RCS Investment Outlook: Q1

Below is my detailed thesis as of the end of Q1.


—Main Thesis—: I still expect housing to double-dip in price terms. Simple supply/demand dynamics point to this view.   Large amounts of shadow inventory along with continued foreclosures and weak demand make a market in which the buyer has pricing power as opposed to the seller.

—What’s Happened?—:   Flat housing prices characterized Q1 and the possibility of statistical bias to the upside might have helped keep them from going into negative territory. It was evident that the gap in time which the credit didn’t cover continued to show that the market remains in dire straits. We have just begun to see improvement in mortgage applications, so in the time leading up to the expiration, sales will improve. This is to be expected, however the increase is rather late to the party and nor is it showing the same strength that the previous expiration showed

—Keeping An Eye Out—:   Will there be enough political will to extend the housing tax credit? I don’t believe so. Failure to pass an extension would be one key factor to keep an eye on. Sentiment surveys have continued to demonstrate a household that no longer views a home as an investment. As long as this continues, a key source of demand will not show. Interest rates would be something else to look at, if we do indeed having an economic recovery, interest rates will increase substantially in my view.  This would completely upend the housing recovery.  However, labor market and wages in particular continue to remain weak. This is highly deflationary and would make US Treasuries quite valuable. While interest rates could increase (due to sovereign credit concerns affecting Treasury yields or widening mortgage spreads due to an end to MBS purchases), I believe that Treasury yields will fall in the end. Deflation as well as stagnation or even a double dip recession will make it so. In the end, real estate is in a checkmate situation. It loses in both scenarios.

Industrial Production (Manufacturing):

—Main Thesis—:   Industrial production has risen due to improved exports as well as an inventory bounce.   I believe that as long as end demand does not increase (in the US or China), this is unsustainable (see consumption). Therefore, I believe that manufacturing will once again slow considerably if not contract.

—What’s Happened?—:   Core capital goods orders increased substantially during Q4, which in turn has led to an increase in industrial production in Q1. Light vehicle sales, an important factor in subsequent increased industrial activity showed a strong increase at the end of Q1 but was mostly on a downtrend before that.

—Keeping An Eye Out—:    …end demand in the US and China (see consumption and emerging markets/global trade). The Inventory to shipments ratio in the factory orders report will be something I’ll also be focusing on as well as commercial paper levels. A rising ratio would signal that end demand remains weak as inventories would be piling up.  After this I would begin looking at inventory levels to gauge when perhaps companies may begin lowering production.  The I/S metric has been rising since December so the signs thus far are not great. Obviously, looking at core capital durable goods orders to get a glimpse of business investment would be a good idea. Q1 has been more of a mixed picture as this metric fell 4.4% in January, while rebounding only 2% in February. I’ll be looking to see if this is just a statistical quirk, or if we are seeing genuine weakness in business spending. Next month will be a big report for the sector.

Service Industry (Non-Manufacturing):

—Main Thesis—:   This sector makes up 80 to 90% of the economy. Weakness here will no doubt have an overall negative effect. I believe that this sector will behave very much like the manufacturing sector, good now but without sustainable demand will slow down or contract.

—What’s Happened?—: Similar to the manufacturing sector, service industries began to also expand in Q1. However, they have lagged considerably. The latest ISM  non-manufacturing report finally showed a pretty solid advance. An increase in new orders also points to continued strength in the months ahead. Certainly the news has been bullish in the manufacturing and non-manufacturing sectors.

—Keeping An Eye Out—: …once again, end demand in the US and China.   Because there are not many reports covering the service industry as a sector, I’ll be combing through one report every month, the monthly Non-Manufacturing ISM report. New orders, production, employment, and backlogs will be subcomponents to keep an eye on.

Consumption and Borrowing:

—Main Thesis—:   I expect consumption to grow but eventually at a tepid pace and will not be a sector that will greatly contribute in the recovery. Unfortunately, this sector represents over 70% of the US economy. So if we have weakness here, you can bet that the overall economy will feel it. High levels of debt, both gov’t and private, will lead to higher taxes and deleveraging respectively. Ricardian equivalence will become more of a factor as debt levels in the US reach 80 to 90%. This will translate to reduced consumption patterns on the part of the affluent consumers as they prepare for oncoming tax hikes. With regards to private debt, deleveraging will continue and will act as a constant drag on consumption growth. This deleveraging will result in little demand for loans on the part of households. A high structural rate of unemployment will also act as a headwind.

