I. The Economy
Now in the sixth year of a recovery and expansion, the domestic economy continues to decelerate. A year ago GDP growth started out (in the first quarter) at a whopping 5.6% annualized pace but then slowed in the second to 2.6%. At that point the Federal Reserve paused in its previously relentless campaign to slow the economy through 17 consecutive raises of the fed funds rate, albeit starting from a deflation-fighting, 40-year low of 1%. Since then it has remained at the more of less neutral level of 5.25%. In any event, growth continued to decline in the third quarter to 2% per annum. As long-time readers of these pages (or even of The Daily Bugle) will know, the reason for the Fed’s exertions was that inflation had reared its ugly head, and the Fed was determined to chop it off even at the risk of choking off a pretty solid expansion. While measured rates of inflation certainly never reached worrisomely distortive levels, the Fed remembers what happened 30 years ago when inflation ran out of control. Hence pre-emptive action was in order. At this writing, it appears that the ghost of 1970s-style “stagflation” (much less Weimar-style hyper-inflation) has been exorcised, and inflation has been tamed without snuffing the expansion. The Fed’s favorite measure of inflation (the core personal consumption expenditure index) has fallen to a hair above the Fed’s stated “comfort zone” ceiling of 2%. The Fed has declared no victory, but since the members of the responsible body, the Federal Open Markets Committee, are paid to worry about inflation and are not unmindful of an unkind fate that awaits them in the history books if they get it wrong, one should not be surprised by their modesty. Still, action (or inaction) speaks more loudly than words so the Fed’s stand-pat policy begins to look like a tacit declaration of victory. If, indeed, the Fed has succeeded, it will constitute the ultimate goal of monetary policy, the so-called “soft landing” (achieved only once in its 90-year history, in 1995) . That such an accomplishment would come only a decade later reflects the fact that the Fed operates today in a very different environment. For one thing, the manufacturing sector, for good reason or ill, has shrunk to only 17% of the economy and is therefore now dwarfed by the much less cyclical and less capital-intensive service sector’s 83%. Second, globalization—again, with its many malign if mostly benign effects—is the Fed’s silent partner as it inexorably constrains inflation as a result of foreign competition. Yet the flip side is that the instrumentalities of the United States government—the Fed, Congress and White House—have less and less autonomy in exercising the levers of fiscal and monetary policy in order to influence, much less control, the domestic economy. We are all in this together, including a couple billion Asians. Aside from whether or not the Fed has correctly calibrated monetary policy, and will continue to do so, the critical factors affecting the near-term outcome for the economy are the continued health of consumer spending, a benign interest rate environment and a gradual decline of the dollar. The first has held up remarkably well, considering the woes of the housing market. The latter, in fact, appears to have plateaued although a chorus of long-time observers of the residential real estate market say that this is only a temporary respite and that worse will come. Interest rates are obviously an important factor in determining the fate of housing, and at this juncture they remain quite positive (in part due to all the “liquidity” flowing into the system, as discussed below). Finally, so far the dollar’s slide has caused no disruptions and no visible rise in inflation. Let it so continue.
II. The Capital Markets
Last year was simply outstanding for global stock markets and certainly vastly better than the pundits predicted. In fact, the domestic stock market did swoon mid-year, leading to much angst among investors and commentators, but a fine rally eventuated in the second half and gained momentum as it ran. The benchmark S&P 500 stock index thus finished the year with a 16% total return, perhaps twice consensus forecasts a year ago. Moreover, during the period the market exhibited very little volatility. Meanwhile, the bond market spent the year asleep as long-term interest rates barely moved, and credit spreads—the difference between the yields on low and high quality bonds—were extremely thin. Also, the yield curve remained inverted for essentially the entire year. Ordinarily, these two phenomena—stock market rally and an inverted yield curve—would be highly inconsistent as an inverted yield curve generally signals an imminent recession and the stock market usually anticipates one with a significant retreat.
