Below is my updated thesis as of mid-2011. The main points are in order of importance (ie the factors that lead the development of my thesis). For example, I believe that the most important factor for the US economy and financial markets currently stands in what our Federal Reserves decides to do with respect to QE3, therefore this topic is first. The global economy is the second most important factor towards shaping the trajectory of the US economy and financial markets (hence it’s second on the list)… and so on.
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To keep tabs on how my thesis is progressing, check out my previous outlooks.
US Dollar/Monetary Policy:
—Main Thesis—: The future of US Monetary policy is coming into better focus. At least in the short term (roughly 6 months), it is likely that the Fed will stand pat with regards to initiating QE3. Their reluctance to turn on the monetary spigot, in the face of a larger than anticipated slowdown in economic growth, is largely in part due to the negative effects spawned by QE2. For starters, housing has deteriorated since QE2 was initiated. This was one of the main reasons Bernanke cited to initiate the program. It is also becoming increasingly clear that commodity-related inflation (gas/food) has adversely affected the consumer. For many of the unemployed and low-income families, increases in food and gas prices are a higher burden. This dynamic has resulted in a creeping politicization of US monetary policy. Bernanke is under substantial pressure not to embark on QE3, thereby risking $4.00+ gas prices. It’s not just domestically where QE has had negative effects; emerging market economies have increasingly blamed the Fed for rampant inflation in their economies leading to a dangerous disequilibrium in capital flows. My main point is that QE has done more harm than good. Criticizing the Fed has become en vogue. The institution finds itself in a situation where it cannot come to the aid of equity (risk) markets at least for a few months. Perhaps we’ll get another round close to the end of the year. But after years of higher oil prices despite a worsening US economic backdrop, when will it dawn on politicians that QE has only served to further destabilize the US economy? What’s important is that for the time being, we have plenty of Fed officials who have expressed reservations towards initiating QE3. This is one of the main reasons why I would be accumulating dollars.
Another reason for accumulating greenbacks is due to a deteriorating situation in the global economy. (Please see my Global Economic Outlook below). A Eurozone-related wave of risk aversion is an elevated and increasing probability. You also have signs that China’s growth is slowing, sparking fears of a hard landing in the medium-term (roughly a year out). Longer-term (1 yr+), I remain uncertain towards the dollar’s future, but I still have an itching feeling to shade bullish. I understand that this is an extremely contrarian position, but while people focus on continued quantitative easing leading to an inflation/hyperinflationary scenario (I’ve done it too: See “Inflation” section), I can’t help but notice the massive movement in investment flows back to the US should China’s wages increase and make the US competitive again. Enormous US bound capital flows due to increased investment in US exporters and a possible revamp of infrastructure certainly make for a compelling bullish argument. The jury is still out.
—What’s Happened?—: The dollar (DXY) has declined roughly 5% since the beginning of the year and 3% since my bullish call in October, 2010. This may have resulted in a run up in precious metals and commodities. Oil prices reached uncomfortably high levels which have since receded. The currency found support in early May at around the 73 mark and has rallied 2-2.5%.
—Keeping An Eye Out—: I’ll be keeping a keen eye on inflation measures. They will become rather important in signaling when it may be politically acceptable to apply further easing. I’ll also be following up on speeches from the Federal Reserve bank presidents for hints that QE3 is back on the table. If we have an exogenous shock (Europe, China or even a hurricane hitting the Gulf of Mexico causing a rise in oil prices) which greatly increases the chances of a global double-dip, all bets are off. It would be pretty bullish for the dollar though. On a possible bearish outcome for the dollar, I would turn cautious if a retest of 73 failed and would be reducing exposure all the way to 71.
Global Economy/Global Trade:
—Main Thesis—: In the short-term, we have a large negative risk for the global economy in the Eurozone. Yield spreads are at record highs for Ireland, Portugal, and Greece. Spain remains in poor shape. Trichet may raise rates in the coming months to battle inflation. French and German economies are showing signs of slowing. Furthermore, you have open sparring between Germany and the ECB over whether investors should participate in any debt restructuring. Markets are becoming increasingly nervous and political risk is making a comeback as a head-on collision between investors and ordinary citizens is at hand. Things are not improving over there presently and the consequences of no positive resolution may imperil the global recovery. Looking into the medium-term for “the Zone”, are her individual countries prepared to cede political control to a higher order? Will it be politically acceptable for Germany to continually sign their name on the dotted line to bailout deficit-ridden countries without having some control over that country’s financial affairs? Will citizens of these countries allow German control? Up to this point, I remain unconvinced they will. A comeback for the Peseta, Lira, Franc, or the Deutsche Mark is becoming seriously probable. Perhaps the Euro will split into 2 currencies, a north/south pair?
