Ben Bernanke, in a speech at the Brookings Institute, declared this past week that the recession is likely over, but that the recovery will be muted. Specifically, he said:
Having said that, I’ve seen some agreement among the forecasting community at this point that we are in a recovery, that we will see growth in the third quarter continuing, and that growth will continue into 2010.
But the general view of most forecasters is that that pace of growth in 2010 will be moderate, less than you might expect given the depth of the recession, because of ongoing headwinds, including still ongoing financial and credit problems, you know, deleveraging by households, the needs for adjustments in the economy, sectoral adjustments in the economy, the need for a fiscal exit at some point, many, many factors that will likely, at least based on current information, make the 2010 recovery moderate, and in particular, not much faster than sort of the underlying potential growth rate of the economy….
Of course, there is on both sides of that forecast; we could have a stronger recovery, we could have a weaker recovery, but if we do, in fact, see moderate growth, but not growth much more than the underlying potential growth rate, then, unfortunately, unemployment will be slow to come down. It will come down, but it may take some time. Obviously, that’s a very serious concern, and that’s one reason why, even though from a technical perspective the recession is very likely over at this point, it’s still going to feel like a very weak economy for some time as many people will still find that their job security and their employment status is not what they wish it was, and so that’s a challenge for us and all policy-makers going forward. (emphasis added)
Considering Mr. Bernanke’s forecasting track record it is tempting to dismiss anything the man has to say about the future of the economy, but since monetary policy is likely to be made based on the clarity of his crystal ball, it is of some importance to investment strategy. Just as important is the consensus expectations of the “forecasting community” Mr. Bernanke speaks of since they are the ones who essentially set the expectations of the investor community.
While there are often divergences between economic performance and investment performance in the short term (see the recent stock market performance), over the longer term, economic fundamentals are the driving force of investment returns. That being the case, divining the future of the economy is a very important part of formulating an investment strategy. If you get the economic forecast right (wrong), you will likely get the investment strategy right (wrong) as well.
What I look for as a contrarian investor is an extreme where seemingly everyone comes to believe that the future will unfold along predictable lines. I believe just such a condition is now present in the expectations regarding future economic performance. As Bernanke points out in his Brookings Q&A, the consensus is that the recovery will be “moderate” and that employment growth will be weak. Bernanke seems even more pessimistic saying that “it’s still going to feel like a very weak economy for some time”. The underlying reasoning for this forecast is pretty simple; consumers are saving more and spending less and since consumer spending is 70% of GDP, the recovery cannot be robust. For sure there are variations of this reasoning and much more detailed explanations, but basically all the forecasters come back to this concentration on consumer spending.
To believe this scenario one has to ignore the history of economic recoveries and make this recession something exceptional. Most accomplish this by making comparisons to the Great Depression which is basically the only other time in US history that recovery from recession/depression followed the weak recovery path (and even that is arguable since the recovery from 1933-37 was quite robust). Other than that one particularly bad example, recoveries have tended to mirror the preceding downturn. The deeper the depression the steeper the recovery. In other words, to believe in the weak recovery scenario, one has to believe that as in the Great Depression, IT’S DIFFERENT THIS TIME. Those are four particularly dangerous words for an investor.
One also has to believe, contrary to years of economic research, that spending is the key to economic growth. But economic growth is a function of investment and the very retrenchment that others so lament – the rise in the savings rate – is exactly what is required to ensure future growth. Investment is funded from savings so the increase in savings which limits current consumption is not something that needs to be corrected but rather something that should be encouraged. Consumption is the result of investment and economic growth, not the cause.
Indeed, looking at the recent GDP statistics reveals that the recently departed recession was not caused by a fall in consumption but rather a fall in investment. In the nine quarters since Q1 2007, Personal Consumption Expenditures have subtracted from GDP in three quarters (Q1 08, Q3 08, Q4 08), but Gross Private Domestic Investment has subtracted from growth for fully 7 of the nine quarters. Since the recession started in Q4 07, PCE has declined by less than 1% ($98.5 billion). By contrast, GPDI has fallen by 29.6% ($656.2 billion). If the recession was caused by a drop in investment spending, why would recovery be dependent on a rise in consumer spending? The answer is that it doesn’t.