All of this sent the pundits back to their textbooks and slide rules, and then they emerged with a unanimous one-word explanation: liquidity. Yet what does that mean? Where does all this beneficent stuff come from? On its face, the rationale sounds only marginally more convincing than the ancient belief that fire was caused by phlogiston. Clearly one source is all the giveaway money the Fed’s monetary policy created after the last recession. Another is simply the vast wealth that has been created over the last quarter-century, which has seen not one major recession. Then there are all those recycled petrodollars and now massive Asian trade surpluses. The former, of course, reflected a much higher price of oil (which is traded only in dollars worldwide) and the latter the Faustian bargain that constitutes the U.S. trade relationship with China and other Asian producers. The U.S. current account deficit (largely the trade deficit) has now climbed to the heretofore unimaginable level of 7% of GDP. As these pages have warned for years, this kind of thing (even at much lower levels) cannot persist—but it has. Perhaps that generalization holds true for cyclical swings in the current account (from surplus to deficit and back), but now we may be witnessing a tacit grand bargain, a kind of new Marshall Plan for non-Japan Asia, in which we facilitate the integration into the world economy of billions of Chinese, Indians, et al. by consuming their goods and selling them billions of dollar-denominated securities to pay for it, a vendor financing scheme of Pharaonic proportions. Or so its apologists claim. Another source of all the stuff sloshing around the capital markets likely consists of the results of a number of years of innovation in the credit markets, where securitization and financial technology have drastically changed that sleepy corner of finance. It is no longer your father’s bond market or mortgage market. Without describing the phenomenon in excessive detail, suffice it to say that it unlocked a lot of frozen value, which thereafter could move to wherever opportunities beckoned. The new reality is not without its risks, not least because it has yet to be stress-tested by some sort of financial crisis or geopolitical blow-up. For now, however, it is balm from Gilead. Looking at stocks, and looking forward, one can only conclude that the fundamentals are excellent. In particular—and no doubt connected to that fount of liquidity discussed above—corporate profits have been excellent, both in size and growth. For the S&P 500, profits growth has exceeded 10% every quarter since the third of 2003 and hit an astounding 18% in the third quarter of this year, the last reported. In the so-called national accounts, total corporate profits have reached a record 8.5% of GDP. Corporate balance sheets, meanwhile, are remarkably strong, with cash for the S&P 500 group of companies, for example, averaging 8% of stock market capitalization, a 20-year high. All that cash flow and cash have been available for uses that benefit stock prices through buybacks and mergers and acquisitions, in a kind of benign recycling. Now, corporate America is not without problems. Labor costs have been rising, now faster than productivity growth, and companies’ pricing power is limited by all that global competition. Manufacturing has been weak (though still growing) as a result of a slowdown in the auto sector and in housing. In judging stock prices’ prospects for the New Year, we first look at valuations, principally price-earnings ratios. Here again the picture is quite positive as they have continued to shrink (the first time that has happened in a bull market in 45 years), having fallen from 17X in the beginning in 2002 (for the S&P500 on a forecast earnings basis) to 15X now. (N.B. As a measure of how crazy were the bubble years, forecast PE peaked at 25X in 2000.) All this means that the downside is fairly well cushioned at this point, barring disaster, while there is some room on the upside for a multiples expansion even if profits growth finally slows, as it must, toward equivalence with nominal GDP growth. It must also be said, however, that so-called stock market “sentiment” has turned somewhat worrisome, which along with those record lows for credit spreads and stock market volatility accounts for Prof. Summers’s observation above. Surveys of investors have suddenly found much optimism while corporate insiders’ ratio of sales to purchases of company stock has likewise skyrocketed. Both are bearish. We see no evidence of dangerous euphoria yet, but when Joe Sixpack is buying emerging markets stocks, we take notice. After all, he probably would not want to visit many of those places. So, what will 2007 bring? We hope that stocks simply advance in line with earnings growth (perhaps high single digits), leaving any multiples expansion for another year, and that the bond market stays asleep..
Jerome W. Anderson
January 8, 2007 |
