The Wall of Worry Becomes An Easy Climb

We all had plenty to brood about over the Labor Day weekend. President Obama was contemplating sending missiles into Syria to punish President Bashar al Assad for using chemical weapons against his own people and to discourage him from using them again. The President also had to choose a successor to Federal Reserve Chairman Ben Bernanke and his preferred choice, Larry Summers, faced opposition in the Senate, threatening his confirmation. The Federal Reserve, by the way, had indicated in May that it might reduce its $85 billion bond-buying program in the fall, causing interest rates to rise and creating turbulence in the emerging markets. Everyone awaited the Fed's decision on how much restraint they would implement. The nation's debt ceiling loomed in October with the Republicans taking the position that unless the Affordable Care Act was deprived of funding, they would not agree to raising the borrowing limit. Finally, as if the political situation in the Middle East were not complicated enough, Iran proceeded with its nuclear weapons development program.

Consider where we are now. Russia proposed a plan to place Syria's chemical weapons under protective custody with the ultimate objective of destroying them. The threat of a missile strike against Syria subsided. Larry Summers, recognizing the difficulties he faced in the approval process, decided to withdraw his name from consideration as Fed chairman. The Fed, in a surprise decision, elected to continue the bond-buying program at the $85 billion level and not taper at all. This is a position I had been advocating because the Fed's targets (a 6.5% unemployment rate and 2% inflation) had not been hit and the monetary stimulus, as inefficient as it is, was one of the reasons the economy was growing at its present modest rate. The economy needed the stimulus. The Fed left open the possibility that it might begin to reduce its bond-buying sometime before year-end, however. Iran responded favorably to a letter sent to President Hassan Rouhani by President Obama saying that the sanctions against the country would be relieved if Iran showed a willingness to cooperate with the international community on the future of its nuclear program. The sanctions have been devastating to Iran's economy and its currency. So, of five major issues confronting President Obama and the country over the Labor Day weekend, four are either off the table or in a state of positive change. Only the debt ceiling issue remains and it is a serious problem. The financial markets have moved higher because the other issues have diminished or gone away.

The absence of bad news has caused investors to become optimistic. Looking at the sentiment data and reports of institutional investor polls in the United States and Europe, it is clear there is a widespread view that the world economy is improving and stocks are headed higher. This makes the market vulnerable to a shock of some kind. I have reflected on where that could come from and continue to believe earnings in the U.S. will be disappointing. Profit margins are at a high and rising interest rates and other cost pressures should begin to show up in the third quarter reports. More than three-quarters of the companies providing guidance to analysts are encouraging them to adjust their estimates lower. Revenues so far this year have been disappointing, and that should provide a clue to possible earnings weakness as the year develops. Whether this will be enough to send the market lower remains unclear.

There are also other potential problems. One of the clear positives in this year's economic expansion has been the improvement in housing. House prices have risen in most areas across the country, and sales of both new and existing homes have been increasing. Since many construction workers lost their jobs in the recession, this recovery is good news. The inventory of new and existing homes is at a low, so the prospects for a continuing positive trend for housing are favorable. Since May, however, when the Fed indicated it may reduce its bond-buying program, medium- and longer-term interest rates have risen and the 30-year mortgage rate has climbed almost 100 basis points. With the Fed announcement that its bond-buying program won't immediately be cut back, interest rates have declined somewhat - more positive news for housing. The rise in rates since May did have a negative effect on mortgage applications and housing sales. It is too soon to know whether interest rates will pull back enough to restore momentum to the housing market. If rates don't drop further, housing's favorable force in the economic expansion may be neutralized. Since the economy was only growing at about 2% in the first half and is expected to do better throughout the rest of the year, any slowdown in housing would be likely to have a softening effect on the pace of the recovery.

Another positive in the U.S. economy has been energy. Hydraulic fracking has increased production of both natural gas and oil, making us less dependent on foreign imports, particularly from the Middle East. We are approaching the point where we will be self-sufficient in energy in North America because of the combined production of the U.S., Canada and Mexico. There are aspects of hydraulic fracking that bear watching, however. Oil deposits in rock have a shorter half-life than those in reservoirs, but the deposits where fracking takes place are often huge. Lifting costs are high, but the wells are profitable at current prices. There continues to be strong environmental resistance, but this is less of a problem in low population areas like North Dakota where the highly productive Bakken area is located. Finally there has been an increase in earthquake activity where fracking has taken place. If this escalates, it could put some restraints on production. Energy will continue to be a positive for the U.S. economy, but its benefits may be stretched out over a longer time period.

One area that has created some media and investor excitement has been the repatriation of manufacturing jobs from the developing world back to the United States. It is important to put this in perspective. There are about eleven million manufacturing jobs in the U.S. and somewhere between 220 and 250 companies are engaged in programs to bring jobs back. So far only about 50,000 jobs have been "reshored," accounting for about 10% of the growth in the manufacturing workforce since 2010. This has not been a major factor in the job recovery story so far.

