We have been of the opinion that the US economy would avoid a return to recession and we haven’t changed our minds – yet – but the data will need to stop deteriorating soon for us to continue playing the optimist. With the European debt crisis seemingly about to climax and emerging market countries entering a monetary easing cycle, we believe the US economy will move back toward the recent 2% growth tendency. Anything better than that would require a major change in policy – something we find unlikely in the short term. We’re not sure what political combination would produce better policy but it is obvious that the current crop of politicians isn’t up to the task. (By the way, speaking personally rather than for the firm, I’m in the throw them all out and start over camp. The new batch couldn’t possibly be worse than what we’ve got – could they?)
We received a raft of inflation data last week and nothing explains our current economic slowdown better. Export and import prices are both rising rapidly, up 9.6% and 13.0% respectively. This is a direct result of the Fed’s easy monetary policy and is affecting growth here and abroad. It is not surprising that these prices are now easing somewhat – import prices actually fell last month due to lower oil prices – after the end of QE 2. The easing of price pressures was also evident in the Producer price index which was flat for the month, although still up 6.5% year over year. Good news hasn’t arrived at the consumer level as the CPI rose 0.4% in August. Year over year, headline CPI is up 3.8% and even the core is up 2%. It is hard to see how the Fed can justify further easing in the face of those numbers but I have no doubt that next week’s meeting will produce more of the same Bernanke blood letting. Inflation is particularly hard on the middle class and the poor which makes it a uniquely inapt policy for a recession that has barely touched the wealthy.
Retail sales were flat in August (and down when adjusted for the above inflation figures) which confirms what we have seen from the Goldman and Redbook reports over the last month. Those reports were a bit more upbeat last week with same store sales tracking a little higher than the 3% rate we saw in August. Businesses are acting cautiously in response; inventories rose 0.4% last month, less than the 0.7% rise in sales. The inventory to sales ratio fell to 1.27.
Manufacturing surveys from the NY and Philly Fed’s remained negative. The Empire state survey fell further to -8.82 while the Philly version improved to -17.5 from last month’s disaster reading of -30.7. The only positive I could find in either report was a rise in employment in the Philly survey but if the trend for production doesn’t change soon that won’t last. There was somewhat better news in the Industrial production numbers, up 0.2% last month. Production is up 3.4% over the last year but the recent surge may not last as it is rooted in increased auto production after the Japan induced slowdown.
The worst news of the week was another rise in unemployment claims, now up to 428k. As I’ve detailed in this space before, jobless claims are highly correlated with the stock market and the economy and figure prominently in our outlook. And they are going in the wrong direction. More than anything else, this is the stat that worries me the most and if it deteriorates much more will flip us to the double dip camp.
Despite the negative news on the economy, we are seeing some positives in the markets. Gold, at least in the short term, appears to be peaking. Oil is now in a defined downtrend although still too high for our comfort. In fact, the same could be said for the broad commodity indexes. The key to all those markets is, in our opinion, the course of the US Dollar which we’ve been saying for months was making a bottom. Although down slightly last week, the dollar index is now 4% above its recent lows and we believe poised for a sustained rally. Stocks – with the exception of Europe – are also trying to put in bottoms. Emerging market stocks, Asian stocks and US stocks have all held above their previous lows in recent sell offs. In our opinion it is too early yet to bottom fish in Europe where markets are still making lower lows.
Given the market action – and our belief the US economy is not headed for recession – we slightly raised our risk exposure last week. Rather than adding to stocks at this point, we instead reduced our Treasury position in favor of an initial position in high yield bonds. We sold our position in high yield earlier in the year – before the selloff – and spreads have widened recently, mostly due to the fall in Treasury yields. We are encouraged by the action in the high grade corporate market which hasn’t shown as much stress as stocks or high yield. Since high yield is fairly well correlated with equities (from 0.5 to .88 depending on the time frame) this gives us an equity-like exposure with a yield cushion. Of course, if we’re wrong about the economy, this will not be a pleasant place to be in a recession – but neither would the stock market.
Even with this move, we remain conservatively invested and cautious about the economic outlook. We don’t yet know how the European situation will be resolved and emerging markets are still dependent on an opaque Chinese economy that is difficult to anaylyze. It would not take much in the way of a black swan – perhaps a black cygnet would do – to push the global economy back into recession. In addition, we don’t know yet what fowl the Federal Reserve will loose on the market this week. So despite our slight shift toward optimism last week, this is not a time to throw caution to the wind. Stay conservative but keep looking for those silver linings.
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