Below is my detailed thesis as of the end of Q2.
—Main Thesis—: I still expect housing to double-dip in price terms. We are faced with a very large supply of homes and very little demand from households. We also cannot forget the large shadow inventory and continued foreclosures, which further reinforce the large supply situation. The recent plunge in housing metrics shows that a stimulus-based policy is not the correct prescription. Eventually it will not be politically acceptable to continue wasting taxpayers money in this endeavor. The simple fact is that we have a large structural imbalance coupled with high unemployment and meager job growth, all factors that will keep demand muted in the months or even years to come.
—What’s Happened?—: The first two quarters saw an improving trend in home sales. However, numerous red flags could be seen that this demand was not genuine. Homebuying intentions as seen in the University of Michigan index of consumer sentiment or the conference Board showed that during this rising sales trend intentions remained very low. Another sign began to show itself in May when after the tax credit expired mortgage applications subsequently plunged. Given that the lead time from application to closing typically takes 1.5 to 2 months, plunging sales reports were expected in the months ahead from my lens. This is exactly what happened and market participants have realized that a double dipping housing scenario is not out of the question.
—Keeping An Eye Out—: At this point there really isn’t an indicator to keep an eye on given that it will take a few quarters for this trend to finally run its course. However from a long-term perspective I’ll be looking at the owners equivalent rent metric as a gauge on whether prices have come down to more normal levels. Keeping an eye on mortgage applications would also be prudent as it is one of the best leading indicators in the industry. I’ll also keep my eye on potential tailwinds such as lower interest rates and employment.
Industrial Production (Manufacturing):
—Main Thesis—: After providing most of the growth for the US economy in the past three quarters, lack of end aggregate demand will lead to a slowing business climate, which could potentially end in contraction if we enter a double dip recession, a high probability in my view.
—What’s Happened?—: Consistently high ISM manufacturing numbers have characterized what has been a vastly improved industrial sector compared to early 2009. We saw increases in railroad activity and strong business spending. Breadth was healthy during the upturn as well. However, starting in April we began to see weakness in some leading indicators such as the Ceridian-UCLA Pulse of Commerce report and railroad statistics in May. Recently we have seen falling ISM numbers and flattening durable goods orders, another leading indicator of industrial activity. This insinuates that industrial production and manufacturing is on the verge of depending on end-demand for its future direction.
—Keeping An Eye Out—: First and foremost, I’ll be looking at end-demand in the US and China. Only when demand recovers could we see sustainable increases in industrial production. The Inventory to shipments ratio in the factory orders report will be something I’ll also be focusing on as well. A falling ratio would signal that end-demand is coming back online, which would lead to positive momentum in the sector while a rising ratio would signal demand is too weak and inventory shedding must occur. I’ll also keep an eye on the exchange rate of the Dollar with the Euro and the Yuan. A weakening dollar would lead to higher demand for exports and therefore higher production for US goods and services, however, without sustainable demand at home, the boost from these tailwinds may not be sustainable.
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, so we should see weakness along this front soon. Lack of end-demand will keep hiring activity at a low level, which will translate to lower consumption growth; all in all this sector is stuck in the mud.
—What’s Happened?—: Similar to the manufacturing sector, the service industry has been on the mend over the course of Q1/Q2. However, the sector has lagged its manufacturing brethren. It’s indicator, the ISM Non-Manufacturing index never showed the upper 50s to 60 point prints that the manufacturing index did. While we haven’t seen a definite slowing in growth, we haven’t seen acceleration either. Overall the sector has shown expansion, though not as strong as the manufacturing sector.
—Keeping An Eye Out—: …once again, end-demand in the US and China. Consumption needs to show some serious increases, while the global economy must produce robust growth rates. Again, I’ll be keeping an eye on the US dollar compared to the Euro and the Yuan. Weakness on the part of the dollar would increase export demand if the global economy remains healthy. I will continue to monitor the Non-Manufacturing ISM report. New orders, production, employment, and backlogs will be subcomponents to keep an eye on for any indication of improvement.
