201012.12
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Weekly Economic and Market Review

I don’t believe President Obama could have been more obvious if he’d taken out a full page ad in the New York Times. He isn’t happy about it and his heart isn’t really in it, but he is shifting policy to a more centrist tack. The compromise with Republicans on the Bush tax rates was seen as betrayal by the left flank of the Democratic party but really he had little choice. He got what he could – an extension of unemployment benefits and a payroll tax cut – in this lame duck session because he would have gotten less next year. If there was any doubt about the politics of this, he put former President Clinton in the White House Briefing room to explain to the Bernie Sanders wing of the party that ideological purity may be fine on the Upper East Side or in Nancy Pelosi’s district but the rest of the country doesn’t even read the editorial page of the New York Times, much less agree with everything on it.

The compromise on the Bush tax rates, contrary to much of the early analysis, is not stimulative for the US economy except in the sense that growth would have been worse at the margin if higher tax rates had been allowed to kick in. Whether borrowing is for higher spending or lower tax rates really doesn’t matter that much at this point so for those who believe that running deficits to retain the Bush rates means this is stimulus but also believed that deficits for the Obama stimulus package provided none, I’d suggest reviewing the definition of cognitive dissonance. A true stimulus would come from cutting spending but neither party seems to have the stomach for telling the American public that they can’t have their entitlements whole and balance the budget too.

Of more importance for future growth was an indication that the President is seriously considering a hard push to enact the recommendations of the Bowles-Simpson commission. He is on firmer political ground here too as Republicans will have a hard time rejecting proposals to do what they said they wanted to do on the campaign trail. If the President offers a reasonable plan to reduce the deficit – and the Bowles-Simpson plan is not perfect but it qualifies – Republicans will have to engage in serious debate. However the details are arranged, a plan that simplifies the tax system, lowers marginal tax rates, lowers corporate tax rates and reduces the deficit will be welcomed by the economy and the markets.

It just so happens too that a shift to better economic policy in the US is exactly what the world economy needs right now. Despite the prevailing, overwhelmingly bullish sentiment regarding stocks, commodities and future economic growth, there are a still a lot of potential problems that could derail the rosy view of the world. Europe’s sovereign debt problems – which are really European bank debt problems – have not yet been resolved but the road to recovery could be eased in the short term by a lower value for the Euro. Better US economic policy may speed that process if it means capital flows back to the US. The developing world’s emerging inflation problem would also be eased by a reversal of the hot money flows that are at the root of the problem. Capital and price controls as are being tried – along with some fairly aggressive monetary tactics – in China and other emerging markets are crude tools that are bound to fail unless a more favorable investment environment is crafted in the developed world. Better economic policy here that reduces capital inflows to China, Brazil and other emerging markets not only eases trade frictions but will reduce inflation there while increasing investment here. It is bad US economic policies that are causing many of the world’s economic imbalances not currency manipulation in Asia. Better US economic policy is the only proper remedy.

But the just announced deal on the Bush tax rates is not nearly enough to attract capital back into productive investments. The relative changes in exchange rates between fiat currencies are not the important metric to watch. We will know that policy has truly changed for the better when the price of gold and other commodities fall and then stabilize at lower levels. You want stimulus? What would be the effect on US growth if oil dropped by 50%? Or copper? Or any of a number of other commodities? What if all that capital tied up in gold were to flow into productive investments?

Allowing companies to expense some capital investments and R&D for the next couple of years as the recent tax compromise includes is not a bad thing, but the change is too marginal to matter much to the world economy. Better, pro-growth US economic policies that stabilize the value of the dollar on the other hand, would free up massive capital to invest in real, productive investments. President Obama’s shift to the center may not be good news to Bernie Sanders or the editors of The Nation, but it may be very good news indeed for the world economy.

There was little in the way of economic data last week and it was a fairly mixed bag. The Goldman and Redbook retail reports both showed a big drop from last week. Shoppers may be spending but they are content to wait for retailers to get desperate and break out the sale signs before running down to the mall. Or it may be that shoppers – like my wife – are doing more on line so they can avoid the phlegm infested masses in line at the bricks and mortar shops. I would also note that according to my retail consultant (my wife) many items have been in short supply at the shops but readily available on line, in many cases with free shipping included.

Mortgage applications for purchases rose last week while refinance applications fell. Mortgage rates have been rising lately and there may be some urgency to get financing in place before the rise even more. Wholesale inventories rose 1.9% in October but that was less than the 2.2% rise in sales so the inventory to sales ratio was basically unchanged. It appears so far that there will be at least a slight inventory build in the fourth quarter which is a positive for GDP and contrary to consensus by the way. Jobless claims fell a bit last week to 421K but we’re still not there on the employment side. There was some modest improvement in the JOLTS report that confirms the improving trend though. Employment is a lagging indicator and as in the last two recessions it is really, really lagging this time, but it is slowly improving.

The trade deficit improved in October on the back of lower oil imports but with prices rising further since this data, it seems unlikely to last. Exports were up 3.2% and that initially sounds like good news but with export prices rising at 6.5% rate year over year, it may be less than meets the eye. We need higher volumes of goods to increase production and therefore jobs; higher dollar figures don’t mean much when dollars are becoming less valuable. The recent change in the economic data to more positive seems to be having an effect on confidence as well; consumer sentiment rose again in early December. I don’t normally put much emphasis on consumer sentiment surveys as they are very lagging indicators but it is confirmation that the positive changes in data are real and not just statistical noise.

Stocks were up last week but it should be noted that the more speculative the issue, the better the performance. The Russell 2000 small caps were up 2.7%, the NASDAQ was up 1.8%, mid caps were up 1.4% and large caps brought up the rear at a +1.3%. The venerable Dow Jones Industrial Average, dominated by the large multinationals, was up just 0.25%. There are different ways to interpret the current preference for smaller shares. One is that better domestic growth will have an outsize impact on smaller firms. Another is that “investors” are speculating more. I think both are true to some degree but I would point out that the latter explanation is bolstered by the fact that margin debt has been rising for some time and is now approaching, believe it or not, record territory.  Using borrowed funds to buy shares is not only speculative but also a good way to make a small fortune – provided you start with a large one.

Sentiment remains too frothy for my taste with over half of respondents claiming the bullish mantle in the AAII poll. Professionals aren’t any more circumspect as the Investor’s Intelligence poll indicates bears have fallen to the low 20s. By the way, bond markets offer the near opposite view with bulls dropping steadily as rates rise. I want to stress though that I am not a buyer of bonds – especially long term ones – right now but in the short term almost every kind of bond is oversold. A countertrend rally to relieve the oversold condition would not be a surprise in the least. If you have long term fixed income I would take any rally as an opportunity to lighten up and/or shorten maturities.

I remain very cautious about stocks right now, especially those of the emerging market variety. As I said above, an improvement in US economic policy would mean a reversal of capital flows away from emerging markets back to the US. While this reversal will be a long term positive it is hard to see how it would be anything but negative for emerging stock markets in the short term. The same is true of commodities by the way and therefore resource based economies like Australia; better US economic policy means capital can exit the purchasing power safety of real assets and start searching for better growth opportunities. While this shift may not be imminent, the recent tax compromise is a good sign for the future. Let’s hope President Obama follows through with further changes to better policy.