Comstock Partners, Inc.June 13, 2013
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.