Sense on Cents

Thanks to the friend of Sense on Cents who shared this commentary on our economy and markets. This commentary for clients emanated from a major Wall Street bank. I believe the writer’s sentiments are consistent with mine in terms of my assessment of a ‘walking pneumonia’ economy.  The writer’s comparison of our economic recovery to a Pyrrhic victory is very interesting. I appreciate his utilization of another ancient Greek lesson as we try to recover, move forward, and live to fight another day.

>More work to do for monetary policymakers.

>Global economic activity unlikely to relapse, but expect growth to stay lackluster.

>Markets more likely to climb than collapse under the wall of worry.

The military victories of ancient Greek King Pyrrhus over the Romans during the third century B.C. were notable for the devastating losses that his armies suffered in the process. Indeed it is said that after his triumph at Asculum, Pyrrhus remarked to his officers that “another such victory and we are undone”. In many ways, last week’s formal pronouncement by the National Bureau of Economic Research that the U.S. recession ended in June 2009 had the distinct feel of a Pyrrhic victory, underlined by the sickly figures released on housing demand.

Existing home sales for August may have risen by 7.6%, but this only came after July’s 27.0% plunge, leaving the level of sales at its lowest in 15 years. Meanwhile the NAHB survey of homebuilder sentiment held at a post recession low of 13 (the June 2009 reading was 15), while the buyer traffic component of the index fell into single digits.

What remains most concerning about the inertia of demand-side activity in housing (and, for that matter, of activity in other early-cycle, rate-sensitive areas such as the auto sector) is its failure to respond to the vast doses of policy support heaped on by both the Federal Reserve and the federal government. The major risk at this stage is that, without a continuation of such external support (in the form of lower interest rates, tax incentives and loan modifications), prices could fall further and inflict even more damage on household wealth. Real estate makes up around 25% of total household assets in the U.S., and further price declines would likely force the saving rate higher (see chart), cutting into consumption as a result.

GDP has already decelerated significantly from its Q409 peak, and with the growth impulse from fiscal support fading, further contraction in private demand would make for an uncomfortably high risk that the economy slips back into recession. Our view is that policymakers are committed to insuring against this outcome, and we would therefore not be surprised to see more monetary support in the balance of the year. Neither it seems would financial markets which – after some initial unease following the Fed’s August 10th decision to reinvest its maturing mortgage holdings into Treasuries – appear to be embracing reflationary trades again. So far this month, for example, stocks have risen by close to 10%, oil by 4.2%, the Australian dollar by 7.7% and palladium by 11.5%.

However, the reaction from the bond market may be more revealing. It is notable that the 14 basis point rise in nominal 10-year Treasury yields so far this month has been entirely driven by higher inflation breakevens. Real yields have in fact fallen by some 15 bps. And the picture in the eurozone and U.K has not been dramatically different. Real yields in both markets have risen over the same period, but only marginally (by 4bps and 1bp respectively), and thus the rise in nominal yields has also been dominated by higher breakevens. The message appears to be that while monetary easing should support nominal asset values and put a floor under consumer prices (keeping outright deflation at bay), its potential impact on real economic activity remains in question.

Nonetheless the latest bout of U.S. dollar weakness gives us some degree of comfort that the Fed is doing enough to avoid another sharp downturn in the global economy. A weak dollar is typically consistent with a lackluster, but not crashing U.S. economy, while a stronger dollar tends to occur either when the U.S. is accelerating smartly relative to the rest of the world (which seems less likely in the current environment) or when a sharp U.S. slowdown leads to a global panic – this has historically made for a ‘smile’ pattern in the dollar, with more appreciation as U.S. growth significantly underperforms or outperforms the rest of the world (see chart). Thus, a dollar that remains on a downward trend looks to be consistent with other risk assets continuing to hold up.

Sentiment took a turn for the decidedly more pessimistic in April and has remained gloomy as the economic data in the U.S. have deteriorated over the ensuing months. But even though many of the impediments to the market’s progress this year are unlikely to be banished in short order, we view low and stable inflation (not deflation), moderate growth (not a double-dip recession) and, crucially, supportive central banks as the most likely combination with which investors will be presented over the coming quarters. To the extent that current expectations reflect a worse outcome on any of these fronts (as surveys of investor positioning, mutual fund flows into equities, relative stock-bond valuations and, arguably, levels of real yields might suggest), the recent outperformance of equities could well persist, especially as we enter a seasonally favorable time of the year. Given the uncertainties – not least over private sector deleveraging in the West, persistently high levels of spare capacity globally, the viability of fiscal austerity in Europe, tax policy and legislative reform in the U.S., the ultimate price implications of quantitative easing and the potential for new trade tensions – we still expect any path higher to be bumpy and protracted. But as long as the worst fears relating to these problems remain unrealized, markets seem more likely to climb than to collapse under the proverbial wall of worry.

Larry Doyle

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I have no affiliation or business interest with any entity referenced in this commentary. As President of Greenwich Investment Management, an SEC regulated privately held registered investment adviser, I am merely a proponent of real transparency within our markets so that investor confidence and investor protection can be achieved.

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