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Soft Patch Already Fading
The soft patch is nothing more than a temporary and superficial blow to the economy. If it was anything more than Japan?s disasters and the tornado season, the good numbers we?ve been seeing lately ? on lending, tax revenue, trade, hours-worked, ex-auto sales, and commercial building ? wouldn?t be happening.
Is It Really a Soft Patch?
The idea that the soft patch could be due to one-off events, like the tsunami in Japan is bothering quite a few people.A good question came from one of our readers and we thought it was important to post the answer. We remain convinced that the economy will accelerate in the second half of this year. The question: "Id like to believe you when you write"Never mind that much of the slowdown is so obviously tied to temporary Japan-related disruptions in manufacturing and tornado-related dips in home building."But where's the evidence of negatively affecting the U.S. economy and/or GDP?"
Economic Rapture?
Harold Camping predicted the "end of the world" on May 21st. Let?s imagine that the world really did end. Let?s imagine that we?re now living in an artificial world. Ben Bernanke is making the sun rise with monetary policy. Federal spending is generating oxygen and enormous increases in federal debt are making water. Everything seems relatively normal, but it?s all ultimately just a mirage, created by artificial means, and it can't last forever. This is an extreme example, but that's what it seems many believe about the economy today.
The
Not since the early 1980s has such widespread pessimism about the US economy been so prevalent. This pessimism ? fueled by political demagoguery and an overbuilt short-selling industry ? denies and ridicules any upward move in growth or stock prices. Basically, if something moves up, then the pessimists argue that it cannot possibly be ?real.? Even smart analysts, like Robert Arnott, have fallen into the trap of looking at the world in a negative way. Mr. Arnott argues that much of our recent GDP growth is ?unreal,? because it has been driven by government debt.
Don't Sweat
Some recent reports on the economy have been tepid and that?s likely to continue for at least a few more weeks. For example, back in early March the four-week average for initial unemployment claims hit a recovery low of 389,000; now they?re 439,000. Manufacturing production dropped the most in April for any month since the start of the recovery. Meanwhile, for May, we witnessed declines for both the Empire State index and Philly Fed index, which are measures of manufacturing activity in their regions. Both were still in positive territory but not as rapid as earlier this year.
Public Policy Looking Better
We think there are five (5) reasons to be bullish about the US economy. First, monetary policy is loose and likely to remain so. Second, the financial panic is over, thanks to the end of mark-to-market accounting rules. Third, technological advances continue to boost productivity growth. Fourth, our free market economy is incredibly resilient, more so than the pessimists believe. And fifth, the policy environment is improving. Despite what Bernanke might say (that quantitative easing lifted stock prices), we think the return in the S&P 500 has to do with a positive shift in government policy.
Bulls Versus Bears, Again
The big news last week was the execution of Osama bin Laden. It was both the end and the beginning of an era. It provides closure on at least some part of 9/11. However, terrorism is still with us, just with a different face. The same is true for the economy and markets. Last week real GDP was released for the first quarter of 2011 and was up for the seventh consecutive quarter, hitting a new all-time high. Even though unemployment is elevated, US economic output has recovered from the Panic of 2008. Nonetheless, investors remain nervous, even bearish, about the economy and financial markets.
Bernanke and the Teflon Fed
The Fed acts like an academic institution, but it operates in a political environment and it is really good at navigating the landscape. Alan Greenspan (Chairman 1987-2006) was one of the most successful politicians ever to set foot in Washington DC.He never won an election, but was called the ?maestro.?His critics could not scratch his Teflon coating. Lately, he has come under attack for the housing bubble. And even though it is clear that 1% interest rates back in 2004 had a huge role in causing over-investment in housing, the Fed and Greenspan have once again come through unscathed.
The Greatest Speculators
It?s as predictable as birds flying south in the winter. When gas prices rise, politicians (most recently, President Obama), feign outrage and then threaten to ?investigate? the ?speculators.? The irony is that these politicians are the real speculators ? making a bet that they can use government to create wealth. No government in the history of the world has made it work, but they keep on trying ? with other people?s money. In one sense, this is all about economic and financial literacy. Of course there are investors who speculate on energy prices. Thank goodness.
