A Message For Those Who Look

Just how stupid are we? This is a rhetorical question of course, but a practical question as well given the current circumstances. The problem with the social ‘sciences’ is that you usually can’t perform experiments. Economics suffers from this problem. But, every once in a while you get people who run the experiment for you even if they don’t know it. We have what may be an answer to a serious question right before our eyes, if only we ask the right question.

Let’s go back in time to the 1990s. The Clintons were in office and the US economy was doing fine. We were basking in the confluence of the Reagan revolution in economics and the Clinton evolution in politics. This nation had rediscovered market-oriented economic principles. Our government was trying to fix problems like welfare. Sure, we had the biggest tax increase in our nation’s history, but it wasn’t so large as to derail a private sector return to leadership in the economy. We had turned-back the first socialist attempt to take-over healthcare. The days were sunny and warm and the nights were alight with stars.

At the same time, in China there was a tumult. It was only a couple of years since the Tiananmen Square massacre in Beijing and the future of Chinese reforms were in doubt. Aging Chinese leaders were arguing about which socialist path China should take. Then, Deng Xiaoping returned from retirement to urge capitalist reforms. Though we cannot be sure he actually said it, he is credited with saying “to get rich is glorious.” China would take a capitalist road to enhance the lives of her people and increase her strength.

If we fast-forward 20 years, we see that the paths these two nations were on have converged. China is more capitalist while America is more socialist. How’s that working out for each side? A couple hundred million Chinese have left abject poverty behind and reached a working-class lifestyle and standard of living. Tens of millions of Americans have lost their homes, lost their jobs or given up on their futures. There’s a message in there if we only look.

You needn’t just look just at China. Brazil is another example where adoption of free market principles has lead to huge advances for the people. A devoted socialist, Lula de Silva turned his back on his arguments from the 70s and 80s to attack Brazil’s problems in 2000s with proven free market solutions. There’s a message in there, too.

There are many examples of each side of this argument. Britain was the leading industrial, commercial, military and social power in the world for 150 years. Then, between the World Wars she was overtaken by America in many of these roles. Starting in the 20s, Britain adopted socialist answers to many of her problems, but the problems only got worse. It took Margaret Thatcher starting in the late 70s to partially reverse Britain’s decline. She closed or sold state-owned industries and deregulated many businesses. There’s a message in there, too.

Which path do you think our grandchildren will think was the right one?

Issue of the Week

The House of Representatives, the lower chamber in our bicameral legislature, was presented a bill that would simply raise the debt ceiling on US Treasury borrowings by a mere $2.4 trillion. There were no riders creating elevated trains in Dubuque or exemptions from duties on Panamanian imports of cocoa, let alone any limitations on how the extra $2.4 trillion would be spent. The bill was voted down by a better than two to one margin, with nearly half of Democrats voting against along with all but a few Republicans. So, the ‘clean’ bill that the Administration had suggested failed to pass. This probably means we will have to hear more wrangling over our budget all summer long.

That is probably a good thing. We need to look in every nook and cranny of the budget to see where money can be saved. Nothing should be off-limits. Politicians should foreswear demagoguery when it comes to Social Security, Medicare and Medicaid. But, we doubt they will do that, just like they wouldn’t vote for a ‘clean’ increase in the debt limit.

What we find amusing is that the Treasury will still sell $66 billion in long-term debt next week, essentially rolling-over the maturing debt and adding to that a modest amount of debt availability. How we can still sell new debt, rather than simply roll the maturing debt is a marvel. Every week, the Treasury sells 13-week and 26-week Treasury Bills. Every month, they sell 3-year and 10-year notes, and 30-year bonds (which used to be sold only once a quarter). Every four weeks they sell 4-week and 52-week bills. They have started selling 2-year notes, 5-year notes and 7-year notes every month as well. On a quarterly basis, they sell 3-year and 10-year TIPS. Every six months they sell 30-year TIPS.

It takes a lot to keep up with the almost $9 trillion in publically owned Treasury debt (the remainder is in trust accounts, owned by state and local governments, etc., we’ve discussed this in the past). Especially since the average maturity of the debt is still about two years.

Economic News

Case-Shiller home prices fell again in March, dropping by 0.8% on the month. This marks the eighth straight month that house prices have fallen.  The survey showed 18 of the 20 cities followed saw declines in house prices. Only Washington, DC and Seattle bucked the trend to show rising house prices. The worst record over the last 12 months now belongs to Minneapolis, Minnesota, which saw much less deterioration in the earlier decline in home prices.

Consumer Confidence fell again as well to 60.8 in May from 65.4 in April.  The decline was attributed to a slowing job market as well as the tornadoes across the South and then again in Joplin, Missouri.

Institute of Supply Management manufacturing survey disappointed Wall Street. In April, the index read 60.4, a decline from March but still very solid. In May, the index fell again to 53.5 and that was a much bigger drop than anyone had expected. Still, numbers above 50 indicate continued expansion in manufacturing and we went through much of the huge economic expansion in the 90s with numbers in the high 40 range on this index and the economy seemed to do quite well, regardless. But, it is another sign of a slowing economy that manufacturing, which has been a leading sector in this recovery, has slowed.

Productivity in the US economy in the first quarter rose 1.8%. The gain was better than expected and in line with the trend of roughly 2% productivity gains. Unit labor costs rose 0.7% for the quarter.

ISM non-manufacturing was better in May, the first good news on the economy we’ve seen in a while. But, the services report was a lot worse than expected in April, so this may be just a modest equilibration. The index at 54.6 was up versus 52.8 in April. Within the index, the segment on new orders rose, employment rose but so too did prices.