Next on the docket, you have China. Since early 2010, I have and remain medium-term bearish on China. I’ve been able to forecast this theme rather well. Inflation is currently China’s most imperative issue. Most forecasts call for decreasing inflation in the second half of the year, which would lead to wiggle room for officials to loosen credit and achieve a soft landing. In forecasting this pivotal factor for the global economic outlook, I believe it is important to consider whether this inflation is sticky or not. It has already proven to be stickier than expected for almost a year now. We are in a situation where officials are still in tightening mode, economic growth is cooling, but inflation persists. Sounds like a wage-fueled stagflationary scenario may be in the cards. In battling these inflation issues, officials have applied the bulk of the therapy via interest-rate hikes and adjustments to bank reserve requirements. The Yuan has risen in value only a little. Reading between the lines, to me this reinforces officials’ worries on the imbalances that remain inherent in their export-centric model. Recently, they have relaxed the use of interest rate hikes due to signs of a softening real estate market, which has well deservingly raising fears of a property bubble popping. They have now indicated that they would use the Yuan to help temper inflation as well. I believe that room for an appreciation of the currency remains limited as it may prove to be a debilitating headwind for the all-important export sector. On the bullish side though, they’ve been able to handle a roughly 5% appreciation. But it may have a ways to go though given that many US politicians believe the Renminbi is undervalued by 30-40%. At least protectionist sentiment from US politicians has taken a back seat for the time being.
My main point with today’s global economy is that it was personalized to fuel the American Consumer over a couple of decades. Why would it take only 3 years to substantially alter its structure? I believe it will take longer than many investors expect. Signs of an un-balanced recovery can be seen today. China has tightened its monetary policy to fight inflation. This has resulted in weakening growth prospects and declining commodity and equity prices. The US, typically the world’s consumer, still has weak demand. And Europe is at the beginning of their slowdown. Not everyone can export their way out. Deteriorating conditions in the Eurozone and China are two strong headwinds in favor of a short to medium term bearish outlook for the global economy. It is imperative in my view to adjust portfolios accordingly for this period of turbulence. I believe that global growth will continue to slow with a greater than 60% chance of a double-dip if factoring in a negative turn of events from Europe. If crisis is averted there, I see a roughly 50% of a big scare in about a year given China’s inflationary predicament.
As if we didn’t have enough issues to worry about, we also have a wildcard in the outlook in regards to the Middle East. Oil prices have held in well and is a testament to a possible geopolitical premium in the commodity. Bloody protests in Syria and Bahrain have been met with intense repression from their leaders and have lead to fears of increasing sectarian violence. I don’t pretend to know what will happen there, but it is a risk to the global recovery if oil makes another run at $110 due to a negative surprise from the region.
Despite gloomy forecasts in the near-term, I’m actually a bullish fellow in the longer-term. The future of the global economy lies in China. The country is in the slow process of preparing for a period of sustainable expansion. If we were faced with a negative market environment in the coming quarters, I’m sure one could find diamonds and diamonds in the rough in regards to US manufacturing and transportation companies. Watch out for protectionism though! I believe that China’s stock market has bottomed and it is currently in the retesting phase.
—What’s Happened?—: I think it’s interesting to point out that the Shanghai Composite Index peaked almost two years ago (already?!). The Heng Seng peaked about 8 months ago. Both markets have run into seemingly incessant resistance on the back of continued tightening fears, growth concerns, and deflating property values. However, we have recently seen evidence that the communist nation’s economy is withstanding tightening measures well. This is raising hopes for a soft landing and may lead to a situation where the indexes are undervalued. Inflation though remains unloved by the rural class and still requires attention. Officials have begun using Yuan appreciation as a tool to fight inflation, however, the move in the currency has been fairly small (roughly 5%) vs. expectations. One long-term theme possibly at work here is the continued push to make the currency a more serious contender for reserve currency status.
