Despite a string of generally weak economic reports, stocks managed to post a decent gain last week. There is apparently an emerging expectation that either the Fed or the administration will pull an August surprise out of their….um…..hats that will get the economy or at least the markets back on the bull run that stalled back in late April. The Fed meets this week and one can’t help but wonder what the market reaction will be if they offer nothing more than the standard we’ll keep rates low until the cows come home rhetoric. I suppose the market may have been supported last week by the James Pethokoukis rumor about mass Fannie Mae/Freddie Mac mortgage balance forgiveness but it seems more likely that a new round of money printing by the Fed is what set traders hearts to fluttering. I guess we’ll find out when the FOMC releases their statement this Tuesday.
The economic data started with an ISM report that was spun as better than expected but in reality offered little in the way of encouragement about the economic recovery. The headline level was indeed better than expected at 55.5 but one would be hard pressed to find anything in the sub indices to hang a bullish hat on. The new orders index dropped to 53.5 down 5 points from last month, backlog orders fell 2.5 points to 54.5 and inventories rose to 50.2. The production index slowed 4.5 points but is still a very strong 57 and employment rose to 58.6 but how you get from a drop in new orders to more hiring is a mystery to this observer. Factory orders, also released last week confirmed the softness in new orders by dropping 1.2% in June. Considering the ISM was for July it seems likely we’ll get another weak factory report next month.
Another report that seemed better on the surface but actually showed weakness was the construction spending report for June which rose 0.1% after a 1% drop in May. Unfortunately, it only rose because of an increase in public outlays while private residential and non residential spending fell. The pending home sales report also showed a steep year over year decline of 18.6% and a month to month decline of 2.6%. The rise in public outlays is presumably from some of the stimulus actually getting spent but based on what I’ve seen there will be little in the way of long term benefit from a lot of this spending. In my neighborhood they recently screwed up traffic for a week to lay down some fancy brick pedestrian crosswalks courtesy of President Obama and the American Recovery and Reinvestment Act – according to a prominently displayed sign. I suppose it would be politically incorrect to point out that in my 20 years of navigating this intersection I could count the number of pedestrians on one hand and have fingers left over so I’ll just say that walkers are really happy about the new crosswalks. I know because I asked him.
Personal income and spending for June came in nearly unchanged while the savings rate continued to tick higher. Some of the softness was no doubt due to the layoffs at the Census Bureau but whatever the cause it seems highly unlikely at this point that consumer spending will be leading any economic expansion. As for the savings rate, that individuals continue to sock away spare cash in a zero interest rate environment is quite astonishing. Imagine how high the rate would be if the Fed allowed banks to actually compensate people for saving rather than allowing the banks to book profits at the savers expense. Here’s a thought experiment for all the Keynesian, paradox of thrift adherents out there. If the recession is due to a drop in investment (it is) and savings are required to fund investment (it is) how can a policy of limiting savings (the Keynesian emphasis on increasing aggregate demand) possibly be the solution to our problems? Won’t that just extend the amount of time it takes to accumulate the savings necessary to fund the investment we need to restore growth? Isn’t that exactly the real world evidence provided by the Great Depression and the current Great Recession? At a time when individuals obviously are content to defer consumption until sometime in the future, what gives politicians the right to spend money as fast as their constituents can save it? Call me crazy but that doesn’t even seem like a sound political strategy much less a sound economic strategy.
Chain store sales and the retail reports from Goldman and Redbook offered further evidence that shoppers remain a picky bunch. Week to week sales were down while the year over year comparisons remain positive at around 3%. Considering how awful things were a year ago it would be nearly impossible to do worse so those year over year numbers merely tell us that things are less bad. Contrary to what is believed by the vast majority of the public, consumption is an indicator of economic weakness not the cause. To say that economic policy should concentrate on increasing consumption is like a NASCAR team saying they will improve their race performance by going faster.
The big news for the week was on the employment front and there was so little good news that Christina Romer apparently found it impossible to stick around to do the usual non farm payroll Friday spin job. She joined Peter Orszag in confirming that when Larry Summers is awake he has the interpersonal skills of a DMV employee and the management style of Vladimir Lenin. Whatever the cause of Mrs. Romer’s departure her tenure as the Chair of the CEA will not be remembered as economists’ finest hour. Intellectual dishonesty is hard on the soul but it is required of any economist with a hankering for goverment service - regardless of party affiliation.
