The Economy Just Keeps on Truckin'
The 2.3% surge in retail sales for January must have warmed the hearts of the bulls. The consumer it seems just keeps on truckin'. And that in turn keeps the economy humming. Economists scurried to revise upwards their economic forecasts. First quarter 2006 economic growth is now median forecast at 4% and upper end forecasts from such luminaries as Morgan Stanley are as high as 5.9%. And this was surmised even if the pace of retail sales slows in February and March. After the anaemic GDP growth pace in the 4 th quarter 2005 of 1.1% everyone was just positively giddy.
The market got giddy as well as the Dow Jones Industrials leaped 136 points closing over 11,000 once again. But before we all get too excited let's keep things in perspective. After hitting a high near 12,000 back in January 2000 the market spent the next 16/17 months trying to break past 11,000 stuck primarily in a trading range between 9,800 and 11,000. Of course it failed despite several forays over 11,000 finally succumbing into the bear market that bottomed in October 2002. The rally back in 2003 was impressive but it hit its first peak in February 2004 near 10,800. We finally hit 11,000 once again in March 2005. This one marks only the third foray past that point over the past 24 months.
That means that the better part of three out of the past five years has been spent trying to get past that illustrious point. Given the inability to break through and the fact that we are entering the fourth year since the lows of October 2002 investors are becoming weary. Ben Bernanke speaking for the first time to the House Financial Services panel noted that rate hikes "may" be necessary as the threat of higher inflation persists despite a year-and-a-half of steady tightening. Higher interest rates are poison to the stock market so while the fervour in the market was cooled, Bernanke survived his first major testimony and the Dow Jones Industrials followed through with another 30 points.
We are reminded that when the Dow Jones Industrials first hit 1000 back in 1966 that over the next 16 years the Dow approached, hit or slightly exceeded that point on five different occasions. These important key numbers whether it was 100, 1000 or 10,000 act as natural barriers. That we exceeded the 10,000 level to 11,000 does not mean that the natural barrier has been broken as 11,000 is 1000 + 10,000. The pause at these levels is measured in years not months as we saw in the 1966-1982 period before we left 1000 behind for good in 1983. In another period the Dow Jones Industrials (and its predecessors) first hit 100 in 1906 then it took until 1924 to leave it behind for good (except for the Great Depression collapse in 1932). Thus far we have only spent roughly five years trying to break through 11,000 when the average period in the past two cases took about 17 years.
By some measures the market is struggling whereas with other measures it appears to be doing fine. Volumes in this three year plus rally have not been as high as we saw to the downside 2000-2002 and certainly no where near the huge volumes seen at the end of the last century. The bulk of this move was made in 2003 and early 2004. While the TSX led by the oils, golds and metals put in an impressive 45% gain in the first part of this rally the second stage has gained only 35%. The US markets have fared worse. The S&P 500 gained more than 38% in the first phase but has added only 11% since. The NASDAQ was a huge winner gaining 70% in the first phase but has added also only 11% since. The first phase lasted roughly 15 months while the second up leg has lasted almost two years and we are still looking for our top. Still the NASDAQ remains down over 55% from its all time highs. Only the TSX has managed to go to new highs. But then once again that is primarily although certainly not exclusively because of the oils, golds and metals.
Other indicators seem surer as the advance decline remains in an up mode but the NASDAQ A/D line is diverging quite negatively. The new highs/new lows indicator has also consistently moved to new highs as well. That remains a very bullish indicator.
The consumer makes up roughly 70-75% of the economy. So goes the consumer so goes the economy. Employment numbers remain low and both the US and Canadian economies have added millions (and hundreds of thousands in Canada) of new jobs since the very mild slowdown of 2001/2002 following the 9/11 attacks. The Canadian unemployment rate is at its lowest in decades. And while the US economy's unemployment rate has not fallen to the levels of the late Clinton years it too has been falling.
We admit it is a very different economy than one we had in the mid-seventies and early eighties and even the recession of the early 1990's when we had three very steep recessions. Blue collar jobs have been falling for years while sales, professional, managerial and yes services (the infamous McJobs) have been growing. It is a different economy. The highly volatile blue collar job sector has been replaced by a far more stable type of job in what is now a service economy. In that respect we do agree with the research of GaveKal as outlined in their book "Our Brave New World" www.gavekal.com that our economy is more stable because of platform companies (companies where the US has the high end jobs in design and sales while the manufacturing process is carried out in foreign countries primarily in Asia), globalization and outsourcing.
The model is bringing higher margin profits to the US companies while putting the volatile manufacturing risk in foreign countries. Cash flow for US corporations has been rising as is R&D spending while spending on plant and equipment has been falling. This has a major booster to productivity growth. The next to move to the model of the platform companies could very well be the big auto companies given their current problems. Jobs have proliferated in finance and insurance while assembly line jobs disappear. Note the huge growth of mutual funds in the past decade and hedge funds in the past five years. This is the new economy.
