Last Friday’s GDP report showed the US economy growing at a 3.2% pace in the first quarter, companies are reporting great earnings and a deal was finalized over the weekend to bail out Greece. There’s still plenty to worry about - Goldman Sachs under criminal investigation and the Gulf of Mexico on fire are not minor affairs - but overall it appears that the economy and the markets are healing from the near death experience of the financial crisis. And yet……something tells me that recovering from the near failure of several of our largest banks and the actual failure of a bunch of smaller ones just isn’t supposed to be this easy (if 10% unemployment can be called “easy”) or quick. Was the economic situation really not as dire as the “experts” told us? Or is this just the eye of the storm and more economic turbulence is on the way? After decades of Federal Reserve monetary mismanagement the chances of the former being true seem unlikely and with the various economic stimulants of the last 2 years rapidly fading, the latter seems a disheartening outcome of increasing probability.
In some ways the GDP report was actually a lot better than should have been expected considering that a large portion of the country was covered in snow for the first two months of the year. Personal consumption increased at a 3.6% pace and companies added generously to inventories, something they aren’t likely to do without some level of comfort concerning future sales. Investment in equipment and software rose a healthy 13.4%, exports rose 5.8% and imports rose 8.9%. And there was other good news in the economic data released last week. The Chicago Purchasing Managers Index showed another acceleration in midwest economic activity, jobless claims fell and consumer confidence rose. So why don’t I feel more confident?
The GDP report showed a fairly rapid deceleration from the fourth quarter’s 5.6% rate of growth and the individual components are worrisome. Durable goods were up 11.3% but motor vehicles and parts were down from the fourth quarter. On the investment side, gross private domestic investment was up 14.8% but non residential (commercial real estate) and residential structures investment was down. Most of the “investment” in the quarter was in inventories. Not exactly adding to productive assets. Exports and imports were both higher but prices paid for imports rose a startling 9.1%, consequences of a weak dollar. And lastly, despite the huge federal deficits, government consumption and gross investment fell 1.8%. State and local government contraction is more than offsetting increases on the federal side of the ledger -and stimulus is ending so that will get worse over the next year.
Whether the economy can re-accelerate and regain some of the momentum it lost in the first quarter is dependent on an improvement in the jobs situation. Unless we start creating paying jobs in copious quantities pretty soon, I don’t see how the rise in consumption can be maintained. A lot of the consumption in the last three quarters was funded by a drop in the savings rate and government transfer payments. The savings rate can only fall so far (and it needs to be going in the other direction anyway) and while unemployment benefits have been extended - again - they won’t be extended indefinitely. Other sources of income in the first quarter such as tax refunds will not be repeated in the second quarter. The Obama administration tax credits do seem likely to continue but the overall tax situation is muddled at best with the Bush rates set to expire at the end of the year.
As of now, we don’t know what the tax rate on dividends and capital gains will be come 2011. The outcome of the midterm elections could theoretically affect the debate but it only seems prudent to assume a reversion to the pre-Bush rates. That means dividends will be taxed as regular income and long term capital gains return to 20% from the current 15%. It seems obvious but I feel obligated to point out that paying a 15% cap gains rate in 2010 is preferable to paying 33% more in 2011. One of the reasons that past increases in the cap gains rate haven’t yielded as much tax revenue as expected is that investors, while maybe not perfectly rational all the time, are not so oblivious that they don’t notice when a politician starts rooting around in their pocket. It isn’t as easy to predict the affect of a rise in the dividend tax rate except to observe that higher taxes on dividends don’t seem likely to motivate companies to pay out more of them.
Meanwhile the Federal Reserve seems oblivious to the damage being done by their zero interest rate policy. The FOMC met again last week and extended the extended period of low interest rates. Gold approaching $1200, oil over $85, copper at $3.35? None of these things matter to Professor Ben and his fellow disciples of the printing press. The only thing that matters is that the banks be allowed to rebuild their balance sheets through the wonders of a steep yield curve. Savers paid less than the rate of inflation? Don’t care. Banks not lending to anyone but the Treasury? Don’t care. Property bubble in Asia? Don’t care. Bank profits almost back to pre-crash levels? Not enough, don’t care. Budget deficit 10% of GDP? Don’t care. Low interest rates helped cause this mess? Don’t care. Election coming up? Oh, wait…..
The second half of this year could be a rough one for investors. The economy is not out of the woods yet and the stimulus spending will be mostly done by the election (hmmm, think that was an accident?). Taxes are set to rise next year and the impending rise in capital gains taxes favors selling as the year progresses. Politicians are looking for scapegoats to put in the stocks and that will only get worse as the election nears; political risk is rising. And if commodity prices keep rising, the Fed may be forced to execute their exit strategy sooner than most expect. I’ve been raising cash for the last two weeks and I don’t think I’m done yet (see here and here for example). As I said last week, if the Fed keeps the monetary spigot open wide, commodities probably offer more upside, but there is a limit to how much I’m willing to commit to one asset class. The point is that it seems more prudent to be watching the downside here than worrying about the market getting away to the upside. Not having an exit strategy for this market is not an option; choose your stop levels and stick to them.
The economy has recovered from the precipice of a depression where it was perched last year but I am not convinced that we’ve solved anything. Fed monetary pumping and government spending has produced higher asset prices and propped up consumer demand (at least temporarily), but the underlying problems of our economy have not been solved. We are still deep in debt and getting deeper. We still save too little and consume too much. The financial sector is still too large and the largest financial institutions still enjoy an implicit government backstop. In short, nothing has changed and that means this might be as good as it gets. For now, it seems prudent to reduce risk and take a wait and see attitude.
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