—What’s Happened?—: Various metrics point to improved consumption patterns over Q1. Goldman and Redmond store sales show accelerating positive trends. Personal consumption and expenditures continue to show relatively larger increases though it has been at the expense of the declining savings rate. Core retail sales also turned in positive prints in January and February. Overall a pretty bullish couple of months.

—Keeping An Eye Out—: The housing market.  If we have a renewed downturn in home prices, banks will be under renewed pressure.  This important sector will strangle an economic recovery as credit further contracts.  Another factor I’m looking at is wages. Without an increase here there won’t be sustainable growth in consumption unless the savings rate goes to zero, which is very unhealthy longer-term. As far as borrowing is concerned, I’ll be looking at changes in bank credit of all commercial banks, senior loan officer surveys (released quarterly), and changes in the household debt-to-disposable income ratio.

Consumer Confidence:

—Main Thesis—:  Consistently high unemployment and poor job prospects will somewhat anchor consumer confidence. I expected it to come back very slowly. A setback is certainly possible if we have the double dip recession.

—What’s Happened?—:   Consumer confidence during Q1 was, in a word: sludge. Main Street continues to not see the recovery incessantly talked about on CNBC and Bloomberg.  Note: An interesting development has been a decrease in the savings rate along with increased consumption regardless of confidence. This leaves me scratching my head and I’ll continue to monitor this ongoing development.

—Keeping An Eye Out—:   …the labor market and housing prices.   If housing prices continue to be supported, then homeowners will be a little more inclined to buy that durable good as they don’t see shrinking equity from their most important asset.  As long as the job market does not recover, uncertainty will be present.  And as long as uncertainty persists, wallets will be held c


—Main Thesis—:    This is one of the key cogs of the whole equation. Without strong job growth, consumption will most likely underperform market expectations. This year may see volatile readings as the census will probably result in stronger jobs reports during Q2. However, Q3 will see a loss of those jobs.  At that point we will need to see strong private sector growth. I don’t believe that this will happen. High structural unemployment from drastic losses in construction and financial sectors, two sectors that thrived in the housing bubble, will keep job growth quite muted. Also, the credit bubble over the last five years created fake demand which was taken from the future. Jobs that existed to feed this fake demand won’t be coming back for a long time as we now have a semipermanent reduction in demand. I expect the unemployment rate to remain very elevated (9%+) throughout the year. However, if we do indeed have an immaculate recovery, rates will surely be on the rise. How the economy reacts to these increasing rates would then be key.

—What’s Happened?—:    Jobless claims continue to trend down, which means that the firing side of the equation has stopped. Job growth has been muted until recently. March brought a pretty good report so we need to see this continue. We need to see sustainable private sector job reports north of 200,000 for the bulls to be right. Leading indicators such as temporary workers and the average workweek have been showing improvement as well. Another interesting development has been the increased use of temporary workers not translating to strong additions of permanent workers. I will continue to keep an eye on this trend as well.

—Keeping An Eye Out—:    I’ll be keeping an eye on the JOLT survey for clues as to if we are seeing a strong resurgence in hiring. I’ll also be looking @ real-time polls (Gallup.com, ABC, University of Michigan, etc.) which concentrate on job creation.


—Main Thesis—:    This is another key cog. On the one hand (the one I’m on) we have continued deleveraging/debt elimination, high-capacity utilization, subdued wage growth, and constrained bank lending. These factors point to a very strong deflationary force. On the other hand, we may begin to see supply-side inflation, fed by commodities, which would then feed into the demand-side if inflation expectations become unanchored.  This may result in a number of effects, mostly adverse. For one, commodity prices would continue to rise and would become an increasing strong headwind for consumers. For us to be at over 9% unemployment and to see commodity prices at these levels is ridiculous and shows what leaving the spigot open will achieve.  If we indeed have a strengthening economic recovery, this very same inflation would undermine its strength (Stagflation). Whether we see another spectacular commodity bubble is the $64,000 question.

