Market Commentary
by Byron Wien

The Battle between Liquidity and Reality

Almost everyone thought it would be different this time.  In 2010, 2011 and 2012 both the economy and the stock market were robust in the first quarter, but suffered slowdowns or corrections afterward.  “Sell in May and go away” became a part of the consciousness of every portfolio manager.  In spite of tax changes and spending cuts ordained by Washington, the consensus for 2013 was more optimistic.  The aggressive monetary stimulus program implemented by the Federal Reserve ($85 billion a month of Treasury and mortgage-backed bond purchases) would overwhelm the potential negatives of government policy, it was thought.

The report of first quarter Gross Domestic Product (GDP), below expectations at 2.5% real growth, may reverse some of that thinking.  The sharp rise of the equity market so far this year has influenced the estimates of both economic observers and analysts.  Back at the beginning of January most forecasts were for real GDP growth to be 2% or even less, but during the quarter many increased their calls to 3%.  The fourth quarter of 2012 was a feeble .4%, so some pick-up was expected.  The end of the 2% payroll tax holiday and the prospect of a sequester on government spending were worrisome headwinds, however.

The Federal Reserve was doing its best to make up for the lack of fiscal stimulus, but monetary policy is a very inefficient way to get the economy moving at a faster pace.  By my estimate 75% of the money the Fed puts into the economy finds its way into financial assets.  Only a quarter of the monetary expansion goes into the real economy.  Higher stock prices and improved home values do increase household net worth and make it more likely that consumers will spend more at the retail level, but the most we can hope for is that this offsets reduced government spending. 

Drilling down into the economic data doesn’t provide much encouragement.  Stephanie Pomboy of MacroMavens (as reported in Barron’s) points out that the Citigroup Economic Surprise Index, a diffusion measure which offsets positive surprises with negative ones, has proven a helpful signal of the economic downturn in each of the last three years and appears to be declining again.   Housing has been one of the most important drivers of the economy recently and the data here is mixed.  Existing home sales were down slightly and single family housing starts were disappointing.  Mortgage applications for purchase were only up .2% in the latest report compared with 4.8% previously.  Still, housing was a first quarter positive, growing at 12.6%, but down from the 17.6% rate of fourth quarter. 

Perhaps more important, real final sales have been decelerating over the past three quarters.  They were 1.5% in the first quarter of 2013, 1.9% in the fourth quarter of 2012 and 2.4% in the third.  Not a good trend.  While consumption in the first quarter was at a 3.2% pace compared with 1.8% in the final quarter of 2012, much of that  additional spending went for heating homes during the cold winter we all endured in the north.  Government expenditures were down 4.1% in the first quarter, which is part of the continuing austerity trend.  As we move forward I think you will see more of an impact on middle-income consumers resulting from the January end of the 2% payroll tax holiday, as well as other taxes on higher incomes that went into effect at that time.  The sequester, which cuts back government expenditures on discretionary programs and defense, will also have a negative effect on growth.  None of this means we are headed into a recession; it only suggests that the 3% growth prospects for 2013 that had begun to appear in the first quarter are likely to prove too optimistic.

If the economy is showing signs of weakness, isn’t that likely to show up in corporate earnings?  So far something over half of the Standard & Poor’s 500 stocks have reported and 70% have beaten earnings expectations.  Only 20% have clearly missed.  If you look at revenues, however, it is a different story; 43% of the companies that have reported have come in with sales below expectations.  While there seems to be increasing evidence that growth is likely to be lower than the optimists thought, there is some question about whether that matters.  If revenues are increasing much more slowly than earnings, you can argue that earnings disappointments are ahead, but only if revenues are insufficient to cover cost increases.  With commodity prices falling and labor costs reasonably flat cost pressures may be limited. 

Ned Davis Research points out that the global economy is experiencing very slow growth.  I have been concerned that profit margins are peaking and that is why earnings are going to be disappointing and in the first quarter there have already been some notable examples of that including IBM, Caterpillar, Bank of America, Procter and Gamble and General Electric.  In the five previous cases where profit margins have declined 10% or more (after rising 10%) the economy has been in a recession.  I don’t think we’re headed into a recession any time soon so the question is, are we in danger of a margin contraction in in spite of this?  Davis shows that the swings in margins have widened over the past 25 years because of financial leverage.  Margins were at a record high in the third quarter of 2011 showing companies had reached a peak of efficiency.  The S&P 500 has rallied 40% since September 30, 2011, but GAAP earnings have grown only 2% in that period.  After previous margin peaks earnings have declined.  The key is whether revenues will be sufficient to keep margins high.  The consumer is 70% of the U.S. economy and both real and nominal consumer spending are above 2008 levels, growing at 2% and 4% respectively.  It is uncertain whether that can continue and I am worried that the rate may slow.  If it does, then earnings could be in for trouble.

Another key to the potential pace of the economy is private sector credit growth.  With substantial cash on corporate balance sheets and operating rates at 80% there may not be a great need to borrow, especially if there are clouds on the growth outlook.  According to Encima Global, private sector credit growth increased at an annualized rate of 9.4% in the five years ending in September 2007.  In spite of the fact that interest rates are at a record lows, private sector credit growth has only increased at a .7% annualized rate in the five years ending in December 2012.  Loan growth has been slow throughout this expansion because of weak demand.  Total loans are only up a modest 3.5% year-over-year, which provides further support to the slow growth (around 2% real) thesis.