GDP at 2%: Seventh Consecutive Quarter of Growth
Anyone forecasting first quarter real GDP growth with a high degree of confidence needs to have their head examined. On the positive side industrial production grew at a 6.1% annual rate in the first quarter. Manufacturing output was up at a stellar 9.2% rate ? the most rapid increase since 1997. Unemployment claims fell sharply, another sign the economy was growing at a robust rate. Meanwhile, total hours worked in the private sector climbed at a 2% annual rate. Add 2% increases in productivity to that increase in work effort and a 4% growth rate in private sector output is easily reachable.
The Taylor Rule Is Wrong
The working hypothesis of just about every forecaster or Fed-watcher in the world has been that the Fed would not tighten at all until 2012. That meant no interest rate hikes this year. And to avoid putting on any brakes at all, the Fed would even think about QE-III. But this view is now coming under fire, not just from the private sector, but from inside the Fed itself. Stronger gains in employment, along with some relatively hot inflation reports have pushed many regional Fed presidents to make hawkish statements.
The Shorts Get Whipsawed by the VIX
Getting to fair value would require the US equity markets to rise 31% from Friday?s close. That assumes no further gain in profits after Q1. These results are pretty robust. If we stress test for rising rates, the 10-year Treasury yield would need to rise to 6.5%, with no intervening increase in profits for the model to show equities are at fair value already. We stand by the forecast we made at the start of the year that the Dow should hit 14,500 by year-end 2011, while the S&P 500 strikes 1575. In other words, short the shorts ? equities are still cheap. And watch out for the VIX, too.
Japan,
While the news coverage of problems at Japan?s nuclear power plants was sensationalized and misleading, the death toll from the Japanese earthquake and tsunami is horrendous. Moreover, the economic damage to the affected areas is substantial and will require a large re-direction of resources. Japan?s economy will not gain from this shift in resources because the cost of repair only replaces what was lost. That said, after the initial economic blow is fully absorbed, Japan?s economy may accelerate for a time because people change their labor-leisure trade-off.
Fed Pays Lip Service to Better Economy and Higher Inflation
The Federal Reserve made several changes to the language of its statement today, acknowledging an improving economy andhigher overall inflation. However the Fed also made it clear it does not think any of this warrants a change in the stance of monetary policy. The Fed was more bullish on the economy, saying it was on a ?firmer footing? and that the labor market was ?improving gradually.? Previously the Fed had said economic growth was not enough to generate ?improvement? in the market. The Fed recognized faster growth in household spending and finally omitted language concerning restraints
It's A Natural Disaster, Not A Black Swan
At times of natural disaster and personal tragedy, it can be difficult to focus on economics. However, there is an economic component to the Japanese earthquake as there is with any disaster. In Haiti, for example, decades of awful leadership have created deep-seated poverty and corruption, which amplified the size and scope of its recent earthquake. In Kobe (1995), Chile (2010), San Francisco (1989), Katrina (2005), mostly free markets, accumulated wealth and a disdain for corruption helped overcome those disasters relatively quickly. In Japan today, the same will be true.
Who Gets Credit For the Recovery?
What?s the opposite of a double dip? Whatever it is, that?s where we are. Remember commercial real estate, re-setting ARMs, foreclosures, muni-bond defaults, Greece, Ireland, Egypt, Tunisia, Libya, high unemployment, more savings, or just plain old government debt? At least one of these, or maybe all of them, was going to make recovery impossible, or end any recovery prematurely. But none of it happened. The double dip turned out to be a figment.
Stay Positive - It's The Right Thing To Do
The gloom is hard to miss: Libya, oil prices, budget battles, a pull-back in stock prices, or downward revisions to GDP?and about how these will cause weaker growth (or even a recession) ahead. But the world is always full of potential events that could cause a panic, recession, even a depression. The world is never perfectly ?safe.? If nuclear war broke out or if Saudi Arabia got into a nasty civil war, the risks to the US economic environment and the stock market would rise immeasurably.
Debt Limit Brinksmanship
Don?t get us wrong. The budget is a total mess. The equivalent of a financial root canal is necessary. We fully support newly elected lawmakers who want to maximize the political leverage created by the debt limit issue to move in this direction. In fact, we?d like to see only short-term increases so the issue can be revisited time and time again, to hold the spenders? feet to the political fire. But ripping all the teeth out at once is not the answer.
