Goldilocks Or The Big Bad Bear?

Once upon a time in a commentary long, long ago I said that we’d know the US economy was on the right track when we saw three conditions simultaneously: rising stocks, a rising dollar and a falling gold price. Those three conditions – sustained – would indicate that the market is anticipating better growth and lower inflation. In case you’ve forgotten – and it has been a very long time – those are the conditions that prevailed from about 1995 to early 2000. It was the “Goldilocks” period of US growth and inflation – not too hot, not too cold. In retrospect, it is obvious now that Goldilocks’ last name was Minsky but we didn’t know that at the time and it was sure great while it lasted. Well, it might come as a bit of a surprise, but those three conditions are in place right now. Has Goldilocks returned for another bowl of perfect porridge?

I have to admit it is hard for me to see how that could be the case. The global economy is not exactly humming right now and economic policy is a mess. Europe is in recession, China’s growth rate has slowed considerably and Brazil is suffering through a bout of stagflation. Australia and Canada have stalled out with the slowdown in China. Here in the US, we are running massive deficits, taxes are rising, the Fed is buying bonds as fast as the Treasury can issue them, the regulatory environment is hostile (and ineffective at the same time; quite a trick) and President Obama is doing his level best to prove Bill Clinton wrong about the era of big government.

And yet….Europe wasn’t exactly booming in the 90s either so maybe that doesn’t matter all that much. Asia continues to hum along despite the Chinese slowdown. In fact, in some areas, Asia looks a lot like it did back in the 90s before the crisis. Stock markets are booming, credit is easy and conspicuous consumption continues despite some growth hiccups. Latin America, if anything, as a whole looks to be in better shape now than it did in the 90s. Colombia and Peru were basket cases back then and are now booming. Chile continues to grow steadily as it has for years. Brazil’s minor stagflation today is nothing compared to the currency crisis they were fighting in the late 90s. Other areas of the world are doing better too. Poland and other central European countries have emerged from the crisis in decent shape. Turkey is growing rapidly. Israel has been revived by Stanley Fischer and an entrepreneurial spirit second to none. And Japan may even be finally taking the necessary steps to revive from its multiple decade slumber.

So what’s not to like? Despite the troubles of the last few years and a pervasively negative economic sentiment, the global economy isn’t doing that badly, right? This might be a good time to remember, that in the story, Goldilocks was doing just fine and even getting a little shut eye – until the bears got home. At that point, things went south in a hurry and so it seems the same can happen with economies and markets. The 1990s didn’t end well although the economic blow was softened by the Fed’s real estate bubble blowing efforts. Still, stocks took a beating after the top in 2000 even with the Fed easing like crazy. That would seem to refute the Wall Street bulls’ argument that the Fed’s QE infinity makes the market safe for widows and orphans once again.

As for the US economy I think it goes without saying – although I’ll say it anyway – that the full effects of the fiscal cliff changes have yet to be felt. Last Friday’s leaked Wal Mart memos would seem to be evidence that while it might have taken a while to sink in, the hike in the payroll tax is starting to bite the working man and woman. And there is still more to come as the President and Congress wrestle with the sequester and the delayed impact of the debt ceiling. I have no idea how those negotiations will come out but since the Democrats oppose tax cuts and the Republicans oppose spending hikes, it seems highly unlikely the result will be labeled “stimulus”. Like the fiscal cliff, the most likely outcome will combine tax hikes and spending cuts, a bitches brew that only economists of the masochistic variety would recommend.

In addition to the potential for further economic pain here in the US, the rest of the world is not as stable as it first seems. As I mentioned above, much of Asia looks a lot like it did just before the Asian crisis in 1997. Capital inflows have pushed currencies higher and created a credit boom in Asia just as it did in in the late 90s. When the capital flows reverse, the currencies fall, the credit dries up, growth slows and the only thing that remains is the inflation. The lesson Asian governments learned from the 90s crisis was to keep plenty of reserves on hand and that might soften the blow but it won’t stop the cycle. The trigger for the Asian crisis in the late 90s was the rising dollar just as it was for the Tequila crisis in Latin America in the 80s. And for a preview, visit the current Brazilian economy where growth is running 1.5% while inflation is hitting 6.5%. It isn’t on par with the devaluation of the late 90s but it isn’t a pretty picture. And let’s not forget Europe where the French economy is best described as imploding.

The stock market, meanwhile, is exhibiting signs of froth. Margin debt is approaching the all time highs set in late 2007. Investor sentiment polls are showing scary numbers of bulls with Investors Intelligence (advisers) at 52.6 to 21.1 bulls to bears and AAII (individuals) a little less alarming at 42.3 to 28.7 bulls over bears. Insider are selling at a rate of 9 to 1 sellers to buyers a level last seen right before last year’s sell off. Interestingly, the sentiment toward bonds is the polar opposite of stocks. Everyone is proclaiming the end of the great bond bull market. The incongruence of that in relation to the aforementioned rising dollar, falling commodities, falling gold environment is one that should make a contrarian drool. Deflation is not generally associated with bond bear markets.

At Alhambra we take a macro view of investing and our first step is to identify the prevailing economic regime. We identify 4 scenarios: rising growth, rising currency; falling growth, rising currency; rising growth, falling currency; falling growth, falling currency. A different set of assets tends to perform best in each of those scenarios. Obviously, the best one is the first – rising growth, rising currency. Better actually would be rising growth and a stable currency but nothing is  stable for long in our floating currency world. The worst scenario is the second one – falling growth, rising currency. That is essentially the situation that prevailed in the US in late 2008 (deflation) and the only thing that works in that environment is Treasuries. Right now, I feel fairly comfortable in saying the dollar is in a rising trend. I feel no such comfort when it comes to growth. If it’s rising, the stock bulls are right and there is a lot more of this bull to go. But if it’s falling, Goldilocks is about to get a rude awakening.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, Joe Calhoun can be reached at: jyc3@alhambrapartners.com or   786-249-3773.

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