Consumption and Borrowing:
—Main Thesis—: Continued meager job growth will keep consumption growth quite low. Additionally a double dip in the housing market will provide the final straw that breaks the camel’s back; consumption will decrease once again. Unfortunately, this is the engine that actually drives the American economy so any troubles here have far-reaching implications. Federal and State/Local governments will grapple with high debt and severely unbalanced budgets (State and Local Government). These factors will lead them to reduce spending, administer additional job cuts, and even rising taxes. The “Ricardian Equivalence” seeds will begin to sow as well. Higher expected tax rates will lead to more saving to eventually pay for them, which will take away from consumption. Additionally you have the baby boomers that are still caught flat-footed as their retirement plans have been turned completely upside down by the Great Recession. Finally, you have the budding psychology of living a healthy financial lifestyle by paying down debt = Deleveraging. This will result in continued weakness in demand for credit. All of these factors should remain formidable headwinds in the quarters ahead.
—What’s Happened?—: The trend that had characterized Q1, a decrease in the savings rate along with increased consumption regardless of confidence seems to be ending. Overall, the second quarter saw a moderate downshift in consumption growth and a rising savings rate again. Consumption metrics such as the Goldman and Redbook same-store sales have stalled. Meanwhile core retail sales have been less than inspiring over the course of April and May. “Personal Consumption and Expenditures” reports further confirm these trends. While we still have growth, it seems to be slowing.
—Keeping An Eye Out—: I’ll be looking at the job market and wage growth. Jobs must be created (or wage growth must be substantial) for consumption to continue increasing as investors expect, plain and simple. As long as the job market does not recover, uncertainty will be present. As long as uncertainty persists, wallets will be held close. In the past one could rely on credit as a way to jump start consumption, however, with credit actually contracting, we cannot depend on this factor anymore; this links into ano
ther area I’ll be closely watching, the housing market. If housing begins to double dip (something I expect to happen), then consumption growth may stall altogether, not just slow down. Next on the watch list will be what happens when the Bush tax cuts expire. Will they be extended or not? From a deleveraging standpoint I’ll be looking at the Household Debt to Disposable Income Ratio and the Savings Rate. As far as government goes, the ongoing development of unemployment benefits not being extended will no doubt provide is an additional headwind soon. Any additional stimulus targeted towards increasing consumption may cause a pop in consumption trends and is something I’ll be looking at as well.
—Main Thesis—: Consistently high unemployment and poor job prospects will continue to semi-anchor consumer confidence. I continue to expect it to come back very slowly, however, a setback is certainly possible if we have the double dip recession.
—What’s Happened?—: Consumer confidence has acted precisely as I have been expecting, very very slow improvement. We have seen improvements in both the University of Michigan and ABC consumer confidence reports, while the Conference Board and Gallup polls have shown an overall deterioration. The job market continues to be mentioned as one of the primary reasons for subdued confidence. The massive oil spill may have actually contributed to an overall somber mood on the part of consumers.
—Keeping An Eye Out—: …the labor market. At this point all people care about is job creation. Psyche has been beaten down so much that any considerable improvement on the job front may result in a significant boost to confidence. I think housing will have less of an effect as people already know that home prices are low and will stay low for a long time.
—Main Thesis—: The key cog of the whole equation needs to step-up NOW or consumption will most likely underperform market expectations. The same goes for wages. We need healthy, organic, and strong wage growth to ensure that increases in consumption are sustainable. For the remainder of 2010, I expect continued volatility in the headline number, but with downside risks. It seems that my earlier prediction of job losses occurring in Q3 will occur. I also stated that at that point we needed to see strong private-sector job growth. As per my previous quarterly outlook I continue to believe that this will not happen. High structural unemployment from drastic losses in the construction and financial sectors will keep job growth muted. Additionally, the credit bubble over the past decade created fake additional demand, which was pulled in from the future. Jobs that existed to feed this pulled demand won’t be coming back for a long time as we now have a semi-permanent reduction in demand. I expect the unemployment rate to remain very elevated (9%+) throughout the year. Recent job growth will not be enough to keep the economic expansion sustainable, therefore, I believe that there is a high probability of a double dip recession and therefore further job losses. Either there must be a rebalancing of the global economy, some new life changing and economical technology developed, or a “New Deal” type of legislation for there to be an increase in aggregate demand once again. I don’t see any of these things coming any time soon. On the bright side though we are taking baby steps that will eventually get us to one or more of those outcomes.
