So here we are at the beginning of a new year full of promise and high expectations and all I can think about is what could go wrong. I don’t want to be the anti lamp shade wearing, early to leave the party stick in the mud but I can’t help it. When everyone else gets loopy, I get sober. When everyone else sees nothing but blue skies, I start looking for dark clouds. When the bulls are running, I start looking for a balcony from which to watch the inevitable gorings and tramplings. The continually improving economic data and the overwhelmingly bullish sentiment puts me on the horns of a dilemma right now. Do I go with the improving data and try to ride the bull to more gains? Or do I go with my gut that says so many have already climbed aboard that the bull is about to buckle?
There are plenty of reasons to be happy - if not ecstatic - about the current state of the US economy and the stock market. The economic data has improved noticeably - and everyone has noticed - over the last several months and the stock market has improved right along with it. Despite the worries of the deflationary, deleveraging crowd, the US consumer continues to defy the predictions of frugal is the new black pundits. Christmas in the US was not of the switch and lump of coal variety; sales were up nicely even if they didn’t meet the expectations of the perennially optimistic Wall Street retail analysts. Interest rates are low and credit spreads are narrow; corporations, at least large ones with good credit, have no problems borrowing for expansion if desired. Indeed commercial and industrial loans have recently ticked higher. Credit crunch? Not except for underwater homeowners and companies lacking good collateral.
According to the ISM surveys, manufacturing is leading the recovery and if the latest survey is to be believed, the larger non manufacturing sector is finally catching a bid as well. The unemployment rate is still too high but it appears to have peaked and the economy is adding jobs just about every month. Inventory building has helped recent GDP figures but the inventory to sales ratio is historically low and doesn’t cause any angst. Investment - at least of the non residential variety - has started to pick up. The yield curve is steep which allows the banking system to rebuild capital. Inflation - at least as measured by the official government statistics - is low and despite the nightmares of Ben Bernanke doesn’t appear in any danger of falling into negative territory.
Disposable personal income is rising and the savings rate is too. Households have paid down their debts and debt service payments as a percent of DPI are no higher now than in the mid 80s or late 90s. Auto sales are rebounding and are now running at about 12.5 million units per year. Exports are up and foreign economies, particularly the emerging markets, are growing nicely. The dollar has recently moved higher when measured against the Euro. Corporate profits and productivity are rising rapidly and balance sheets are generally in good shape. The housing market is still in the dumps but even here in South Florida, it feels like a bottom has been found. The condo glut down here has turned into, believe it or not, rising rents. Housing starts are still low and inventories too high but with a still growing population, new construction will have to start up sometime soon. Indeed, homebuilder stocks have already started to rise in anticipation.
So, yes there is a lot of good news out there about the US economy and yet…..and yet, I still can’t shake the feeling that this is all somehow artificial, that it won’t last, that the bulls are overlooking something. That might be the understatement of the new century. My list of worries runs at least as long as the good stuff and truth be told the negatives scare me more than the positives reassure me. The worries start right here in the US and mirror to some degree the positives. Corporate profit margins are high? Yep, and would appear to have nowhere to go but down. ISM surveys are high? Yep, and based on history have likely peaked. Good Christmas? Yep and despite the fact that no one has ever made any money betting against the US consumer, I wonder if the sales trends can be sustained in coming months without more significant job growth. In addition, the new credit card rules are reducing available credit to consumers so even if the job market does improve it may not help consumption much.
Low interest rates and narrow credit spreads? Well, yes, but is easy credit really the cure for a problem caused by too much debt? Do we really want another round of leveraged buyouts that loads US corporations with more debt? Steep yield curve and rising bank profits? Yes, but is that something we really want? We got in this mess to some degree because the US economy became overly dependent on financial industry profits. Maybe we shouldn’t want to restore the status quo? More financial industry profits don’t seem to translate well into more productive jobs. Auto sales are running at a 12.5 million rate? Yes, but roughly 25% of that total is now from foreign manufacturers and GM is about to lose their (our) shirt trying to sell an overpriced but politically correct Volt. Inflation is low? Only if you use CPI and don’t look at gold, silver, copper, oil, platinum, palladium, corn, cotton and sugar. And on a related note, yes, the dollar is up against the Euro but not against the Australian dollar, Canadian dollar, Japanese Yen, Swedish Kronor, Swiss Franc, Brazilian Real or the Chilean Peso.
Looking outside the US doesn’t give me any more comfort despite the alleged emergence of the emerging markets. China, Brazil and now Chile are among a group of countries actively attempting to prevent further capital inflows that are wreaking havoc with their domestic economic management. These countries don’t want their currencies to rise which might hurt their exports but neither do they want the inflation that accompanies their efforts to hold down their currency values. Capital controls have proven ineffective in the past and will no doubt prove so again. I cannot help but wonder how much of the recent good times in Latin America and Asia are a result of nothing more than an old fashioned inflationary boom. If that’s what it is - and rapidly rising commodity, real estate and now consumer prices would seem to indicate it is - then ending the inflation will also mean ending the boom. Is the US or any other world stock market prepared for the lower world growth that comes with these countries succeeding in their inflation fighting efforts? Do all the rosy US economic growth forecasts take into account the potential for lower growth outside the US? I suspect not.