While at risk of sounding a bit alarming since I’m trying to be objective here, I can think of a pretty good comparison with what’s going on in Europe. We have a town in Hawaii named Europe. This town is next to a volcano. The volcano has erupted but it was a quiet one characterized by a ton of lava. The township knows that the volcano has been erupting and that lava is headed their way. So far, they’ve been powerless to stop it but it is creeping closer. If they don’t stop the lava, the town could be destroyed. It’s a slow motion process and everyone can see it occurring. Many know that it will be very painful if not dealt with in time. That’s the Eurozone (real life version here).
—Keeping An Eye Out—: If there’s an indicator that I’m looking at every day without fail, it’s the Spanish 10-yr yield. That sole indicator may be a harbinger of things to come for the global economy. Right now it is dangerously high and a break of 5.5% would be a negative signal for risk. It would effectively break a resistance line in place since the beginning of the year. Confidence in the Euro may decline quickly should yields rise above this level. Regarding the Euro/USD, I’ll be focusing on a resistance and support line. A break of the highs posted in early May (1.49) would signal that there is renewed confidence in the currency and the global economy. A break to the downside below (1.40), would signal the opposite. Finally, I’ll be looking at a long-term trend line starting roughly a year ago when the euro hit its low. If the Euro breaks below this upward trend line, it would signal to me that prospects for the region are deteriorating. Obviously, being on the lookout for any continued protests in Europe would be prudent as it reflects thinning patience for bailouts.
In regards to China, My first priority will be to look for clues on whether inflation over there is sticky or not. I, like the rest of the world, will be looking at Chinese inflation metrics. Will we have more public protests as a result? An important factor to keep tabs on is a continued rise in the Yuan. If exporters are able to withstand continued appreciation of the currency, then the potential for a negative surprise in China would decline a fair amount. Over the longer term I’ll be periodically checking up on continued progress with regards to social safety nets and continued consumption-based policies. Most of the Chinese population has a very high savings rate. Enacting a program such as Social Security would raise their confidence and result in more spending and less saving.
—Main Thesis—: Since my last outlook, I’ve begun to focus more on inflation given that it will dictate various investment themes in the coming quarters. In the short-term, there is notable negative risk with the Eurozone. A blow up here would trigger a surprise deflationary episode as global markets undergo a turbulent period of selling. Given that confidence in the global recovery is waning, it may be perilously fickle if we have a default in the Eurozone. Further down the pipe, we are seeing a profound global dichotomy where inflation has seriously affected many emerging market economies, while developed ones have seen continued disinflationary pressures. Policy makers in the Emerging Markets are actively restraining growth to cool down surging prices. China remains dealing with its inflationary problems and is an elevated risk factor in the medium-term. If a hard-landing occurs in the communist country, it will translate to falling commodity, raw material, and equity prices around the world. Overall, I still worry about deflation, not inflation.
From a secular view, I remain a US deflationista (disinflationista?) and will see my thesis tested in the following months. Our economy is stuck in a negative feedback loop. High household debt levels have led to lower consumer demand growth as well as soft credit demand. Consumers have become more sensitive to price. The bargaining power of buyers has increased considerably. This has resulted in retailers consistently competing for a higher share of consumers = Lower Prices. Meanwhile, beneath the retail level, we have various tailwinds in favor of inflation at the producer level. Oil and food prices have been on the rise. US businesses have cited higher commodity costs as an issue. Corporate executives have said in their Management’s Discussion and Analysis (MD&A) that they would begin passing higher costs over to the consumer in the second half of the year. Imports from China have been rising in cost due to accelerating wage growth, electric blackouts, and Yuan strengthening. We have two very strong forces that will meet in the short-term. This much I will admit, we may see higher CPI readings in the short term, but they will reflect company’s attempts to pass costs to the consumer. I am picking the power of high debt and anemic growth over inflation at the producer level when both these forces meet. In my view, companies will be unable to pass through the bulk of the costs. Historically high profit margins are at risk of mean reverting. Business confidence may be affected, resulting in sub par hiring plans. A tepid labor market leads back to lower end demand, which along with high debt, brings us back to square one. That’s a negative feedback loop. This is one of the more secular reasons why I believe we will remain in a disinflationary environment marked by a few persistent deflationary risks for the foreseeable future. One interesting aspect in the possibility for rising CPI prints in the second half of the year will be how market participants and the Fed react. The Fed would have little justification to initiate another quantitative easing program. Higher CPI metrics may temporarily tie the Fed’s hands.
