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Well, thank goodness the politicians finally managed to find a budget compromise that allows both sides to stockpile talking points for the next election and keep the government operating through the end of the fiscal year. The amount cut from the budget amounts to a rounding error but will either save the US economy from bankruptcy or cost hundreds of thousands of jobs and a plague of locusts depending on which side of the political aisle you believe. Meanwhile, the dollar continues to sink, commodity prices continue to rise and the uncertainty of the US fiscal position remains. We’re $14 trillion in debt and our politicians are busy donning their togas and warming up their fiddles.
The compromise was mere political theater and the market didn’t seem to care much whether a deal was struck or not. And for good reason; the real budget battle will evolve over the coming months and any shutdown would not have lasted long. The public may want to cut government spending but shutting down the national parks isn’t part of the preferred solution and woe to the politicians who screw up the family vacation. It occurred to me at one point last week that we’d be better off shutting down the “essential” parts of the government and keeping the non “essentials”. I’ll trade keeping Everglades National Park open and my friend in the parks service employed over paying ethanol subsidies to Archer Daniels Midland any day.
Now that the small detail of a budget for a year that is half over is resolved comes the hard part of negotiating a budget for next year and beyond. Paul Ryan presented a Republican budget last week that is heavy on theoretical savings, light on the actual kind and essentially dead on arrival. There is no way a Democratic Senate would pass the document and no way President Obama would sign it. And frankly they shouldn’t but not for the reasons they’ll list. Ryan’s budget isn’t much better than the one presented by the President. Neither side of this debate has had the guts to tell the public the truth about our budget situation. We cannot cut the deficit down to size - much less balance the budget - by merely taxing the rich and we can’t do it without reforming entitlements. And from a moral perspective we shouldn’t do it without cutting military spending. Furthermore, any positive change on the fiscal side needs to be matched by reform of our dysfunctional monetary regime.
Stocks have been rising since the Fed announced its intention to expand its balance sheet last fall but measured against gold, stocks have made no progress. They have done slightly better in relation to the trade weighted dollar index but with most of our trading partners also stomping on the monetary accelerator that measure seems insufficient to capture the true picture. Meanwhile, the prices of anything found in the ground or grown from it are rising rapidly offsetting any positives we might have seen from rising stock prices. All the Fed has done is introduce another uncertainty into an economy already beset with too many unknowns. And now, the market must also contend with the impending exit of the Fed from a Treasury market where yields are rising despite the Fed’s heavy buying.
One thing the Fed’s policies have accomplished is to raise the “animal spirits” of investors. The herd of stock and commodity bulls - species not normally known to comfortably co-exist - is expanding rapidly and bears are hard to find outside the zoo. Having fostered and then burst a housing bubble, the Fed is now nurturing another in the apparent hope that all those out of work construction workers can find employment in the mining, oil or finance industries. Unfortunately they’ll need a visa to get the resource jobs because most of them are found in emerging markets and construction workers are too honest for the finance industry.
Speculation is not a substitute for real economic growth. Until we get budget and tax reform that really addresses our problems the US economy will be captive to the start/stop policies of the Federal Reserve. If the start of QE II ushered in a phase of speculation that pushed up stock and commodity prices isn’t it logical to assume that the end will do the opposite? The one wild card in that equation is the introduction of new liquidity by the Bank of Japan in response to the earthquake there. The G-7 intervention to cap the rise of the Yen is so far having the desired effect with the Yen falling nearly 12% from its recent high. It isn’t coincidence that commodity prices and emerging markets have risen in lock step with the fall of the Yen. QE II may end here in the US, but QE III is already underway courtesy of the BOJ. Speculative markets are not for the faint of heart or conservative investors. We remain very cautious and continue to hold a large reserve of cash, TIPs and gold.
The economic data last week seemed to confirm what we’ve suspected for a while - the rate of improvement in the US economy is peaking. That is not a comforting thought with no progress on the budget front, the impending end of QE II and a still high unemployment rate. Of course a peak in the rate of improvement is not the end of the world or the expansion but with growth in the first quarter already pretty lame, it surely isn’t good news.
The Goldman and Redbook retail reports were mixed with the former showing improvement and the latter not. Chain store sales later in the week seemed to support the Redbook version as same store sales were positive but only in the low single digits. Many chains also claimed that gas prices were siphoning off sales which isn’t surprising but does beg the question of why the Fed believes that only core inflation matters to the economy.
The ISM non manufacturing report, like its manufacturing version last week, showed a slowing of the expansion. Business activity, employment and new order growth all slowed. Prices remain severely elevated. By the way, this report does not reflect any impact from Japan yet which might slow things further.
Jobless claims fell ever so slightly last week to 382k. Claims have stalled in the high 300s and that just isn’t good enough to get excited about employment. I suspect a lot of the stall in jobs is related to the rise in prices. Companies are likely to remain reluctant to hire as long as their other costs are rising rapidly. They might also be more likely to layoff an employee; a chemical company can’t function without fuel but it can probably get by with one less worker.
Wholesale inventories rose again in February adding to a build that spans the last two quarters. Again this doesn’t reflect what is happening in Japan but it is noteworthy that a rising number of respondents to the ISM survey are saying their current inventories are already too high.
Overall, the reports last week showed an economy whose rate of growth is peaking. Unless we get something positive from economic policy that isn’t likely to change. The Fed is hoping that the recovery will turn into something self sustaining but my rose colored glasses are in the shop so I’m not sure what they are seeing to arrive at that conclusion. Growth is already below par and I don’t see anything on the horizon that improves the outlook. Maybe the Fed is about to hire a bunch of helicopter pilots?
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