I. The Economy
The current economic expansion, now six years old and therefore somewhat long in the tooth by historical standards, took a welcome pause in the first quarter of the year. Even though private demand rose healthily, the nation’s GDP grew at a very modest 0.7% annual rate compared to 3.3% for all of 2006. The decline was largely attributable to the slump that grips the housing industry, although some observers would argue that the Fed’s long campaign to raise short-term interest rates finally worked its way through the system and produced the desired, inflation-subduing results. Either way, it is clear now that the pause has ended, and the economy is growing well again, with most professional watchers expecting second quarter GDP growth to hit not less than 2.5% (annualized) and perhaps much more. Every major metric of growth is now positive as companies restock depleted inventories, respond to heavy export demand abroad and invest in new plant and equipment while the consumer—God bless him—continues to spend, spend, spend. It has been said that we live in a golden age of synchronous global growth not seen since the late 1960s and not unlike that which preceded World War I. What, me worry? The best news for the economy is that the housing slump appears to have been contained, and the only evidence of contagion has been seen in the credit markets, as discussed below, and not in the real economy. Otherwise, the economy hums along, although some signs of strain have begun to appear. For example, with the labor market very strong (e.g., unemployment is a mere 4.5%), productivity growth has slipped, measuring only 0.3% in the first quarter (the lowest since 1993), far below the 3% pace registered during the boom years from 1995 through 2005. Most economists expect productivity growth to rebound somewhat for the rest of the year and perhaps to resume a longer term pace of more than 2%. In any event, the recent poor performance partly reflects the usual cyclical pressures of a mature expansion, but other, more secular forces are also at work. One is that domestically, capital expenditures by American businesses, especially on information technology, remain quite modest compared with that in the late 1990s, and there has been no New Big Thing for quite some time (however clever a gadget, the iPhone does not qualify). A second relates to the positive “productivity shock” of low inflation and interest rates that the integration of Asian labor into the global system gave the developed world. It has evaporated, and now the impact of Asia is mixed. For example, rising commodity prices, including those for food and energy, are clearly tied to the enormous demand added to the global system by India and China in particular. As a result, American consumers—individual and corporate—of those commodities must pay more than they otherwise would (even if individuals still pay less for tchotchkes at Wal-Mart), which for businesses means either lower profit margins or higher prices or both. Productivity growth is an inevitable casualty. Still, even if the age is not quite as golden as the Panglossians portray, it ain’t bad. Thus, inflation recently has actually declined, and the Fed’s favorite gauge now reads within its stated comfort zone. Even the current account deficit, which heretofore threatened to eat us all, has begun to shrink (as a percentage of GDP) as exports climb and imports stall, largely because of a much weaker dollar. Globally, financial conditions remain loose, although foreign central banks have been tightening monetary policy. While the Fed has stood pat for a year now, both the pundits and the fed funds future market tell us that there is essentially no chance now that the Fed will ease off the brakes this year as had been hoped. Indeed, a rate hike is more likely. Given the flood of liquidity sloshing around the system, as previously discussed in these pages, that is probably a good thing. II. The Capital Markets
The big noise in the nation’s capital markets last quarter erupted not in the stock market or even the overall bond market but rather in that obscure corner of the credit market known as “subprime mortgages” and the securitized products that Wall Street’s financial engineers have devised to repackage and resell them using the magic of derivatives. Last quarter’s essay described the “dyspepsia” then visible in this market. In June, a combination of the long decline in the overheated housing market and a sudden spike in interest rates (discussed below) caused instant, massive damage in it. Most spectacularly, two multi-billion dollar private investment funds managed (but not owned) by the venerable Wall Street firm, Bear Stearns, teetered and would have fallen but for an infusion of almost two billion dollars by Bear Stearns itself, a bailout of both its investors and its reputation for sound risk management. All participants in the subprime danse macabre and those beyond in the hedge fund and “private equity” world at large, who live by cheap credit and fast computers, breathed a huge sigh of relief as no further “contagion” was detected and interest rates subsided. No further post mortem is necessary or appropriate here, but suffice it to say that those who have long looked askance at how the global glut of liquidity and the massive proliferation of all kinds of derivatives had turned the credit markets into the equivalent of the stock market’s “dot-bombs” in the late 1990s were vastly vindicated. But the dance, of course, goes on. As to that sudden spike in interest rates, it must first be recalled that the yield curve (which graphs interest rates from short to long) has been inordinately flat for some time and for a while even inverted (i.e., short rates were higher than long). The conventional wisdom holds that what former Fed chairman Greenspan called a “conundrum” was the result of the gigantic recycling of petrodollars and Asian trade surpluses into dollar-denominated debt, artificially depressing intermediate and long-term interest rates. What happened? In May the bellwether 10-year Treasury note yielded a little over 4.7%. Suddenly, in early June that yield jumped to an astonishing 5.3% (intraday) over a few trading days. Why? The answer is not clear although some observers attribute it to new indications that the appetite of foreign central banks and sovereign investors for dollar-debt had waned (e.g., only 11% of a Treasury debt auction in early June was subscribed by foreign investors). By early July, the yield on the 10-year Treasury had fallen back under 5%, letting many Wall Street bankers and their clients head off to the Hamptons for Independence Day celebrations feeling much relieved. Nonetheless, the bell has been tolled, and all should now be alert to the dangers that liquidity and leverage (through derivatives and direct borrowings) can bring for those for whom greed has triumphed over fear. For some time, skeptics have predicted a “Great Unwinding,” when all these collective dynamics go into reverse. That moment for now has been postponed but may not be permanently averted. So, if it is not Apocalypse Now, where are we? Well, in the perverse nature of things, the stock market has emerged unscathed by all these tribulations, especially now that interest rates have relapsed. The S&P500 stock index, after seven biblical years in the wilderness, regained its bubble-market peak early in the second quarter. And on virtually every vector, it is a much healthier market (and index) than it was seven years ago. It has much greater breadth, and its valuations are considerably more modest. For example, ordinarily the market enjoys a “multiple expansion” (i.e., average price-earnings multiples rise) during a bull market, but in this case they have radically shrunk—because they were so stupidly high at the market peak, as these pages strenuously argued at the time. Now they are at levels that can be readily justified given current corporate profits growth, interest and inflation rates. No, stocks are no screaming bargain, but given the scant chance of imminent recession, they remain attractive, even if there is a Great Unwinding. Curiously, stock prices have been fortuitously supported by unusual levels of “de-equitization”—the net removal from the publicly-traded stock market of material amounts of supply. This has occurred in two ways: stock buy-backs and company buy-outs, whether through mergers and acquisitions or the private equity phenomenon. Both buy-backs and privatization are heavily dependent on low interest rates, but as long as rates remain low, we can expect supply to shrink. Constant demand + shrinking supply = rising prices. All this is more curious because it is precisely at this point late in a bull market that one would expect Wall Street to crank up the printing presses to help companies either go public or issue more stock—the market cycle phase known as “distribution.” Instead, precisely the opposite has happened. Further, one would expect this late in the cycle, after the market (as measured by the S&P) has doubled, that the retail public would be leaping in with both feet—the process known as “capitulation” (when the last bear throws in the towel) and “participation” (as when Bernard Baruch’s shoeblack was offering him stock tips in 1929). Instead, there is nary a sign of either. Oddlot Harry shuns U.S. stocks and, if he buys any stocks at all, they are foreign ones. Once burned twice shy? Perhaps—for now.
Jerome W. Anderson
July 4, 2007
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