Over the last couple of months I’ve dedicated a good portion of these weekly commentaries to the various headwinds I see facing the global economy and markets. Everyone, it seems, knows what the risks are and I’m beginning to wonder if, being so well known, the actual events may prove less jarring to sentiment than I’ve been expecting. There is, of course, the possibility that the bad things everyone expects will be eclipsed by something worse completely out of left field but there is also the possibility that the bad things just won’t turn out to be all that bad. One thing I insist on here at Alhambra is that we continually question our theses about economies and markets. And so this week, rather than rehash the same negatives, I want to take a look at some of the positives I’ve noticed in recent months.
Earnings have been pretty darn good. Yes, I know, profit margins are near all time highs and will inevitably revert to the mean, making stocks a lot more expensive than they now seem. But the timing of that reversion is something no one can predict and in the meantime those big profit margins are producing good earnings. Growth has certainly slowed but earnings are still rising and absent an external shock, seem likely to continue doing so in the near term. The impact from any slowdown in China and its dependent resource providing countries may be offset by any drop in commodity prices that results. Europe is already in deep recession and further weakness seems unlikely to upset the US earnings Applecart.
Commodity prices, despite the Fed’s herculean monetary efforts, may also emerge as a positive and not just because of a global slowdown. West Texas Intermediate – the US crude oil benchmark – has traded in a 10% band around $100 since mid-October and has yet to exceed the peak near $115 set early last year. Oil prices and commodities more generally are a long ways from the peak set in mid-2008. Crude oil inventories in the US are at 21 year highs thanks to shale drilling and while the glut isn’t as significant as the one in natural gas, prices may be set to fall further. That natural gas glut is also having a positive effect on the economy although I’m a bit skeptical of its durability as many of the wells drilled over the last few years are not profitable at these prices. If crude prices fall further, many of the shale oil wells drilled recently will fall into the same category. Breakeven prices are hard to pin down and depend on the area but somewhere around $60 – $70/barrel, many of these wells are not economic. But for now, the supply/demand picture for energy is very positive and the potential for lower oil prices has to be seen as a positive for the economy as a whole.
Central to the oil/commodity pricing picture is the new found steadiness in the value of the dollar. The US dollar index is at roughly the same level now as late 2010. It did weaken during QE 2 but has since settled into a steady, if unspectacular, upwardly rising trend. More importantly, the dollar has steadied against gold as well. Gold peaked just over $1900/ounce right near the end of QE 2 but has since settled into a range of roughly $1500 – $1800 with the current price around $1650. The monetary base peaked in late February and has now contracted below the QE 2 peak while M2 money supply growth has fallen from double digits last year to a mere 4.4% recently. Meanwhile, inflation expectations as measured by TIPs spreads have stabilized around 2%. I don’t know what the Fed will do from here but at least for now, the monetary situation appears to have stabilized.
The credit markets also appear to be doing better at least if you measure that by lending. Total bank credit has expanded by roughly 5% in the last year while commercial and industrial loans are up nearly 15% over the same time frame. One could argue – and I have – that a lot this new lending will be proven to be just more malinvestment somewhere down the road, but until it ends, malinvestment is hard to distinguish from I guess what should be called bon-investment. Overall, the recovery in investment has been fairly weak – and distorted by Fed policy – since the end of the recession but it is rising. On top of that, residential investment, which is obviously a big part of the investment gap in GDP, is now at least adding modestly to the recovery.
The most obvious positive for the US economy has been the manufacturing sector which is benefitting from several trends. The large devaluation of the dollar over the last decade has made US manufacturing more competitive as aggressive monetary easing here has narrowed the wage gap with China. Chinese wages have been rising at double digit rates while wages here have stagnated. Now, I don’t believe the proper way to encourage manufacturing in the US is to impoverish American workers through devaluation but it does get the job done eventually. The natural gas glut has also made it cheaper for many industries to locate in the US as prices in Asia are 7 to 8 times the US price. High oil prices – for now – have also benefitted US manufacturers as the cost of shipping goods back to the US has risen. Manufacturing will never be the employer it was in the past thanks to improvements in productivity, but it is improving and looks set to continue.
Lest you think I’ve gone soft, I’d like to emphasize that most of these positives are of a short term nature and the long term challenges facing the global economy remain. The debt levels in the US and Europe in particular must eventually be reduced as a percentage of GDP. The best way to accomplish that is through higher growth but the sclerotic pace of growth in the developed world cannot be improved through monetary policy alone. Fiscal policies must improve and become more pro growth to complement monetary policy. Merely cutting spending would get the job done eventually but as European politicians are now discovering it is politically difficult to sustain. France’s election of Francois Hollande would seem to point in the wrong direction by the way. You won’t cut the Gordian debt knot with higher taxes alone either.
As always seems to be the case, there are positive things going on in the US economy but make no mistake, the long term outlook is still not as bright as it could be with better economic policy. I am still quite cautious about the near term outlook for all the reasons I’ve detailed in this space over the last few months. But I also have to acknowledge the positives. Whether they prove sufficient to overcome the negatives we’ll only find out in hindsight and as you might have surmised from reading these commentaries recently, I have my doubts, but as an investor I’ve learned to stay open to even the most unlikely of events.
As for stocks, I still expect a correction but it may not be as deep as I’ve feared. The economic statistics have turned mixed over the last two months but the US economy has proved surprisingly resilient. I have previously characterized our markets as enjoying a cyclical recovery in the context of a secular bear market and I have not changed my mind. But the cyclical upturn may continue for a while as some of these positives continue to feed through to the economy. We have not changed our investment stance yet but if last week’s selloff develops into a larger correction over the coming weeks, we’ll be watching the data closely for signs of strength.
Last week’s employment report got most of the attention but as has been the case for the last two months, it was another mixed week with some good reports and some bad. On the positive side of the ledger were Personal income and spending, the Chicago PMI, the ISM manufacturing report and jobless claims. On the negative side were the Dallas Fed manufacturing survey (which turned negative), car sales, construction spending, factory orders, productivity and costs, the ISM non manufacturing survey and the aforementioned employment report. (John Chapman has a full analysis of the employment report here.)
Next week is light on US data but the fallout from the European elections may provide some direction. With the election of Hollande, I expect to see some turmoil as the market sorts out whether he can enact his agenda. The most immediate reaction may be a weakening of the Euro. With monetary policy a global affair now, it will be interesting to see how the ECB and the other central banks react to such a development.
For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: firstname.lastname@example.org or 786-249-3773.
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