In the developed world there are equally worrisome issues with which to deal. Australia and Canada have benefited greatly from the boom in emerging markets and the associated rise in commodity prices. If China slows, all of Asia slows and Australia will feel the brunt as demand for their iron ore and other commodities moves with Asian growth. If lower Asian growth materializes, Australia’s housing boom also likely comes to an end and bank losses and housing busts are as closely associated as Lindsay Lohan and rehab. For our northern neighbor it cannot be stressed enough how much of their overly hyped good economic performance is a direct result of high commodity prices. There have been persistent whispers of lax lending practices at Canadian banks for years now and lower commodity prices may just be the thing to reveal how much they really learned from the US bust.
In Europe, the banking system has so far been saved from itself by forcing first the Greeks and now the Irish to borrow from Peter to pay Paul. Greek and Irish citizens aren’t happy about being forced to bail out German and French banks. Germans aren’t happy about bailing out Greece and Ireland. The Spanish, French, Portuguese and Greeks are upset that they can’t find someone - anyone - to pay for their early retirement. The Italians, as always, don’t seem too upset about anything yet and unless someone threatens to prevent them from being too damn cool for the rest of Europe they probably won’t join in the protesting that seems so de rigueur on the rest of the continent. But make no mistake the political mood in Europe is far from calm and further efforts to bolster the banking system may run into insurmountable public opposition.
Europe’s debt problems are now at the stage where the ECB has little choice but to buy the debt being issued by Spain, Portugal, Greece and Italy. The banking system is so insolvent it makes the US system look conservatively financed by comparison. With Germany essentially the last healthy economy in the Euro bloc, the powers that be can hardly afford to see the European banking system implode. A lower Euro is seen by the ECB much as a lower dollar is seen by the Fed. They might not have a fancy name for it like the Fed but the ECB is just as guilty of Quantitative Easing - debt monetization - as the Fed. Unfortunately, it is the same emerging markets that are already suffering from dollar flight that will bear the brunt of the capital flows out of Europe. Some of it may come to the US - hence the higher dollar against the Euro - but the majority will likely seek higher growth rates in Asia and Latin America.
What all this means is that the global imbalances that have been blamed by so many for our problems, rather than getting better, will only be getting worse. These imbalances, contrary to the belief of US politicians in the thrall of faulty mercantilist policies, are not caused by the Chinese or any other emerging markets holding down the value of their currencies. The imbalances are caused by bad economic policies in the US and Europe and can be reversed only by correcting them. Refusing to do so will only further bolster the protectionists and inflationists in the developed world and increase the chance of a major policy error. And this is where I find my greatest cause for anxiety.
In the US, the mood of the electorate means that our politicians have a once in a lifetime opportunity to finally address our fiscal problems. The public understands that hard choices need to be made and are seemingly prepared to accept a certain amount of sacrifice as long as it is fairly shared. President Obama seems to understand that and has let it be known that he intends to push for major tax reform and deficit reduction. Done right, deficit reduction and tax reform have the potential to reverse the capital flow to emerging markets back to the US. Combined with monetary policy that strengthens and then stabilizes the value of the dollar that could mean much higher growth rates for the US, a rebalancing of world economic growth and less pressure to enact trade restrictions. Done wrong or not at all, deficit reduction and tax reform have the potential to accelerate us toward higher inflation, protectionist policies and international conflict.
President Obama and the rest of the political establishment may eventually do the right thing but I do not expect it to be an easy or quick compromise. There is a lot of water yet to flow under the bridge of deficit reduction negotiations and there lies a lot of potential market anxiety. Right now the market is priced as if all this is already assured. History tells us that is unlikely and that more often than not politicians choose the easy path rather than the proper but harder one. If that happens this time, the market fallout could be considerable. Alhambra enters this year with a larger than normal allocation to cash that pays us nothing but has the virtue of maintaining at least its nominal value. I would not be surprised if at some point this year other managers find themselves scrambling to get to our position. That will be the time to start looking for silver linings and filling the punch bowl. Until then we will maintain our cash reserve and our reserved mood.
If you'd like to receive this free weekly commentary by email, click here.
Weekly Chart Review, click here.
Yep, hopeless hopeful maybe.
Regards, Ken
Name (required)
Mail (will not be published) (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>
© 2008-2009 A.I. Research. All rights reserved.
wikinvestStockQuotes_callbackUrl = 'http://alhambrainvestments.com/wp-content/plugins/wikinvest-stock-quotes/wikinvest-stock-quotes.php'; wikinvestStockQuotes_blogUrl = 'http://alhambrainvestments.com'; wikinvestStockQuotes_wpVersion = '2.6';© 2008-2009 A.I. Research. All rights reserved.
Read Full Article »