From Contrary Investor [12]
(Economic) Drivers, (QE) Drive By's And Dives
In many senses, both macro economic and financial market rhythm in 2012 has been very similar to what we experienced in 2010 and 2011. In each of those years the domestic economy was perking up in trajectory as the year began, only to witness slowing into the second quarter and through both of the last two summers. But as summer 2010 and 2011 came to a close, commodity prices had eased as had Federal Reserve monetary policy, leading to economic and financial asset price firming late in each year. Sound familiar? It should as this rhythmic similarity is again evident in the current year.
We started 2012 with domestic economic growth firming, albeit the anomalistically warm weather in the current year was a big help to growth in an otherwise seasonally subdued period. But as spring headed toward summer, once again macro US economic growth has slowed and financial asset prices have moderated. The good news is that the key drivers of firmer economic activity in the latter half of 2010 and 2011 are again present this year – meaningfully lower commodity prices and a central bank apparently on the cusp of yet another round of monetary easing. Will the latter half of the current year resemble the rhythm of the domestic economic and financial markets of ’10 and ‘11?
The reason we're asking this question is that more than a good number of Street strategists and soothsayers are currently pointing to this type of outcome similarity directly ahead. Not hard to understand in that they are simply expecting yesterday’s financial market and real economy experience once more. But in the current year, there exists one differentiating factor not present in either of the prior two – the potential for a fiscal cliff dive as we head into early 2013. The purpose of this commentary is to highlight a few key data points that may indeed be the determining factors as to whether latter 2012 and early 2013 will be a similar or dissimilar experience with 2010 and 2011. We believe this is very important in that the financial market in 2012 has already gone a very long way toward discounting the supposed positives of another round of monetary stimulus. If QE3 does arrive, as we believe it will in August/September, will improvement in the real economy justify the positive anticipation already built into financial asset prices this year due primarily to US Fed and global central bank “vocabulary” (repeated and ongoing promises to print money?
Let us set the stage a bit with real data. In the past we have mentioned that in a zero bound interest rate environment, traditional monetary policy really cannot move the economic needle. In the current cycle, the monetary policy transmission mechanism has been money printing that has acted to lift asset prices, in the hopes that the “wealth effect” generated by higher asset prices will engender spontaneous growth along the lines of a conceptual economic multiplier effect. Bottom line being that in a zero bound environment traditional monetary policy is ineffective. But what does replicate the action of interest rate movement in historical cycles in the current is the movement of commodity prices that are the input costs to manufacturers and business broadly. The chart below is a look at the ISM ( Institute of Supply Management ) prices paid index. It’s an indication of the direction of input cost pressure in the manufacturing sector. The bottom clip of the chart is the Commodity Research Bureau index, a broad measure of real world commodity prices.
Very simplistically, when commodity prices fall, they are a benefit to manufacturers. In other words, in a zero bound interest rate environment, falling commodity prices act as an economic stimulant by lowering the cost of manufacturing inputs.
Please notice the rhythm of the current economic cycle in these numbers. Clearly the domestic US economy was heading into trouble in 2008 on into early 2009. But, what is also clear is that commodity prices had more than dropped in half in 2008 and by early 2009 the Fed’s Quantitative Easing 1 (QE) was also unleashed. The prior period drop in commodity prices plus the QE stimulus set the stage for real US economic recovery and acceleration in 2009 and into early 2010. As mentioned at the outset and in similarity to the current year, in early 2010 the US economic was perking up nicely. But by the end of the first quarter of 2010, commodity prices had risen meaningfully from 2009 lows and the ISM prices paid index likewise showed us a very large rise in business inputs costs. As QE1 came to an end in early 2010, the economy was also faced with much higher commodity and manufacturing input costs – the exact set of circumstances that sowed the seeds for the 2Q 2010 economic slowdown.
Without belaboring the point, commodity prices and manufacturing input costs declined as the economy slowed into the summer of 2010. As the Fed then unleashed QE2, it came at a point of already subdued commodity and business input costs, now setting the stage for resumption in economic growth moving into early 2011. But one more time commodity and business input costs rose into early 2011 along with the economy, once again setting the stage for slowing as commodity price increases essentially act as an economic restraint or a tax, if you will.
This has been the rhythm of the current cycle and that rhythm continues to this very day. We believe based on the data relationships above, it is very fair to say that the commodity and business input costs have been two of the key drivers of the rhythm of the real economy in the current cycle. Without question the second key driver has been quantitative easing, via its wealth effect impact. And as of now, we are yet again anticipating another QE drive by occurrence. This time not only by the Fed, but also by the European crowd as well as Japan .
So here we stand today with commodity prices having already declined not only in the current year, but also meaningfully since 2011 highs. In like manner, expectations of more QE run very high. It’s a darn good bet we will see more QE reality in the next few months. Is this déjà vu all over again? Will 2012 look very much like 2010 and 2011? Prior period commodity price and manufacturing input price declines along with QE were the magic elixir in late 2010 and 2011. We have exactly the same set of circumstances facing us right now. So as per recent strategist commentary, should we be betting on higher financial asset prices and a resumption of economic growth into late 2012 and early 2013? Although the story will be told dead ahead, as mentioned the fiscal cliff remains the key differentiating factor in the current year.
