Comstock Partners, Inc.June 02, 2011
It's The Recovery That's Temporary----The Pause Is Real
Although the economic slowdown we've been discussing in recent comments has now hit the headlines the stock market has resisted a major downturn. Fundamentally, strategists have offered two reasons for this reluctance. First, they maintain that the pause in economic growth is only temporary and second, they say that if the economy continues to falter the Fed will simply initiate yet another round of quantitative easing----QE3. We think this seemingly consensus view will prove to be wrong on both counts. In our view it's the economic recovery that is temporary while the deceleration of growth is real. As for another round of quantitative easing, Bernanke himself has indicated that the hurdles are very high and a number of other members of the FOMC sound as if they would be even more opposed.
There are a number of reasons to believe that the economic recovery itself has been temporary. The economy has been highly reliant on government stimulation, both fiscal and monetary. Not only is the fiscal stimulation now petering out, but as the acrimonious discussions in Washington indicate, fiscal policy is highly likely to become more restrictive from here on. Now QE2 is about to end as well. It is instructive that when QE1 ended in the spring of 2010, the market dropped 17% and the economy faltered. It was only with the announcement of QE2 that the market began to recover strongly and the economy perked up, although not by much. It is notable that with all of the massive stimulation, the economic recovery has been by far the weakest in the post-World War ll period.
We also point out that the economy has been kept afloat by artificially low interest rates, and that the Fed believes the economy is still so fragile that it is keeping rates low for an indefinite period. Additional major headwinds to economic growth are the moribund housing market, continued unresolved problems in commercial real estate and the desperate plight of state and local budgets.
In addition we question where this assumed resumption of growth is going to come from. In the past two decades the economy was sparked by consumers who spent far more than their income by running up record debts and converting house price appreciation into cash. Those days are over. If anything, consumers have to pare down debt, and that will be a tremendous burden on the already tepid economic recovery. We see no other segment of the economy that can pick up the slack.
We also think that QE3 is off the table under present circumstances. Although QE2 was successful in sparking stock prices, any addition to net worth has been at least offset by the resulting rise in commodity prices that have acted like a tax in reducing real household income. Another key consideration is that with the Fed balance sheet already having ballooned to almost $2.8 trillion from $780 billion in December 2007 , any program that increases it even more makes it that much more difficult to exit when the time comes. In addition, any move to initiate QE3 is likely to meet substantial opposition in congress as well on the FOMC itself. And as Jon Hilsenrath pointed out in today's Wall Street Journal, Bernanke has already indicated that the hurdle to more quantitative easing is very high.
This is not to say that QE3 is off the table forever. But QE3 will only become a reality after the economy deteriorates to a point where deflation again becomes a clear threat and most opposition to the program fades away. The problem is that, by that time, most portfolio managers will have thrown in the towel and the market will be far lower.