The Trifecta Bet
The Republicans took back control of the Senate with the mid-term elections (poor Jeffords). The quick analysis was centered on the possibility of easing the double taxation on dividends. While this is a noble pursuit and is good policy long term, with the dividend yield at an anemic 1.7% and with companies struggling with profitability, it is doubtful that companies will be able to increase dividend payments. One development that has not been discussed as much is the high possibility of deficit spending. If the Republicans cut taxes and increase spending to fund the war on terrorism, the bond market will likely anticipate an increase in the supply of government bonds, pushing long-term yields higher. Any increase in long-term interest rates could have dire consequences on a perceived economic or stock market recovery.
With the Republicans in control of all branches of the government, one concern popping up in conversations is who will get the blame if/when the recession really hits and severe financial fallout ensues. Or what last ditch efforts will be made to hold the economy together. Right now Saddam looks to be the excuse for any additional economic weakness. Of course, this assumes the government is cognizant of the economic and financial problems we discuss here. One glimpse that this is the case is the pending departure of Larry Lindsey, current economic advisor to the President. Based on the transcripts of the 1996 FOMC meetings, Lindsey appears to understand how the economy has been transformed buy the bubble. In a 1996 Fed meeting Lindsey said, "I think it is far better to do so while the bubble still resembles surface froth and before the bubble carries the economy to stratospheric heights." As one of the few that recognizes the important issues, we think it is a mistake for Lindsey to leave the administration.
Talking about solutions, leave it to the Fed to perpetuate the situation and not worry about stopping the maladjustments. The second part of the bullish trifecta for the day was the Federal Reserve rate cut. Most investors were only expecting a 25 basis point cut, but were handed 50. An immediate debate ensued asking if the Fed panicked because it knows something that investors don't. In the announcement the Fed said, "today's additional monetary easing should prove helpful as the economy works its way through this current soft spot." The Fed sees the "current soft spot" stemming from, "incoming economic data have tended to confirm that greater uncertainty, in part attributable to heightened geopolitical risks, is currently inhibiting spending, production, and employment." Two months ago the "emergence of heightened geopolitical risks" was partly responsible for the "considerable uncertainty persists about the extent and timing of the expected pickup in production and employment." We don't think the possible war with Iraq or another terrorist attack is causing consumers to inhibit spending. Why is the Fed focused on geopolitical risks and not the multiple homegrown problems: record debt levels, continuing layoffs, plunging consumer confidence, increasing bankruptcies, soaring insurance costs, lousy corporate profits, underfunded pension plans, crooks running billion dollar companies into the ground, the US dollar trading about 12% lower than at the beginning of the year, and oh yeah, the considerable stress in the credit markets?
But the Fed thinks another 50 basis points can get the economy going. Unfortunately, lower interest rates are supposed to encourage borrowing, which spurs consumption. The problem with that is the consumer is proving to be tapped out and nobody wants to lend to businesses. Plus, I doubt there are too many CEOs that are saying, "Okay, now that the Federal Funds Rate is 1.25% I think we can increase capacity and hire 1,000 workers." The economic backdrop has not changed. The economic quagmire we are in is a result of easy money and easy money will not solve it. Unfortunately, I think we are past the point of no return.
The lull in business investment, especially technology and telecom has devastated companies like Cisco. Cisco's earnings were the last race on today's trifecta card and at first it seemed to be a winner, but upon further review Cisco said, "we expect revenue in the second quarter of fiscal year 2002 to be sequentially flat to down 3 to 4 percent." So it looks like the bulls will not be able to cash in the ticket. We will have to see if winning two out of three will have any value.
The recent low interest rate environment has pushed investors to assume more risk as they chased after higher yielding instruments. The problems associated with risky investments have surfaced in the ABS market. We have long warned of the coming dangers of the ABS market and the economic implications, namely credit markets seizing up. This would diminish the amount of credit available to consumers to keep the economy going. This week's blow up of New Century Finance and with Ambak announcing it owned almost $150 million worth of its bonds showed that due diligence was not performed. Last Friday, Doug Noland detailed how, just by reading publicly available information on New Century Finance, it didn't pass the smell test.
Merrill Lynch is forecasting that this holiday shopping season may be the worse in over a decade. Trying to put a cheery spin on this forecasts, Merrill sings the "Twelve Nays of Christmas:"
12th: Slowing Real Wage and Disposable Income Growth - Both wage growth and disposable personal income growth, which propped up consumer spending during last year's recession, appear to finally be slowing.
11th: Plummeting Consumer Confidence - Consumer confidence measures are at eight-year lows.
10th: Impending Threat of War In Iraq - The threat of war in Iraq is tightening consumer wallets and the outbreak of war could keep consumers glued to the TV.
9th: Rising Oil Prices - The threat of war has boosted oil prices by nearly 50% year-over year.
8th: Backed Up Merchandise At West Coast Ports - The backlog of containers at the West Coast ports could result in retailers marking down late arriving goods.
7th: Low Financing Rates May Boost Auto Sales - Lower interest rates and increased promotional activities may boost auto sales, to the detriment of general merchandise sales.
6th: No "Must-Have" Fashion - For the second consecutive year, there are few, if any, "must-have" fashion items to drive apparel sales.
5th: Six Fewer Shopping Days - This year's late Thanksgiving will result in the shortest possible Christmas selling season (26 days). We estimate that this factor could reduce Christmas sales (Nov/Dec combined) by 1.6%.
4th: Declining Payrolls & Increasing Unemployment - Payroll declines and increasing unemployment will pressure consumer wallets.
3rd: Potentially Bloated Inventories - Weak sales in September and October may leave retail inventories (most notably at the department stores) somewhat bloated, leading to increased markdowns over the next two months.
2nd: Stock Market Declines Cause Negative Wealth Effect - A 40% decline in the S&P 500 over the past two years has hurt consumers' perception of their own wealth and may limit discretionary spending.
1st: The Post-9/11 Sales Surge - Last year's "Post-9/11 Sales Surge," when consumers increased their spending on general merchandise at the expense of travel and lodging, has created difficult comparisons for broadline retailers.