The stock market continued to defy gravity last week in its ongoing attempt to make me look like a fool for trying to predict its movements. We’ve recently moved our portfolios to a neutral risk position from the more aggressive stance we adopted during the great sovereign debt scare of last fall and are contemplating an even more conservative posture. While no one can predict the market’s short term movements, that shouldn’t be an excuse to ignore the risks of a market – and an economy – primarily supported by monetary excess.
There is a group of prominent economists, from Paul Krugman to Scott Sumner and many others, who believe what ails the US economy is a lack of inflation. In their view, the Fed has the ability to raise the nominal growth rate of the US economy but hasn’t taken sufficient action to get the old animal spirits flowing again. I am somewhat sympathetic to this view in that I believe the Fed can produce more economic activity through inflationary policies. Where I part company with this august group is on the question of whether the Fed should use monetary policy to produce economic activity. One need look no further than the recent housing bubble to confirm that the Fed can induce investors to part with their hard earned dollars through the application of loose monetary policy. And one need look no further than the bursting of that bubble to understand the limitations of doing so.
There seems little doubt that the global easing of the last six months has produced more economic activity than would have prevailed absent the easy money policies of the ECB, Fed and other central banks. One of the reasons we remained fairly positive about the macro economic backdrop despite the problems in Europe was our belief the ECB, likely in concert with the Fed, would provide this stimulus and that the deleterious effects of the policy would lag the implementation. Unfortunately, the lag appears to be over and the consequences are now becoming more obvious. Commodity prices are rising and with them the odds of renewed economic weakness if not outright recession. When the world’s central bankers stop inflating, in response to higher prices, so will the global economy.
The problem with attempting to force recovery through monetary means is that central banks cannot control how the new money they create will be used. What the Fed wants is for their easing to induce investments in productive activities but what they keep getting instead is a rush to real assets as investors try to protect their hard earned wealth from currency devaluation. Instead of investments in factories we get investments in high cost shale oil and oil storage facilities in Cushing, OK. Instead of new companies we get an expansion of grain storage because corn has become a more reliable store of value than the US Dollar.
I don’t like having to shift the risk stance of our portfolios every six months. It’s tiring, difficult to do well (although I think we’ve done a better job than most) and most definitely not my preferred way to invest. But in a world of stop/go monetary policy and risk on/risk off trading, it is the only prudent course of action. I would much prefer to spend my days researching promising companies around the world rather than reading the latest Fed speech or trying to decipher the latest round of LTRO by the ECB. Unfortunately, this is the environment in which we live and the one in which I must invest. So, now, I’m once again on the defensive as the ill effects of easy monetary policy come to the fore. As I’ve said for years now, true recovery must come from the fiscal side of the equation. Until then, this is all just money illusion. Don’t be fooled by the monetary sleight of hand.
The economic data was a bit thin in a holiday shortened week and what there was continued the mixed trend of the last few months. For sure there are some signs of solid improvement – weekly jobless claims for instance – but overall there is little evidence that the economy is accelerating. Housing construction has expanded some but the data on existing and new home sales last week was, if anything, disappointing. Manufacturing continues to be a bright spot but one wonders how long that will last as China and Europe both appear to be slowing.
Existing home sales rose in December but less than expected to a 4.57 million rate. Prices were down substantially and while inventory is relatively low at 6.1 months it appears we haven’t yet worked through the full price adjustment. New home sales fell sightly, down 0.9% and remain at a paltry level of 321k annualized. There are still reasons to believe that construction of housing will add to GDP this year but at this rate it won’t be much. Inventory is extremely lean at these reduced sales levels though so any pickup will likely mean an immediate increase in building.
The Kansas City fed manufacturing survey was solid showing a slight improvement in the growth rate. Offsetting that was a slight slowing in the Chicago Fed National Activity Index. The latest readings for January show a sharply slowing contribution from production, a rising contribution from employment and from sales/orders/inventories, and a slightly decreasing drag from consumption & housing. The Goldman and Redbook retail reports both showed year over year growth at the slowest rate in the last year (around 3%). It will be interesting to see if these reports show more weakness as gas prices rise.
Jobless claims showed further improvement, falling to 351k on the week. This is likely behind the improvement in consumer sentiment which is at its highest reading since the recovery began. It should be noted that sentiment is still well below readings of prior expansions. Employment is a lagging indicator so I would not be surprised to see another solid month of gains in the February report which comes out in two weeks. However, rising commodity prices and peaking profit margins will make corporations reluctant to go on a hiring binge so the gains will probably still be limited. Claims are a coincident indicator and should give us warning if employment is stalling long before the actual employment reports.
Stocks were up again last week but as has been the case for the last three weeks, commodities outperformed. Gold was up again last week but other metals, including platinum, copper, aluminum and palladium are also rising again. Oil also had a big week with WTI up over $7 and nearing $110. Most of the recessions of the last 40 years have been preceded by a rise in oil prices but of course that is a consequence of easy monetary policy. Oil prices, as discussed above, are an effect of inflation, not the cause. The real damage is the distortion of investment caused by hyperactive monetary policy. Capital is wasted on projects that only make sense during the inflation. When the inflation ends we’ll discover that capital has been wasted and our economic hole has become that much deeper. How soon that happens, no one knows but my guess is that it will be a lot sooner than anyone, including the Fed, currently expects.
For 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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