Newsletters 2010 Newsletters QE2
Friday, 13 August 2010 18:06
Buoyed by emerging signs that fears for a “double dip” in the U.S. economy may have been overblown, the stock market rallied from the depths of its recent correction, with the S&P 500 Composite, Dow Jones Industrial Average and NASDAQ Composite catapulting 6.88%, 7.08% and 6.9% respectively during the month. These important market benchmarks are now mostly flat year-to-date, with the S&P 500 down 1.21%, the Dow up 0.36% and the NASDAQ down 0.64% for the year through July.
Recent economic data continues to support a slower level of growth consistent with the notion of a post-crisis “new normal”, an economy weighed down by the lengthy process of consumer deleveraging, high unemployment and increasing government regulation. Indeed, second quarter GDP increased 2.4%, slightly below the consensus estimate for 2.5% GDP growth, led by a 21.9% increase in business investment in equipment and software. Meanwhile, GDP for the first quarter was revised up from 2.7% to 3.4%, so the recovery is clearly decelerating. If the level of sustainability for the “new normal” economy remains below 3%, it will not create sufficient “escape velocity” to materially improve the high level of unemployment.
The government’s latest report on the labor market revealed the creation of only 71,000 private-sector jobs in July, below the average 90,000 monthly private sector jobs that have been created so far this year. It is estimated that 125,000 new jobs need to be created each month just to keep up with population growth, let alone make up for the approximate 8 million jobs that were lost during the Great Recession. The unemployment rate held steady at 9.5%, mostly due to an increasing number of discouraged workers dropping out of the labor market altogether. The only silver lining of the jobs report is that the average workweek edged higher to 34.2 hours per week from 34.1 hours, and average hourly earnings increased by four cents to $22.59 per hour in July. The 90% of Americans that are working will have additional money to spend, save or invest as a result.
Other economic indicators offer a mixed outlook:
• The ISM Manufacturing Index slowed in July to 55.5 from 56.2 in June. This was better than the consensus expectation for the Index to decline to 54.2.
• The ISM Services Index rose in July to 54.3 from 53.8 in June, topping expectations for a drop to 53.
• Construction spending increased by a scant 0.1% in June, but this was better than the expectation for a 0.8% decline.
• Factory orders fell 1.2% in June, worse than the 0.5% decline expected by the market, after declining 1.8% in May.
• U.S. auto sales improved in July to a seasonally-adjusted annual rate of 8.94 million, up from 8.57 million in June.
• Home sales in June jumped 23.6% to 330,000 units, a significant leap from May’s 267,000 units sold.
• The Conference Board’s Consumer Confidence Index fell to 50.4 from 54.3 in June and is now at its lowest level since February.
• While orders for durable goods declined in June by 1%, business capital investments increased by 0.6%.
• Stripping out the sales of the more volatile auto dealers, building materials and gasoline stations, core retail sales rose by 0.2% in June after falling by 0.2% in May.
• Industrial production rose by 0.1% in June, beating the consensus estimate for no growth in industrial production.
Collectively, the recent economic data point to a slow recovery, but do not substantiate the fears for an imminent “double dip”. Moreover, earnings reports for the second quarter have been far better than expected. According to Thomson Reuters, 75% of all earnings reports have bettered consensus estimates. During the last eight quarters, an average 69% of companies beat the consensus. The average for a typical quarter going back to 1994 is only 62%. Whether it be economic or earnings data, the consensus had become too pessimistic.
While earnings growth has been particularly strong of late, on pace to increase 36% for the second quarter year-over-year, the consensus calls for a deceleration going into the second half of the year and into 2011. S&P’s lead analyst Howard Silverblatt now estimates 2011 earnings for the S&P 500 at $93.55, down roughly 3% from previous estimates. With the S&P 500 currently trading near 1,100, the stock market is reasonably priced at only 11.74 times next year’s estimates. Many “known-unknowns” remain unanswered, so we are satisfied with a higher than usual allocation to cash, despite these obviously attractive valuations.
In addition to data in the United States that is clearly “less worse”, recent reports from Europe and China offer no support to the “double dip” theory. In the United Kingdom, GDP expanded by 1.6% in the second quarter, much higher than the 0.6% growth expected by economists. In Germany, business confidence surged unexpectedly to a three-year peak, the highest such increase “since the reunification of Germany”. And the European bank stress tests offered no unpleasant surprises.
Meanwhile, it appears that China is successfully engineering a soft economic landing. Industrial output rose 13.4% in July, slightly lower than the 13.7% increase in June. And growth in “urban fixed-asset investment” (China’s measure of capital spending), slowed from the 25% pace of recent months to 22.3% in July. A new Wall Street Journal economic survey now expects China’s GDP growth to slow to 8% in the second half of the year, down from 11.1% during the first half.
In recent newsletters, we have written about risks to the recovery and the U.S. economy’s path to “escape velocity” in the face of waning stimulus by the Federal Reserve. After cutting short-term interest rates (through the Fed Funds rate) to a range between 0% and 0.25% in December 2008, the Fed embarked on a number of programs intended to ease tight credit conditions and stimulate economic activity, the most notable of which was the so-called “quantitative easing” campaign whereby the Fed expanded its balance sheet by buying over $1 trillion worth of mortgage-backed and U.S. Treasury securities. This quantitative easing or “QE” campaign ended in March of this year and the Fed’s balance sheet had begun to shrink in each month since March by an estimated $10 billion to $20 billion, resulting from monthly maturities in its mortgage portfolio.
In the wake of the recent economic deceleration, the Fed has announced that it will keep its balance sheet steady at current levels, approximately $2.1 trillion, by reinvesting the estimated $10 to $20 billion of proceeds from monthly mortgage maturities back into U.S Treasury securities, essentially extending their quantitative easing campaign. This second chapter of quantitative easing or “QE2” is accompanied by a further commitment to keep rates at “exceptionally low levels” for an “extended period”. Fed Chief Bernanke, a well-known student of the Great Depression, is again demonstrating his commitment to do whatever it takes to support the economy and avoid premature tightening, the great policy mistake that exacerbated the Great Depression.
The Fed Funds futures now price in a mere 16% chance for a rate hike at the June 2011 meeting of the FOMC, down from 28% just before the recent Fed announcement. The Fed is clearly maintaining its highly accommodative stance, yet the threat of higher taxes, rising health care costs, escalating deficits and increased regulation is muting unprecedented monetary stimulus. We continue to expect more checks and balances to emerge after the November elections which should dramatically improve the odds for monetary and fiscal policy to work in tandem towards “escape velocity” and a more robust economic recovery.
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