin lessening the rate of buying in the next few months. The result was a drop in stocks and a sudden significant rise in bond yields. We note, however, an extremely relevant caveat, namely, that the Fed Chairman stated that such a reduction would take place only if the economy improved in a “real and sustained way.” The problem is the strong likelihood that it is not going to happen since economic growth, rather than accelerating, is, at best, slogging along at a 2% growth rate, and, at worst, something less.
The rate of inflation has also been coming down, yet another reason not to tighten too soon. The Fed’s favorite inflation indicator, the PCE deflator, has gone up only 1.1% from a year earlier. Furthermore, we think that Bernanke did not have in mind a quick 50-basis point rise in bond rates that would wreak havoc on the economy, and may do something to rectify that at next week’s press conference following the regularly-scheduled FOMC meeting. That would be in keeping with the Fed’s past history of recalibrating its statements when they have resulted in unintended consequences.
The problem is that stocks will not be helped by any hints that the Fed will not pull back on its purchase program as soon as investors believe. Not only does the domestic economy remain soft, but the global economy continues to slow down as well. The World Bank has now followed the IMF in reducing its estimate for global growth. Japan’s easy money policy as well as China’s falling imports has hit the economies of emerging market nations. It sees a deeper than expected recession in Europe and a slowdown in some emerging markets. Industrial commodity prices have been declining and a large number of emerging nation stock markets have taken nasty tumbles. In addition emerging nation’s currencies have started to weaken, and, ominously, a couple of them have already taken steps to tighten monetary policy.
As for the U.S., the so-called economic acceleration that is supposedly taking place is far from evident in the numbers. Although the payroll employment number for May was higher than expected, it was still well below the average of the prior six months. In addition, both average weekly earnings and hours worked were flat, a negative sign for income growth in the period ahead. Corporate hiring plans still remain weak.
Similarly, the perceived strength in consumer spending is also a case of wishful thinking. The latest monthly report shows declines in consumer spending of 0.2% and disposable income of 0.1% along with a savings rate of only 2.5%. Combined with the lack of growth in disposable income, wages, hours worked and hiring, the outlook for consumer spending remains tepid at best. Also adding to the economic malaise is the lowest reading in the ISM manufacturing index since June 2009 and weakness in the majority regional of ISM and Fed regions.
All in all, we think that economic growth will remain too sluggish for the Fed to cut its bond buying program as early as investors believe. However, we think that rather than reigniting the upward trend in the market, the focus of investors will shift to the weak economy and the disappointing earnings that are likely in the second half. The guidance being issued by an unusually large number of corporations already points in that direction. In our view there is a good chance that the market high for the year has already been made.
The Stock Market Is Topping Out
6/06/13 7:30 PM
The recent return of high volatility to the stock market, bond market and currencies suggest the end of the rally that started in November and probably to the upsurge since the March 2009 bottom. As we stated in last week’s comment the market now appears to be entering a lose-lose situation where economic growth is bad since it forces the Fed to “taper’ its bond buying program, a move that investors, as they have most emphatically demonstrated this week, do not like one bit. On the other hand, if the economy continues its tepid pace (or worse), as we think it will, employment won’t meet the Fed’s goals and earnings will take a dive. In the latter case, the Fed would likely delay tapering of its bond-buying program and investors will interpret bad news on the economy for what it is----bad news.
In comments over the last two months we have shown how various important sectors of the economy have either been slowing down or failing to meet expectations, a condition that has indicated no signs of reversing. The four-week moving average of new weekly unemployment claims has moved from 338,000 to 353,000 over the past month. The ADP employment report for May came in far under expectations, and has averaged 124,000 over the last two months compared to 203,000 over the prior five. The majority of Fed regional surveys have showed weaker hiring in May than in April. The National Federation of Independent Businesses (NFIB) recently reported reduced hiring in May.
The ISM manufacturing index of 49 for May was the lowest since June 2009, when the recovery was only getting underway. That number was even worse than it looked since new orders plunged 3.5 points while inventories rose. The ISM non-manufacturing index for May was down from a year earlier, and has not recorded a monthly increase since December. Moreover, its employment index component dropped from 52 to 50.1, its fourth consecutive decline. Consumer expenditures for April declined 0.2% and disposable income 0.1%. Compared to a year-earlier, real consumer spending is up a paltry 2.1% and real disposable income only 1%. Even then, consumers were able to maintain this inadequate rate of spending only by reducing their savings rate to 2.5%. Notably, the savings rate was under 3% in each of the first four months of the year, whereas prior to this year the rate had not been under 3% for any month since December 2007, the peak of the economic cycle.
