Weekly Economic and Market Review
Phew! Thank goodness that’s resolved. The President’s fiscal commission released its recommendations for solving the budget deficit and the plan was promptly embraced by a majority of the panel that crafted it. The plan will now be enacted forthwith, eliminating all manner of tax breaks, while simultaneously lowering marginal tax rates, cutting government spending across all departments, raising the retirement age for Social Security and Medicare and, of course, stopping the rise of health care costs. Our budget problems are solved. The economy, starting next week, will grow indefinitely at 4% a year and all unemployed Americans will get the jobs of their dreams. The debate over the Bush tax rates is moot and there is no need to extend those unemployment benefits again. Cats and dogs will get along, college football will end the BCS and shift to a playoff system, peace will break out in the Middle East and Dancing with the Stars will be canceled. Kumbaya, my friends, kumbaya.
Well, okay maybe not, especially that last one; Dancing with the people who have somehow convinced themselves despite mountains of evidence to the contrary that they are Stars is some fine entertainment. The President’s fiscal commission gored everyone’s ox and has little chance of being enacted and signed into law, but I hope it really does start an adult conversation – as Esrkine Bowles called it – about what is required to get our economic house in order. Unfortunately, I have serious doubts as to whether any adults actually reside in DC so I don’t have high hopes but all us taxpayers can dream that someday the politicians will run out of stupid things on which to spend our hard earned – if slightly devalued – dollars.
The plan released by the commission is a mixture of tax reform and spending restraint. On the spending side, contrary to the popular perception, the plan does not actually reduce spending. In what passes for logic in DC, spending that is not allowed to rise as fast as it has in the past counts as a spending cut which probably goes a long way toward explaining why we have a budget problem to solve. The plan also depends on some dubious assumptions about future health care spending that are probably more fantasy than reality. Having said that, if economic growth can be raised, merely cutting the rate of spending growth – assuming future Congresses can even accomplish that – is probably sufficient to keep spending as a percent of GDP to a reasonable level.
On the tax reform side, the plan essentially offers to cut tax expenditures – loopholes to anyone not serving on a presidential fiscal commission – in exchange for reductions in marginal tax rates. For those of you old enough to remember the mid 1980s that might sound familiar. The Tax Reform Act of 1986 did essentially the same thing and almost from the day it was signed, the politicians have been collecting brib….er, campaign contributions to restore all those loopholes and add a few more to boot. In fact, that might be the best reason to hope that tax reform might actually get passed sometime soon. If tax reform eliminates all the loopholes, the politicians and lobbyists can spend the next quarter century collecting campaign contributions and lobbying fees to ensure their eventual restoration. Yes, I’m that cynical.
Whatever the eventual outcome of the commission’s plan or any of the plethora of competing plans being released almost daily, it is irrelevant to today’s economy and markets. It is rendered irrelevant by the more pressing issue of what tax rates might be come January 1 and by what the ECB and/or the Federal Reserve might do when another European country runs into trouble trying to make sure Germany, France and the UK don’t have to rescue their banking systems. The tax issue, it is said by some analysts, must be resolved by about mid December or anyone with a capital gain is likely to start locking in today’s 15% rate rather than waiting for it to rise to 20% next year. I have my doubts about that but that doesn’t mean much if the hair trigger hedge fund traders become convinced of the self fulfilling nature of the prophecy. As for Europe, it seems more likely by the day that the ECB will be joining the Fed soon in its own version of quantitative easing.
It was that prospect of even more monetary easing that moved markets last week, although the economic news didn’t hurt things either. As I’ve been writing in this space since late summer, the economic data continues to steadily improve and last week was no exception. Yes, the employment report released Friday wasn’t great but the other data released last week was quite a bit more upbeat. Retailers reported great same store sales numbers and that was reflected in both the Goldman and Redbook reports which both showed robust year over year readings. The Redbook report was actually the highest year over year change since the beginning of the recovery at +4.9%. The death of the US consumer has been greatly exaggerated.
The Chicago PMI and both the ISM reports showed solid growth. The Chicago report continued a string of upbeat regional Fed surveys with gains in new orders, production, employment and the overall index. The ISM manufacturing survey remained strong although it did moderate a bit from last month. The headline, new orders, production and employment remain solidly above the 50 level that indicates expansion. The ISM non manufacturing report rose to the highest level in six months. New orders and employment rose strongly. Backlog orders and exports also rose. Factory orders did not confirm these reports though falling 0.9% in October. The drop was concentrated in durables with orders for non durables rising 1.5%.
Mortgage applications for purchase rose for the second week in a row but refinance apps fell as mortgage rates rose. In what I hope is the beginning of a trend, pending home sales and construction spending both rose in October. The pending home sales index is up 18% from its post stimulus low in June. Construction spending rose a surprising 0.7% on higher multi family spending. The year over year rate of change has now reached single digits at -9.3%. Spending on single family units was down 1.2%. I’d be remiss if I didn’t mention the fall in house prices reported by Case Shiller. I’m not convinced it is that much of a problem yet but year over year prices are up just 1.6% and this is the third month in a row of month to month price declines.
The jobs picture continues to be the biggest problem facing the economy. Jobless claims rebounded last week rising back to 436K from the revised 410K of the previous week. That is disappointing but the four week moving average is still falling and eventually we’ll get a print below 400K. The employment report Friday was also a disappointment with the private sector adding just 50,000 jobs. Including government cuts, the total came to just 39,000. That was way short of expectations and reflects the continuing rise in productivity. Companies are still finding ways to do more with fewer workers and until growth – and sales- picks up it seems unlikely they will need to add to payrolls in a significant way. That is why, by the way, tax reform as well as monetary reform is critical to getting our economy back on track.
Stock markets last week managed to tack on nearly 3% and the S&P 500 now sits at about the same level as the highs in early November. While certainly the economic news is having an impact on the markets, it is the actions of the world’s central banks that are really moving things. Not much moved last week until Wednesday when Jean Claude Trichet of the ECB said enough to convince traders that he’d do what’s necessary. What’s necessary in traders’ eyes is the purchase by the ECB of the government bonds of any European country with higher rates than Germany. Whether Trichet actually meant that is a bit murky but surely traders long Portuguese and Spanish bonds imagined that’s what he said and meant.
That commodities rallied along with stocks is a clue as to the cause. Inflation moves risk assets in unison and the prospect of the ECB joining the quantitative easing party may be a lot of things but deflationary isn’t one of them. The Euro rallied a bit against the dollar but gold was making new highs almost no matter how you measure it. Oil is also gaining, now approaching 90 very devalued dollars. For now the traders are enjoying their nominal gains and trying to figure out how to goose the bonus pool a little higher before the end of the year. Assuming the slow motion European train wreck has been put back on the tracks until the end of the year – which may be a risky assumption – there seems little in the way of potential news to sidetrack the rally.
That doesn’t mean I have to like it or approve of it but I do have to acknowledge it I guess. I’ve been – and remain – quite cautious about markets because of the overwhelmingly bullish consensus. I don’t know when but it seems to me that rising commodity prices and rising stock prices will eventually become incompatible. Bond markets are already taking it on the chin with the biggest losers further out on the yield curve. If you believe the Fed, that’s what they wanted – rising inflation expectations – but one can’t help but think that falls into the category of be careful what you wish for – you might get it. Higher inflation will seem like a miracle cure right up to the point when it doesn’t.
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