My second reason stems from a fragile economy but revolves around the bond market. If we began to see widespread signs of increasing inflation, bond markets would react with a vengeance. Strong sell-offs in the bond markets would lead to higher interest rates on fears of depreciating fixed income payments. Higher interest rates would become a significant headwind on an already weak housing market. Aside from declining housing values, consumer demand would also suffer as the cost of credit would rise as well. Also, at what point do higher Treasury yields begin to compete with stock market returns? All these factors would result in risk aversion. What I’m getting at is that if we have any sign of persistent increases in inflation, the bond market will do its part in stopping this trend. It would, in effect, undermine further development of the recovery.
Longer-term, I am becoming very concerned with what our Federal Reserve is doing. Constant application of quantitative easing is a very myopic strategy and leaves us at the mercy of unexpected future market forces. Will policymakers see quantitative easing as a destructive policy in time? See here for more detail.
—What’s happened?—: Prices at the producer level have trended higher since the beginning of the year. This factor could clearly be seen by reading commentary on many monthly manufacturing surveys. However, pressures at the consumer level, remain relatively low. We have seen a recent acceleration in headline CPI, but much of it has been related to motor fuel. Core CPI remains at a comfortable level for the Fed to continue its easing policy. Job growth remains tepid and credit, while rebounding, isn’t making much of an impact. Inflation expectations have fallen somewhat and seem to be considerably affected by oil prices. In my prior outlook, I didn’t focus enough on the growing dichotomy with CPI vs. PPI inflation but I did cover it extensively on Rational Capitalist Speculator as the phenomenon became more apparent.
—Keeping An Eye Out—: In the short to medium-term, I’ll be focused on what’s going on in the Eurozone and China. If either of those two countries has a negative surprise, deflation will make a comeback. If we have higher CPI prints in the second half of the year, the Fed would have little justification for QE3. How would they react? I’ll also be looking for improvement in the job market. We need to see strong and sustainable gains in job creation, as they will lead to improved wage growth. Once we have better job prospects, confidence will make a comeback and we’ll have sustainable gains in consumption. Improved conditions may see a return of the Animal Spirits as credit growth strengthens. Over the longer term, a sustainable recovery in China will be my primary focus. Once achieved, it would lead to higher commodity costs as well as increased demand for exports.
US Government Policy:
—Main Thesis—: Current plans to cut government spending are very alarming. The private sector is still very vulnerable to any exogenous shock and is not in a position to take the economic baton from the government sector. Furthermore, I believe there won’t be enough political will within Congress to pass additional stimulus in the short-term (roughly 6 months) if economic activity deteriorated further. Deadlock would be detrimental to the economy. Republicans, in an effort to up-end Obama’s reelection hopes, will blame any upcoming economic malaise on his failed policies. It will make passing another stimulus package very difficult for the Democrats. Eventually we would get another one as the pain of a double-dip recession becomes too much to bear and politicians unite like they did in 2008, but I don’t see help from Washington for the remainder of the year. Reductions in US debt levels are on the minds of many voters and politicians. Overall, I believe this new mentality of austerity is an elevated and rising risk for economic growth. Further moves to cut back spending or not initiate a stimulus package in time may result in a large policy error that allows the US to slip back into a double-dip recession. I expect this trend of “political frugality” to continue at least in the short-term.
In the longer term I believe that we may eventually be in a situation where government officials finally address the structural causes of this prolonged period of economic frailty. We may get a giant jobs-based stimulus, which ties together a revamp of the nation’s infrastructure along with large investments in alternative energy and exports.
—What’s Happened?—: Out-of-control budget deficits are front and center as Democrats and Republicans debate on what to cut and if to increase taxes. We have an important deadline coming up in early August and our Vice President remains confident that the necessary cuts will be made. My prior outlook has been quite inline with what’s occurred except for two points. Recent news of a possible surprise payroll-tax break may pose a risk to my Gov’t outlook. Protectionism has all but disappeared from the scene.