Real GDP has increased only 1.8% over the last four reported quarters, within a range that has been in force since the first quarter of 2010. The current quarter is shaping up as no better. Manufacturing production has declined for the last two months and three of the last four. Even vehicle sales, which recovered strongly from the recession bottom, have now flattened out for the last six months. The Chicago Fed national activity index, which covers a broad swath of the economy, showed deterioration in growth in April, and has been negative in three of last four months.
Although there is a lot of talk about a stronger economic recovery, the facts, as outlined above, indicate otherwise. Furthermore, the effects of the sequester, which started very slowly, are starting to become more evident in slowing wage growth and reduced hours. The original estimates of a 1.5% drag in GDP growth from the tax increase and sequester still appear to be valid and will likely be felt in the 2nd and 3rd quarters. We therefore think that the overly optimistic earnings forecasts for the rest of year will be highly disappointing. Although 1st quarter earnings slightly beat the consensus, revenues were flat, and corporations will find it exceedingly difficult to increase earnings with no help from revenues, which are likely to remain under pressure.In addition, global growth is slowing with much of Europe in recession, China coming in short of expectations and emerging markets weakening. We have continually pointed out that following a huge buildup of consumer debt it would be difficult to generate a normal recovery in either the U.S. or the rest of the world, and there is little that governments can do other than to choose between undergoing a major crisis or to endure prolonged sluggish growth. Four years after the recession bottom, we see no reason to change this view.
The Fed Is Now In A Lose-Lose Situation
5/30/13 7:00 PM
The sharp and sudden rise in long-term interest rates in response to the perception that the Fed will taper down its bond-buying program is coming close to placing the stock market in a lose-lose situation. If you believe, as we do, that economic growth will remain tepid at best and that the Fed, therefore, will not slow down its purchasing program anytime soon, S&P 500 earnings will fall far short of the big second-half increases that the “Street” is forecasting. If, on the other hand, you think that organic economic growth will be strong enough to enable the Fed to reduce its purchases, long-term rates will climb by enough to stop the economy in its tracks and result in the same negative outlook.
The bullish case for the market rests on continuing massive easing by the Fed, supposedly reasonable valuation for stocks, big increases in second half earnings and a more rapidly growing economy. The result has been a market that is overbought and overvalued.
While history indicates that Fed monetary policy is an important factor in the market, it is not everything. The market declined substantially in 2001 and 2002 despite major monetary easing, and the same happened in 2008. In a period such as now where excessive household debt is holding back consumer spending, the economy has been unable to sustain any traction despite massive easing over the last few years.
The Fed will keep its current level of bond purchases going indefinitely only if the economy continues to look anemic. In that case, second half earnings will be highly disappointing. Bernanke continues to believe that Japan tightened too soon in the previous decade and that the Fed tightened too soon in 1937, causing another recession. He has constantly made it clear that he would rather err on the side of staying easy too long than in tightening at a point he considers premature.
On the other hand, if we are wrong about our tepid outlook for the economy, and it grows fast enough for the Fed to taper off its bond-buying program, we have only to look at the rapid rise in long-term rates over the past week, when even a hint of slowing down the purchase program caused a 50 basis point rise in rates and a drop in stocks. It seems almost a no-brainer that an actual tapering of the bond-buying program would send rates soaring. In that case, an economy that has become overly dependent on low interest rates and abundant liquidity would be stopped in its tracks, and the market would likely undergo a substantial decline.
In our view the Fed has stretched the rubber band as far as it can go in the face of major fiscal restraint, and is facing the dilemma that whatever it does from this point, it cannot save the economy or the stock market. That is why economists and strategists, after Bernanke’s congressional testimony, have been complaining about the seeming fuzziness of the Fed’s goals and its perceived lack of transparency. The Fed simply cannot tell investors what it is going to do and when because it just doesn’t know. Overall, it’s not a situation that is conducive to continuing strength in the market, and we therefore reiterate our view that it will all end badly.
