Last Friday, August 6th, we received July’s jobs report from the Bureau of Labor Statistics (BLS) which solidified investor fear and drove many from the market on Friday. However, despite mixed economic reports and recovery concerns, the markets managed to build on their recent gains in July. The Dow Jones Industrial Average rose 1.8% for the week, the S&P 500 added 1.8% and the Nasdaq gained 1.5%.
Although unemployment stayed steady at 9.5% in July, jobs were still shed and contributed to concerns that the US economic recovery is losing steam. Is this another sign of a looming double-dip? In the plus column, corporate earnings have been coming in pretty strong this quarter — 75% of S&P 500 companies have topped their earnings estimates for the 2nd quarter and 65% of MSCI World index companies have beaten analysts’ expectations — isn’t that worth something? In the minus column, bond investors are betting on a strong bout of deflation as proven by rates dropping to historic low levels (10 year Treasury at 2.82% and the 2 year at 0.53%). Ugh! We are in for a tough slog for sure, but I’m not in the double-dip camp. I am leaning towards slow 2-3% growth (yes, growth) for the rest of 2010.
As I mentioned last month, we’ll get a better handle on things after summer ends as investors and money managers return from vacation and get the kids off to school. Times like these are best to take a step back, yet pay attention. This pause creates an opportunity for me to head off to the Sierras to enjoy some hiking and cycling, clear my mind, as well as to study and tune up my investment themes. While I may not take books of fiction with me on vacation, the non-fiction reading of economic and corporate reports keeps my summer reading full and helps define client strategies for the remainder of the year.
I hope you are able to enjoy some time away from the office to recharge your energy and enjoy time with family and friends.
Stay healthy, wealthy and wise.
Eric Linser, CFA
Chief Investment Officer
To Dip or Not to Dip?
Over the past few months (since late April), the markets have been manic to say the least. The S&P 500 Index fell more than 5% in June, only to rally more than 7% in July. This level of volatility and changing direction has left many investors dizzy, and certainly is deserving of analysis and review, as I have done in several of my recent economic and market commentaries. Some of you have been asking the deeper questions about overall economic health and the potential for action by either Congress or the Federal Reserve. These are key questions and get to the heart of where some investors’ focus has been.
Certainly the recent data coming out about the US economy has been one of trend line slowing. We have seen this in the US GDP announcement of 2.4% growth in the second quarter, with consumer spending coming in at a 1.6% increase. That was slower than both their first quarter showings of 3.7% and 1.9%, respectively, and below economists’ expectations. I think this will continue to fuel the debate about the need for more stimulus and the cost of such a move (billions more).
How To Spur On Economic Growth
There are two decidedly different ways the US economy can be stimulated:
- through direct spending — Congress mandated fiscal stimulus
- through central bank activities — Federal Reserve monetary stimulus.
We have already seen the former, in the 2009 stimulus package, of which $400 billion is yet to be spent. And we have seen the latter in the form of quantitative easing (QE) and securities purchases by the Federal Reserve. Today, most economists are divided between the need for Congress to enact more stimuli, at a cost of increasing an already unsustainable deficit, or of austerity and tax increases at a cost of continued protracted unemployment and potential GDP contraction. We are also seeing a Federal Reserve which is acting with a wait and see approach as outlined by Chairman Bernanke in his address to Congress, and the president of the Federal Reserve Bank of St. Louis who went on record stating the need for the Fed to buy government debt now (more quantitative easing). I think the eventual answer will tend to be somewhere in between in both cases; stimulus that can be shown to be revenue neutral or close to it, and Fed actions that are moderate and directed by specific economic measures.
Tax Man Cometh
The current tax law places a large portion of the revenue burden on the wealthiest of Americans. As the Obama Administration considers the Bush-era tax cuts and their sunset provisions, there is a desire to maintain a tax advantage for those with income below $250,000 annually, which requires an increase on those making more than this amount. At issue, though, is that as annual income increases, the elasticity of taxation also changes. In other words, as wealth increases, so does one’s ability to decide if he or she is going to recognize income and pay a tax. California has seen this very issue over the last few years, and we think the Federal government may be reminded of it again. Decreasing the deficit by tax increases is a very hard thing to do, and using tax increases to also fund stimulus makes it even harder.
I think stimulus, if used, will need to take the form of projects that have higher multiples of impact than what was seen in the last round. That is to say, a dollar of stimulus should be spent in a way that creates two or three dollars of increase in the overall economy. Tax refund checks may sound good for jump-starting the economy but refund checks don’t go far; they tend to be used immediately to reduce credit card debt or to make a house payment — those dollars tend to stop there. On the other hand, dollars used for infrastructure construction, for example, make their way through contractors, suppliers, and others, increasing the stimulus’ impact – or thevelocity of money.
What Will The Fed Do?
The Fed also has its hands full. The chairman has said he stands ready to act if the economy warrants it, and most believe that action would be in the form of increasing liquidity by buying more of our own government debt. I expect that action would tend to lower longer-term interest rates, based upon where along the maturity range the Fed makes its purchases, as well as weaken the dollar. The lowering of rates would be the primary objective, as the Fed would be trying to get private sector credit moving again (getting banks off their duff to actually lend). There has been considerable contraction in personal and business debt, which supports less spending and production. Such a purchase of securities by the Fed could also have positive impacts on stocks, at least in the near term, as the stock market will see some of that increased liquidity. Reflating the economy tends to re-inflate the value of many asset classes, particularly stocks.
Our Forward-Looking View
So what do I see happening? In a word, plenty, though it will take time to play out:
- I continue to think that we will see positive GDP growth for the rest of 2010, though at rates materially slower than the first half of the year.
- Because of the sluggishness of the economy and the continued levels of unemployment, the Fed will keep rates at their current levels into 2011 and may be forced to begin securities purchases, should growth slow even more.
- I do not see any appetite for additional government spending, beyond the current programs, to stimulate the economy and Congress will not consider it until after the November elections, if at all, in 2010.
- I also do not believe Congress will address the income tax issues of the 2010 sunset provisions until after the elections, leaving a lame duck session to make some of the most important economic decisions of the next several years. In the end, we expect increases in taxes for the highest income earners, either in 2011 or perhaps a few years out, if Congress has the desire to punt the ball during the current economic environment to, say, 2012 or 2013.
- Finally, the current levels of both debt and almost non-existent credit growth will mute overall demand and might even lead to price contraction. While the Fed is watchful for signs of deflation, or dis-inflation as I like to think of it (since in modern fiat monetary systems, the central bank has the ability to create whatever level of near-term price action it wants), I do think the continued waning of growth has the potential for prices of goods and services to drop, for consumers and producers alike, much as they have been in Japan for years.
Given all these moving parts, Green Valley Wealth Advisors continues to support a widely diversified allocation. We believe this really is the best defense, and potentially offense, for portfolios today. The currents of uncertainty should continue to stir markets, causing higher volatility and more periods like the ones we have seen over just the past few months. Like the fog in San Francisco, it’s been heavy as of late, but it will soon lift and so will the markets and the economy.