200912.21
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The Illusion of Progress

If all you do is read headlines, it would seem that the US is making steady progress toward solving some of the most pressing issues of the day. President Obama went to Copenhagen last week and came away with an agreement which calls for developed nations to provide $30 billion to help developing nations deal with the effects of climate change from 2010 to 2012. The agreement also sets “a goal of mobilizing jointly $100 billion a year” to poor nations by 2020 although it wasn’t specified from whom this lucre would be “mobilized”. In exchange, the developing countries will be required to….um, well they aren’t actually required to do anything in order to collect this bounty of climate cleaning booty. The Obama administration hailed this as an “important first step” toward something or the other. Where I come from, they call it getting rolled.

It also appears that Harry Reid has now crafted a health care reform bill that manages to displease liberals and conservatives alike and yet also somehow garners the support of 60 US Senators. While details are scarce, as best as I can tell, the bill requires everyone in the US to purchase a health insurance policy to be named later and that the Capitol be moved to Omaha. Whether the Senate and House versions of health care reform can be reconciled is unknown but I suspect whatever emerges will also be hailed by the Obama administration as an “important first step”. I’m also sure it will be just as effective at reducing health care costs as the Copenhagen climate deal will be in reducing CO2 emissions.

Ben Bernanke has been named by Time magazine as Man….oops make that Person of the Year because “his creative leadership helped ensure that 2009 was a period of weak recovery” and he “still wields unrivaled power over our money, our jobs, our savings and our national future”. One can only assume the editors at Time hope that by bestowing this honor on the man from Dillon that he might have mercy and stop exercising that “unrivaled power” long enough so the economy might be allowed to recover a bit. The Time article which accompanies the honor mentions that prior to moving to the Fed, Bernanke was working on a book called The Age of Delusion. Initially my admiration for Bernanke’s crystal ball gazing skills rose immensely until I realized that the book was a history of the Great Depression and not about his own tenure at the Fed. Assuming he can find 60 votes in the Senate, the Age of Delusion will continue for another four years. Let’s hope he doesn’t consider his first term an “important first step”.

In the last two weeks Bank of America, Wells Fargo and Citigroup have all sold enough new equity to pay back their TARP loans. Is it really possible that these three prime examples of the need to end the doctrine of “Too Big to Fail” have returned to sufficient health so they no longer need the assistance of government capital? Apparently so since the Treasury seems eager to accept the repayments (and spend it on something else) and their primary regulator, the Fed, hasn’t objected. More likely, the managers of these institutions are more interested in paying bonuses out of the profits generated from using our capital for the last year than making new loans. And thanks to Fed policy that holds their borrowing costs down and Treasuries offering a positive spread, they won’t have to make any new loans to keep the bonus payments flowing.

The headlines about the economy have been generally positive. The housing market appears to be healing with sales of existing and new homes rising from very depressed levels. Residential investment rose smartly in the last quarter and was a big reason GDP printed a positive number. Retail sales are rising again after the big drop last year. Industrial production is rising and the ISM manufacturing index indicates that growth will continue. Exports have started to rise as have imports; trade is reviving. Corporate profits have made a gigantic turnaround. Disposable personal income and consumption barely fell and are rising again. Individuals are saving again. There are a few areas where improvement is not apparent yet with employment being the prime example, but in general the economic improvement of the last year is nothing short of amazing considering the outlook just a year ago.

So, yes, reading the headlines is a generally positive experience. It is when the details are considered that one starts to feel a bit uneasy about the future. After the Bernanke induced delusion of growth we experienced in the middle part of this decade it is hard to accept the economic statistics at face value. From 2002 to the peak in the second quarter of 2008, GDP rose nearly 40% in dollar terms and yet I don’t know anyone who believes we should repeat that experience. And no wonder – measured in other currencies, the US economy performed miserably in that time. In Euros, US GDP contracted 26.1%; in terms of the major currency trade weighted index -10.7%; in terms of Brazilian Reals -3.5%. GDP may tell us something about the economy but as an indicator of overall economic health, it obviously leaves a lot to be desired. 

Ben Bernanke seems likely to be reconfirmed as Chairman of the Federal Reserve and since our government seems intent on maintaining an illusion of progress that seems quite appropriate. Much of the improvement we’ve seen in the economy since the spring is no more real than the growth from 2002 to 2008. The improvement is built on a foundation of currency devaluation; even after the recent rally the dollar index is down 13% since the early March peak. And gold has gained 55% in the last year in dollar terms. So yes, GDP has recently recovered and based on the economic statistics, probably will continue to improve in the new year, but adjusted for the devalution of the dollar, we’re still losing ground.

The climate deal struck at Copenhagen will not reduce CO2 emissions, but it provides the illusion of progress on what a large segment of voters perceive to be a problem. The health care reform compromise will not reduce health care inflation and it will not achieve universal coverage, but it also provides an illusion of progress for Democratic politicians to trumpet during their re-election campaigns. Ben Bernanke cannot produce real economic growth through monetary policy but money printing can provide an illusion of economic progress for a while. Banks paying back TARP early provides an illusion that all is well in the banking industry, but with potential commercial real estate problems, 10% unemployment and one quarter of homeowners underwater the jury is still out on whether these banks will regret not keeping a bit more of a cushion.

There is a lot we don’t understand about how economies work but we do know that confidence is an important component of growth. Sometimes just believing things will get better is enough to actually make things better so the illusions may be necessary. But the illusions need to be followed up with concrete action to produce real economic growth. If that happens it will be reflected not just in the macro economic statistics but also in the value of the dollar. The recent rally in the dollar is encouraging, but it may prove fleeting unless the illusions are turned into reality.

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Weekly Economic and Market Update

The economic reports last week were generally positive with the exception of the inflation reports. Producer prices in particular surprised to the upside rising 1.8% on the month. I’ve been warning about this all year and we’ve now reached the point where the year over year comparisons for inflation will be quite tough. Prices collapsed this time last year but have basically been rising since the beginning of the year. The illusion of deflation is now ending and it will be interesting to see how the bond market reacts. The early verdict isn’t pretty. Consumer prices also rose but not as much the wholesale numbers. Nevertheless, the year over year rate has now turned positive (1.8%).

Both the Philly and NY Fed surveys showed continued growth although the Empire State survey did flatten out a bit. Housing starts and permits rose sharply in November although most of the gain was for multi family housing. The housing market continues to stabilize but there are still deep problems that won’t be solved quickly. There is still a lot of inventory in the bubble markets (like here in South Florida where we still have two years worth of condos to sell) and prices probably still haven’t hit bottom in some areas. From a national standpoint though, the worst is probably over. Jobless claims rose slightly last week continuing the sawtooth pattern of recent months. Claims are still in a downtrend but good grief it is slow. Leading economic indicators were up again and continue to point to higher future growth.

Stocks continue to trade in the range that has persisted since early November. This is true for US markets as well as foreign markets, although there are some exceptions (Israel and Chile continue their uptrends). Health care stocks have been particularly good performers of late which should tell you something about health care reform. The dollar was generally stronger last week and that is reflected in the price of various commodities, most notably gold and oil. I’m not convinced yet that this move in the dollar is anything more than year end profit taking, but I did reduce my exposure to foreign bonds recently. It didn’t make sense to risk the large gains I’ve already reaped from the trade.

Selected Charts

Stocks are still marking time:

But REITs are on the verge of breaking out:

The dollar rally has already moved more than I expected. Will it last into the new year? Fundamentally not much has changed so I have my doubts:

Pharma stocks have performed very well ahead of health care reform:

Long term bonds are in a downtrend that I think is just beginning: