Rosenberg On The Illusion Of Prosperity, The 7 Biggest Downside Risks, And The Fed's Third Mandate: "Higher Equity Valuations"
It is refreshing to see that an economist of David Rosenberg's statute agrees with Zero Hedge that the third mandate (we personally believe it is the one and only) of the Fed is "Higher Equity Valuations." While a faux-indignant Corker pretends to attempt to cull the Fed's powers and remove the inflation mandate, maybe someone can finally eliminate the one mandate that the Fed does not even have in its charter, yet which is the only one that it is beholden to: namely to get the Dow to 36,000. Which brings us to another point: instead of giving us his forecast on the GDP, maybe Bernanke can simply give everyone his price target for the Russell 2000. It will save everyone a lot of second-guessing effort: after all the Fed now has complete control over the stock market, and the whole frontrunning the Fed shtick is getting old.
Must read from David Rosenberg:
CREATING AN ILLUSION OF PROSPERITY
How can it be all bad? After all, the Fed’s “Beige Book” did highlight that all 12 districts have reported an improvement in the pace of economic activity. In the previous Beige Book, which covered the month of October and early November, there were 10 who reported the same. During the “double dip” concern days of last summer, the Beige Book stated that only 8 of the 12 districts were seeing a pickup in growth. And it looks like that lower-than-expected trade deficit for November is going to open the floodgates for more upward revisions to fourth quarter GDP estimates, ahead of the first release of the data in two week’s time (the consensus just moved up the Q1 forecast for real GDP growth to 3.3% from 2.4%, which we think will prove to be the peak for the year). The Ceridian-UCLA Pulse of Commerce Index™ (PCI), a real-time measure of the flow of goods to U.S. factories, retailers and consumers, surged 2.47% in December as well. And the IBD/TIPP economic optimism index shot up 13% in December to 51.9 ? the best reading since Sept 2009. Even the Presidential leadership subindex leapt to an eight-month high of 50.4.
No doubt a lot has happened to generate the newly-found optimism ? optimism underscored not just through the V-shaped bounce back in the equity market, but when the VIX comes down to the 16-17 area, it provides an additional signal that investors are very confident over the outlook for sustainable growth in the quarters that lie ahead.
In August, we had Ben Bernanke verbally hinting that more central bank balance sheet expansion and liquidity were on its way. If the name of the game was to revive investor “animal spirits”, it has worked wonders so far even if Treasury yields are up around 100 basis points from the lows. I’m sure Ben would gladly accept 100bps on the 10-year note for a 10% runup in the S&P 500. Tiffany’s should probably consider giving Bernanke a discount after the high-end jeweller managed to rack up an 11% sales pickup in December. Of course we then had quite a favourable midterm election for investors, though not entirely surprising.
And in November, another bailout deal was cobbled together by the EU and IMF to prevent Ireland from sliding into the abyss.
The saga continues, however, but investors are emboldened by the aggressive actions taken, not to mention the ECB stepping in with massive support of its own.
Then in December, not only are the Bush-era tax cuts extended for all, but bells and whistles were added to put more borrowed money from China into the hands of consumers and businesses.
And let’s face it. The incoming economic data have not looked that bad at all.
In addition, President Obama looks willing to be a compromiser and his recent political appointments would seem to suggest that he will be governing more from the center in the next two years. This is good news but what will it mean for the markets if this enhances the President’s re-election chances? A dilemma for another day.
Nobody should be reading this and jumping to the conclusion that my fundamental views have changed over the contours of this post-bubble-bust economic recovery. The economy remains on government-assisted life support, and the government has been very successful in creating the illusion of economic prosperity. It is doing this to buy time and help preserve social stability as the adjustment towards housing deflation, consumer deleveraging, and chronic unemployment takes its toll on the growth rate in organic final demand.
The question really is still one of sustainability. If the Fed and our public officials were as comforted as the financial markets now seem to be over the sustainability of the recovery, then after a full year into it the central bank would not have embarked on another monetary experiment and the government would not have dipped into Social Security as a means to put more change in people’s pockets for spending purposes. Money, as an aside, that isn’t really ours.
This is not an attempt at being a moralist or merely waxing philosophically. It is an attempt to understand what is really going on. Binges are inevitably followed by hangovers. Sugar highs are just that. Let’s not forget the lessons of the last few bubbles and how they ended.
The bubble of 2000 reflected the dramatic expansion of technology companies. A complete saturation even if many of these companies did indeed play a pivotal role in enhancing the nation’s capital stock. But corporate balance sheets expanded dramatically to a point where the gap between tech-heavy capital spending budgets and internally generated funds surged to unprecedented levels. The bears of 1998 and 1999 weren’t exactly wrong as much as being early.
The bubble of 2007 reflected the rapid expansion of the housing stock (not a productive asset) and the speculative leverage that ignited the boom. This was about a radical expansion in two balance sheets at the same time ? household balance sheets and banking sector balance sheets. The extent of the excess leverage made the previous debt-induced dot-com bubble look like a mild affair in comparison.
This bull phase, yet again, is being fuelled principally by the radical expansion of the Fed balance sheet (+170%) and the Federal government balance sheet (the debt/GDP ratio has ballooned from 65% in 2007 to approximately 95% today). Washington is now spending 1.60 for every dollar it is taking in from the revenue base. This is really pushing the envelope.
Still, the United States is the world’s reserve currency so that means it has a printing press. But there may come a day when these reflationary policies do ignite an inflation cycle, in which case, interest rates will rise very sharply. That is not on the radar screen now, but it will be at some point. The folks who believed that the housing and mortgage market collapse would stay contained are not the ones we can rely on to rein in their pregnant balance sheet when the time comes. As for the Federal government, is there really any appetite for true fiscal reform until a crisis forces the adjustment on American society? The same quarter that U.S. GDP growth is moving into a 3-4% annualized trend is the same quarter that the White House and Congress inked another budget-busting deal that guarantees yet another year of a trillion-dollar-plus deficit. In fact, by 2012 the debt/GDP ratio will, under status quo, pierce the 100% level, which is well above the ratio that mental giants like Ken Rogoff have found to be an obstacle for overall economic activity as opposed to a source of support.
Herb Stein once famously said that anything that can’t last forever by definition won’t. Now forever is a long time, but I would expect the current set of ultra expansive monetary and fiscal policies to have a fairly short lifespan from here. The U.S. may be the reserve currency and it may have the printing press but alas, it also has racked up such a foreign debt tab that after years of large-scale current account deficits, the by-product of spending beyond one’s means for an elongated period of time, is that over half the Treasury market is owned by foreigners (outsiders who have invested in these bonds for their liquidity, safety, and optionality). But these folks are not U.S citizens and will ultimately act in their own interest.
So what if at some point, they lose confidence in U.S. economic policies? Economic policies, as well as fiscal policies, that are jeopardizing the sanctity of the central bank balance sheet and that are clouding the country’s future fiscal flexibility. And the point must be made here that what the governments are doing is creating the illusion of a prosperous recovery. But wealth is not created by printing money or by expansion of the public sector balance sheet. What these policies are doing is buying time and nothing more, and a payback to the piper down the road.
Every country pursuing these profligate policies ultimately hit some sort of wall ? it sure happened to Canada back in the early 1990s. The Canadian government spent and borrowed like drunken sailors for a long time and these policies, as we see unfolding in the U.S.A. today, do create an illusion of prosperity. But as any Canadian will tell you (or perhaps anyone from New Zealand a decade earlier), there is no such thing as a free lunch.
