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I spend a lot of time reading the economic tea leaves. Given my well known distrust of politicians and government, it is a bit of ironic that I spend so much time poring over the details of government produced reports but there really is little choice. I also look at privately produced reports such as the ISM surveys but the real concrete data is produced by the government. I use these reports to try and gain some insight about the future of the economy and how that future might be reflected in markets. It is a difficult endeavor at best and I don’t trust all the data but one must work with what is available.
It is no secret that I’ve turned more negative about the recent economic data. That is primarily a function of what I see as an emerging inflation problem created by loose monetary policy. The Fed’s quantitative easing program was designed to raise inflation expectations and it has succeeded beyond Ben Bernanke’s wildest dreams (see below). It has also succeeded in raising actual inflation though and that is what concerns me. Inflation produces uncertainty along with pressures on businesses and individuals that reduces long term growth. Individuals and companies spend more on essentials while saving and investing less. They spend more time necessarily worried about the present and less time planning for the future. It might push up current consumption - which was the Fed’s goal - but it comes at the cost of future investment and growth.
There is no denying that the economy has improved since the worst days of the recession. My wife and I eat regularly at a small Vietnamese restaurant near our home in Miami. This establishment is in a strip shopping center with ample surface and rooftop parking. In the 80s and 90s a popular sports bar was the anchor tenant and when it was hopping the only parking was on the roof. The sports bar is now closed (although a new pub has recently opened in the space) and surface parking has been sufficient - until now. In the depths of the recession we parked right in front of the restaurant. A year ago we parked one row back. Six months ago we parked two or three rows back. Last Friday we parked on a crowded roof.
There is also no doubt that markets have improved since the spring of 2009. Stocks have had a big run and individuals are again bullishly pouring money into domestic stock funds (along with emerging markets again). Junk bonds have performed almost as well as stocks. REITs have done even better than the general stock market despite recurring worries about the commercial real estate market. In what most see as a sign of a better economy and I see as a potential worry, commodities have also moved up considerably. (One question for those who see rising commodity prices as evidence of a better economy: If rising commodities are evidence of an improving economy, why did commodity prices fall the 90s?) Credit spreads have narrowed. Profit margins are at near record highs. In other words, despite a lingering employment problem, things are pretty good right now.
Unfortunately, investing is not about how things are right now. If I invested based on how full the parking lot was in the spring of 2009, I would not have been buying stocks back then, I’d be buying them now after they’ve gone up 100%. That is a recipe for buying high and selling low, a strategy I don’t recommend. Investors have to look past the bad times and the good times as well. It is axiomatic that one follows the other; the only issue for investors is the timing. So when things are good - as they are now - investors should be thinking about and planning for what could go wrong.
For the current cycle, it seems to me the most important issue is how the economy will fare when the various and sundry “stimulus” efforts fade. We have yet to correct the underlying problem with our economy, namely excessive debt. Individuals are saving more but massive public deficits have kept our total debt rising. We may have put off the day of reckoning - and my Vietnamese friends surely appreciate it - but the piper must still be paid. I see no way we can solve our debt problem without more - possibly significant - pain. To this observer, markets are not currently priced to reflect that reality. Ignore the parking lot and act accordingly.
If you just read the headlines, last week’s economic data looked fairly strong. The details, on the other hand, revealed a common thread that will have to be addressed sooner or later - inflation. Sooner may be sooner than the market expects too. A number of speeches and comments from Fed officials indicate a growing uneasiness with the course of inflation, actual and expected. QE II was intended to raise inflation expectations and now that it has accomplished exactly that, it seems at least a few Fed governors are wondering if it might have been too effective.
Last week’s data started with the readings on personal income and outlays for February which showed nominal gains for both. Unfortunately, when adjusted for a rise of 0.4% in the PCE price index, income fell 0.1%. Consumption rose by an inflation adjusted 0.3%. The savings rate, not surprisingly, fell again to 5.8%. The Fed’s goal of raising inflation expectations seems to be achieving its goal of inducing spending today due to fears of reduced purchasing power tomorrow. I’m not sure what the Fed expects will happen when inflation expectations turn into actual inflation but like most of DC, they don’t seem much concerned about the future. By the way, it should be noted that a large part of the rise in PCE was due to higher gasoline prices. We are indeed spending more dollars; we’re just not getting more stuff.
Inflation expectations in the Conference Board’s consumer confidence report hit 6.7% in March up from 5.6% in February. The overall report came in at 63.4; higher inflation may be good for nominal GDP but it sure doesn’t make people confident about the future. The fear of higher prices also shows up in the Chicago PMI and ISM reports. Although both reports remain well above the 50 level that marks expansion, it is the price components that are the highest. The Chicago PMI showed a slight slowing in new orders and production as it appears the index may have peaked last month. There was a big gain in the employment reading though and overall the report was positive. The ISM manufacturing survey showed similar readings. Every industry surveyed reported paying higher prices so the inflation isn’t confined to one area. This isn’t a matter of relative prices changes. The higher purchasing managers reports did not translate into higher factory orders which were down 0.1% for February. That followed a very strong January report though so it might not mean anything.
The weak reports were once again related to housing and construction. Pending home sales rose but considering the steep drops of the last two months, the gain of 2.1% was pretty weak tea. The Case-Shiller home price index showed another decline, down a seasonally adjusted 0.2%. This data is lagged by almost a quarter so it doesn’t tell us much about what is going on with prices right now, but with consumer confidence in the dirt, a rise in prices doesn’t seem imminent. Mortgage applications fell 7.5% so a quick pickup in sales doesn’t seem to be in the cards. Construction spending also fell in February, down 1.4%. Private residential spending was down 3.7%. The continuing drop in home prices and little construction will eventually clear the inventory, but government efforts to prop up prices are delaying the process.
Several reports pointed to a better employment situation. Challenger reported fewer layoffs with the quarterly announcements falling to the lowest since 1995. The Monster employment index rose 7 points, the second strong report in a row. Sectors showing strong demand include retail, utilities, education and public administration. The official employment situation report was also fairly strong at +216,000. 230k of those were private sector while government employment continued to decline. Average hourly earnings were unchanged but obviously after inflation that means a real drop. There was a sizable jump in temporary hiring. That can be taken two ways. Temp hiring is often a precursor to permanent hiring but it also shows a lack of confidence on the part of employers.
Looking at the data today, one can’t help but see the overall improvement in the economy. A quick look at history also tells us that today’s pace of recovery is anemic by any standard. Job growth is barely enough to keep up with the expanding civilian labor force which rose 160,000 last month. If job creation remains at this pace it will take almost three years to get back to the peak number of employed hit back in November of 2007. And the unemployment rate - considering population and labor force growth - will still be high.
The Fed’s policy of quantitative easing has accomplished its goal of raising inflation expectations and there are early signs that it is also raising actual inflation. How long before the hawks on the FOMC gain the upper hand and force a tightening of policy? Even if the Fed doesn’t tighten, rising prices - especially energy - will eventually slow the economy. I suspect the day of reckoning is much closer than most believe or admit. If monetary policy was the primary driver of this recovery - weak as it is - reversal of that policy is likely to have the opposite effect. If the Fed ignores inflation, the slowdown will come anyway as higher prices squeeze profit margins and real spending. I have in the past compared this era to the 70s and I stand by that. Increased dependence on monetary policy produces errors that cause inflation and a more volatile business cycle. What looks good today can change rapidly when Fed stimulus ends or commodity prices get too high. Investors need to be forward looking and start preparing for a slowing of activity no matter how it comes about.
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