By John L. Chapman, Ph.D.     June 24, 2012    Washington, D.C.

The Federal Reserve met this past week, and in his post-meeting press conference, Chairman Ben Bernanke reiterated that a tepidly growing U.S. economy is going to run in slow motion for a long time.  Other U.S. data out recently, combined with the continuing slow train-wreck in Europe, have heightened investor nervousness. It is important to understand the multiple-sourced realities that affect asset prices in an era of diminished growth.

When Margaret Thatcher stormed into Number 10 Downing Street in the spring of 1979 to become Britain’s first female Prime Minister – and the first woman ever to head a major western government – the British economy was plagued by decades of Keynesian pump-priming, stagflation, elevated unemployment, and chronically slow growth.  Since 1955 Britain had grown at a 2.4% annual rate in terms of real GDP, and the government’s “footprint” approached 50% of the whole economy, with nationalized steel, gas, mining, automotive, rail, air transport and telecommunications sectors dominating much of the British economy.  The situation seemed as irreversible as the problems were considerable, and as Mrs. Thatcher’s platform offered Britain only Adam Smith’s simple laissez-faire growth formula (summed up in her slogan, “Britain’s better off with the Conservatives”), staid commentators such as those at The Economist were skeptical of her prospects (“We are not confident that it will be proved, but we would like to see it tried. The Economist votes for Mrs Thatcher being given her chance.”).

In truth, when Thatcher left office 11 years later, the British economy had averaged growth of only 2.7% during her tenure, albeit being a third bigger in that time and after suffering the horrible recession that reduced inflation in the early 1980s.  More importantly, though, her reforms had set the stage for a stronger Britain during the Major and Blair governments in most of the following decades: a smaller government sector thanks to major privatizations, an end to the “incomes policies” that favored Labor’s trade unionists via heavy spending, a stronger currency and growth-inducing tax policy improvements.  Most important of all, the Thatcher era’s policy approach re-energized Britain’s historic impulse to entrepreneurship that after World War II had grown inert: after the United States, Britain today boasts of the most vibrant and dynamic private equity and venture capital sectors of anywhere in the world. (Sadly the U.K. is today into the second dip of recession since 2008, having reversed Thatcher; government spending again comprises more than 50% of the total economy, and 70% in Northern Ireland.)

It is important to keep the dramatic changes in Britain thanks to Mrs. Thatcher’s inflection (which Tony Blair’s “New Labor” approach did little to overturn after 1997)   in mind, because it does parallel the current status of the economy in the United States. That is to say, the U.S. certainly has entered a new era of slower growth, stagnant incomes, and diminished expectations (which the Federal Reserve now calls less than 2.5% annually “long term”, and quite possibly less than 2% again this year), and only a positive “jolt” in terms of policy – such as that of Thatcher’s election in 1979 proved to be – will lead to stronger growth and, ultimately, significantly higher real-valued equities tomorrow.  To say it differently, the current below historical average price-earnings ratios in U.S. equity markets cannot and will not change appreciably without policy shifts that approach the significance of Mrs. Thatcher’s.  (Though it is beyond our scope in this essay, we would further assert that until U.S. policy changes, the global economy cannot and will not significantly improve, either; the idea of China- or Europe- or emerging nations-led global growth is still and will be for decades a chimera.)

This is the primordial fact to keep in mind when tracing financial market developments in the U.S. at the moment, as it does put a cap on U.S. equities. Countervailing this, and hence necessary to factor into analysis of market-moving data releases, is the flow of international hot money into the “safe haven” U.S. (and in our view this goes beyond the bond market to provide some lift to equities, too), as well as the more favorable demographic data in the U.S. (e.g., new household formation of the millennial generation which will demand a housing ramp-up in coming years here) than elsewhere in the OECD that signals higher growth in the future.

With this in mind then, the following drove markets this week:

  • The Federal Reserve held current policy in abeyance.  As noted above, the Fed Chairman was his usual dour self in his press conference, repeating yet again the litany of “headwinds” and financial market pressures facing the global economy, but that the U.S. will continue its path of “modest” growth (albeit with continuing “elevated” unemployment that may still have unemployment at 8% a year and a half hence).  In unspoken fashion, Mr. Bernanke nonetheless implied a fairly significant chance of recession in the near future (though, again, the Fed’s official revised forecasts – which never include a recession call – merely decreased to 1.9-2.4% growth this year, 2.2-2.8% in 2013, and 3-3.5% in 2014), and reiterated that a substantial body of his empirical research – optimal policies to fight recession, including deflationary slowdowns such as that of Japan’s in recent decades, and the U.S. now – was still on the table for the near future if need be.  There was little of substantive change announced, as only the continuation of “Operation Twist”, or the attempted flattening of the yield curve via another $267 billion in swaps of short-term for longer-dated U.S. Treasuries, was announced.  Bluntly, this program has marginal effect on long interest rates, which are swamped by real forces, and indeed to the degree it has any effect at all, it may actually be harmful at the margin by making short-term credit markets slightly more illiquid. The main intent and effect of the announcement however was to signal to the markets that the Fed’s propensity for action is still in a high-readiness state.

