The US Syndrome
by Paul J Nolte CFA, Dearborn Partners. May 30, 2007
The China Syndrome – a movie from 1979 describing the conditions in a nuclear power plant that if the core melts down (as was the fear), it would go clear through the Earth to China. If made today, it may have to be renamed the US Syndrome, for if the Chinese economy melts down, it will wind up in our lap. Once again, the Chinese government instituted policies that are meant to slow their fast growing economy. However, unlike the meltdown at the end of February and again last month, this was met with more of a yawn in the US markets than frantic selling that met the first rate increase in late February. Investors have been "taught" via the various declines beginning with the one ending in July 2006, that buying the dips is profitable and the right thing to do in this bull market. However, while this bull market may yet have further to rise, the foundation of the markets are being eroded slowly – putting investors' profits at risk and the risk of yet another "meltdown" more real with each passing day.
The economic numbers continue to deteriorate – even if consumer sentiment remains buoyant. The housing figures remain poor, judging by the release of the MBA refinance index. Both new purchases and refinance activity were well below expectations, with the refinance activity near a new low for the year. This should come as little surprise, given the dual dynamic of lower overall housing prices and higher interest rates (with the 10 year bond touching 4.9% - also near the highest this year). We will get the equivalent of the Super Bowl for economists on Friday (via a month beginning on Friday) with the ISM manufacturing data, employment, spending and income. This should go a long way to setting the stage for further market gains or the beginning of a summer correction. Let's look at what may be reported. First, the employment situation: after months of corrections and adjustments, a rolling 12 month average of non-farm payroll gains has turned lower after peaking in March 2006 at the lowest level since the late '50's. This follows the largest losses since the recession of 1981-82. Given that May 2006 non farm payroll gains were only 103,000 – anything above that number will bump the averages higher a bit, however gains then averaged 183,000 for the summer months – even in the face of a slowdown in the housing sector. So while employment may provide a good read this month, it may be only a temporary respite as the hot summer begins to unfold.
Source: Federal Reserve
The second biggie – the ISM manufacturing data will be watched closely to provide some guidance as to the health of the once important manufacturing sector of the economy. However, since much of the economic growth over the past couple of years was built on the backs of the housing market (which is not fully captured in the ISM data), gains or losses in this index will provide little clues to the implied health of the housing market (better to look at the NAHB data – which is at/near record lows). In fact, when looking at a sum of key components of the report, only six months of the past two years were actually positive – so manufacturing remains in the doldrums. Looking at last year's report as a clue, the index fell by over two points, surprising investors that we may be entering a recession. Based on other reports that have been out over the past couple of weeks, we may get a decline, but I doubt it will put investors on the defensive.
Finally, the consumer income and spending reports – to assist in determining whether the consumer is spent or still has spending resources. While many bemoan the savings rate (or lack of) that is implied by this report, it ignores wealth generated by 401k savings growth in the overall asset base etc. Like many reports generated by the government, it is flawed. However, it does a decent job of looking at how much consumers are spending – whether it is growing or contracting. Over the last few months, the report showed a modest slowing in the rate of spending (relative to income gains) that led many to believe that consumers were actually beginning to save and repair a very poor balance sheet. We will look to this report as a gauge of spending levels, especially in light of much higher energy prices.
Today's markets (and for that matter this week) has been focused upon the economy, both here and abroad. The Fed released their minutes from their May meeting, which indicated they were still very worried about inflation and that growth had moderated some, but not of a major concern. It was enough to reverse stock prices that had fallen as a result of more issues in China. This is their third attempt to slow the speculation in their markets, causing ripples across the oceans of liquidity floating around the world. While the move today will not have an immediate impact, especially here, it does say a lot about what the China government's intent is regarding their economy and financial markets – they want to clamp down. With China being an important "marginal" player in the world marketplace, the ignoring of these changes will come at the peril of investors worldwide. For now, we are happy within our shores that China will produce all we can buy and all the money we send over there will get reinvested in our bonds that fund our spending of these goods. At some point the dancing about the Maypole will end – but not today!
The economy is certainly slowing – not falling out of the sky. The equity markets are functioning upon the carry trade (see China's investment in Blackstone) and merger and acquisition activity that is going on separately from the economic landscape – not because of it. So it goes in the equity markets today – after stumbling early, a rally ensued pushing the S&P 500 to all-time high levels that the Dow surpassed a couple of months ago. Bonds, after being the safe haven investment early in the day, sold off as the Fed minutes were released indicating inflation was still job #1. Finally, oil stabilized and gold continued its decline and more importantly milk is pushing levels seen only once in the past 10 years. Maybe all the corn being converted to alternative fuel is having an effect?
© 2006 Paul Nolte