The Federal Budget: It's a Mess
If the US federal government were a bank, the FDIC would close them down this Friday night. Earlier today, President Obama submitted next year?s budget. The new budget, despite ?cutting? the deficit by $1.1 trillion, will require Congress to pass a large increase in the ?debt ceiling.? Claiming budget savings by freezing spending at today?s levels is like an alcoholic who says he?s sober because he?ll never drink more than yesterday?s bender. Trouble is, this alcoholic doesn?t even pay his own tab.
FASB Surrenders - America Wins
The good news, which went virtually un-reported on January 25, 2011, was that FASB surrendered on fair value accounting for loans. In the face of overwhelming opposition, banks will be allowed to carry loans on their books at amortized cost, reflecting cash flow (payments), as well as reasonable estimates of likely loan losses.
This decision is a huge win for the markets and the economy.
Egypt, Dollars and History
When the Fed prints too many dollars, the inflation that results often shows up in commodity prices first. When it lifts energy commodities, countries and regions of the world which export oil typically benefit and have largesse to throw around. Egypt is an oil producer and a large refiner. So, rising energy prices are neutral to slightly positive for the nation?s economy. Food prices are a different story.
US Politics - Cage Match Or Pillow Fight?
The good news is that because of the elections last November, the politics have changed. Politicians in Washington, of both parties, are being forced to consider more free market solutions to problems and to address the growth in government. Time will tell whether a new leaf has really been turned, but for now, the direction of policy is much better for markets and the economy than it has been in many years. Politicians have pulled out their pillows and are now debating how to shrink government, not expand it.
China and the Dollar
The US should not take this week?s visit as an opportunity to lecture the Chinese about the yuan. If we do, Fed Chairman Ben Bernanke may find himself on the receiving end of a lecture about the importance of price stability and how to run a central bank. And he would deserve it.
Government, the Anti-Stimulus
After a strong ADP jobs report last Wednesday (297,000 new private jobs in Dec.), we raised our jobs forecast. Going into Friday, we expected the official report to show a net gain of 220,000 new jobs in December. When added to the weak November report (+39,000 jobs), the December rebound would bring the two month average back to about 130,000 per month.
2011: Dow 14,500, S&P 1575, 10-Year 4%
Seven weeks ago our Monday Morning Outlook was titled ?Stocks Are Cheap, Bonds Are Not.? We said, ?the bull market is still young?.and bond yields are headed higher.? Since then, the S&P 500 is up 6% and investors in the 10-year Treasury note have lost more than 4%. Our models tell us to expect more of the same in 2011. We use a capitalized profits model to value stocks. We divide corporate profits by the 10-year Treasury yield, compare the result to each quarter for the past 60 years and use it to find an average fair value for stocks.
First Trust Sees 4% Real GDP Growth in 2011
In 2011, we expect 4% real GDP growth. The biggest difference between the First Trust forecast and the conventional wisdom is deleveraging. We do not view the deleveraging process in as negative a light as the conventional wisdom. Once deleveraging begins to slow, it will not hurt the economy. If a consumer (or a business) pays down debt but pays down less than she did the prior year, then her spending can go up faster than her income (or profits). Higher saving is not going to be a negative for the economy.
It's a Good Deal
Some analysts are trying to tie rising Treasury bond yields to fears about a bigger deficit and the ?cost? of the tax deal. This is a misreading of the markets. Treasury bond yields are rising because a tax hike has been avoided and economic growth is likely to be robust. The bottom line is that stocks remain cheap, while bonds are certainly not.
Elections Have Consequences
Congress and the President are going to agree to extend all the income tax cuts enacted in 2001 for all earners, including the ones with the highest incomes. Washington has not yet become a bastion of libertarian thought, but elections have consequences and there is a huge shift in the direction of government policy underway right now. This shift is not yet as dramatic as the one following the 1994 elections, but it could become so given some time. This is great news for the economy and financial markets.