The party went on in Canada into the early 1990s when a record deficit became increasingly structural in nature (i.e., no way to grow out of it or inflate our way out of it). Credit downgrades ensued. It became tougher to raise funds externally without sharply raising risk premiums, and it is worth noting that in those days, half of Canada’s debt was also held by foreign investors. You see, that is when you ultimately end up losing sovereign control over your interest rate structure. The fact that Japan merely owes its 200% debt/GDP ratio to itself means it doesn’t share this challenge of having to rely on the kindness of strangers.
Canada endured not just the ignominy of credit downgrades but also recurring financial market gyrations that frequently disrupted business activity. The Liberal government that found its way to power in 1993 after nearly a decade in opposition spent most of the next five years enacting tough deficit-reducing policies that it never campaigned on.
Former finance minister Paul Martin emerged as Canada’s “Sir Roger Douglas equivalent” and was so successful at turning the bloated deficit around, not to mention reversing Canada’s long-standing reliance on big government, that he has been hired on as a consultant to the Cameron-led coalition in the U.K. And so if you’re wondering why it is that global financial markets have responded favourably to the financial plan unveiled by the new U.K. government, now you know why. Notice that Hank Paulson and Larry Summers weren’t offered any postings. Canada did endure years of painful austerity as taxes were raised, spending was cut, government operations privatized, social contracts re-written, and what at one point would have been deemed “untouchables” (like means testing and claw backs for social security) were not just touched, but squeezed.
Then again, the political will was there. And the Liberals stayed in power long after the last year of budgetary deficits so in fact the party was rewarded, not punished, for reclaiming fiscal sanity.
So back to the markets. We are in a very powerful bear market rally. In fact, in less than two years the S&P 500 has managed to accomplish what it did over a five-year span from 2002 to the 2007 peak. That was a bear market rally too.
You see, a primary or secular bull market requires a positive exogenous shock to the economy. One that is self-sustaining. One that adds to the productive capital stock. Not only did we have the baby boom stimulating demand growth in that 1949-66 secular bull run, but we also had Eisenhower roll out the nation’s highway network, which exerted a powerful multi-year impact on transportation costs and productivity. In the 1982-2000 era, we had a central banker committed to dampening inflation (today we have a Fed Chairman who is committed to creating it) with obvious beneficial impacts to the market multiple. The P/E expansion in that cycle was responsible for two-thirds of the entire secular bull market. The other one-third that was earnings-related did not require financial engineering from the government but reflected the prosperity ignited by the wave of technology spending which greatly enhanced the growth of the nation’s capital stock and provided an enormous and enduring boost to productivity growth. In these two secular bull markets of the post-WWII era, what we had on our hands was true prosperity. Today, we have a capital stock that has stagnated and an illusion of prosperity created by the rapid expansion of the Fed and federal government balance sheet.
A similar illusion was created in that 2002-07 bear market rally as well, but the S&P 500 did manage to double over that time frame and generate some nice paper profits for those who managed to get out at the top. No doubt we have much more clarity this time around with respect to toxic assets on bank balance sheets. The problem now is more of a 1937-38 nature because at some point, just as Herb Stein said, the party on the Fed and federal government balance sheets is going to end.
Look, we are not zero-weight equities but in our asset mix we remain cautious, risk-focused and still oriented towards capital preservation ? divvied up between stocks (barbell of income equity and oil/precious metals), fixed-income, and our hedge fund strategies. The tortoise won the race in the end and we prepare our models for a marathon, not a sprint. I fielded an email the other day with the oh so original saying “Dave, you do realize that the market can stay irrational longer than you can stay solvent”. Well, yes, I do know that, but the reality is that we don’t want to be fully invested in anything that is irrational, and the reason we have an equities weighting is because there is the share of the market that we can identify as trading at multiples that seem sensible and .... rational.