But the new economy has also brought considerable and growing imbalances. The largest imbalance is the US's trade and current account deficit financed by foreign countries primarily China and Japan as they desperately recycle their savings back to the US in order to prevent their currencies from rising. Add in as well the growing huge budget deficit to finance the so called "war on terror" and homeland security. But the new spending priorities trump funding for domestic issues. The recent record budget presented by the White House called for increased spending on the military and homeland security while key items for people such as Medicare and education face huge cuts.
GaveKal has no problem with this nor do they have any problem with the growing wealth disparity and wealth concentration as we outlined in our previous "Scoop" "The disappearing savings". Social stability is not attained in a society with huge disparities in wealth. Millions both here in Canada and in the US live pay check to pay check and if the economy ever tipped they are the most vulnerable who would be thrown out in a society where the safety nets built up following the Great Depression have been torn down. Overall, the consumer's debt to income stands at almost 125% up sharply even over the past decade. Given the high concentration of wealth the likelihood is that the debt/income imbalance is higher for a much higher proportion of society than the average would suggest. And now with the change in bankruptcy rules in the US far more are going to be in a permanent state of debt with no way to get out from under it. Bankruptcies both here in Canada and in the US have consistently set records every year but the ability to start over again has been the way for many to get out from under the burden.
The US$ remains overvalued by at least one-third. The huge global financial imbalances remain a clear threat to the US$. Japan, China and others are concerned about the growing imbalance. They are trying to diversify. As much as they want to keep their currencies down to encourage their huge exports to the US they are caught between a rock and hard place with the growing US$ surpluses in their current accounts. The question is for them how do they manage sound monetary policy when their bank accounts are flush with a currency that isn't there own. The answer is they can't run sound monetary policy when they are captive to another country. And vice versa. The US and Japan and to a lesser extent China are swimming in a sea of liquidity. It this huge pool of liquidity that keeps the economies humming (or truckin') and of course causes further imbalances with inflated asset prices or housing bubbles. The other question is then that they can't sop up any of this excess liquidity by raising interest rates for example for fear of triggering a financial crisis.
But things sometimes have a force of their own. A financial collapse, a war or major confrontation for example could change everything in a hurry. Recall how the collapse of the Thai Bhatt in 1997 triggered the Asian flu (not the bird kind) then again in 1998 when the Russian Rouble collapsed and triggered the collapse of Long Term Capital Management (LTCM) and a subsequent bail out and huge liquefaction of the banking system. We survived those dislocations as we survived the war attack of 9/11 and its subsequent economic fallout through huge liquidity injections. But all of this just creates a massive build up and the global financial imbalances just get bigger. Trying to predict what event might trigger or the timing of a collapse is conjecture as all we as risk managers can do is point out the possible risks and watch for technical distribution patterns and cycles in the markets to try and batten down the hatches.
The risks are clear. While everyone expects the Fed to stop interest rate hikes very soon the current mood is one of complacency that we are near the end. We wouldn't be so smug. Chairman Ben, who is not Greenspan, may end of hiking rates higher than everyone expects. Excess liquidity in the financial system is good certainly in the early stages of an economic cycle and is probably good even as the up cycle continues along. But when we get into the latter stages of the economic cycle, and that latter stage can still play itself out in years, not months, it becomes bad money. It creates complacency and smugness that nothing can go wrong and if a hiccup happens we will just flood more money into the system. We have been at that stage for years long having passed the point of early stages of coming out of a recession.
War is the other major risk and here we continue to hear or read nothing that has deterred our thoughts that Iran is fully on the radar screen for bombing quite possibly sooner rather than later. The noise and rhetoric is the alleged nuclear weapons program (where they are at the best calculation years away from having any) but of more immediate importance is the clear threat to US$ and US economic supremacy the Iranian oil bourse trading in Euros will mean when it starts in March. But Iran is not Iraq and allies of Iran like Russia and China will not sit idly by. As well Iran has spread its nuclear facilities all over the country and they are buried deep underground. A limited nuclear attack to dislodge these bunkers has been conservatively estimated that it could kill at least 10,000. Invading Iran is out of the question as the country's mountains and considerably larger and better equipped army and air force would mean very high casualty rates. And as well a probable blockage of the Straits of Hormuz choking off the world's oil supply.
So whether it is economic or war (which is economic as well) the risks to the system are there. The timing and the trigger are always the speculation. But we do not buy into because the economy is fundamentally different from what it was in other periods if recessions and depressions that "this time it is different". It is not different just what is behind it and how it plays itself is different. The US consumer will have nothing to hide behind if a shock to the system comes. And when they stop buying the cheap goods from Asia all the design and sales teams in the world will not be able to revive the fallout. We continue to believe that gold and precious metals as the ultimate currency are key for investors to hold in hard form of at least 10% of their portfolios.