—What’s happened?—: Signs of supply-side inflation are starting to permeate the economy. Subcomponents of the ISM surveys dealing with pricing pressures continue to show increasing “Prices Paid” while “Prices Received” shows less growth.  Oil prices are now at highs seen in the summer of 2008. The signs will eventually make their way to the PPI. January & February show pretty high year-over-year rates while CPI continued to lag. Consumer inflation expectations remain well anchored while various wage trend indicators to point to weakness ahead. All in all, a developing stagflation scenario.

—Keeping An Eye Out—:   I’ll be keeping an eye on “Excess NSA”, a gauge of banks willingness to use their mountains of reserves to lend. If this begins to trend lower, a sign that banks are lending more, then inflation will become a bigger issue. I’ll also be looking at pricing power gauges in the ISM surveys (prices received) to see if companies are having any success passing these costs on to the consumer. I’ll also be looking at consumer expectations of inflation.

Govt’ Policy

—Main Thesis—: It’s amazing how much policy affects the economy and financial markets in general. I’m becoming more and more convinced that in this day and age, what the government does has a direct impact on the future of financial markets. Therefore, it is imperative to learn the dynamics of today’s politics in order to try to foresee future government action.   I believe that policy will continue along the lines of withdrawing stimulus. Increased concern regarding the level of our deficit will lead to decreased political will to pass additional stimulus. The government may not be there to bail us out the next time we are in danger of a crisis. It may be out of bullets for the time being. While, a worsening economic backdrop may bring about renewed calls for stimulus, it may be political suicide at that point to fulfill Einstein’s definition of insanity. Because of this, I believe that there won’t be sufficient political will to deploy additional stimulus until the economy is back into a recession (if this indeed happens).

—What’s Happened?—:   Overall we have seen a withdrawal of stimulus as MBS purchases have ended and a plethora of government programs designed to create liquidity have expired. It seems that the government is trying to pass the baton onto the private sector albeit, at a slow pace.

—Keeping An Eye Out—:  Over the next month we will have two special elections (one in Hawaii and one in Pennsylvania) which may shape up to be another black eye similar to the one administered to the Democratic Party when Scott Brown won Massachusetts. A defeat for the Democrats here would definitely sound the panic alarm and would eliminate any momentum the Obama administration had due to the passage of the health bill. Geopolitically, I’ll be looking at developments between the US and China (see Emerging Markets/Global Trade) as well as the US and Iran.

US Dollar

—Main Thesis—:   I believe that the US dollar will strengthen over the course of 2010 as liquidity and safety become valuable. Lackluster growth versus expectations as well as sovereign debt issues around the world will result in renewed accumulation of dollars. Issuance of dollar denominated bonds by sovereign nations may come back to bite them in the arse.  Substantial short positions exists and the wall of worry remains very high

—What Happened?—:  The dollar rallied during Q4 as sovereign debt issues began to take center stage.  Increased strength in the US economy is also pointed to as a catalyst as this would lead to rate increases.

—Keeping An Eye Out—:  …government policy and Sovereign Debt Issues. If Bernanke decides to re-institute MBS, this may break the dollars back. I see re-instituting QE as an increasing possibility as economic conditions deteriorate, however, will the need for liquidity trump this?  I don’t know, but it’ll be a situation where I would want to be liquid in order to see the market reaction.  I’ll also be looking at sovereign debt issues, which are all over the world like mines.  PIIGS, STUPIDS, whatever; there are a lot of countries with problems. Any blow up on this front would trigger some drastic reaction in the currency markets.


Stock Market & Commodities

—Main Thesis—:   Over the course of 2010 my thesis calls for a sizable fall in the stock market and commodities in general.  The S&P will have a negative year.   Commodity prices have risen not due to increased demand, but instead to inflationary expectations as central banks around the world have opened their money spigot’s in an attempt to reflate their economies. China has imported massive amounts of commodities, though I don’t believe that it is for immediate use, but rather as a hedge against a decline in the dollar as well as overall speculation.