A Shot Across The Bow
5/23/13 7:00 PM
Wednesday’s market action revealed more about the overbought and overvalued status of the market itself than it did of the perceived reasons for the downturn, as the underlying monetary and economic fundamentals did not change anywhere near enough to justify such a reaction.
Briefly, the Dow jumped 155 points on release of Bernanke’s statement that eased market fears by stating that premature tightening of monetary policy would be undesirable. So far, so good. Shortly thereafter, however, in answer to a question by Committee Chairman Brady asking when QE could be expected to taper off, Bernanke stated “We could, in the next few meetings….take a step down in our pace of purchases.” The market immediately turned around and started downward. Within a short time the Dow was down 122 points from the previous day’s close, a total swing of 277 points.
A few hours later the Fed’s minutes of the last board meeting was released and re-emphasized the fear by stating that “A number of participants expressed willingness to adjust the flow of purchases downward as early as the June meeting.” The result was that the market ended up recording a so-called “key reversal day”, meaning a day in which the market makes a high that is significantly higher than the previous day’s high, only to close at point substantially below the previous day’s low. This is usually a sign of an important trend reversal, a signal further emphasized by the fact that Wednesday’s highs and lows exceeded the highs and lows of each of the prior three days.
The 7.3% decline of the Japanese market the following night was a separate event. Despite knowing about the monetary events in the U.S., the Japanese market opened higher, only to be shocked by the release of China’s Purchasing Managers Index, which came in at a recessionary 49.6, abruptly ending a powerful run that began with the Japanese central bank’s announcement of a massive easing program. The Chinese data also helped extend the downtrend in industrial commodities that are so important to many of the world’s economies.
We regard the action of the U.S. market as a “shot across the bow” that indicates a significant change in the trend of the market rather than a change in Fed policy The Fed did not change policy, but was basically restating its prior stance. Strategists and economists get paid to parse all the Fed’s words to pick up any minor change and put it under a magnifying glass where it seems much larger than it actually is. In the name of transparency, they also expect the Fed to tell exactly what it is going to do and when. But the fact is that the Fed doesn’t know what it’s going to do at any future point. No matter what words the Fed uses, they always follow and react to the data.
In our view it is best to go back to Bernanke’s written statement indicating the undesirability of a premature tightening of monetary policy. That is what he and his allies on the committee believe, and it is they who are the majority. They may well consider a reversal of the current policy at future meetings, as Bernanke stated, but that is dependent on their confidence that the economy has indeed turned around and can sustain growth on its own without further monetary help.
In our view, however, the economy is showing distinct signs of softening as we discussed in our most recent comments, and the Fed may have to continue its QE program at current levels for a longer time than many think. The irony is that the pending market downturn may be a result of a weakening economy and declining earnings estimates rather than the cessation of QE. All in all, the market rally will end badly, and sooner rather than later.
Why We Remain Bearish
5/16/13 6:30 PM
It has long been our underlying thesis that the huge amount of household debt accumulated during the housing boom would inhibit consumer spending and economic growth for some time to come, and this is what has been happening over the last few years. The errors recently found in the famous Rogoff-Reinhart (RR) book do not change this view.
Simply put, household debt averaged 77% of disposable personal income (DPI) over the 61-year period since 1952. It crossed over the average line in 1985 and took a sharp upward turn in 2000, eventually peaking at 130% of DPI in 2007. Since that time, consumers have reduced their debt to a level that is now 105% of DPI, still significantly higher than in the past. The result has been a significant slowdown and tepid recovery in consumer spending growth, a process that is far from finished.
The role of household savings is a key element in analyzing both debt and spending. For 41 years between 1951 and 1992 household savings rates as a percent of disposable income were consistently between 7% and 11%. However, as income growth started to slow down, consumers increasingly maintained their old spending habits by going into more debt and reducing their savings rate. This reached an extreme during the prior decade, when the savings rate stayed below 2% from 2005 through 2007, while debt soared. We all know how that ended.
No matter what you hear from the politicians, the media and “the street”, keep in mind that the combination of the household debt, low savings rates and tepid increases in income has been the reason for the deep recession and subsequent below average growth, and will continue to be the reason why economic growth will likely be slow for some time to come.