The question then becomes, what will cause a rise in investment spending? For the answer to that, one must only go back to the top of this article and read Mr. Bernanke’s remarks about the expected trajectory of recovery. The Chairman believes that the recovery will be muted and employment will lag. Because of the Fed’s dual mandate – low inflation and full employment – that means that monetary policy will remain accommodative until employment starts to improve and probably for a good spell after. Why? The answer to that can be found by reviewing the statements that accompany the FOMC meetings. Here’s the relevant portion from the last statement:
The prices of energy and other commodities have risen of late. However, substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.
Bernanke and the other members of the FOMC believe in the output gap theory of inflation. As long as the capacity utilization rate stays low, they believe inflation won’t be a problem. With that rate scraping along 11% below its long term average, the likelihood of the FOMC tightening policy anytime soon is basically nil. And as long as interest rates are held artificially low and the Fed remains intent on providing liquidity to all comers, almost any investment project can make sense. Low rates also act to increase investors’ appetite for risk as holding low risk investments such as TBills is decidedly unrewarding. Savers have to go out on the risk curve to find acceptable yields. For evidence of such behavior, I offer this:
Including high-yield, high-risk, or junk, debt, companies have borrowed at least $892 billion in bonds this year, a 31 percent increase from 2008. High-yield bonds are rated below BBB- by Standard & Poor’s and less than Baa3 by Moody’s Investors Service.
Now just because investors are willing to purchase these bonds is not evidence that the investment which drives GDP growth is about to rebound. The proceeds of these bond sales could have been used to retire other debt or it may be husbanded for a future rainy day, but the point is that the capital to fund investment, even of the risky variety, is available. And at some point companies will once again start using their funds to invest for the future and even a relatively small improvement on that front will mean a rather large improvement in GDP.
Regular readers may wonder, after I’ve criticized the Obama administration (and the Bush administration for that matter) so frequently, how I can believe that the recovery will be substantial. Quite simply, whatever my complaints about the current administration’s policies, those policies aren’t sufficiently bad to offset other factors. The most obvious is the powerful dose of monetary policy introduced by the Fed since the panic last fall. A less obvious one is the incredible resiliency of capitalist economies. I recently reviewed some of the history of the Great Depression and it reminded me that the Roosevelt administration’s economic intervention was more extreme than most realize.
The alphabet soup of government agencies, the demonizing of business and the micro management of the smallest details of the economy during FDR’s tenure would make the average tea party patron’s head explode. FDR’s “brain trust” was a group of young idealists with the best of intentions – and a deep admiration for the planned economy of the Soviet Union. And their policies reflected that to a degree that most Americans today do not appreciate. If the US economy overcame their best efforts, it will surely survive anything the Obama administration can throw at it.
Just to be clear though, my anticipation of a significant economic rebound does not in any way endorse the current efforts of the Fed. Their current policies will be effective at reviving economic activity but the fact that low interest rates, at least to some degree, were responsible for getting us in this mess should not be forgotten. As I said above, with interest rates this low almost any investment project can be considered viable. There is no doubt in my mind that a lot of the “investment” that comes out of this episode will prove to be just as ill considered as what emerged from the last.
As for the preferred policies of the Obama administration I suspect the fear over them is a bit overblown. Yes, taxes will rise and something that will be called health care reform seems likely to pass, but Congress isn’t interested in any big changes which might threaten their re-election chances. And as the recovery takes hold, their desire and justification for radical reform will be lessened even more.
So, after roughly 1600 words of positive outlook, I come to a warning. I cannot foresee the future any better than anyone else. My expectations are based on history and are therefore limited by the fact that the present is, like any other period, unique. Exogenous shocks, as we discovered last fall, do happen and the only thing we can do is adjust when they do. I am, as always, worried about a lot of factors: the falling dollar and the consequent rise in commodity prices, the increase in the federal debt load, our high corporate tax rate, a recent rise in protectionism not just here but around the world, the effects of higher taxes and the potential for terrorist acts just to name a few. As worried as I am though, I cannot ignore the lessons of history.