The low cost of natural gas has also added to our positive feeling about a manufacturing renaissance. Natural gas is $4 per million BTU in the U.S., $12 in Europe and $16 in Japan. But energy is a relatively minor part of manufacturing costs in comparison with labor. I took a look at its relative importance across a range of industries. In chemical product manufacturing: energy costs represent 3.4% of total costs; employment compensation is 12.5%. In machinery: energy is .8%; employee compensation is 24.5%. For computers and electronics: energy is .4%, employee compensation is 38%. The energy to employee ratio is highest in agriculture, fishing and hunting where energy is 8% and employee compensation is 10.5%. The energy advantage will still have a hard time overcoming the labor cost disadvantage.

In conjunction with the Russian proposal to remove Syria's chemical weapons, Russian president Vladimir Putin wrote an op-ed for The New York Times in which he criticized the idea of American exceptionalism. Many American observers were critical of Putin's comments, but while I believe we are exceptional in some ways, there are definitely areas where we need improvement. There is no question that much of the world's innovation takes place in the U.S. We have a culture of creativity nurtured by what are widely recognized as many of the best universities in the world. Our scientific achievements are likely to continue in a broad spectrum of disciplines. We have a powerful military force maintained at great cost and we are willing to deploy it for peace-keeping purposes. While we have not had to use it thus far in Syria, it was effective in Bosnia and Kosovo. The threat of using force in Syria may have brought Iran to the negotiating table just as the invasion of Iraq more than a decade ago may have caused Muammar Gaddafi to give up his nuclear weapons. We are a global leader on human rights and are willing to use our influence to spread these principles to other countries.

On the other side of the ledger, our kindergarten through twelfth grade education has deteriorated and we have made little progress reversing the trend. This may be more of a social problem than a pedagogical one. Our legislative effectiveness has become intractable. It has been hard to pass any bills in Congress because of the polarity of the political parties. We need to maintain and improve our infrastructure. We have not been able to deal with the structural problems of job creation. At this point in a recovery unemployment is generally about 5%, but we are now at 7.3%. There are downside aspects to employment from both globalization and the Internet and they fall mainly on the less educated segment of the population. We have not dealt effectively with the job retraining problem. We have also not been able to reduce civil violence through gun control and we are among the last of the developed nations of the world to implement universal healthcare for its citizens.

My own view is that we should be proud of our strengths and humble about our weaknesses. I think we would be more effective in exerting our influence as a result. Stressing our exceptionalism has a tendency to make us appear arrogant, resulting in our partners becoming defensive and resistant. There are many, however, who believe that our military strength which defines us as a superpower is the reason Syria and Iran appear to be willing to be less belligerent. Proponents of exceptionalism often cite our "values," but a World Values Survey which collects data from 100 countries examined this issue more closely. On being religious, the U.S. ranked 54th. In terms of commitment to democracy and tolerance America was 15th. We are 64th in terms of nationalism but 15th in free choice. Russia is 95th in free choice, so Vladimir Putin has some work to do at home.

The continuing resolution and the debt ceiling are likely to be the thorny issues the market will be focusing on over the next month. Even The Wall Street Journal thinks the Republican strategy of passing a continuing resolution to keep the government running at sequester levels only if the Democrats will agree to defunding or delaying the Affordable Care Act for a year is dangerous. Only 40 or 50 Republicans out of 233 support this and a CNN poll shows that if a government shutdown occurs, even for a few days, most Americans would blame the Republicans for it. The Republicans would be better off maintaining the sequester and taking a broader approach toward entitlements. Most investors think a compromise on the debt ceiling will be reached so that U.S. can continue to pay its bills, but a battle on that issue is also a real possibility with a further downgrade of our federal debt a risk. It is not clear that this situation will be resolved without some market disturbing dissention.

One final geopolitical situation that could take a turn for the worse is Syria. The process of surrendering the chemical weapons is prone to setbacks and deceit. If Syria proves uncooperative and/or if the Russians prove complicit in their intransigence, we would be faced with the prospect of confronting Syria once again. The market reaction to that would not be good. Breaking news on the positive side is that Angela Merkel did well in the German election, and that's constructive for the European Union and the euro. The continent will continue to "muddle through" as a result of a reduced emphasis on austerity and ample liquidity. The structural changes that are so necessary for the long term revitalization of Europe have been slow in coming, however.

I recognize that I have been cautious all year as the market has moved higher. Valuations are still not extreme, so the market can rise further. The general reaction to the Fed's decision not to taper was more apprehensive than might have been expected because investors know that a pullback in the bond-buying program is coming at some point in the future. Perhaps there is also some renewed concern that growth will not increase during the remainder of this year and into 2014. I have learned over the years that it is a good idea to be at least somewhat defensive when most others think almost everything is headed in the right direction.