—What’s Happened?—: After growth rocketed up in Q1, reaching the zenith beginning Q2, we have seen a decline since then. One important leading indicator, growth in Temporary Workers, has been showing a slowing second derivative since January. Small business indexes such as the NFIB continue to show very sour prospects in small business expansion, while initial jobless claims remain stubbornly high. However, not all the news has been poor. The JOLT survey does show positive trends in job openings while the American Staffing Association and Monster Online Job Demand indexes have risen strongly. So you see, we do have demand for additional labor; the problem has been that this demand has only been satisfied by an increase in temporary positions, not permanent ones. If you look at my previous outlook, I had mentioned this trend as something to watch.
—Keeping An Eye Out—: I’ll be keeping my eye on the government to see what legislation they pass to battle this chronic illness. If they keep passing consumption-based gimmicks, I really won’t get excited about potential job growth as employers will see this as unsustainable demand and therefore will not spend precious capital on expansion. If the government attacks the problem with an economically sensible strategy (I don’t know what it may entail) then we may be onto something positive. Additionally I’ll be keeping an eye on the JOLT survey as well as consumer confidence and real-time polls (Gallup.com, ABC, University of Michigan, etc.) for signs of accelerating job growth.
—Main Thesis—: I’m now more confident that we are headed toward a deflationary environment, as opposed to my previous outlook in which I wasn’t all that sure, though I was leaning towards the deflationary outcome. Low consumer demand, caused by a lack of credit, overall slow job and wage growth, and the deleveraging on the part of consumers will produce a negative feedback loop in which consumer demand does not grow at a sufficient rate for firms to have pricing power. The probability of higher inflation remains on the low end.
—What’s happened?—: Over the course of Q2, the core CPI has continued to show a decreasing trend as YoY levels have come from 1.1% to 0.9%. Average hourly earnings have continued to show very little growth, while consumer expectations of inflation have been anchored. ISM surveys have also shown that firms have little pricing power. Given the recent turbulence in the markets, we have also seen large decreases in commodity prices, which should ultimately translate to lower prices at the producer and consumer levels. Capacity utilization has increased, but remains very low when compared to the historical norm. Bank credit of all commercial banks continues to contract as well. While last quarter we were seeing signs of a potential stagflationary scenario due to increasing commodity prices, a lack of demand may be beginning to take the upper hand in determining future pricing trends. However, on the inflationary side we have seen excess reserves beginning to decline (Excess NSA has begun to trend lower). This begs the question “are the banks beginning to lend again?”
—Keeping An Eye Out—: I be keeping an eye on “Excess NSA”, a gauge of banks willingness to use their mountains of reserves to lend. Recent increases in this indicator may be developing into a thorn in my inflation thesis, however numerous other bank lending indicators such as “Credit of all Commercial Banks” and the “Credit Managers Index” would have to confirm so I’ll also be looking at these as well. Also I’ll be taking a look at the job market as well as consumer inflation expectations. I see inflation expectations as a gauge of confidence in the dollar. If confidence begins to wane, consumers will begin to expect goods to cost more as the purchasing power of the fiat currency becomes eroded. Finally I’ll be looking for signs that companies are having more success in passing higher costs to consumers. This means that we would need to see more healthy and organic strength in demand.
—Main Thesis—: Contrary to what I wrote in my Q1 Outlook, I would not surprised if we had another sizable stimulus passed as it becomes evident that the economy is not on the mend. “Political will” will be replaced by fear. However, I believe that this may mark the last stimulus package we see in a while. The government will not be there for the next eventual fall in economic activity. They will be out of bullets.
Every day that passes by brings more evidence that the effects of the massive stimulus package and Quantitative Easing, which lasted throughout 2009, were simply a sugar high and did not address the structural imbalances that remain in the economy; in other words it was mostly a failure. Not only was it a failure, these policies actually increased our national debt and weakened our dollar (without producing any future benefit), factors which set us back on the road towards a real sustainable recovery. My gamble here is that the population begins to realize that bailouts, consumption-based stimulus and quantitative easing are a long-term negative for our nation. Political blood will be on the streets come November. A fresh batch of politicians, put in power by an extremely frustrated electorate, will set a different fiscal path for our nation, one which does not involve failed consumption-based gimmicks. Unfortunately this new path will further solidify my double-dip recession thesis, but these new politicians may set very low expectations when they come to power as they will preach that we must take our medicine in order to form a stronger foundation for our long-term future. At this point the nation may actually well accept this fate as they understand that they have been irresponsible with their profligate spending for decades. This is indeed a very bold prediction and I expect it this trend of “political frugality” to take place over the course of more than just one quarter. I see it as a long psychological secular trend.