(As a related but very side comment, we would offer this far-afield prediction for our readers: if President Obama is re-elected, Mr. Bernanke will be re-appointed Chairman in 2014, and the Fed will move toward even more “innovation” in policy, in this case by buying U.S. equities and mutual funds directly on the open market.  That will, if it really does happen one day, have serious ramifications of course, not least of the Constitutional kind, but we are driven to this conclusion thanks to knowing well the Chairman’s irrepressible self-confidence in effecting real-world changes in outcomes, as well as both listening to the Beltway chatter lately and reading Fed minutes in recent months.  These note the grave concern held by Mr. Bernanke and the likes of the Fed of Chicago’s Charles Evans that equity markets are not significantly enough “re-inflated” so as to stoke animal investing spirits, making inflationism an official policy eventually, rather than semi-official as per now.  A Romney Presidency is far less likely to witness such an historic crossing of the Rubicon, but even there, the possibility for such high-octane interventionism exists, and will force those in the investment management profession to think anew of the subsequent consequences – intended and, alas, otherwise.)                

  • Housing starts fell 4.8% last month, but are well up year-on-year.  The month of May saw building starts fall to 708,000 units (annualized), well down from April’s 744,000 pace thanks to multi-family unit drops, but happily are far above year-earlier levels (+28.5%, of which single-family starts are +26.2%, and multi-family starts up +35.2%).  Starts were down everywhere but up in the western U.S., a good sign given the depth of the housing crash in the West.  Separately, new building permits were up +7.9% last month, and both single-family as well as multi-family unit permits are up in high-double digits from a year ago.  With May’s data, total homes under construction is up for the ninth straight month, the first time that stretch has happened in eight years, and given demographic shifts in the U.S. coming online now, housing market activity is set to potentially double in the next five years.
  • The report on existing home sales for May showed a decline (-1.5%) to an annualized 4.55 million units, due more than anything else to lowered supplies of housing inventory (the usual big gain in U.S. inventory in the springtime did not occur in 2012).  In any case, monthly sales over the prior year period increased for the 11th straight month, and in this case were up +9.6%.  These sales gains have reached all four major geographic regions in the U.S. during this period (Northeast, West, South, and Midwest).  In May, the decline in overall sales hit both single-family and multi-family homes, but very crucially – in our view, recession-preventing crucial – the median price of an existing home rose to $182,600 last month, up +7.9% from a year ago (mean prices are +6.4% in this time).
  • Lastly, the Philadelphia Fed’s important economic activity index, as portrayed in its survey of manufacturers contained in a regional business outlook report it does each month, fell to -16.6 in mid-June, from -5.8 a month ago.  The data were mixed: new orders, shipments, and average work hours were all negative in this June survey, only 32% of respondent firms had or planned to increase investment in 2012, and prices paid and received were both down, month on month.  But the employment index rose (albeit showing fewer hours worked), current unfilled orders and delivery times both improved, and firms intent on decreasing spending fell to 20% of respondent firms, down from 33% last fall.

Summary of Recent Indicators

What does all this add up to?  The answer is simple: this is a “tough economy” or, to say it in a preferred way that captures the pith of the matter, this is, like Britain after the war for decades or the U.S. from 1974-82, sclerotic growth.  The biggest impediment in the immediate term is lack of appetite for investment and risk-taking; these are dependent on market psychology and driven by emotional response to policy.  The print for newly-unemployed seeking insurance fell to 387,000, but remains in a range roughly 35,000 per week above what would correlate with a healthy and vibrant economic dynamism that is sustainable in terms of net job creation.

The data in and of themselves are not terrible in the sense that there is still growth in the U.S. economy, after all.  And indeed, the seemingly unending pessimism, espoused by “pundits” who are still shell-shocked by 2008-09 and refuse to do the tedious homework of looking deeply into the data, presents investors with buying opportunities around the world – again, for those who do the tedious legwork.

But there is no denying the whiff of fear that hangs in the air, not unlike, in a different context, the summer of 1939.   Something (or things) hugely negative could certainly happen in the short term from multiple sources around the globe, and people everywhere sense this.  This directly caps global equities without a doubt, alas.  At the same time, the current situation is fraught with opportunities on the upside, too, and events may yet transpire – most signally thanks to the U.S. election in just 19 weeks, but starting this coming week in the Supreme Court’s ruling on ObamaCare – to present big-gain opportunities in the months ahead.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@4kb.d43.myftpupload.com. The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.

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