In the last two years, between the 1st quarter of 2011 and the first quarter of 2013, real consumer spending has increased by a meager 3.8%----and this was accomplished on an increase of only 1.1% in real disposable income as households reduced their saving rate from 5.1% to 2.6%. It therefore should not have been a surprise that spending looked so weak in March, and it should be no surprise when spending remains subdued in the period ahead. With consumer spending accounting for about 70% of GDP, it is easy to see why this puts a damper on the rest of the economy, particularly in a time of fiscal drag. The Fed is undoubtedly well aware of the outlook as they continue their attempt to try and offset, at least in part, the major headwinds elsewhere in the economy.
None of the above analysis depends on the Rogoff-Reinhart (RR) research, some of which was recently found to be erroneous. First, RR emphasizes mostly government rather than consumer debt. Second, they maintain that when the government debt-to-GDP ratio crosses 90%, economic growth slows down. The idea that there was some specific threshold of government debt-to-GDP that led to slower growth was probably not valid in the first place. In any event, we think that for the near-to-intermediate term, it is the still-high level of household debt that is the key drag on the economy.
As we headed into the spring there was evidence that the already lackluster economy was slowing down even further. Although the payroll employment report for April touched off a euphoric rise in stocks, the headline belied the underlying trend. While that was a positive surprise over the expected rise of 140,000 jobs, the reported increase of 165,000 for the month was nothing to write home about. It was well below the 1st quarter average of 206,000 per month as well as the 4th quarter average of 209,000. If anything, it looks as if employment increases are decelerating, certainly not a reason for celebration.
In addition to the mediocre employment report there was a lot of other evidence that an already lackluster economy was slowing down further as we headed into the spring. The ISM manufacturing index fell for two consecutive months to its lowest level since December. The ISM non-manufacturing index also declined for two straight months and is now below its 1st quarter average. April vehicle sales slipped to under 15 million units for the first time since October. First quarter GDP grew at a disappointing 2.5% following only 0.3% in the prior quarter. Average GDP growth for the last four quarters has averaged only 1.8%. Real consumer spending has increased only 2% over the past year, and this was accomplished on an exceedingly weak 0.9% rise in real disposable income over the period. Only a sharp drop in the savings rate enabled consumers to reach even that disappointing level.
Furthermore, March core capital goods orders were up only 0.2% following a 4.8% decline in February. The year-over-year gain was 0.3%. The NAHB housing market index for May increased for the first time in four months and remains below the December/January peak. April housing starts dropped to the lowest level since November. Although the NFIB Small Business Index rose in April, it is only five points above its lowest level for the past year and two points lower than a year earlier. The index remains lower than at any point prior to 2008. Manufacturing production has declined for the last two months and three of the last four. The Philadelphia Fed survey fell to minus 5.2, its lowest since February, and showed negative results for new orders, shipments and employment. All in all, despite the optimistic views of the economic pundits, the facts show otherwise.
As for foreign economies, the IMF once again reduced its 2013 global and EU growth forecasts and China reported disappointing results for 1st quarter GDP and exports. This has resulted in a significant drop in commodity prices that is having adverse effects on a number of commodity-oriented emerging and advanced economies.
Although the Fed, so far, has been able to lift stock prices, it has failed to elevate the economy to a point where growth is self-sustaining despite over four years of extremely easy monetary policy. The headwinds from fiscal policy will actually intensify in the months ahead while Washington shows few signs of alleviating the dysfunction that has plagued Congress for the last few years.
It is also noteworthy that the market is losing the important boost it has received from rapidly rising earnings. Over the last four quarters earnings are up only 0.4% from the four prior quarters. Given sluggish U.S. and global economic growth, we think that current estimates of 22% second half earnings growth are highly unrealistic. Furthermore, the S&P 500 is now selling at 20 times cyclically-smoothed trailing GAAP earnings, at the very high end of the zone that was considered normal prior to the serial bubbles of the last decade and a half.
All in all, we believe that economic growth and corporate earnings will be highly disappointing in coming quarters and that investors will drop the pretense that the Fed can fix everything that ails the economy. Although Bernanke, himself, has been virtually begging for help from fiscal policy, it does not seem likely that he will get it anytime soon. In our view, the risk of a substantial decline in the market outweighs the limited rewards from current levels.
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