Meanwhile, even as the coincident economic data and pieces of anecdotal evidence have been constructive, we still have a murky outlook on our hands, which we identified last week (interesting too how in the recent set of Federal Open Market Committee (FOMC) minutes, “downside” risks were mentioned twice but there was not a sound about the upside. In recent days, those downside risks have actually come to life even more than before:
First, during my just completed trip to LA (considering the weather gap during my stay I couldn’t help but think of the Mamas and Papas) I found there to be a vast majority of folks who believe that Bernanke will “do as many QE’s as he wants”. Well, maybe. Or maybe not. He faces different congressional oversight (the Fed is now being audited for crying out loud) and there are more policy “hawks” on the FOMC voting roster this year. So what happened a couple of days ago was the revelation from the recent meeting among Federal Reserve district banks that two of them ? Kansas City and Dallas ? voted for a hike in the discount rate to 1% from 0.75% (and the Dallas guy is a voter this year). At the same time, Philly Fed president Plosser (also a voter) just gave a speech questioning the wisdom of tapping the entire $600 billion QE2 program.
Second, home prices are definitely double-dipping. CoreLogic just came out with its November results and found the YoY national trend deflating by 5.1% YoY from 3.4% in October. And the plurality of states seeing home prices sagging again is really disturbing ? 44 in November, up from 18 in June when the market was receiving some artificial support in the form of the temporary tax credits. Zillow also found that U.S. housing values were down 5.1% YoY in November, the 53rd decline in a row (now that sounds Japanese) and down to the lowest level since October 2003. It may not hurt (though it probably will) to have a read of Mort Zuckerman’s column on the real estate outlook on page 9 of yesterday’s FT titled Housing Weighs Down the Recovery).
Foreclosure filings are easing again as the banks move yet again to clean up their sloppy paperwork, and in the very near-term may put a floor under home prices, but it won’t be sustained. The banks will ultimately work through the backlog, and when they do, expect a flood of supply to hit the market as was the case following last year’s brief government-imposed moratorium. As an aside, for something truly scary, have a read of the article that found its way to the front page of yesterday’s WSJ ? The Housing Slump Has Salem on a Witch Hunt Again. Surreal.
Third, the need for draconian fiscal actions out of state and local governments. So in the last few days, we saw Illinois pass legislation that will massively raise taxes (to 5% from 3% for individuals and to 9.5% from 7.3% for businesses) as well as cut services (the state has a $30 billion cumulative budget gap to close this year and next). Note that the bondholders are not touched, and we have to say here and now that a generic long-dated AAA-rated muni yielding just over 5% is pretty juicy despite what Meredith Whitney’s forecast is over looming default risks.
Orange County defaulted 16 years ago, and believe it or not, the creditors were ultimately made good. If Illinois can manage to reverse years of fiscal mismanagement then we may well look back on this as a huge opportunity ? the State’s 10-year bond trades at a record 215bps over Treasuries. Not even Puerto Rico is that high (at 210bps). Even California trades at a spread of 125bps but I have to say that I was literally taken aback by the positive feedback I received over Jerry Brown’s fiscal plans, even from those who are not his supporters. But as a sign of just how much out of favour the group is, retail investors liquidated more than $13 billion from muni bond funds in November-December, topping their net redemptions in this space at the height of the financial panic in 2008. This conjures up the memory of Bob Farrell’s rule number five: “The public buys the most at the top and the least at the bottom”.
Fourth, we clearly have a global food crisis on our hands. This is a particular risk for various emerging Asian countries ? China, India and Indonesia come to mind. Corn futures have now doubled in just the past six months, and corn and its extracts show up in just about everything we buy from the grocery store. And the latest update from the USDA was that the 2010 harvest fell some 93 million bushels short of forecast (at 12.4 billion) while domestic demand was revised up by 100 million bushels (to 4.9). U.S reserves are down to 15-year lows and if that isn’t bad enough, stockpiles of soybeans (the second largest U.S. crop) are down to 30-year lows (China is absorbing one-third of the harvest, largely to fatten its cows as the country’s masses increasingly afford and discover the pleasures of being a carnivore). Between food and energy (most retail analysts see food inflation more than doubling from 1.5% last year to 3.5-4% this year, the December tax cut just siphoned into the gas tank and grocery bill.
