Comstock Partners, Inc.
Bernanke Fails To Allay Market Fears
Last week we wrote that Bernanke could not be happy with the way long bond rates reacted to his press conference answer that the Fed could begin lessening its rate of bond purchases in the next few months, and that he would attempt to sooth the market in yesterday’s press conference following the FOMC meeting. Well, he tried, but ended up making things worse, at least in the perception of the markets.
The Chairman attempted to allay fears by setting specific dates and economic parameters for reducing and eventually eliminating the latest bond purchase program that, until recently, was assumed by the market to be open-ended. He further took pains to assure the markets that just reducing the amount of purchases was not the same as tightening and that the fed funds rate would not likely be increased before early in 2015. He also assured one and all that the decisions would still be data-dependent, and subject to adjustment.
Investors, however, took what Bernanke apparently thought was increased clarity to mean greater hawkishness, and, as a result, bond yields soared as stocks tanked. In addition the markets gave far greater importance to the potential reduction of bond purchases, whereas the Fed attached greater significance to the continuing expansion of their balance sheet. (On a separate topic, we also don’t want to overlook the financial and economic turmoil in China as an important contributing factor to the market drop. We’ll have more to say on that in upcoming comments.)
That said, there are some puzzling aspects to the reasons Bernanke gave for cutting the program. Although he referred to an “improving” economy, the Fed slightly reduced its 2013 GDP forecast range. The more optimistic outlook was actually based on its forecast for 2014, which is still over six months away and, therefore, more speculative, particularly in view of the Fed’s poor forecasting record. In each of the last three years the Fed forecast a strong second half economy, and each time their prediction fell short. Indeed, both QE1 and QE2 were stopped, but had to be restarted again with the current program.
In our view, economic growth is not improving as the Fed and many others appear to believe. The Fed’s 2014 economic forecast seems to us as highly optimistic and is unlikely to be met. In that case the FOMC reduction of the pace of bond purchases may be started much later than they are currently projecting. The Fed’s reduction of its inflation forecast also lends credence to our belief that QE may go on for longer than the Fed is indicating. Growth has been tepid throughout the recovery and, if anything seems to be decelerating. When asked where the improvement is, most observers cite housing and autos. While housing has improved for now, vehicle sales have been flat since November, and major segments of the economy such as consumer spending, disposable income, production, employment and capital spending, are still in the doldrums.
The belief that economic growth is improving is not supported by the numbers. For the four quarters ending March 31st GDP grew by 1.8%, within the range of growth since the first quarter of 2010. The second quarter is expected to come in at slightly under 2%, continuing the sluggish pattern. Consumer expenditures for the year ended April 30th were up only 2.1% on a disposable income increase of only 1.1%, as the savings rate declined from 3.5% to 2.5%. Since April 2010, consumers have had to reduce their savings rate from 5.3% to 2.5%, just to maintain a tepid rise in spending. The savings rate is almost down to where it was in 2007, meaning consumers will have to depend increasingly on income that is barely rising.
Job growth is also weaker than many believe. The three-month moving average of payroll employment is 155,000, the weakest of any moving three-month period since October. Both the 4-week and 8-week average of new weekly unemployment claims have moved up, while wages and hours were flat in the latest reporting period. Growth in durable goods orders is also decelerating. Year-to-year gains in the period ended April 30th were 2.4%, compared to 7.6% last year and 7.9% two years ago. May industrial production rose only 1.6% over a year, a significant drop from the 4.5% in May 2012.
All in all, we believe that economic growth will be too slow for the Fed to reduce QE as early as Bernanke indicated in his press conference, and that the low rate of inflation supports this view. However, a delay in slowing down the bond purchase rate is not likely to help the market as a deteriorating rate of economic growth along with lower earnings expectations and the threat of deflation is consistent with a falling market. In our view, the market top has been made and an imminent bear market is in store.