Stocks Are Cheap, Bonds Are Not
Stocks are still cheap and the bull market is still young. Bonds are expensive and bond yields are headed higher. Quantitative easing is under attack and better fiscal policy is on the way. Put it all together and the bearish (or ?risk aversion?) trade of recent years is losing ground.
No Soft Patch, No Excuse for QEII
The bottom line here is that QEII ? which we believe is ineffective anyway ? was unnecessary, especially when the ball and chain of fiscal policy is under attack. Not only will current tax rates likely be extended for two (possibly three) years, but the White House has made it clear it is willing to eliminate the 1099-reporting requirement for purchases over $600. This was a part of Obamacare and other parts of that law may also face the knife as well.
Fed Embarks on QEII
The Fed's new round of quantitative easing will have little to no impact on the larger economy. Banks already hold roughly $1 trillion in excess reserves. Adding to this pile of reserves will not influence the desire of financial institutions to lend, nor will it lead to any near-term increase in the supply of currency in circulation. All it will do is sit idle on the liability side of the Fed's balance sheet and on the asset side for the banks. More importantly, the economy is already accelerating.
Political Economics
Political spin is ubiquitous these days. But it's important for investors to know that it's still just spin. The underlying economy is doing much better than recent Republican rhetoric suggests. While a 2 percent growth rate in real GDP is not worth writing home about, it certainly masks an underlying strength in demand that investors should not ignore.
Beating Bridgewater's Big Bear Bet
A prominent investment story in last Friday's Wall Street Journal said that so far in 2010 Bridgewater Associates, a Connecticut-based hedge fund run by Ray Dalio, had racked up a 38 percent return with a 'wager that the U.S. economy would be in worse shape than many expected.' Unfortunately, this entire premise ? that it pays to be bearish, especially about the U.S. ? is highly misleading. In reality, a 'bullish bet' on the NASDAQ would have provided even better returns than Bridgewater over the past two years. Believe it or not, bullishness has been more rewarding than bearishness.
Fed Ignores Gold, Targets Higher Inflation, and Plays With Fire
By ignoring rising gold and commodity prices and signaling that it won't quit applying monetary stimulus anytime soon, the Fed is trying to force banks to change their behavior. If it works, look out for inflation to reach multiples of 2 percent in the years ahead. The Fed hasn?t been successful yet when it ignores gold and commodity prices.
No More Steroids Needed
Three things are lifting the U.S. economy: productivity, easy money and the natural economic healing process. Two things holding back the economy: massive increases in government spending and heavy-handed government interference in economic activity. The U.S. could grow faster if it stopped spending and interfering so much, but it is growing nonetheless.
Emancipation From What... Capitalism?
In a speech last week, President Obama called belief in capitalism 'blind faith.' The real problem with the economy today, however, is not capitalism, but the fact that we have moved too far away from free markets. As government spending has increased, so has unemployment. This is not a mystery; the bigger the government is, the smaller the private sector gets and the less dynamic the economy will be. If there is any emancipation needed, it's from the government, not from capitalism.
The Myth and Mistake of Quantitative Easing
Last week the Federal Reserve signaled its readiness to engage in further quantitative easing. This would be a colossal mistake. Quantitative easing does not boost real economic activity or inflation - it is not an injection of new money, like traditional monetary easing. During quantitative easing the Fed borrows money from banks and the Treasury to buy assets. All this does is shift what would have been held in the private sector onto the Fed's books. This does not create new money and therefore does not create inflation or lift aggregate demand.
Be Careful of the New Normal
The consensus is forecasting 2 percent real GDP growth for the remainder of the year, with some of the 'double-dip' crowd shifting to a forecast of a 'growth recession' - whatever that means. First Trust, by contrast, is predicting an average growth rate of 3 percent in the second half of 2010. This combines a tepid growth rate of 2 percent in the current quarter and a 4 percent rate in Q4.
Unfunded Liabilities and Cheap Stocks
Despite cries of 'uncertainty' that reverberate through the financial markets, U.S. equities remain grossly undervalued. Risk premiums are exceedingly high. Relative to bonds, stocks are undervalued by a considerable margin. And with profits expected to continue their upward climb, this gap is highly likely to increase even more in the next few quarters. So, what's holding investors back? Why are bond flows continuing to outpace equity flows?