—Keeping An Eye Out—: In the short-term, I’ll be keeping an eye out for any exogenous shock coming from Europe in the shorter-term and China in the medium-term. Negative events in any of these factors would significantly increase an already heightened probability of a US recession. Maybe that would change the picture and result in a stimulus package coming sooner than I believe. I’ll be checking political stories to keep tabs on this recent “payroll-tax break” development, as it is a risk to my outlook and bullish for the economy. However, I remain confident that my “Political Frugality” theme remains in place.
Industrial Production (Manufacturing):
—Main Thesis—: After providing most of the growth for the US economy, lack of end aggregate demand will lead to a slowing business climate. Manufacturing may potentially end in contraction if we enter a double dip recession, an alarming probability in my view. Overall I have a bearish view on the sector in the short to medium-term. Longer-term though, company cash levels are very high, and emerging markets may provide the secular growth that is needed for the sector to stage a renaissance in the years ahead. While I don’t believe this scenario is knocking at our door, it’s progressively getting closer.
—What’s Happened?—: After dazzling growth in the back end of 2010 and Q1 of 2011, manufacturing growth has weakened recently at an alarming rate. One of the main reasons was the unexpected headwind from a massive tsunami, earthquake, and nuclear disaster in Japan. This has led to widespread disruptions in global supply chains. Other reasons cited have been a sluggish economy at home, while China’s economy is slowing. The business environment in the past six months was in line with my expectations.
—Keeping An Eye Out—: First and foremost and just like the prior outlook, I’ll be keeping a pulse on end-demand in the US, China, and Europe. If China or Europe experience any negative surprises, demand from those countries will drop and will have a negative effect on manufacturing activity. Given that we are still experiencing a recovery in the US at this point (a very weak one in my view), industrial activity may be buoyed by continued demand at home. I’ll be keeping an eye on how transitory this soft patch really is. Finally, I’ll continue to focus on the development of consumption-based policies coming from China. As Chinese officials put these policies into place, the outlook for their consumption will improve. This will in turn improve my outlook for Industrial Production at home.
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. Similar story here: in the short term, it’s all about what happens in Europe. In the medium term, China may provide for a clouded growth outlook. A negative event from Europe or China may end up tipping this large sector of the economy back into contraction. The probability is increasing. Absent any negative event, I still believe that this sector’s growth is self-sustaining, however, it remains quite vulnerable. Lack of substantive end-demand growth will keep hiring activity at a low level, and low job creation will keep end-demand growth insignificant; all in all, this sector will be hard-pressed to find any impetus for strong growth. The longer-run story is similar to manufacturing (secular expansion), though not as magnified.
—What’s Happened?—: Similar to manufacturing, the service sector has seen cooler growth since the beginning of the year. The regular 57+ point readings in the ISM Non-Manufacturing survey have subsided to the low to mid fifties but have remained in healthy territory. Overall, this activity was inline with my prior outlook.
—Keeping An Eye Out—: End-demand in the US and China. I’ll be looking at developments in consumption trends at home as stronger growth would feed into improved business conditions. Once again it’s all about the positive feedback loops. 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.
—Main Thesis—: I feel like I’m a tap recorder now. In the short and medium we have a dangerously large risk in Europe and growing risk in China respectably. The foundations on which the global recovery has been built are off-balance. If an acute negative event develops, we would most likely see additional job losses in the shorter-term given how vulnerable the labor market remains.
In the bigger picture, the job market remains the biggest missing cog in the recovery. The probability of a self-sustaining recovery is quite dependent on a healthy and growing job market. Substantial and consistent job creation is needed so that we have a healthy, organic, and strong trend in wage growth. If this occurs, then consumption growth will have more staying power (sustainability). However, we are currently in a “chicken-or-egg” scenario. In times past, the use of credit, and/or rising home values served as the sparkplug for consumption growth; this would lead to job creation then consumption and the positive feedback loop was in motion. This is no more. Furthermore, in the build up of the credit bubble for most of the prior decade, demand was actually being pulled forward. This was not genuine above-trend growth in end-demand. The bill is in the process of being repaid. Jobs that existed to feed this pulled demand are gone as we have a semi-permanent reduction in demand growth for the foreseeable future. The credit growth during the 2000s also resulted in large amounts of mal-investment in the property sector. The construction industry is a only a shadow of itself. High structural unemployment will persist for a while. These factors will act as considerable headwinds towards job creation, which I expect to continue being very tepid. On the bright side, absent any substantial negative shock to the system, I actually believe that the job market has the ability to heal itself. Think of it as a pre-born baby in an incubator (job market = baby). Lack of a negative shock is like keeping the baby in the incubator so that it may gain strength. You don’t want to take the baby out of its incubator too much.