The monthly Employment Report from the Bureau of Labor Statistics was a big disappointment to nearly everyone except the roughly 54,000 folks who managed to get jobs in May. That is misleading because the 54,000 is a net number of new workers minus displaced workers. Manufacturing actually lost jobs (-5,000) while services added 51,000 and the government sector shed 29,000 jobs. The unemployment rate went up to 9.1% from 9.0% in April, this is the highest unemployment rate since December. Average hourly earnings rose by 0.3% or roundly $0.06 to $22.98.

Adding to the sour note struck by this report, the last two employment numbers were revised down by 12,000 in April and 25,000 in March. Just a week ago the guess on Wall Street was for a gain of about 175,000 jobs. So, what happened? Partly it was fall-out (pardon the pun) from the earthquake and tsunami in Japan which disrupted supply chains causing shortages of crucial parts for many manufacturing processes. This helps explain why the manufacturing job losses were concentrated in the auto sector. Partly, it was the impact of gasoline prices robbing consumers of buying power. Partly, it was McDonalds hiring a bunch of people in April that threw-off the Labor Department’s method of accounting. Partly, it was the notorious birth/death model that tries to estimate the number of new businesses being created and old businesses going out of business.

So, what does all this mean? That’s subject to a lot of opinion and conjecture, but it probably means we’ve had a slow patch in our recovery. The same thing occurred last spring when the Greek crisis focused the world’s attention on the fiscal problems in the developed world and caused many governments to begin austerity programs. The government sector in most European nations is above 25% of the economy and is over 40% in some. Even a small cut-back in a quarter of the economy will make a big difference in growth rates. We saw nothing like that here, the Obama administration is spending like there is no tomorrow (to what end?). But, that did mean that a few fewer widgets were bought by those governments, their employees, their pensioners and others on the dole. That translates into less overall spending and so less overall demand. So, the suppliers to that spending have to retrench and that impacts all sorts of people across the globe. We have seen a small version of that in the state and local government arena as states big and small have had to cut services, cut employment and cut spending to live within their budgets.

Add to those effects the impact of weather and calamities both domestically and globally and you get a small negative for growth. Economies in much of the emerging world have actually been trying to slow their growth, and this will have an impact on people who sell goods to those markets. It all adds up.

Weekly Stuff

Recalling that the week we will be talking about is just the last three days of last week, since we included last Tuesday in the week prior so that it would line up with the month-end, it was the worst week in quite some time. We went back to the beginning of the year and didn’t see a week where declines in US stock indexes were as bad as this past, short week. Now, our short week was worse than the calendar week, since Tuesday was up as we missed it in our week. The market is abuzz with the idea that the market has been down for five consecutive weeks and that this is somehow indicative of something. We don’t understand why that after five down weeks something good couldn’t come of the situation, but already the calls are coming in that this pundit or that pundit is saying the sky is falling. Okay.

What lower prices usually lead to is higher prices. Sometimes the wait times are irregular and often quite long, but sooner or later prices tend to rise. This is because there is no magic correlation between what happened eighty years ago or thirty years ago and what is going to happen next. There is a strong correlation between what is happening in the fundamentals of the market and what will happen to prices next. The fundamentals are all screaming that stocks are going higher. We have earnings rising, dividends rising and cash flow rising. That is due to a strong corporate sector in an otherwise slow-growing economy. We have virtually no competition from bond returns as rates are at some of the lowest levels we have seen in years and that can be said for government, corporate or mortgage bonds.

The only real competition with US stocks are foreign stocks, which face much the same combination of better underlying fundamentals and little competition from yields. Both the real estate and commodities spaces have their own set of question marks about the future. Commodities need a fairly ebullient economy to justify even higher prices for many industrial commodities. Commercial real estate can compete if you want to buy a whole building but if you look to buy real estate securities, you have to swallow the large premiums you must pay over the underlying property prices. So, stocks are the market with the best risk/reward relationship right now. Besides, these are small, volatile markets and not usually the core of anyone’s investment portfolio.

That could all change. If rates start to go up, we could see the competition from yields start to hurt by the time they got to 5% or so. Of course, by that time most investors in bonds would be so discouraged that they might not recognize the opportunity before them. But, it takes 5% rates to make stocks unattractive given today’s fundamentals. By the time we get to 5% rates, that may have changed.

We have seen investors get quite cautious lately. That is usually a good thing. When investors are bullish, they never seem to make much money. But, when investors are cautious, they often do surprisingly well. Funny, but that is the crux of contrarian analysis.

Anyway, what got us started on all this was a drop in US stocks of more than 3% in three days (nearer 5% for the small caps). The selling seemed to be pretty darned indiscriminant most of the time. We had risk-off come into play, but then when the dollar started dropping on Friday, there was no accompanying risk-on. Foreign stocks did rather better but the falling dollar was a big piece of that. The dollar was off more than 1% against a basket of developed market currencies.

Bond prices were pretty solid across the high grade sectors, but especially in the Treasuries. Rates on 10-year Treasury bonds dipped below 3% on Friday, but didn’t close there. Rates in Euros, pounds and other currencies were generally higher.

Real estate securities were down 3% in US markets but less overseas. Commodities were mixed with energy prices down, industrial metals down, grains mixed and precious metals mixed. Usually, when the dollar is down commodities are pretty much higher across the board.

Have a great week.

Karl Schroeder, RFC, CSA

Investment Advisor Representative

Schroeder Financial Services, Inc.