President Obama's Best Gift to Labor
Under current law, companies that buy plant and equipment have to depreciate these expenses over several years. This depreciation makes investment look less attractive, as inflation and the time value of money erode the value of depreciation year by year. Under a new proposal leaked by the Obama Administration, however, companies would be able to fully expense capital investment. This proposal would make it more attractive for companies to buy capital goods, simplify bookkeeping and make taxable profits more equal to cash flow. It is President Obama's best economic policy idea so far.
Odds Brightening for Tax Cut Extension
On January 1, 2011, the top income tax rate on ordinary income and dividends will go back to 39.6 percent, the top tax rate on capital gains will revert to 20 percent, and the top tax rate on estates will go back to 55 percent. Some in Congress want to extend the tax cuts for everyone, some want to extend them but not for the 'rich,' and others want to hold the dividend tax rate to 20 percent. Ultimately, all the current tax rates on regular income, dividends, and capital gains will likely get extended for another year, but precisely when this will happen remains a mystery.
We Knew Reagan... And He's No Reagan
No matter how many of Obama's economists say that stimulus has a positive multiplier, it's simply not true. Stimulus spending does not stimulate, is de-stimulates, because it takes resources from growing sectors of the economy and pushes them to shrinking sectors of the economy. It taxes and borrows from good business models to support bad business models. It?s simple math. The larger the government's share of GDP, the higher the unemployment rate.
Politics and Pessimists
The forces underlying economic growth have turned positive. At the same time, the Fed is accommodative and unlikely to change its stance. These two factors alone will prove the pessimists wrong. In addition, the political winds are howling toward a divided government. The odds of putting off a tax hike in 2011, and possibly reversing healthcare legislation, cannot be ruled out. Add this to the mix, and the future could bring a sharp boost to the upside that makes short-sellers very uncomfortable.
The Fed Gives the Treasury a Gift
Tuesday's announcement from the Fed means that the U.S. Treasury will pay even lower interest rates to finance its burgeoning debt levels. By holding rates steady, the Fed will become more accommodative as the year progresses. As a result, Fed policy will cause both growth and inflation to accelerate throughout 2010 and into 2011. The bond market is stuck between a rock and a hard place. Fed policy on one hand is pulling rates down, while growth and inflation will push rates up. Easy monetary policy, however, eventually results in higher interest rates down the road.
Please - No More Stimulus
Canada has been cutting spending and tax rates for the past decade or so. If Keynesians are right, the U.S. economy should be outperforming the Canadian economy now and Canada should have done better back in the 1980s and 1990s, right? Wrong. It's the opposite. The unemployment rate in Canada is currently 8 percent and has been below the U.S. level since October 2008, when government spending started to go crazy. The lesson is clear: Less spending, less taxing and more freedom work. Let's not stimulate anymore. The U.S. economy just can't take it.
GDP Data - Better than the Spin Suggests
Even though the economy should be growing faster, to say it?s not growing at all is just wrong. Nor is it responsible to be overtly political about it and say it?s all Obama?s fault. Some are trying to say that the Bush stimulus and TARP were good, but what Democrats have done is bad. What a bunch of partisan malarkey! It's hard to do, but investors need to separate their politics from their economics. Staying positive is as important as fighting for what you believe in.
The Good, Bad and Ugly of Austerity
It doesn't matter where we look: National, state and local government budgets are in crisis. This cannot continue. Major policy shifts are underway. The time for austerity has come. The only question is what form that austerity will take. There are three types of austerity: Good, bad, and ugly. Good austerity puts the pain on the government sector. Bad austerity tries to spread the pain across the public and private sectors. Ugly austerity tries to put all the pain on the private sector.
'New Normal' Nowhere in Sight
With GDP scheduled for release next week, Brian Wesbury and Robert Stein's estimate for annualized second quarter real GDP growth is 3.5 percent. While this is a significant reduction from their 5.5 percent forecast made in March, it is still higher than what the 'new normal' camp is predicting. Productivity growth is strong, monetary policy is (and will continue to be) easy, inventories are razor-thin, and corporate profits are growing rapidly. For the next four quarters, ending in mid-2011, Wesbury and Stein thus again anticipate growth at around a 4 percent rate.
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