In the medium term, absent my main risks in Europe and China, I expect the job market to remain tepid. Housing is in the process of double-dipping, which along with the aforementioned factors, won’t help consumer psyche much. Growth in consumption will remain subpar.
In the longer term, the global economy must continue to rebalance itself. Once China or a group of emerging markets can positively affect demand growth and embark on a sustainable recovery, a secular tailwind will be at the job market’s back. We would also need to see some new life-changing technology developed (alternative energy anyone?), or a job-targeted “New Deal” type of legislation for the secular tailwind to be even stronger. If I had a kid, I’d be guiding him/her towards learning science or engineering.
—What’s Happened?—: Over the course of the year the job market has continued to improve on the whole but with fits and starts. The unemployment rate has held stubbornly high, recently moving back into the 9% territory. Jobless claims had been treading down for much of the year until April, when the four-week moving average began to steadily climb again. Wage growth has found support. We have good news of improved hiring trends but bad news of no resolution to Europe and weakened demand growth in China..
—Keeping An Eye Out—: I’ll be keeping an eye on the JOLT survey as well as consumer confidence and real-time polls (Gallup.com, etc.) for signs of accelerating job growth. On this front, we have seen some improvement but it remains painfully slow. I’ll be keeping my eye on the government to see if they begin discussing the possibility of legislation being passed to battle chronic unemployment as well. Recent talk of a payroll-tax break is a step in that direction.
Consumption (Domestic End-Demand) and Borrowing:
—Main Thesis—: In the shorter-term, consumption remains in growth mode but the horizon is becoming very clouded with a bearish shade. As noted in my prior outlook, higher commodity costs became a problem for consumer psyche in April and consumer spending has shifted down a gear since then. On the bright side, it has only shifted down a gear, not neutral or reverse and gas prices are receding. Additionally, there is reason to believe that the some of the weakness might have been transitory given that it coincided with the earthquake in Japan. However, these recent episodes have confirmed that consumer spending remains weak and vulnerable to an exogenous shock. Unfortunately, we have a few big ones in the pipeline. Issues in Europe are front and center and is the largest risk to consumer spending today. A negative surprise there would result in lower stock prices and a negative wealth effect. A currently ongoing double-dipping housing market will act as an increasing headwind in the short to medium-term. Finally, the Middle East is a wildcard in the outlook with a potential to throw a monkey wrench into everything. A flare-up in that region would result in sharply higher oil prices in my view.
In the Medium to Longer-term, consumption in the US will remain weak due to a myriad of reasons (Let us count the ways):
- Continued meager job and wage growth, high unemployment, and a moribund housing market will equate to significant long-term headwinds. Organic growth in consumption (higher job creation and rising incomes) will be limited.
- The US government has been paring back spending and this has resulted in a continual drag on job growth as government employees are let go. What will be interesting to see are the results of the upcoming budget bill. Will spending be cut back even more?
- In relation to the above point, the seeds of “Ricardian Equivalence” are being sown. Higher expected tax rates will lead to more saving by consumers in the medium-term to eventually pay for them.
- Most baby boomers are still caught flat-footed as their retirement plans have been turned upside down by two giant bubbles in the past decade. They cannot count on the automatic housing ATM to deliver spending power anymore. Most Retirees won’t be spending what they had planned in the past.
- With regards to credit, you have the budding psychology of living a healthier financial lifestyle by paying down debt = De-leveraging. This will result in continued weakness in demand for credit over the medium to long-term. While we have seen a slight increase in credit use, I believe the psychological secular trend of saving more is still intact. The most common sense reason why this long-term trend would change is if job creation staged a furious comeback.
- Related to “what’s happened” recently (read below), I’m beginning to see a possible repeating long-term trend here. As global growth inevitably continues, commodity prices will continue to climb (especially if the Fed continues with quantitative easing). Every time the global economy begins to embark on a sustainable recovery, commodity prices may act as a semi-cap for the US consumer/economy. I’ve written about this before.
