An Economic Picture
by Paul J Nolte CFA, Dearborn Partners. May 31, 2006
Data dependent, meaning investors are left to interpret each data point to determine whether the Fed will move or not at their meeting later this month. Unfortunately, investors tend to look at data as if looking at a Seurat painting from a foot away – all they see are the dots, and miss the entire picture. Let’s see if we can push everyone away to a “safe” distance and look at the overall economic picture.
The US and global economies begins and ends with the US consumer. Today, the consumer is effectively 20% of the global economy – twice that of the entire Japanese economy. So it may be little wonder that the consumer confidence figures had such a large effect on the equity markets yesterday. Combined with a confirmation from Wal-Mart, investors spent much of the day beating a path to the exits. Look at any “confidence” poll; from the University of Michigan to ABC, they are all near multi-year lows. What is interesting among all the discussion of inflation fears is the lack of income growth and employment opportunities for workers – without either one, paying for anything higher in price is difficult. So the focus on Friday’s employment report should be on overall compensation and the duration of unemployment. Currently the duration of unemployment remains in the peak range we saw during the 1992-1997 period, before the final boom.
Why is the consumer so concerned about the future? The usual suspects are front and center – higher energy, interest rates and lower housing. The newly minted Case-Shiller Home price index, using actual home sales as an indication of pricing, show the New York City decline roughly 0.4% during March and up only 0.1% nationwide. However, housing inventory, or the amount of unsold housing on the market is now at 3.5 million units or a record level. Simple supply and demand would indicate that with record supplies, it is hard to demand higher prices. No matter where you look at housing, the story is the same – the markets are weakening and have been for the last six to nine months. As usual, it is the lag effect that the Fed will have to deal with in attempting to guess EXACTLY when they should stop raising rates.
Ben Bernanke is in a no-win situation today. He was grilled about stopping raising rates when he visited Congress last month (in effect Congressmen were wondering if the Fed’s mandate was to raise rates every time they met) and due to some ill-advised comments made YEARS ago regarding dropping money from helicopters – no matter what happens at the June Fed confab, Ben will upset someone. Many fingers are pointing to money supply (or lack of M3 being reported) as a key to the “blown-up” US economy. However, the reality points to places outside the US. The various Ms are running at relatively low year over year rates – MZM 3.9%, M2 4.5% and M1 a measly 1.8%. This contrasts with the big inflation years during the 70s & 80s when these aggregates were well over 10% (and sometimes north of 15%). Even the monetary base is growing at a 4% rate, less than one third of the pace of the early 90s. So where is the liquidity coming from? One place is Europe, where the European Central Banks are boosting money supply by a torrid 8% annual rate. While “Helicopter Ben” may have a tough name to overcome in the months ahead, investors need to look elsewhere when complaining about excessive monetary growth.
The comments coming from the last Fed meeting indicated that nearly everything was on the table, from no change to a 50bp change. Instead of the “usual” 25bp rate hike and discussion around the economy, it surprised the financial markets that such a wide view was taken – in fact the bond market sold off once they saw the report. The interpretation is that the Fed may indeed pause in June, however they still show little urgency to completely shelve the rate hiking cycle. It was very clear that the Fed is much more concerned about inflation than slowing growth here in the US. The statement keeps the door wide open for nearly anything at the June meeting and the chance that the Fed remains a long way from being done, hence the reason for the sell-off in the Treasury market.
So the BIG numbers coming up this week, that have generally been market movers in the past, are the unemployment report and the ISM data. First, second and third will be the employment report, where current estimates remain in a wide range around 150,000. The surprise to the numbers may actually be to the downside, and historically the May data has been the beginning of the end for employment growth. May 1989 – payrolls were 82,000, in May 1995 only 7,000 and May 2000 they DECLINED by 125,000. In each case, the Fed had been late in their tightening cycle (and we can say after 16 hikes, we are late in this cycle!), with expectations of more rate hikes in the future (that never materialized). Looking at the weekly claims numbers (up 10k from last employment report), help wanted ads are now at a 42-YEAR low, and finally various reports (Philly Fed, NY Empire, Richmond Fed and Conference Board data) all indicate a large drop in their employment component. Our guess is that we could see a print well below 100,000 on Friday – giving the Fed yet another reason to stand aside.
What to do in today’s markets? Don’t do what everyone else is doing! Simple enough, but looking at net inflows to mutual funds, released by the Investment Company Institute, show investors remain hungry for international funds – net total equity purchase of $26 billion in April and $34 billion in March – but all but $8 billion went international in April (about half of the March number). It should come as little wonder that the US markets have held up much better than nearly every other market (small, international or emerging markets). Bonds have been spurned as investors anticipate higher inflation and more rate hikes; in fact, there is a 96% chance (according to Fed futures) that the rate will be at least 25bp higher come September. However, with all the negative possibilities outlined above, we believe that the Fed may actually be done and rate cuts will be the focus of discussion come 2007. Since much of the economy operates with various lag effects, the last 100bp rate hikes HAVE YET to make it through the economy (and certainly have not yet been figured in equity loan payments), there remains a fair headwind for the economy and consumers to work through in the months ahead.
Finally, a couple of comments regarding the appointment of Hank Paulson to the position of Treasury Secretary – the first from Goldman Sachs since the legendary Robert Rubin. Historically, those that have come from Wall Street have had a better time of it regarding both the dollar and even the stock market. Since 1971, there have been four that have come from Wall Street: Rubin, Nick Brady, Don Regan and Bill Simon – in each case, the dollar actually rose during their tenures, as did the SP500. Only three other Treasury Secretary’s in the last 13 actually saw the dollar rise, but in all cases the dollar rise was below the 3.7% rise achieved during the Brady tenure.
Stocks could do little to maintain their gains on decidedly lower volume as some institutions square books for month end reports. The interesting portion of the markets continue to be in the commodity sectors – with energy and gold both falling on the comments from Secretary of State Condoleezza Rice regarding working with global partners to curb Iran’s work on nuclear weapons and enriching of uranium. The markets have been trading on jagged emotions for the past two weeks, and some of the comments from Secretary Rice temporarily calmed some investors. Treasuries sold off after the comments from the Fed, while global markets recovered from the prior day’s selling. As much as the bears are excited stocks are falling – they have been unable to control the market for very long. The bulls have the same trouble, after rising from the October lows; they have been unable to control the show for very long either – better for traders rather than investors.
© 2006 Paul Nolte