The employment picture dimmed considerably last week with jobless claims rising to 479k, non farm payrolls falling 131k and the unemployment rate continuing to stall at 9.5% thanks only to another big drop in the workforce. The optimists among us will point out that private payrolls increased by 71k but the details are less inspiring. Of the 33k in goods producing jobs created, two thirds were in auto production which has a lot more to do with the fact that the auto companies didn’t shut down this summer as they normally do than any actual increase in employment. In the services side of the economy the big winners were education and health services which makes one wonder why Nancy Pelosi believes the House needs to return to DC to approve more “emergency” aid to states to further increase employment in these already bloated sectors. I suppose she would point to the 202k drop in government jobs - of which only 143k came from Census layoffs - but I think most Americans would think that the most positive aspect of the entire report.
The negatives in the report are numerous. Construction layoffs continued, losing another 11k jobs. Temporary help, often a precursor to permanent employment, fell by 5.6k. In what most consider good news, average hourly earnings rose. If there is a surplus of labor wouldn’t a fall in the cost of employing people be a better outcome? Don’t the rules of supply and demand apply to the labor market? The demand for workers is so weak that the number of people not in the labor force rose by 381k. As long as the government continues to raise the cost of hiring the demand for workers will remain sluggish and supply will continue shrinking until the two balance. Someday…..
There are some positives to report. People working part time for economic reasons fell again, down 98k. The statistics on the duration of unemployment all ticked in the right direction. Unemployed for over 27 weeks fell by 179k, 15 to 26 weeks fell 57k and 5 to 14 weeks fell 61k. Re-entrants and new entrants to the workforce were the most common reason for unemployment. The biggest uptick in unemployment was again among teenagers. Transportation and warehousing showed another uptick in employment by 12.2k jobs. Financial activities fell by 17k as the bloated sector continues to shed jobs. We need to reduce the size of the financial sector and should not lament the loss of jobs there.
As I mentioned in the opening paragraph, markets performed pretty well even with all this lousy economic news and that seems primarily due to this expectation that QE II from the Fed is right around the corner. It seems likely the recently released Bullard paper on preventing deflation was intended by Bernanke and Co. as a trial balloon to see how the market would react to the prospect of further quantitative easing. Expectations play a big role in monetary policy and further easing seems well embedded in markets at this point. The dollar has fallen roughly 10% since its peak in early June and commodity prices have rallied substantially over the last two weeks. Even inflation expectations in the TIPs market have risen slightly since mid July. To the Fed I’m sure these are hopeful signs that the market will welcome more inflation and I’m sure they are right. Unfortunately, the market is not the economy and with the average American bailing on mutual funds at a rapid clip, how much of a wealth effect can we get from higher stock or commodity prices? Is it just me or is the prospect of the Fed creating more inflation just when everyone gets long the bond market just a little ironic?
So will they or won’t they? The Fed is in a bit of a tight spot because of timing. Launching a new round of QE at this point might be seen as political this close to the election but frankly I’ve never put much stock in the idea that the FOMC is all that politically oriented. There have been Fed chairmen who were obviously political such as Arthur Burns under Nixon but I think he was the exception rather than the rule. Assuming they aren’t worried about the potential political fallout from a new QE move, the decision then hinges on how much of a threat they believe deflation really is. Based on Bernanke’s panic back in the early part of the decade one has to assume he takes it very seriously and will do damn near anything to keep his promise to Milton Friedman.
One of the reasons I haven’t jumped on the deflation bandwagon – I’ve got bonds but not in extraordinary allocations – is that, like Bernanke, I know the Fed can prevent deflation. The ability to create new money out of thin air is a superpower that even Marvel Comics didn’t bestow upon its superheros although that was probably more due to the fact that teenage boys don’t know much about monetary theory than a fear of the inflationary consequences. Expecting deflation in a country with a central bank means assuming that either the bankers are stupid or they actually prefer deflation. I could maybe make a case for the former but the second is almost impossible to believe in the US. Yes, Japan has had persistent mild deflation but their demographic situation and culture means that deflation is actually preferable for the BOJ. The BOJ will create inflation when it is in their best interests to do so – and that time may come sooner rather than later. Ponder that while we wait for the statement from the FOMC this week.
The markets have a decent tone to them and sentiment remains quite negative. If we do get more Fed easing or a hint of it next week, the market will probably respond positively. I don’t think though that stocks will be the best way to take advantage as it was in March ’09. For a variety of reasons I think commodities – not necessarily gold by the way – might be the better play this time around. If commodities do lead the way that could end up being a negative for stocks as it will increase corporate costs. Take a look at what happened to Kellogg and some of the other food companies as wheat prices spiked. Be careful assuming that QE the sequel will have the same beneficiaries as the original.
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