—What’s Happened?—: We had a close call with regards to consumption when oil prices climbed up over $110 in April. Various surveys and metrics reported diving confidence and deteriorating consumption growth. However, it has not fallen out of bed. While headline retail sales have recently gone negative, retail sales excluding autos have maintained growth. Personal consumption and expenditures have shown a steady MoM increase, however their growth rates have weakened since February. Since hitting four dollars a gallon nationally, gas prices have fallen roughly 8%. The job market has shown inconsistent growth this past year and has acted accordingly as a tailwind for consumption. Finally, it seems that the supply of credit is now secured, however the demand side has remained weak.
—Keeping An Eye Out—: In the short-term, I’ll be checking out a few factors. Will the situation in Europe improve? Note that this is an exogenous risk that can’t be ignored. A negative event here would result in the beginning of contraction in my opinion. I’ll also be keeping a close eye on falling gasoline prices and their effect on consumer psyche. Lower prices may result in improved confidence and increased spending, improving the economic outlook. Next, will the job market improve? Finally, what will the results of the budget bill be? Will a promise of no taxes but the go-ahead of a payroll-tax break or stimulus in the upcoming budget-bill nullify point (2)? Answers to those questions will yield the keys to the outlook in the short to medium-term imho. Also as forecasted in my prior outlooks, housing prices have begun their double-dip, however, we haven’t seen a significant effect on consumer spending, I’ll be keeping an eye on this increasing headwind on consumer psyche and spending.
In the medium to long-term, can China handle its inflationary problems? That would be my largest external risk during this time frame. I’ll also check on how the de-leveraging theme is progressing. In the past one could rely on credit as a way to jump start consumption. If de-leveraging continues, credit may remain in low demand and consumption growth would in turn be affected. From a deleveraging standpoint I’ll be looking at the Household Debt to Disposable Income Ratio and the Savings Rate.
—Main Thesis—: The short-term prospects for confidence are becoming negatively clouded due to the threat of the Eurozone. An eruption due to sovereign debt problems would cause virulent sell-offs in the financial markets and affect consumer psyche. This is becoming a dangerous possibility. Moving into the medium-term, housing may negatively contribute to confidence due to falling prices. I don’t believe that housing prices will have as much of an effect on confidence as it did in 2006 though.
Looking at the bigger picture, consistently high unemployment and poor job prospects will continue to semi-anchor consumer confidence. Absent any exogenous shock I believe confidence would crawl back with strong risks to the downside if we have a double-dip recession or commodity prices make a comeback.
—What’s Happened?—: After reaching the highest level in 3 years near the beginning of the year, consumer confidence experienced a setback due primarily to higher commodity prices. Gas prices have fallen roughly 8% since the end of April, in turn, consumer confidence has been slowly improving.
—Keeping An Eye Out—: In the short term, the Eurozone. Increased market volatility may affect consumer confidence. In the grander scheme of things I’ll be looking at whether the labor market is genuinely improving. 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. Finally, I’ll keep tabs on how the housing market is doing. I think housing will have less of an effect on confidence than before but if prices begin to fall quickly, the impact will be seen here.
—Main Thesis—: Housing will remain in a deep funk for the next couple of years. More home price declines are inevitable. We are still faced with a very large supply of homes and very little demand from households. We also can’t ignore continued foreclosures or the overhanging shadow inventory hiding in the marketplace. These factors further reinforce the large supply situation. Political will for another homebuyer tax-credit is very low and there is a high probability that we will not see another credit for a while. The simple fact is that we have a large supply/demand imbalance, high unemployment and meager job growth. These factors will keep demand muted in the years to come. From a sentiment standpoint, I’m beginning to see some hate for housing. A sense of indifference and helplessness towards this asset class is developing. A secular bear market low may be occur within the next couple of years.
—What’s Happened?—: Housing prices as per the Case-Schiller Index continue in their double-dip as I had forecast in my previous outlooks. Mortgage applications have remained anemic in growth.
—Keeping An Eye Out—: Real Estate is a very slow market and trends take years to develop/complete so at this point I would be focusing more on longer-term economic metrics (such as the homeownership rate and national household debt/income ratio). I’ll be looking at the owners equivalent rent metric as a gauge on whether prices have come down to more normal levels. In the short to medium-term, the job market will be a factor to watch. Keeping an eye on mortgage applications would also be prudent as it is one of the best short-term leading indicators in the industry.
This completes my overall thesis. My next update will occur around mid-December/early-January.