Is the great bear market of 2011 over? Stocks have risen relentlessly this month culminating with a giant 3% move last Thursday. The plan revealed that day to address the European debt crisis is the most often cited reason for the rally but the resilient performance of the US economy, as evidenced by the GDP report the same day, also played a prominent role. Unfortunately, both of the “reasons” for the rally leave a lot to be desired. The debt plan produced by Europe’s politicians, long on rhetoric and short on details, has already failed if the purpose was to soothe bond investors nerves. Italy’s bond auction Friday did not go well and China indicated over the weekend they are not prepared to buy more bonds from the EFSF until further details of the fund are worked out. Meanwhile, the US economy may have managed to skirt a return to recession – the verdict is still out on that front – but it is far from healthy.
What bothers me about the rally over the last month is that it looks so much like all the other rallies of the last year. Stocks and other risk assets are rallying while the US dollar is falling. That would seem to indicate that the rally is based, at least partially, on expectations of further monetary alchemy from the Fed. If the FOMC, which just happens to convene for a two day meeting this week, doesn’t meet those expectations, the risk switch may get flipped to “off” very quickly. In addition to the FOMC meeting, we get both the ISM reports and an employment report next week. If any of those reports show a backsliding US economy, stocks could easily give back a sizable portion of the recent gains.
Further evidence that this rally is based on inflation expectations can be seen in other markets. The Australian dollar, Canadian dollar and Brazilian Real all moved higher last week which often presages higher commodity prices. Copper, platinum and gold all outperformed stocks last week. The spread between nominal and inflation adjusted bond yields also widened as long term bonds continued a fall that started at the beginning of the month.
Even if the Fed doesn’t announce new easing, the world’s other central bankers may take up the slack. China and the other emerging market nations have been tightening monetary policy but now are entering an easing cycle. Brazil has already cut rates and there are rumors that China may not be far behind. And don’t forget the ECB where Jean-Claude Trichet has held his last press conference. If the pseudo plan announced last week starts to unravel, his Italian successor will come under tremendous pressure to inflate as a last resort to hold the union together. How this affects the US will depend on what the Fed does and how it affects the US dollar. If the rest of the world is easing, I do not expect the Fed to be able to resist the urge to join the party. We may be about to get an inflationary boom. Don’t confuse it with the real thing.
Last week’s economic data continued the trend of no trend that we’ve witnessed for most of this year. There is nothing in the data to indicate significant deterioration and nothing to indicate significant acceleration. The GDP report got most of the press and you know your economy is in trouble when 2.5% growth is hailed as good news. The fact is that the US economy merely returned to the previous pace of mediocre in the third quarter from the more dire pace of the first half. It is still a long way from good and the rest of the data gave no indication that good is right around the corner.
The Goldman and Redbook retail reports both showed a slowing that has become more apparent over the last few weeks. The year over year gains are still not in recession territory although the Goldman report at a mere + 2.4% is getting closer. Redbook shows healthier gains of 4.1%. The official personal consumption report on Friday showed a healthy gain of 0.6% but with income up only 0.1%, the gains came out of savings. That could be interpreted as a positive meaning that consumers are more confident about the future and are willing to draw down savings to spend. It could also be viewed as negative since a lot of the gains were from nothing but prices increases – inflation. In the Employment Cost Index, also released Friday, a moderation of benefits costs in the quarter restrained the rise to just 0.3%. Wages rose a respectable 0.3% but one can’t help but notice that the year over year gain in wages is significantly less than inflation. Wage earners are still losing ground to the Fed’s inflationary policies and that would seem to support the more negative conclusion regarding consumption.
The most disheartening reports of the week came on housing which continues to be the biggest drag on the economy. The Case Shiller house price report showed flat prices which is better than the previous three months of declines but still not very encouraging. The year over year decline was -3.8% which is the best we’ve seen since February. New home sales did rebound by 5.7% in September to an annualized rate of 313k but only because prices fell again. Year over year, new home prices are down around 10%. Pending home sales fell 4.6% in September for the third straight monthly decline. Cancellations are still running high due to credit conditions and because buyers can’t sell their previous home. If existing homes aren’t selling well – outside of sales to investors – then new home sales are not going to pick up anytime soon.
The best report of the week was on durable goods orders. The headline showed a 0.8% decline but that is a bit deceptive. Ex-transportation, which was the only major category to decline, orders rose 1.7%. More importantly, orders for non-defense capital goods, ex-transportation rose a very healthy 2.4% following a 0.5% gain in August. Shipments, as noted by our economist John Chapman, were down slightly (-0.9%) but that follows a gain of 3.1% in August. This jibes with the GDP report which showed a 17.4% rise in equipment and software investment.
The GDP report was positive but only in comparison to the much weaker first two quarters of the year. Nominal GDP – before subtracting the effects of inflation – was up 5% which would normally be a respectable number but considering the depth of the recession, leaves a lot to be desired. The GDP deflator cut the nominal figure in half for a 2.5% real growth rate in the quarter. Too much of this “growth” is nothing more than inflation and with the Fed contemplating even more monetary stimulus, I’m not all that positive about future real growth. Getting more real growth will require changes in fiscal and regulatory policies that I don’t see coming until at least after the next election. And that assumes that a new administration and Congress actually enact pro growth policies which based on the experience of the Bush administration is quite an assumption.
I don’t want to downplay the positives in the report. They were numerous when compared to the recent past and at least point in the right direction. Investment continues to rise and even residential will likely add to GDP this year for the first time since 2006. Trade continues to expand with both exports and imports rising again, albeit at reduced rates of growth. But this overall rate of growth is barely enough to maintain current living standards and does nothing to raise them. Until we address the underlying causes of our problems – which for me is a very long list – I’m afraid this is as good as it gets.
For more information on Alhambra Investment Partners money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at firstname.lastname@example.org
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