Weekly Economic and Market Review
The economic releases for the week were again relatively positive. One wonders how long it will take for the analysts to recognize the trend; the surprises continue to be on the upside. The inflation numbers released last week, while offering soothing year over year trends, continue, in my opinion, to show inflation lurking just beneath the surface. The Producer Price Index was up 1.7% in August after a 0.9% decline in July, but fell 4.3% from the same month last year. Unless we see a big drop in oil prices soon though, those year over year declines will soon come to an end. In addition, intermediate and crude goods prices rose in the report. The Consumer Price Report showed similar dynamics. The year over year decline was 1.5% but that includes a 30% drop in gas prices. As noted above, the comparisons with last year will soon turn positive and it should be noted that ex food and energy, the year over year comparison is already positive. And the Fed is still worried about deflation; go figure. Retail sales came in higher than expected thanks primarily to cash for clunkers and higher gas prices, but the report showed fairly widespread improvement. The only categories to fall were furniture and building materials.
The Empire State and Philly Fed surveys were also better than expected and point to substantial improvement. Inventories fell again, but as I’ve pointed out before, the inventory/sales ratio is still a little too high. It is moving in the right direction though and production will have to increase soon to replenish inventories. Industrial production rose for the second straight month. IP tends to bottom with the economy so this is a trend that bears watching. Jobless claims fell a bit but are still stuck at a high level over 500,000. Housing starts and permits rose, but it was a pretty weak followup to last month’s report. And finally a note about the TIC data released last week. The TIC data covers the flows of capital into and out of the US and this month showed that private investors are still abandoning the US as the dollar falls. Or is the dollar falling because capital is leaving? The bottom line is that private investors see better opportunities outside the US. While I hate to find myself in the consensus, in this case, I happen to agree. There are many economies outside the US that I think offer better investment opportunities even as I expect a significant recovery here.
Stocks continued to defy the underinvested who so desperately want a correction, rising over 2% on the week. If bull markets are built on a wall of worry as the old saying goes, this one still has plenty of building material. I see nothing in the sentiment indicators that worry me although the bulls in the AAII poll have risen to 42%. Fortunately the bears are just behind at 40% so there is plenty of skepticism on the part of individual investors. That can be seen in the mutual fund flow numbers as well which continue to show mutual fund buyers pouring money into bond funds and selling US equity funds in favor of the international variety. It seems that most individual investors are still more worried about return of their capital than return on capital. So will the bull continue to run? While a short term correction could be right around the corner, I suspect there is more upside to this market. My target range for the S&P 500 (1100-1200) is rapidly approaching though, so the rate of ascent may slow. That target though is based on technical factors and may have to be revised if the fundamentals improve more than expected. On that score, earnings season approaches soon and like last quarter I expect earnings to beat expectations handily. It will be interesting to see how the market reacts.
If you’d like to receive this weekly update by email, please click here.
The S&P 500 is rapidly approaching my target. Caution is warranted:
The US dollar’s descent has moderated a bit; a bounce may be in the offing, but the long term trend is still down:
Gold has gotten a lot of attention lately but platinum has outperformed gold this year and is breaking out above resistance:
Copper has been a great performer this year but has stagnated over the last 6 weeks. There have been persistent reports of stockpiling by the Chinese and if their buying is sated, even an increase in economic activity may not be enough to move it higher. I will take profits on a break below 270 and wait for a better entry point.
There may be trouble in the commercial real estate market, but you can’t find evidence of it in the REITs:
The mortgage REITs, which I recommended earlier this year, had a good week. As long as the yield curve stays steep, the trend should continue:
The recovery in high yield bonds continues:
The stock markets of commodity based economies continue to outperform. Australia, Canada and Brazil remain favorites: