We traveled to New York this week to attend the annual conference of the National Association for Business Economics and to talk with Wall Street sources. We ended the week in Philadelphia at the annual gala for the Global Interdependence Center, where we spoke with a wide range of local executives and economists from across the country. Our strongest impression was that the vast bulk of economic players are in the acceptance stage of the healing process. Economists are no longer expecting a rebound north of 3% next year. The consensus has settled on the muddle through with forecasts largely bounded between 1.5% and 2.5% real growth. Optimists and pessimists alike have been battered by the undesirable, yet very sustainable, muddle through of the past three years. Indeed, one of the more interesting presentations, by Blu Putnam, Chief Economist of the CME Group, pointed out that real GDP growth over the first twelve quarters of recovery has averaged 2.2% — almost precisely the same as the growth averaged over the last twelve quarters of the expansion in 2005-2007 (2.4%). Bottom line, modest real growth is becoming the accepted reality among those tasked with advising their strategic planning departments on the big picture outlook for the economy.
Similarly, the investment community on Wall Street appears to have settled into a muddle through consensus as well. While clearly happy with the performance in the securities market over the past year, many investors are concerned about the sustainability of the rally given the level of profits relative to GDP – and the risks of the fiscal cliff. On the fixed income side, the unappealingly low interest rates on Treasuries and mortgages due to quantitative easing have forced investors out the risk curve; bringing down yields on high yield corporate debt, revitalizing the subprime lending picture, and narrowing spreads on even the most hated sovereigns. Italian, Spanish, Portuguese and Greek ten year notes are at or near their lows over the past three months, while US, UK, French and Swedish rates have moved back toward their recent highs. Bottom line, concerns abound despite the favorable trends in these markets. Many expect a broad trading range as long as the economy muddles along (see the paragraph above) with professional bottom-up securities pickers outperforming the broad basket diversification approach.
Finally, commodities investors are dealing with the realities of a hard landing in China restricting demand for hard commodities and the shortage of feed grain lifting the softs. Over time, the Chinese are expected to add more stimulus to lift hard commodities demand. Meanwhile, farmers are expected to plant hedge row to hedge row next year to lift soft commodities supply – but that will take time. The Chinese authorities announced real GDP growth slowed only marginally to 7.4% for the year ended in the third quarter, but also revised the quarterly pattern of the past year to put weakness earlier and claiming a 9.1% annualized growth rate for the third quarter. This seems unlikely based on other government data like electricity use, rail traffic and bank lending – and is also inconsistent with both the government and private source purchasing managers surveys. We suspect growth is closer to a 4%-5% annual rate in the current quarter – consistent with a severe profit squeeze on corporations, which are dealing with tight labor markets and weak external demand. The authority’s response is clear as we see ever more infrastructure projects approved, now near 5% of GDP with roughly a three year time horizon. This would be a 1.5%-2% stimulus program, similar to the typical jolt in developed economies during normal economic downturns. However, we suspect that as policy acts with a long and variable lag, Chinese authorities will continue to up the ante on stimulus until they see an actual turnaround. Given the Chinese economy is a direct driver of about 25% of global GDP, a substantial rebound in actual growth toward their 7.5% target could add almost 1% to global output over the next twelve months.
Quantitative Easing Piles On
Closer to home, the latest round of quantitative easing appears to be piling on to a modest recovery that was already being driven by low rates. Housing and autos have been the main drivers of the expansion in the past year – with autos’ surge now fading a bit, but the smaller housing sector ramping up quickly to fill the gap. The industrial production data out this week showed a virtually flat manufacturing sector over the past six months, but still up 3.2% from a year ago. Most of that gain was from the auto sector – which is up 13.2% from a year ago, despite the fact that domestic output in September fell below a 10 million unit annual pace for the first time this year. Domestics are correcting a modest excess inventory situation, exacerbated by import producers boosting incentives to win back market share in this recovering sector. Meanwhile, housing starts surged ahead in September, with single family starts now 43% ahead of a year ago. This overstates the recovery as one-unit permits are up “only” 27% and units under construction up 15%. Still, low interest rates and tightening supply in some markets has sparked the long awaited recovery. Existing home sales were up a disappointing 11% from a year ago – but with both median and average prices up roughly 10%. Some of this gain reflects the 6% decline in the share of distressed sales.
However, more important is the decline in rates combined with easing credit restrictions. The market remains dominated by new buyers (32% of sales) and all cash buyers (28%) — groups that largely do not overlap. For these groups down payments are not a problem, as FHA is the ticket for small buyers and cash only, well…. For all buyers that make it past the down payment hurdle, the realization is that an extra few thousand in purchase price has never been cheaper. Borrowers are paying about 3.5% interest rates — or just $100 a month for an additional $25,000 in value (allowing for property taxes and insurance, but not principal.) For all cash buyers the carry is even less when one considers the alternative uses of money. The best houses do not last long on the market, attracting more sellers – but the quality differences are significant. Poor quality houses still do poorly. We are still far from the bad old days of the rising tide raising all houses.
Meanwhile, total retail sales reflect the ongoing malaise in spending – up strongly on the past three months after three months of decline – but still just 4.0% year on year in the third quarter. Indeed, if we average the past six months, the growth rate is 3.8% at an annual rate – right in line with income growth. The boom/bust pattern suggests a strong Christmas selling season – but weakness before and after unless products are on sale.
Moreover, inflation fears are never far below the surface. The CPI climbed 0.6% for the second straight month in September, after declining -0.3% in the previous four months. Oil prices are largely responsible for the see-saw, but the underlying trend remains clear – both headline and core CPI are up 2.0% from a year ago, and have grown at roughly that rate during the see-saw of the past six months. With inflation at 2.0% and ten year notes at 1.75%, many on Wall Street are concerned about a long bout with financial repression as during and after the Great Depression. Others are concerned about what happens when the Federal Reserve begins to unwind its balance sheet. We wonder if they ever will.
Three from the Road
Three comments caught our attention this week from sources that are best not to ignore. The first was an observation by NY Federal Reserve President William Dudley at the NABE conference that someday the Fed may return to a balance sheet that is driven by currency demand. This poorly understood concept was elucidated in a piece by David Kotok some months back and I steal his central thesis by noting that prior to QE the main reason the Fed increased its holdings of Treasuries was in response to banks’ demand for currency – where the bank traded a security for Federal Reserve notes, most of which were used for transactions outside the US. This is the reason economists have spent little time on the balance sheet (effectively M0), and rather focused on changes in M2, which is reflects growth in bank lending.
Under QE, when a nation buys treasuries by creating an offsetting reserve in the banking system – and then restricts those reserves from being lent (via either reserve requirements or by paying interest on reserves) we see little difference between those excess reserves and vault cash. Basically, banks are still giving the Fed treasuries in return for “currency”, but instead of for the Reserve notes used outside the US, it is for zero interest earning checking deposits used inside the US. Today, investors would rather hold zero interest short term near currency equivalents at banks than invest in longer term risk free securities that do not promise to beat their inflation expectations (or risky ones that won’t provide an expected positive risk adjusted return). It seems like the Fed’s balance sheet is still determined by currency. When will “currency” demand abate forcing the balance sheet to shrink – and the Fed to begin issuing treasuries in competition with the government? We suspect that event is a long way off, because when the recovery accelerates faster deleveraging in the consumer sector will continue to offset stronger credit demand elsewhere. Moreover, baby boom investors’ fear of rising inflation during a recovery will likely outstrip the rise in ten year treasury rates as the deficit recedes keeping expected real rates on longer term investments negative and demand for “currency” high.
A related comment was from Paul McCulley, chair of the Global Interdependence Center’s Global Society of Fellows, in reply to a question about when we would pay down the debt. He replied, the US is a going concern and a going concern always has debt – the question is only how much. Liquidating firms pay down debt, not going concerns like the US government (or one might add the Federal Reserve.) Again, we expect growth will erase a lot of concerns about levels of debt if and when deficits begin to recede.
Finally, there was a projection by former Pennsylvania Governor Ed Rendell that Romney may win the popular vote, but lose to Obama in the Electoral College. Indeed, this is a concern high on our list of fears about the fiscal cliff. If Obama wins Ohio and either Nevada or Iowa, in all of which he currently leads in the polls, he would win the Presidency – despite the fact that current national polls suggest Romney up by 2% or over 2.5 million votes. Gov. Rendell pointed out a similar occurrence was possible in 2004, when Bush beat Kerry by 3 million votes, but just 100,000 separated them in critical Ohio. We have stated that an outcome that puts the President and Senate in the same party would be good for a fiscal cliff solution. But this possible scenario would leave a sour taste in many mouths – especially if the Senate were to end up fifty-fifty with committee chairmanships dependent on the Presidency. Tomorrow’s debate on foreign policy is key – but even more important is the amount of money being spent in Ohio to win residency in the Oval Office.