—What Happened?—:   After dropping most of January, the S&P and risk assets in general staged a dramatic comeback in February and March. This has occurred due to better economi
c numbers as well as few signs of negative profit announcements. The statistics to the rally have been ridiculous but one cannot fail to acknowledge that financials, consumer discretionary, and home builders have led this latest rally, not to mention the transports. On the bearish end, volume action has been dismal and MACD is starting to show larger bearish divergences in the weekly charts (quite similar to the 2007 top…will see another head and shoulders pattern?).

—Keeping An Eye Out—: The US consumer, job creation, inflation, and technicals. A strengthening US consumer (due to job creation) would improve top-line growth in already very lean and mean corporate income statement. If top-line growth does indeed return, corporate profits may accelerate quickly.  However, if inflationary expectations begin to increase this may result in difficulty for the equity markets as expectations of an interest-rate move would increase. Once again, how will the economy respond to higher interest rates should the recovery actually take hold?  Would they derail the recovery?

Treasury Market:

—Main Thesis—:    My view on the treasury market still remains bullish, however, there will be many crosswinds and prices may be volatile. I still believe that treasury yields will decline as deflation wins out in the end.  New sources of demand will appear in retirees, banks, pension funds, as well as overall an overall risk aversion due to disappointing economic growth over the course of the year. While we may see pricing in of a credit quality premium (US = AAA?), it should be offset by an overall deflationary outcome.  Also let’s not forget that this is one of the most hated asset classes out there…another wall of worry in my view.

—What Happened?—: After early appreciation in this asset class during January, we have seen a turnaround as equities/risk assets have surged forth. 30 year bond yields have actually broken to the upside while 10 years are about to break higher. Overall a pretty bearish scenario. Fears of massive debt issuance coupled with reduced demand (China?) have further added fuel to the fire.

—Keeping An Eye Out—:  …inflation expectations/a strengthening economic recovery.  If the economy actually begins to recover, yields will move up and Treasury prices sink. Will a strengthening recovery force the Fed to raise rates?


Global Economy/Global Trade:

—Main Thesis—:   Overall I expect the global economy/trade to slow and possibly double dip.  Europe and China, the two other large blocs in the global economy, will be unable to substitute US demand that was developed during the credit bubble.   All countries outside of the US are very reliant on exports.  The global economy has been shaped for the last few decades on fueling the American Consumer.  There will have to be a massive recalibration of economies and financial markets.  This structure will need to change to blocs providing their own domestic demand, in a sense, a more organized form of globalization.  China is probably the most interesting enigma today.  They are between a rock and a hard spot in my view.  One the one hand very accommodative policy and an enormous stimulus package have heated up inflationary expectations, a factor that absolutely cannot be ignored by the communist regime.  On the other hand, if they move to stem it, either by raising rates or appreciating the Yuan, there will be unintended the consequences of possibly bursting a real estate bubble or creating a large headwind for a razor-thin margin exporting sector (making up 35-40% of the Chinese economy). Overall the outlook doesn’t look too rosy for me as structural deficiencies continue to exist and have not been dealt with.

—What Happened?—:   Since indicators on global trade typically lag, I’ll also include Q4 action.  In Europe (Germany), 2009 ended with a thud. I’m approximately 10% point drop characterized November and December, far more than the rise in October. Q1 isn’t looking too good either. For China the story was different Q4 finish strong while Q1 has produced two poor numbers in a row. This could easily be dismissed by the lunar holiday falling in February. The next report is quite important in my view.

—Keeping An Eye Out—:    Chinese gov’t actions:  Will China continue to curtail credit in an attempt to stem inflation?  Will they revalue its yuan or not? Decisions by China’s political elite will have profound consequences on the direction of the global economy. I’ll also be keeping an eye out for foreign debt issues. There are a number of risks on this front starting with Greece. Next you have Spain Portugal and even the UK. Next will be Iran/Israel. A scary report surfaced regarding a former high-ranking Israeli official making comments  on a possible attack within the year if there is no diplomatic solution. While the issues are numerous they may take time to develop, except for Greece. The second half of the year will indeed have its mines.

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