We have written about the fiscal cliff in the past and the ramifications of this are more than well known. If left unaddressed, a US recession at least beginning in 2013 seems a virtual guarantee. Our personal bottom line is that there will be legislative action to stop the magnitude of tax increases and automatic Federal spending cuts. But it’s August and nothing has been done as of yet. Although the financial markets seem completely unconcerned about the fiscal cliff at present as they dote on each and every central bank utterance regarding money printing, the economic reality of the cliff is looming ever closer for businesses, small and large, as well as consumers. Business decision makers do not have the luxury of assuming all will be well, especially in the currently divisive political environment. How does one plan in an environment where taxes as well as the magnitude of government spending are outright question marks? Of course the correct answer is one doesn’t.
This finally leads us to what we believe is important to monitor in the months directly ahead. Commodity prices are now supportive of economic acceleration and QE will come. So what about the real economy? When we wrote about the fiscal cliff in the past, we suggested that the importance of the issue was in the anticipation of such by businesses and consumers, not necessarily in the ultimate reality. Business decision making uncertainty between now and the time we have some type of political resolution or certainty is the critical issue, especially for the reality of the US economy. Uncertainty tends to delay business decision making and in a sense freezes activity until a higher level of certainty and ability to plan is achieved. So although we have the positive ingredients of economic growth from 2010 and 2011 present today (lower commodity prices and more QE to come), we have a major item of economic uncertainty not present in 2010 or 2011 that is the economic cliff dive that will result from the fiscal cliff mandates if not changed. Financial assets in 2012 have already bolted higher primarily on supposed central bank money printing promises. But the most important question at this point now becomes will the real economy follow?
What do we watch directly ahead to get a sense of economic reality to come over latter 2012 and early 2013? As mentioned, businesses do not have the luxury of waiting around to find out what happens with the fiscal cliff. As of now, they have to plan as if it will be a reality. We would expect that the more capital intensive the business, the more we will “see” just how businesses deal with this period of uncertainty. How they deal with this issue will determine real world economic outcomes.
To the point, we first need to watch capital goods orders. Capital goods are very often expensive and require meaningful lead times in terms of ordering. Below is a chart of the year over year change in non-defense and aircraft capital goods new orders (core capital goods). We’re currently looking at the lowest number in the current economic recovery period to date, very close to no growth at all over the last year. Alongside is the ISM new orders data from the ISM manufacturing report. Important in that it “leads” the year over year change in broad capital goods new orders themselves. For now, we are not seeing any acceleration upward, despite lower commodity prices and high expectations of more QE.
We've taken a bit of a different look at capital goods new orders using a quarter over quarterly moving average to smooth out the volatile monthly data in the bottom portion of the chart. Point being, trips into negative rate of change territory have in the past been a warning. If the economy is to reaccelerate over the latter portion of 2012 and into 2013, capital goods orders must improve. Any type of deterioration from here suggests business are factoring in the negatives of the approaching fiscal cliff and directly ignoring the 2010 and 2011 look alike positives of lower commodity prices and printed money to come. This data point may be THE key to differentiating 2012 economic outcomes from those in 2010 and 2011.
The final data point to monitor true business decision making in the period of uncertainty clearly ahead is employment. First, you may remember that in 2009 the Worker Adjustment and Retraining Notification (WARN) act came into being. Simplistically, this act requires all employers with more than 100 employees to give 60 days notice if 50 or more of the employees are to be laid off, as well as plants or divisions closed. Again, this is the simple overview as there are more than a number of additional specifics. Think about the defense contractors and the fiscal cliff. They are right in the crosshairs. With no legislative change, we should expect to see layoff notices in the weeks directly prior to the election if employers plan to act prior to fiscal cliff reconciliation. That ought to be fun politically, no?
The issue for employment right now is forward demand. Yes, we may see additional layoffs, especially in those businesses potentially hardest hit by fiscal cliff spending cuts. But in terms of forward economic growth, it’s new hires that matter. This is where we need to look for any potential weakness. Very tough to expect businesses to pick up hiring when they are facing very significant business uncertainty in five short months.
So in the weeks and months directly ahead, we need to monitor the tone of business capital spending and hiring. If businesses freeze up, economic growth will slow even further. This may be great for Bernanke in terms of providing cover to implement more QE, but for the real economy and financial asset investors it’s another story entirely. In fact it’s a story that stands in direct contrast to outcomes in the latter parts of 2010 and 2011. Moreover for equity investors, we need to remember that in the latter half of 2010 and 2011, the trajectory of corporate earnings growth was very strong. That’s not the case any longer in terms of growth rate. That tells us that economic growth must reaccelerate in good part to justify the already seen upward movement in financial assets largely driven to this point by QE sugar plum fairies dancing. Stay tuned. We know the key drivers to monitor. In the months ahead, it’s all about the interaction of key economic drivers, central bank QE drive by’s, and potential US fiscal cliff dives.