The next few months will be extremely important in determining whether the economic recovery is a brief respite or something more sustainable. The Federal Open Market Committee meets this week to discuss monetary policy at a critical point. Their quantitative easing program is winding down and it is an open question what happens to interest rates - and specifically mortgage rates - when the Fed is no longer buying on a daily basis. There are a number of other events in the next few months that will have the ability to significantly change the course of the recovery as well.
It has been said that the recovery of the housing market is the key to economic recovery and while I don’t agree with that sentiment completely, there is some truth to it. Regardless, a confluence of events in the housing market over the next few months seems likely to test the thesis. First, as mentioned above, the Fed will complete its purchases of mortgages for its QE program by the end of March. Second, the mortgage reset tidal wave that so many have warned about is starting to happen now:
There are some unknowns when it comes to this chart and how they play out will go a long way to determining the macro economic outcome. How many of these loans have already defaulted? How many have been refinanced? And obviously it matters what rate these loans reset to; if the reset rate is only marginally higher than the current rate it won’t make much difference in the rate of foreclosure. And that explains why the Fed chose to use so much of their QE firepower buying mortgages. The Fed could have conducted the QE purchases in any type of security but when you look at this chart it really wasn’t a contest now was it? The Fed did not want to take a chance - indeed could not take a chance - mortgage rates would not follow other rates and so chose to make sure they held down mortgage rates specifically. While that would seem to wander rather far into market manipulation territory one can’t help but think they had few alternatives. And it has seemingly worked so their withdrawal from the market is awaited with great anticipation and trepidation.
In addition to the mountain of mortgage rate resets we will also witness the end of the home buyer’s tax credit at the end of April. It was once the first time home buyer’s tax credit but that proved too limiting so when they extended it Congress made it even easier to legally claim. (Apparently not being a first time buyer wasn’t much of an impediment to claiming the credit anyway - it was the source of numerous fraudulent claims in 2009.) The upshot of this is that we will find out soon the true health of the housing market. If it can withstand these coming shocks, we’ve probably passed the worst; if not the banks are looking at more write-offs and REOs which wouldn’t be good for lending or existing home owners - even those without resetting mortgages.
More broadly, the end of quantitative easing by the Fed will also be a test for the market. What will happen to interest rates when the Fed exits the market? Will rates rise due to less demand from the Fed? Will the Treasury auctions for new government debt be well subscribed? The deficit this year is already exceeding last year’s record and the CBO just announced that the proposed Obama budget will add $1.2 trillion more to the national debt by 2020 over and above what the administration has already projected. In case you missed it, the CBO now says the President’s budget will add almost $10 trillion to the national debt in the next decade, a nice round $1 trillion per year that never falls below 4% of GDP. Somebody has to buy all that debt and while the Fed’s recent purchases were concentrated in mortgages the banks used the sales proceeds primarily to purchase Treasuries. In other words the Fed indirectly financed the budget deficit last year so the obvious question is who finances it this year and what doesn’t get funded instead?
(On a side note, why does the CBO score the stimulus package as a net gain to the economy but reduce growth in their long term forecasts due to higher debt levels? Does debt add to growth or retard it? Which is it? Is there a magic level at which it becomes bad?)
It also appears we are nearing the end of the healthcare reform debate and the outcome could also have implications for the economy and the market. The obvious concern for markets is that passage will increase the future cost of hiring and while the implementation of the plan is phased in over a number of years, companies will adjust their hiring practices today if it passes. Furthermore, passage will increase corporate expenses and assuming companies don’t have the ability to pass on the costs, will reduce corporate profits. So passage of something resembling the Senate bill will reduce hiring and profits just as both are recovering which would not seem to be a positive development for stock prices. Of course that doesn’t consider the potential political implications of passage. As Democratic pollsters Pat Caddell and Douglas Schoen put it last week in an article for the Washington Post:
Unless the Democrats fundamentally change their approach, they will produce not just a march of folly but also run the risk of unmitigated disaster in November.
I suspect that some portion of the current market level is based on an expectation of failure for the Democratic health care reform plan and also an expectation of Republican gains in the midterm elections. That isn’t, I hasten to add, so much because voters are enamored of Republicans as it is disgust with Democrats - and big government in general - and nostalgia for the divided government of the mid 90s that produced such a good economic outcome. Unfortunately I’m not sure Democrats won’t find a way to pass health care reform and I don’t think divided government will be as beneficial this time as last. While I am normally firmly in the camp that says the less the government accomplishes the better, I think we might be at one of the few points in history when the economic situation demands political action. We have reached a point in our ongoing effort to bankrupt the country where either our politicians will act or the market will eventually force them to react as it has in Greece.
