Financial shares led the market lower – the sector had bounced 50% off of its March 6 low so traders took some money off the table. Comments from Bernanke and Geithner, speaking of the need for a “super financial regulator” – and amazingly they propose placing this responsibility with the same institutions that failed in their regulatory duties over the past several years, certainly didn’t help the financials. Utility shares were the second-worst performing sector after additional legislation was introduced to tax fossil-fuel power plants.
Despite the pull-back yesterday we think the rally has legs to it. The policy that is being rolled out (whether it be via the Fed, Treasury or Congress) is going to drive economic activity higher in the short term, and the equity markets will reflect this. Further, we are likely to get some modification to mark-to-market accounting and reinstatement of the uptick rule -- the market is currently anticipating these moves.
The issue, 18-24 months out, is that current policy will lead to additional problems; all we’re doing is shifting credit excesses from the private sector to the government. This will have an adverse affect on the dollar, inflation and thus interest rates (although with patience a great opportunity will present itself regarding the fixed income side of investing).
Market Activity for March 24, 2009
Economic Releases
FHFA Home Price Index
The Federal Housing and Finance Agency (FHFA) released its home price index for January, showing home prices rose 1.7%. The rise was fueled by price increases in the Northeast, Atlantic Coast and Southeast regions, up 2.0%, 3.9% and 3.6%, respectively (this survey gets very region specific by breaking out into nine areas, most housing surveys just measure the typical four). The only decline in home prices occurred in their Pacific region, the area that has shown the most damage during this period of housing-market contraction.
Based on the existing home sales data we received on Monday, I’m not sure this FHFA data got much attention – since this data is for January and the existing home sales for February showed single-family home prices were flat last month and down 6% since December. Nevertheless, the FHFA index offers a broad-based look at the housing market (basically the only segment it misses is high-end homes) and thus at the least should be viewed as a mild positive.
Richmond Fed
In a separate report, the Richmond Federal Reserve Bank released it latest index on manufacturing activity in the region, which showed the rate of deterioration eased substantially. While the survey remains deep in negative territory, the figure bounced to -20 in March from -51. The record low was hit in December when the survey printed -55 – although we’ll note Richmond doesn’t have a long history, going back only to 1993 so record lows don’t mean all that much.
As mentioned above, this is not one of the more important regional factory surveys -- Chicago and Philly are the one’s to look to for much better guidance regarding the direction of overall manufacturing activity. Nevertheless, we’ll take the improvement in Richmond as slight evidence factory activity has bottomed. We’ll need to see this flow through via Chicago, Philly and ISM to put some conviction behind this belief.
The Coming Denial
We’ve talked about, for some time now, how expectations regarding deflation risks are wildly over-blown. To the contrary, massive liquidity injections by global central banks along with trillions governments will spend on the fiscal side (stimulus packages) are highly inflation – particularly since production has been subdued over the past couple of quarters. We have also spent time touching on how, as inflation rises, Bernanke and Co. will do their best to explain that this is nothing more than a transitory event – they certainly won’t want to shut down what may be a nascent housing rebound a year down the road by raising interest rates (tightening policy), as is the typical way of dealing with higher rates of inflation. The fact that the Fed is not at all independent from the legislative branch right now only reinforces this view as politicians will pressure the Fed to keep policy very accommodative to housing activity ahead of the 2010 House elections).
As an early sign of what’s coming, yesterday morning we see saw UK inflation hit 3.2% on a year-over-year basis. This alone is not a worrisome level but it definitely signals we’re not in a deflationary environment and shows inflation is embedded – if it were not, this level would not be possible considering the rate of economic deterioration at present. So, we’re starting at a high base for this point in the business cycle and when commodity prices truly rise, via all of this “stimulus,” overall inflation rates may quickly soar. The Bank of England (the UK’s version of our Fed) is in the process of explaining that this inflation is a short-term event and prices will hardly rise at all by 2011. These are the early signs of denial.
Central bankers refuse to believe, not just because it will be politically impossible to address high levels of inflation over the next 12-24 months but because their models are flawed, prices can rise to harmful levels with the current slack in resources. That is, the labor market is currently under-utilized and thus the old Keynesian models (models that get central bankers in so much trouble) they precariously continue to clutch to do not allow them to accept that inflation can rise in this environment.
Problem is inflation is largely a monetary phenomenon, too much money chasing too few goods, and we have the classic set up of this environment arising over the next year to two – remember, production has been in decline for a while. It is likely production will remain weaker than it otherwise would be as the economy rebounds because businesses will remain cautious due to increased government involvement and the likelihood, if not certainty, tax rates will rise across-the-board as a result. Thus we will get that scenario of too much money chasing too few goods and much higher than acceptable levels of inflation will result.
Get ready for the coming denial.
In the short term (next couple of years possibly), this means commodity-related stocks should outperform. Longer-term, this means central bankers will eventually have to deal with this inflation, causing another round of economic angst. But every situation brings opportunities and very attractive rates for the fixed income side of the portfolio will arise. But it will require plenty of patience before we get there.
Have a great day!
Brent Vondera, Senior Analyst
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