Fifth point, and speaking of energy, this was cited as a key downside risk by the Fed last month, and we showed just the other day that recessions typically follow a two-year 120% surge in oil prices (only in 2005-2006 did the economy escape a recession ? it was delayed to 2007 ? as the impact of surging home prices and a massive credit expansion provided a strong antidote). Oil is now well north of $90/barrel and the experts we speak to see the price heading north of $100 and sooner rather than later, owing to the tenuous supply-demand balance at the current time (we say this following the news from the DoE that U.S. crude stockpiles plunged 2.2 million barrels last week). As an aside, Brent is already within two bucks of re-attaining the century mark.
Sixth, while a calm seems to have surfaced in the Euro area, the situation remains extremely tenuous. Portugal did indeed pass a critical test with this week’s successful bond auctions (followed by Spain and Italy, with market chatter of an even more pronounced rescue fund being established) ? a degree of success that has been in no small part due to the massive support being provided by the ECB’s balance sheet. While Portugal did manage to issue its 10-year debt with a 6.71% yield, nine basis points lower than the prior auction in November, but still perilously close to the 7% yield that would very likely touch off the need for a bailout package.
Then we have the unlucky number seven ? the debt ceiling issue looms. At the least, this will prove to be a distraction that may depress the market multiple. For how this could become something a little more than just “background noise”, have a look at Arthur Laffer’s “take” in the op-ed column of yesterday’s WSJ (page A17 ? A Price for Raising the Debt Ceiling).
Finally, valuations remain somewhat of a concern. On either a Tobin Q replacement cost/historical cost comparison or a Shiller normalized P/E basis, it can be argued that the S&P 500 is overvalued by at least 20%. Even on a trailing basis, and even with the fact that earnings in 2010 did surprise to the high side, the traditional P/E ratio has expanded a full point in the past year to 15.4x and are now trading at their highest level since last March ? just ahead of one of last year’s significant market setbacks. Not only that, but measures of investor sentiment have moved into a wild extreme ? the bear share in the latest Investor Intelligence poll is down to 19.1% from 20.5% last week. The bull camp is all the way up to 57.3% from 54.5%. Again, numbers we last saw during those complacent days of April 2010, ahead of what turned out to be a decent (or indecent) correction.
By way of comparison, back on Labour Day, the Investor Intelligence survey flashed 29.4% bulls and 37.7% bears. Now, with perfect hindsight, we know what represents a nice buying opportunity and what doesn’t.
Finally, as a sign of just how overbought this market is, it has been brought to our attention that the S&P 500 has now been above its 50-day moving average for 92 days running — this has occurred just 17 times since 1928. Moreover, the equity market has not closed below its 10-day moving average at any time in the past 30 days, which has never occurred before, at least not in the past 82 years.
Back to Bernanke. In a speech he just gave to the Federal Deposit Insurance Corporation forum on small business:
“Our policies have contributed to a stronger stock market just as they did in March 2009 when we did the first iteration of this program … a stronger economy helps small businesses more than larger businesses. Interest rates are higher but that’s mostly because the news is better. It has responded to a stronger economy and better expectations.”
So the Fed Chairman seems non-plussed that Treasury yields have shot up and that the mortgage rates and car loan rates have done likewise, even though he said this back in early November in his op-ed piece in the Washington Post, regarding the need for lower long-term yields:
“For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment.”
But the Fed Chairman is at least getting what he wants in the equity market. Recall what he said back then — “higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
So now the Fed has added a third mandate to its charter:
1. Full employment
2. Low and stable inflation
3. Higher equity valuation
The real question we should be asking is why Ben didn’t add this third policy objective back in 2007 and save us from a whole lot of pain over the next 18 months?
And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.