It is not often that I have agreed with Ben Bernanke over the years but in his testimony to Congress last week, the Fed Chairman said something I agree with almost completely (HT to Alan Abelson at Barron’s):
“The long-term health of the economy depends mostly on decisions taken by Congress and the administration.”
In the immortal words of Frank Zappa, Great Googly Moogly. Given that our politicians are more adept at slinging the deadly yellow snow (from right there where the huskies go) than being Mothers of Invention, Bernanke’s statement ought to strike fear into the hearts of all Americans. If we are dependent on politicians for the long term health of our economy, we are waist deep in the big muddy with weasels ripping at our flesh (thus ends the musical & Zappa references).
Unfortunately, Bernanke is largely correct and it also happens to be an election year so the odds of the politicians joining hands, singing Kumbaya (ok, one more bad musical reference) and coming to an agreement on substantial economic reform are about as good as the odds of a Greek bondholder getting paid in full. Which are, in case you haven’t been paying attention, exactly zero. Thankfully, the ISDA (International Swaps & Derivatives Association) ruled last week that getting paid 50 cents on the Euro for your Greek bonds isn’t a “credit event”. Maybe Congress can adopt a similar version of Newspeak and declare that high unemployment, high gas prices and a hopelessly corrupt tax code aren’t “economic events”.
Bernanke’s testimony also included, to the dismay of risk-on traders everywhere, no reference to QE3 which prompted an immediate selloff in gold and stocks, although the latter recovered fairly quickly. What this should tell investors – and traders – is that a fair portion of the recent rally has been built on expectations of continued monetary easing. As I’ve said before, if – when – the inflation ends, so will the rally and at least some portion of the so called recovery. It isn’t coincidence that inflation expectations, as derived from the TIPs market, have been rising right along with stocks and commodities. Inflation does produce activity, however wasteful it may prove when the inflation ends.
As Bernanke says in the quote though, the health of the economy is mostly dependent on the politicians, at least in the short term. If Bernanke stopped the inflation and the politicians did nothing, we would almost certainly enter another recession, but market economies are amazingly resilient, self correcting organisms and we would eventually arrive at growth again. In fact, we are seeing evidence of that resilience right now. Our current economic growth is a function of two factors in my opinion – cyclical and monetary. The cyclical factor can be seen in the recovery of construction spending (up 7.1% year over year) and auto sales (up over 20% to a 15 million annual rate). The monetary factor can be seen in items such as mining output (up 6.4% year over year), rotary rigs running (up 14.5%) and the savings rate (down 25%). If Bernanke stops the inflation we’ll lose the monetary portion of the “recovery” and maybe some part of the cyclical portion as well. Needless to say, neither stocks nor commodities are currently priced for such an event.
What Bernanke’s statement also tells us is that the inflation will continue until fiscal policy improves. The beatings of the middle and lower classes will continue – with intermittent interruptions – until morale improves, Bernanke is tarred and feathered or we elect some politicians who understand basic economics. For investors, this means more of the same – rallies during the inflations, stomach churning drops during the lulls. I would like to tell you, dear reader, that the election in November will produce a President and a Congress finally willing and able to do what’s necessary to put our economy back on track, but based on what I’ve seen so far, I have my doubts. President Obama wants to raise taxes so he has sufficient tax dollars to continue playing venture capitalist and Mitt Romney wants to start a trade war with China. And Congress, seemingly no matter what party is in charge, produces more bad ideas than a fifth of Jack Daniels. Don’t count on the politicians to solve our problems any time soon.
Investing in this environment is difficult but not without its rewards. Investors who are able to see through the monetary illusion can produce good returns by adopting a purely contrarian approach. During the lulls in central bank inflation, embrace the volatility and assume the inflation will return and with it risk assets. As the inflationary period nears its end, adopt a more conservative stance and wait for the fall. Rinse, repeat. Of course, this is easier said than done and it isn’t for the faint of heart, but we’ve been reasonably successful using this approach since the crisis began.
For those who don’t want to spend all their spare time deciphering Fedspeak, a passive investing program that includes a dynamic rebalancing process has produced an acceptable return over the last, supposedly, lost decade and will likely continue to do so. I would be remiss in my marketing duties if I didn’t mention that at Alhambra we use both approaches. I should probably also mention, in case you haven’t been reading every week, that we have recently been moving to a more conservative allocation in our actively managed programs. These inflationary periods have a limited shelf life and the expiration date appears to be nearing.
———————————————————————————————————————————–
The economic data last week seemed a bit more downbeat and markets reflected the uncertainty of both the economic outlook and the monetary outlook produced by the Bernanke testimony. While large caps managed to end the week almost flat, small caps had a rougher time of it (down almost 3%), reflecting the increased uncertainty of the outlook for the domestic economy. International markets, where central banks are still inflating more aggressively, generally outperformed their US counterparts. Europe has been outperforming the US since the beginning of the year and emerging markets are performing best of all. Whether that continues is likely a function of central bank policies. On that note, I would just point out that the Bank of Japan has recently adopted a more aggressive easing stance and seems determined to finally weaken the Yen.
As mentioned above, the construction industry is in a cyclical recovery but January’s numbers came in less than expected at down 0.1%. That was a function of non-residential spending though as both private and public outlays fell. Residential spending was up 1.8%. Pending home sales also showed a slight rise, up 2%. Also in the cyclical category, auto sales were quite robust, selling at an annualized rate of 15.1 million.
On the consumer side of the economy, the Goldman and Redbook retail reports were contradictory with the Goldman report showing a slowdown while the Redbook report showed an uptick. Chain stores reported generally increasing rates of same store sales however. Personal income and expenditures for January were both somewhat below expectations up 0.3 and 0.2% respectively. The PCE price index was up 0.2% and 2.4% year over year. Even the core inflation number is approaching the Fed’s limit at 1.9%. That would seem to justify Bernanke’s reluctance to commit to another round of QE.
On the production side, the manufacturing data continued to show growth with the Richmond and Dallas Fed surveys rising more than expected and the Chicago PMI also beating expectations. The national ISM was a bit disappointing at 52.4 with most components growing at a slower pace. One exception, strangely considering the situation in Europe, was a jump in export orders. One report of particular concern was Durable Goods orders which fell 4% in January. Non defense capital goods ex-transportation, an indication of business spending, fell by 4.5%. That is likely due to an acceleration of spending in late 2011 to capture the full expensing deduction. Having said that, durable goods orders are one of the most volatile series we follow and one month does not make a trend.
Jobless claims were down slightly to 351k and while this continues a trend lower that started last summer, I think it is important to remember that we saw a similar improvement last year with claims in the same week at 375k. We’ll get a full employment report this Friday and expectations are pretty high. A disappointment could have a major impact on psychology and the markets.
For information on Alhambra Investment Partners' money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@alhambrapartners.com
Click here to sign up for our free weekly e-newsletter.
Name (required)
Email (required)
Website
XHTML: You can use these tags: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>
Read Full Article »