—What’s Happened?—: Obama’s approval rating continues to fall, while political bickering has increased. It seems that neither political party knows what to do or has he guts to make the difficult decisions. We are beginning to see a new crop of politicians such as Gov. Christie from New Jersey who are slashing spending and having intense face-offs with unions. European leaders have turned their backs on Obama’s plea to continuing stimulating their economies by putting the deficit problem front and center.
—Keeping An Eye Out—: I’ll be scouring the “Political news” websites searching for clues to see if candidates began to run on a platform of reduced spending, smaller government, and a negative stance against the Fed. Obama may already be thinking ahead as he recently said that difficult choices will come in 2011. More importantly I’ll see if the electorate bites on this pitch. I’ll be looking at this dynamic all the way up till the midterm elections. These elections will be by far one of the most important events in determining our future. Geopolitically, I’ll be looking at the bubbling Iran/Israel situation. The China/US Confrontation has largely subsided as China actually took steps to loosen the peg to the dollar, allowing US policy makers to concentrate on other issues. However, the threat of senators proposing protectionist legislation due to China not “having done enough” on the Yuan’s appreciation continues to loom. Remember, they are fearful now that their jobs are in jeopardy so they’ll go after anyone if it is politically “en vogue”. One last note, some stimulus spending that would produce jobs and positive returns would be massive revamps in infrastructure…could something like this begin to gain political favor?
US Dollar/US Monetary Policy:
—Main Thesis—: In my previous outlook, I had mentioned how I would take more of a neutral position when the probability of more Quantitative Easing increased. After the dollar’s large rally since late 2009, we may see some underperformance as weaker than expected economic reports bring back renewed anticipation of Quantitative Easing, which would amount to an increase in the supply of dollars. Given that numerous Fed bank presidents (Kohn, Yellen (nomination upcoming), and Bernanke) have supported this course of action should the economy take a dive, market chatter continues to grow louder with every subpar economic reading and the dollar has been underperforming as a result. The truth of the matter is I really don’t know what would happen since there are very powerful forces at work. On the one end you have continued liquidity/debt problems as the economy goes into a double dip recession, more sovereign debt concerns and the dollar continuing to be a despised asset class, while on the other end, you have Bernanke opening the spigot once again and economic policy supporting a weaker dollar as Obama plans to increase the economy’s dependence on exports.
—What Happened?—: The dollar has continued to rally and recently tested the highs put in place in 2008 when the world was falling apart. The increases in DXY have been on the back of a weakening Euro as EU contagion fears continue to grow, while growth currencies such as the Aussie and Canadian Dollar have struggled.
—Keeping An Eye Out—: I’ll be keeping an eye on the Fed bank presidents to see what steps they would take should the economy begin to weaken substantially. I’ll also be looking at the Eurozone and whether it can contain its own list of problems as well as the UK or Japan for flare-ups in those countries. Finally I’ll be looking at possible protectionist acts as this would reduce global trade and cause another strong headwind for the global recovery.
Stock Market & Commodities:
—Main Thesis—: The S&P will have a negative year in 2010. Sizable drops in cyclical sectors and commodities will be due to subpar economic growth as well as China recovery concerns. The enormous rally in risk assets that began in March of 2009 was due to massive global stimulus packages, a zero-interest rate policy and Quantitative Easing, all of which acted like gasoline when we had a hint of recovery. I continue to forecast drops in the stock market in the quarters ahead. However, at the same time I expect passage of an additional stimulus package and/or the reinstitution of Quantitative Easing, which may spark a sizable rally near the end of the year. In the end though, I continue to believe that the lows for the US market cycle have not been put in as we have not seen a secular bear market low, which would be characterized by indifference and a sense of hopelessness towards US stocks.
—What Happened?—: The S&P 500 peak thus far occurred in the mid to late days of April. Since then, the market has fallen more than 10%. A large head and shoulders pattern has also been completed which bodes ill for risk assets in the months ahead in the months ahead. Commodities have suffered as well as the Shanghai index has fallen more than 30% and is officially in a bear market. Worries over economic growth in the US and a possible bubble bursting in China have dimmed prospects in that region. Fears of a slowing in China’s export sector have also grabbed headlines.
