It’s a Rick Ocasek market, “let the good times roll,” as stocks engaged in another significant rally yesterday. This brings to mind another song from the Cars: “Don’t Cha Stop.” The great reflation of asset prices continues as the Fed keeps easy-money policy floored.
The broad market has nearly erased the decline of the previous two weeks as investors appear pretty upbeat regarding the third-quarter earnings season, which will officially get underway today, but not in earnest until next week. The market is sanguine that we’ll see revenue growth for the quarter. I think it is more likely that the bottom line will be assisted via aggressive cost-cutting, mostly through the slashing of payrolls – just as was the case with second-quarter earnings (still profits will be down at least 15-20%).
If we do fail to get top-line improvement, which depends upon final demand, I think the music’s going to run out on this leg of the rally – but I’ve been saying that for 150 S&P 500 points now; as the Fed keeping the pedal to the metal, one never knows another asset bubble may just ensue. One thing is pretty clear, a prolonged period of cost-cutting via payrolls today means a lack of aggregate demand tomorrow.
Another weak session in terms of volume as less than 1.2 billion shares traded in the NYSE Composite. One would like to see these rallies exhibit more conviction, say 1.5 -1.8 billion shares, but no one seems to be too concerned about it.
Energy and basic material stocks led the rally as the surprise hike in rates by the Reserve Bank of Australia (their central bank) delivered yet another body blow to the greenback, which we’ll discuss below. Tech, consumer discretionary and financials performed very well too.
More positive comments from analysts/economists helped yesterday’s extension. A top executive at Fidelity International stated sustainable economic growth and low interest rates worldwide will spur a “multi-year” bull market in equities. Also, Deutsche Bank’s chief U.S. economist appeared to reverse course after being pretty pessimistic over the past few months by stating, “[t]he momentum in the economy is moving forward” and “housing is poised for a rebound.”
Market Activity for October 6, 2009
Interest-Rate Differentials – a Driving Force Again
The Australian central bank unexpectedly increased their cash-rate yesterday, becoming the first G-20 nation to begin tightening. This will keep the Aussie dollar in rally mode, and have the opposite effect on the greenback. The USD got hammered again yesterday, resulting in another rally for metals and oil – gold hit $1,040 per oz.
One-month Aussie bills now yield more than our 10-year Treasury note. The fact that U.S. long-term interest rates are so low is not only because the Fed has pushed short-term rates to zero and have engaged in actually purchasing bonds (quantitative easing). It is also because we continue to enjoy huge global demand for U.S. government debt. How long will this continue at the current level of U.S. rates? That’s a big question.
I think we’re going to see interest-rate differentials become a driving force again for currency values as foreign central banks begin to de-link their policy from the super-aggressive easing campaign that the Federal Reserve is currently engaged – something we talked about last week. If other central banks begin to tighten (raise rates), even mild increases, this is going to put intense pressure on the U.S. dollar and may force Bernanke’s hand more quickly than the market currently expects.
Trying to gauge these things is impossible, but it appears things may be moving in this direction. The U.S. has the luxury of enormous levels of liquidity that allow us to get by with lower rates on government bonds than other regions of the globe, but with gold tracking to $1,050, copper back on its horse toward $300/lb and oil back above $71/barrel (even though energy demand remains weak) one wonders when the trade will change full-blown to commodities and away from the USD.
While the Federal Reserve decides nary a mention of the dollar in any of their statements (which is strange considering they have a monopoly on dollar creation), they will not be able to sit by and idly watch a greenback in freefall – if that happens to occur. This would have huge ramifications for stocks, as the current rally is more a function of easy money (extremely low rates that keep money flowing into stocks as there are very little alternatives -- at least from an attractive interest-rate perspective -- in the bond market. That will all change if the Fed is forced to change course in order to throw a lifeline to a drowning dollar and begins to increase U.S. rates.
What will the Recovery Look Like?
This is a big question and something I think about on a daily basis. I had been assuming, even if I’ve carried a pessimistic tone since May, that we’ll get a decent upturn in GDP – even if it is a short-lived expansion as the Fed reversal alone will crush it – as the inventory dynamic and infrastructure spending combine to catalyze activity. However, I am really beginning to question even half the bounce we usually get from such deep levels of contraction. Sure, we are likely to see a two-quarter bounce in economic activity from these low levels but I’m not sure government spending will be able to fully offset consumer weakness. And there is also a payback effect to this government intervention as the private sector holds back – we’ve got to pay for this spending and businesses have seen this game before, they know what follows – one gets this sense that the business community will remain cautious for a prolonged period.
The drag from the consumer side of things (currently 70% of GDP and on its way to the historic average of 65%) will be quite large. How is consumer activity supposed to get going? The jobless rate is sky-high, the duration of unemployment is at record lengths and we don’t have credit to fall back on this time as consumer credit is in decline – a high level on unemployment is unlikely to change this reality as default rates will remain high and this will keep both the supply of and demand for loans moving lower.
And then we have consumer confidence (CC), which many people have pointed to as a bright spot. Bright spot? The reading only looks good next to near-record lows. There has never been a meaningful economic expansion when CC is below 60 without an ability to extend on the credit side (at least going back to 1967). The long-term average on the main confidence reading is 95.6 – it currently sits at 53.1.
What is typical coming out of a deep recession is for GDP to bounce back at 6%-8% real annual rates, and this seems to be what most expect. I’m sorry, but don’t see how this is possible.
What the economy needs is broad-based tax rate reductions to really cement an expansion that extends past a couple of quarters. A cut in marginal income tax rates will drive aggregate disposable income, very needed at this time of stagnant incomes and high joblessness; slashing the corporate tax would drive profits; stating that capital gains and dividend tax rates would remain at current levels would be a big help to stock prices (although at this rate it doesn’t appear stocks need much help); and higher current-year write-down allowances would spark a business spending expansion – it would also have a positive effect on job creation as the orders for plant and equipment would drive hours worked, a necessary condition for an increase in hiring that follows. In total, what broad-based tax cuts would do is help the economy to withstand the coming (even if the timing is delayed) reversal of monetary policy.
But policymakers have painted themselves into a corner. After spending their time vilifying lower tax rates, the administration can hardly turn and engage in such policy. Higher scheduled tax rates and tighter monetary policy will prove to be a deathblow to economic recovery. All they have for now, regarding the tax-rate lever, is an extension of the first-time home-buyers tax credit, which we wouldn’t be surprised to see extended to all homebuyers. But this is hardly enough, I even question if it can keep home sales going as the credit has already front-loaded sales and labor-market conditions will make it tough to keep housing activity in rebound mode.
We’re moving from what has been termed the “great moderation” of the past quarter century to a period that exhibits significantly more erratic business cycles. Going back to 1982 expansions became longer and contractions shorter – smart economic and correct (for most of this period) monetary policy were the driving forces. Returning to higher tax rates, more regulations and misguided monetary policy will bring a scenario in which recessions become more frequent.
Policy can always shift, and sometime in a fairly rapid manner; although, history shows it generally takes a significant electoral transfer to foment such a change in direction. I’ll certainly turn much more upbeat if pro-growth policies even begin to get a look from the President, but wishful thinking seems to be a wasteful and dangerous activity in this environment. For now, I would remain cautious.
Correction
Yesterday I was referring to the Cap and Trade bill as C&I – what can I say, I’m an idiot; must have had the decline in Commercial and Industrial loans on the mind. Anyway, obviously I meant to type C&T.
Have a great day!
Brent Vondera, Senior Analyst
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