The stock market has staged a relief rally over the last
three days as various Fed officials have tried to walk back Bernanke’s
statement that implied a tightening of monetary policy. In addition, the first quarter GDP revision
that indicated a slower economy gave investors hope that a Fed withdrawal of
stimulus would occur later rather than sooner.
Adding to the mix was China’s injection of funds to various lending institutions
in response to soaring short-term lending rates. However, we believe that a slower U.S. economy
is nothing to cheer about, while China’s economic and financial problems are
too deep-seated for any instant cure.
Although others talk about an improving U.S. economy, it
is not happening. The second revision of
first quarter GDP reduced the annualized growth rate to only 1.8% from a
previously reported 2.4%. Although the
data in the report is now a few months old, it signifies that the economy
entered the current quarter with slackening momentum that has continued. Most of the reduced growth rate was a result
of consumer spending growth dropping to 2.6% from the 3.4% reported in the
first revision. Moreover, final domestic demand grew a meager 1.3%, compared to
the prior estimate of 1.9%. This is a
distinct slowdown from the average growth of about 2% that had been the case
The slowing momentum has carried over into the second
quarter as well. Real consumer spending
dropped 0.1% in April and rose 0.2% in May.
As a result, even a 0.2% increase in June would bring second quarter
spending to only a 1.6% gain for the quarter, compared to 2.6% in the prior
quarter. Since consumer spending
accounts for about 70% of GDP, it now appears that GDP in the current quarter
will not even match the meager 1.8% rate of the first quarter. While this outcome will likely mean a delay
in the Fed’s plans to pare their bond-buying program, we doubt that an even
further slowdown of an already inadequate economic growth rate will be looked
at kindly by the market.
In addition, China’s economic and financial problems are also
likely to impact the U.S. and the rest of the world. China’s massive stimulus over the last few
years into industry and infrastructure has built hugely excessive capacity that
is generating little or no returns.
Soaring debt associated with the buildup was hidden by new loans, much
of it done through the shadow banking system.
The Chinese central bank, fearing a credit bust that
would hit an already slowing economy, has recently attempted to rein in runaway
financing. But the attempt resulted in short-term
lending rates suddenly soaring into double digits from the 3.5% in force for
most of May. This happened at about the
same time that Bernanke raised the prospect of curtailing QE, and contributed to
the decline in the U.S. stock market.
China’s central bank was then forced into injecting funds into some
financial institutions to ameliorate the sudden credit squeeze that threatened
the economy. This also coincided with
the Fed’s attempt to walk back some of its previous tightening talk, and
contributed to the bounce-back rally in the stock market.
In our view, China’s move to temper the credit squeeze is
only a temporary Band-Aid. The nation’s
corporate debt alone is almost 200% of GDP.
Massive overcapacity exists in a wide number of major industries such as
chemicals, cement, steel, autos, aluminum, shipbuilding, and metals smelting at
a time when its export growth rate is declining. As a result they have also had to cut
purchases of raw materials from the rest of the world, creating slowdowns or recessions
in nations dependent on sales of commodities.
All in all, this is a situation that cannot end well for either China or
most other nations.
In sum, we believe that the deteriorating economic and
financial situation in the U.S., and the rest of the world, will result in a
major market decline. Although investors
now view any delay in the Fed’s plans to cut back QE as positive, we think that
the opposite is the case. An economy
that is too weak for the Fed to pare back their bond-buying program would be
highly negative for corporate earnings, and probably push the economy into an undesirable
deflation as well. This is not a
situation that is conducive to a robust stock market.