Has the Fed Engineered a Soft Landing?

by Paul J Nolte CFA, Dearborn Partners. November 16, 2006

For all the fears over inflation, especially when the headline PPI/CPI figures were running high due to energy prices, are beginning to come down. And this phenomenon is not just in the US, but in countries around the world, inflation rates are coming down. Interest rates are another story, as rates in the US remain well above those around the world. According to data from ISI, their composite inflation index from 36 countries shows 30 with slowing inflation and the index now at the "deflation fear" lows of '03-'04. And like the Energizer Bunny, the stock market keeps going and going. While theories abound about economic growth, the impact of housing and an irrational financial market – let's take a look at what IS going on and make some guesses as to what may follow.

The economy is most definitely slowing down – from over 5% at the beginning of the year to under 2% today. While housing may be to blame for some of the decline, I think much of it rests with the consumer who continues to shoulder heavy debt loads. Consumers have reigned in spending a bit, to allow the savings rate to actually rise, albeit from a negative figure (just what the "savings rate" figure actually measures is a discussion for another time!). Consumer debt, especially revolving debt is coming down – again as consumers SLOWLY repair their balance sheets.

Chart: Total Consumer Credit Outstanding

What makes the above chart all the more interesting is the very slow decline in the rate of growth of debt especially following a recession (where debt growth slows dramatically). So the consumer remains on the not too hot, not too cold side.

Housing has been the major theme of economic bears (I am one), however what has been unfolding has not been the implosion around the system that many thought – it too has been a decline that has not upset the overall economic applecart. While many will argue that "just you wait," what we are seeing is certainly affecting the home builders and suppliers (CTX & HD for example), however it has not affected, based on the retail figures released earlier this week, the broader retail industry. Yes, Wal-Mart has been hurt, but judging by their competition, it may be just a WMT problem. One benefit of the housing slowdown is the major decline in "flipping" properties – especially condos. The once high-flying condo market is actually beginning to exert downward pressure on inflation data as investors, now forced to rent the property (to get some return) are doing so at lower prices (higher supply of rental units – lower prices). We get one last look at housing information tomorrow that shouldn't jar the markets either way (it may bounce a bit or decline a bit, but much of the damage has already been done), and then it will be two weeks before we once again get meaningful data on the economy.

The inflation numbers released this week did little to light a fire under the bond market, as was expected – especially given the Fed's comments regarding their focus on inflation instead of economic growth. Although the Fed will not cut rates this year, any rate cuts early in 2007 will not be dependent upon inflation, but lack of economic growth. We won't see much data regarding growth until early December, just before the Fed's last confab of the year (a short one, filled with good cheer!). The next meeting at the end of January should be their first with some decent "trend" numbers and certainly the holiday sales booked. The Fed normally pauses after a tightening cycle for roughly nine months before they embark upon an easing cycle – so that would put their first rate cut at the March meeting. That will give them four more months of data from both the manufacturing and service sectors to help them determine whether to maintain the pause or begin cutting rates. That should also provide plenty of time for the housing impact to be seen in more than just a couple of sectors (as of yet, employment has not been impacted, thanks to some BIG revisions).

Moving toward the corporate side of the economy (and the more healthy side) the merger and buyout activity has been staggering. A benefit of all the activity has certainly been stock prices – as supply is being reduced faster than the IPOs are able to replace it. The combination of corporate buybacks or buyouts is putting money into investor's pockets that, given the sharp rise in stock prices, will be put back into stocks. In what can only be called "keeping up with the Joneses," investors (especially the professional ones) have been playing a game of catch-up since the bottom in August. Valuation levels remain elevated and earnings growth should slow (especially if the economy remains cool) and margins may also contract (as wage growth picks up a bit). So why are investors willing to pay top prices for earnings that are likely at or near a peak? The same question was asked in 1997, WELL BEFORE the peak nearly three years later. My contention is that the market is risky at current levels – but that does not say WHEN the markets will turn south. The signposts have been there for some time, but so far ignored – and it could be a while before they are heeded. So for those who have a penchant for shorting the markets – the old adage certainly applies today: the markets can stay irrational much longer than you can stay liquid. We prefer to see the beginning phases of the decline before we jump ship, realizing that to "pick a top" is a fool's game – better to stay with the trend and take the fat out of the middle.

So corporations are flush with cash, the consumer is slowly beginning to repair their balance sheets and the housing market (so far) has been a relatively contained mess. The odds do not favor a soft landing, as the Fed has only engineered one in the past ten attempts – BUT SO FAR, it looks like it has succeeded. Investors are reacting in the normal way by buying stocks. In fact, we are seeing hedge funds increase their equity weights and those in RYDEX funds shun the short funds. As mentioned above, the market is already at a high valuation and room for a new bull market seems rather small. So, where should investors go for return? How about them bonds? We saw this in the late 90's as investors piled into stocks and left the safety of treasury bonds. Over the period from 1997 to 2002, even though stocks rose dramatically until 2000, the performance of treasuries clobbered stocks for that five-year period. I believe that a similar period may be at hand. While not exciting, total returns on ten-year treasuries could approach 10% for the next five years as the Fed cuts rates (we haven't seen a cycle of rising rates followed by a pause and then another rising rate environment – I know there is always a first!), while stock returns may struggle just to be positive.

One quick note as it will be covered much better elsewhere than in the time and space available here: we note the passing of a giant in the financial field, Milton Friedman. His lasting contribution was extolling the virtues of a reduced size of government that was embraced by both President Reagan and British Prime Minister Margaret Thatcher in the 1980s. While many deride his monetarist views, his impact upon economic policy and views over the last quarter century cannot be questioned.

Finally in today's markets: they finished higher as the inflation data came in better than expected and a large drop in oil prices ahead of option expiration Friday. Still struggling with the 1400 level, the SP500 has finally broken free of the 1390 level from which it has been turned back three times this year. Bonds struggled to maintain their gains, even in the face of bond friendly data. The yield curve remains inverted, keeping the risks of a recession at a level something above zero (likely closer to 35-40%).

Paul Nolte

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