—Keeping An Eye Out—: Will Ben Bernanke reinstitute Quantitative Easing? Will another stimulus package be passed? At this point the economy is in a secular restructuring process as deleveraging takes place and unemployment remains high. As far as I can see, the highest probability of an impetus in growth leading to a sizable rally in US stocks would have to come from a fiscal or monetary source. Because of this, I’ll be looking at these factors the most. Obviously looking at economic fundamentals, investor sentiment, and market technicals would be prudent. For commodities, I’ll be looking at China’s transformation from an export-oriented to a consumer-based economy. The potential demand emanating from China as millions of farmers/peasants move up the consumption ladder is enormous and will be a main source for a secular bull market in that country in the years to come. Will China turning the corner (having a sustainable recovery based on consumption instead of exports = higher demand for commodities) while the US continues
with Quantitative Easing, lead to a crisis as commodity prices skyrocket?
Treasury Market/Interest Rates:
—Main Thesis—: For the next couple of quarters I’m still bullish on the Treasury market as deflation continues to win the battle. This will point to lower interest rates in general. New sources of demand for Treasuries will appear in retirees, banks, and pension-funds. A general risk aversion due to disappointing economic growth will also produce a good amount of demand. While we may see the pricing in of a credit quality premium (US = AAA?), it should be offset by an overall deflationary outcome. This is still a very disliked asset class so the wall of worry remains high. In the years ahead though we may see a situation where a sustainable recovery in China coupled with a very loose monetary policy here may result in significant increases in commodity prices, which may be enough to produce a supply-side inflationary scenario at home.
—What Happened?—: A complete 360 from the prior quarter. The 10-year yield is now under 3%, while the 30-year is just under 4%. Rising sovereign-debt concerns coupled with disappointing US and China economic numbers have produced a safe haven trade into this asset class. Inflation expectations have also recently collapsed as commodities have plummeted.
—Keeping An Eye Out—: …commodity prices, China demand, and consumer inflation expectations. As long as inflation expectations remain low, I see treasuries maintaining their bid. Will China embark on a sustainable recovery dependent on consumption? If this is indeed the case, I’ll be looking for rising commodity prices. Will these increasing prices translate to higher prices for the consumer in the US and increasing inflation expectations?
Global Economy/Global Trade:
—Main Thesis—: Overall I expect the global economy/trade to slow and possibly double-dip as we undergo a second phase in the global trade restructuring process. Europe and China, the two other large blocks in the global economy, will be unable to substitute US demand that was developed during the credit bubble. Most countries outside of the US remain very reliant on exports as the global economy was shaped in the last few decades on fueling the American Consumer. The new global economic structure could see individual blocs providing their own domestic demand or the “Chinese Consumer” replacing what was the “US Consumer”. In this case, Europe and the US would become exporters in this new structure. This is a very long-term view, which may experience numerous setbacks such as protectionism and armed conflict. As I forecasted in my previous outlook, China’s growth has continued to slow as a property bubble continues to deflate and the country’s leaders take on policies restraining growth in an effort to reduce inflation. However, I believe that the recent wave of labor unrest and subsequent increases in wages are sowing the seeds for what will become a sustainable consumption-based recovery. Although I’m not sure when this would occur, I would venture to say that downside risks still remain strong for the time being. In contrast to the US, I believe that China’s stock market has bottomed and we are currently in the retesting phase.
—What Happened?—: The Shanghai index has continued to fall on the back of growth concerns and a deflating property bubble. Increasing wages and a stronger currency have created formidable headwinds for exporters as well. The Eurozone has seen its share of financial problems as the Euro has tumbled over the course of the second quarter. However, ironically it is this weakness that has produced economic outperformance in this export-oriented block. Overall global trade continues to expand but at a decreasing rate.
—Keeping An Eye Out—: The structure of the Chinese economy will be of utmost importance in my view. It would be providing clues as to when the country’s economy could develop sustainable growth on the back of consumption, rather than exports. Another thing I’ll be keeping an eye on is the progress China makes on establishing a social safety net. Having this in place would reduce the need to save, which would translate directly to increased consumption. Protectionist actions are also something I’ll look out for. It seems that US Senators continue to not be satisfied with the steps China has taken in correcting the “perceived” currency imbalance. Rash decisions based on political fear may spark a trade war and would obviously be a very negative catalyst for global trade. Finally Iran/Israel continues to simmer as we now have reports of US aircraft carriers being stationed off of Iran. Conflict in this region would no doubt produce risk aversion and lower global trade. It is indeed a mine field in the geopolitical sense.
This completes my overall thesis. My next update will occur around the beginning of October.