The situation in Europe is also a problem.  That the continent was likely to remain in a mild recession was always a given.  The latest report on executive and consumer sentiment from the European Commission showed it was the lowest since December.  Business confidence in Germany, Europe’s largest economy, dropped more than expected.  Sentiment among manufacturers and service providers dropped also.  Nevertheless Mario Draghi, head of the European Central Bank (ECB), believes that the continent will be recovering by the end of the year.  One troubling aspect of the European situation is that the balance sheet of the ECB has contracted from €3.1 trillion to €2.6 trillion in contrast to the expansionary policy of the Federal Reserve.

Over the past month a major controversy has erupted over austerity.  Many countries in Europe have been cutting back on government expenditures to reduce their deficits and the United States has been engaged in a budget deficit reduction program as well.  The important academic research supporting deficit reduction has been done by Carmen Reinhart and Kenneth Rogoff, now both at Harvard.  Recently researchers at the University of Massachusetts at Amherst have uncovered some errors and omissions in the Reinhart/Rogoff research, which has raised questions about their conclusions.  The Reinhart/Rogoff work argues that when debt to GDP reaches 90% for a country, growth slows down significantly, so countries have reason to control their deficits to prevent this from happening.  Policy makers who believed governments should be spending more to create jobs, retrain workers and improve infrastructure had been forced by these findings to temper their views. 

Now, with the validity of the academic study called into question, critics of austerity have taken on a louder voice.  The real issue is causality.  Does a weak economy cause government debt to rise as federal spending increases to counteract the slowdown or does high debt cause the economy to weaken because of government cutbacks in spending?  In the United States, government expenditures account for more than 20% of GDP.  If the sequester is fully implemented the economy is likely to feel it, but, as we saw in the case of furloughs for air traffic controllers, the public reaction to the implementation is likely to be adverse here as it was in Europe.  In any case restraint in spending at the government level coupled with somewhat higher taxes is likely to dampen growth in 2013.

The Reinhart/Rogoff research argues that growth over the long term is about 1% lower when debt/GDP is 90% or more.  In an op-ed in The New York Times on April 26 they point out that the UMass Amherst revelations don’t overturn that finding.  As for causality they say that it runs in both directions with slow growth causing high debt and vice versa.  In the 26 cases where debt to GDP exceeded 90% for five years or more, the high debt period lasted 23 years.  In 23 of the 26 cases the average growth was slower than it had been when debt was lower: 2.3% versus 3.5%.  I think many of us would settle for 2.3% real growth on a consistent basis going forward. 

According to their methodology the debt to GDP ratio is now 106% in the United States, 82% in Germany, 90% in Great Britain and 238% in Japan.  Historically high debt levels have also increased borrowing costs on sovereign debt, but so far that has not happened for these countries.  Even Italy and Spain have ten-year yields hovering around 4% which is surprising considering their financial condition.  Clearly investors believe the European Union is going to hold together and liquidity will be provided so that the major financially troubled countries can meet their obligations.

Also helping is the abundant liquidity around the world seeking a reasonable return.  Reinhart and Rogoff say that austerity programs rarely work without structural reform which includes taxes, regulation and labor market policies.  They also advocate, in some cases, partial debt default and reducing the mortgage on homes underwater in the U.S.  In no case do they believe that fiscal stimulus should be wound down quickly.  In general they see a transfer, “often painful”, from savers to borrowers.

The key argument, sometimes shrill, against austerity is made by Paul Krugman, Nobel prize–winning Princeton economist and op-ed columnist of The New York Times.  Krugman points out that the austerity issue has become a morality play in which our society has been living beyond our means and now we are paying the price in terms of slow growth.  His point is that the people who are suffering now are not the people who enjoyed excessive prosperity during the good times.  He believes we need more fiscal stimulus to provide jobs and improve infrastructure and argues that we can afford to do this because Treasury borrowing costs are so low. 

I have some sympathy for that viewpoint but my major concern has been the rapid accumulation of debt.  In 2000 total Federal debt was $6 trillion accumulated over more than 200 years and the blended interest rate was 6% or $360 billion.  Today, 13 years later, the debt is $17 trillion and the blended interest rate is just over 2% or about the same $360 billion.  Some 60% of our federal debt is being financed short-term, which is not good financial planning.  The Congressional Budget Office is optimistic about our ability to reduce our annual deficits over the next few years from over $1 trillion to below $500 billion.  I am skeptical.  Ten-year Treasury rates have generally correlated with the nominal growth rate of the economy, which is now about 4%.  If the 10-year Treasury yield (now at 1.67%) were to go to that level, the debt service cost increase would offset much of the progress we are currently making on cutting government spending.

I believe most investors are surprised by the strength of the market so far this year and with the Federal Reserve likely to continue to provide liquidity in the face of slow growth it looks like prices will continue to rise.  I have been cautious and remain so, thinking the S&P 500 may not make much progress from here by year end.  For me to be right about this either interest rates have to rise or revenues and earnings have to come in lower than is now expected.  I think the latter is much more likely.

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