Lastly, we have the prospect of financial reform coming in the next few months. Christopher Dodd wants this done this year as his legacy and he’s pushing hard to get something passed before the year dissolves into campaigning. I have no idea what reform will ultimately look like but I am certain of this - the reforms will not prevent the next crisis and there will be unintended negative consequences. In looking through the post mortem on Lehman last week one thing stands out - the only group that got it right with respect to the true condition of Lehman’s balance sheet were the short sellers and Lehman’s counterparties. In other words parties with capital at risk if they were wrong. As best I can tell, none of the proposed reforms would have prevented Lehman from committing financial hari kari.
For the next few months we’ll be in a zone of uncertainty where risk is heightened. Valuations on the market are not particularly worrying based on current earnings estimates but those estimates do not incorporate unknowns such as health care or financial reform or a relapse of the housing market. How those items are resolved could have a large impact on future earnings and so until there is more clarity on these issues the markets are likely to remain on edge. There is no reason to make portfolio changes yet since we don’t know how these events will be resolved, but investors should remain vigilant and ready to change course if necessary.
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Weekly Economic Review
It was a light week for economic data but the news was generally positive once again. Week after week, month after month the economic data has continued to surprise the naysayers. I still have serious doubts about how this recovery has been built but there can be little doubt at this point that the recovery is fairly robust. It is primarily a product of monetary policy and that worries me since that is how the last two recoveries were also built and I am getting too old to deal with another bubble. The Fed printed their way out of the 2001 recession and the result was massive malinvestment in housing. They're doing it again and one wonders where the malinvestment will manifest itself this time. Ah well, I guess malinvestment is better than nothing at this point. Someday we'll actually address our problems but it doesn't appear it will be this recession.
The light data week started with the Goldman and Redbook retail readings on Tuesday which showed big rebounds from the snowed in numbers of the last few weeks. Goldman's same store sales metric jumped 2.9% week over week. By the way, I spent the week in Chicago visiting my daughter (who is attending the School of the Art Institute of Chicago) and when temperatures moderated the city fairly jumped to life. Tuesday was a beautiful spring-like day with afternoon temperatures around 60 with sunny skies. I went out for a jog and passed 4 parks packed with parents and kids. I think the harsh winter has people itching to get out of the house and my guess is that they'll be spending when they do. It has never paid to bet against the US consumer.
Mortgage purchase applications rose for the second straight week (+5.7%). This might be a precursor to a surge in sales before the expiration of the tax credits in April. It could also have something to do with the weather warming up - I don't want to read too much into these numbers.
Wholesale trade numbers showed rapidly improving sales (+1.3%) and falling inventories for durable goods. A lot of people pooh poohed the 4th quarter GDP report because much of the gain was a result of inventories falling more slowly. It has been suggested that GDP gains built on inventory gains are temporary and that may be true but it should be noted that the inventory building hasn't even started yet. Indeed the inventory to sales ratio is just now at the level I suggested months ago would be the trigger for a rise in production. So if the inventory correction is over so be it, but an increase in production should offset the effects on GDP for at least another quarter.
The disappointments for the week were released on Thursday. The trade deficit shrank in January with both exports and imports falling. Neither was due to significant prices changes but imports fell faster than exports producing a slight drop in the deficit. These numbers were for January though and activity likely rebounded in February. China reported big gains in exports and imports in February. And it shouldn't be forgotten that exports are up over 23% year over year. The other disappointing release of the week was the jobless claims report which showed only a small drop in claims. This is the one report that continues to worry me week to week. There have been some positive trends in the jobs reports - temp jobs and manufacturing - but we are not likely to get significant growth in jobs until claims fall under 400,000 on a weekly basis and that is still a ways away (462k).
Retail sales for February were up 0.3% and up 0.8% ex autos. And excluding both autos and gasoline, sales were up 0.9%. Sales are up 3.9% year over year and this was a very solid report. As mentioned above, it has never paid to bet against the US consumer; sales continue to beat expectations.
The last report of the week was the U of Michigan mid month consumer sentiment report which showed a small drop from February. I don't usually pay much attention to these reports, but the market has reacted negatively to the last two reports so I feel I should comment. These reports are interesting but are, at best, coincident indicators. They don't lead the stock market or the economy and as such don't provide much guidance for investors. Sentiment will improve after conditions have already improved.
The economic recovery continues to surprise most analysts and investors and it is gaining strength. If history is any guide at all, it is also likely just getting underway.
Selected Charts
The S&P 500 is back to its recent high but we are overbought on a short term basis. Sentiment is also a bit too bullish and the VIX is back near the lows that set off the last correction. Don't be surprised by a correction and don't mistake it for something more absent more information on the unknowns discussed above.
The Mexican peso, which I highlighted in this space a while back as a long, broke out last week.
Emerging market bonds recently broke out to new highs. That has implications for....
Emerging market stocks which are highly correlated to emerging market bonds. I would expect the stocks to play a bit of catch up.
Regional banks, which I've highlighted here several times recently, have accelerated to the upside. There is resistance in this 25 area though so don't chase it here. Longer term target is around 30.
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