David Rosenberg: "RIP Wealth Effect"

by David Rosenberg of Gluskin-Sheff

Wealth Effect R.I.P.?

So the Fed is pinning its hopes on stimulating the economy via the wealth effect again, as it did when it revived the post-tech-wreck asset bubble in housing and credit in that now infamous 2003-07 period of radical excess. But here's the rub. While there is a wealth effect on spending, the correlation going back to 1952 is only 57%. But the correlation between spending and after-tax personal incomes is more like 75%. The impact is leagues apart. And that is the problem here, as we saw real disposable personal income decline 0.3% in August for the largest setback of the year. The QE2 trend of 1.7% is about half the 3.2% trend that was in place at the time of 0E2. Not only that, but the personal savings rate is too low to kick-start spending, even if the Fed is successful in generating significant asset price inflation. The savings rate now is at a mere 3.7%, whereas it was 6% at the time of QE1 back in 2009 and over 5% at the time of QE2 2010 — in other words, there is less pent-up demand right now and a much greater need to rebuild rather than draw down the personal savings rate. This is a key obstacle even in the face of higher net worth.

What is fascinating is that the rise in net worth looks fairly tenuous. Yes, home prices have risen on the back of tighter supplies but the builders have ramped up production by nearly 30% over the past year. And the first-time buyer is dormant, which means that the key source of demand in the food chain is still missing, and investor-based buying will only go so far in terms of sustaining any further home price appreciation.

But it is the action in the equity market that is most telling. This is the first time after any major central bank incursion — QE1, QE2, Operation Twist and LTRO — that 13 (trading) days after the announcement, the stock market is lower. The S&P 500 has dropped 1% since the day of the Fed meeting whereas it was up an average of 4% at this juncture following the other four announcements. I had said earlier that the Fed has likely established a firm floor but it looks clear that the more ominous global economic backdrop has also established a ceiling — I mean, weren't the lagging hedge funds supposed to have been piling in by now? And all of the cyclical sectors are lower which again is highly atypical—all down around 2%. And if there was a group that the Fed was really trying to support it was the Financials and this sector is down 3% along with basic materials. Go figure. The more defensive areas like Health care, Utilities and staples have outperformed, which is very rare after a QE announcement out of the Fed.

At the same time, the yield on the 10-year T-note. which is usually steady around this time following a post-QE announcement, has fallen more than 10 basis points this time around. The TSX has turned in a similar though less dramatic swing this time - Financials and Materials, which had cheapened up far more going into this than their U.S. counterparts, have actually hung in, as has the overall Canadian market (though to be fair, it is usually up 2% by now).

As the accompanied charts illustrate, one obstacle for the equity market of late has been sentiment and positioning. The Market Vane Bullishness index is at the high end of the range and as the latest CFTC (Commodity Futures Trading Commission) data indicate, the net speculative long positions on the S&P 500 and Nasdaq on the CME have already surged to record high levels. In other words, a lot of the buying power that pundits were expecting has already been exhauisted.

The pace of economic activity is weakening, with all deference to ISM. With profits faltering and wage earnings slowing down, we have a situation where Gross Domestic Income softened to a mere 1.7% annual rate in Q2 from 6.1% in Q1 and 4.6% in Q4 of last year. This was the weakest performance since the third quarter of 2009 just as the worst recession in seven decades was ebbing. In real terms, GDI actually stagnated — up a mere 0.16% annual rate, a buzz-cut from the 3.8% pace in Q1 and 4.5% in Q4, again the weakest tally since Q3 last year and the second weakest since Q2 2009. This puts the GDP slowdown in Q2 into perspective. GDP is all about spending. GDI is all about income. And it is income that drives confidence, spending, and ultimately prosperity — not the other way around.