“It is a pickle, no doubt about it.” – The Oracle, in The Matrix Reloaded
There was a time when I might have found it difficult to explain the investment business to my son. No longer. All I have to do is tell him that some of us try to guess what the Fed’s next move will be, some of us criticize what the Fed’s last move was, but mostly we sit around waiting to see what the US central bank says. There isn’t much more to investing than that, really – who needs a CFA?
It would be easy to draw that conclusion when comparing events of the last few weeks with the changes in asset prices the last few years. It seems that the whole world now depends on the Fed. That point was brought home to me not only by the action in bond and stock markets alike the last few weeks, but also by the latest report from the International Monetary Fund and its current chieftain, Christine Lagarde. After a week in which turmoil in markets around the globe was all laid at the doorstep of the Fed (Japan is running second), the IMF and Madame Lagarde weighed in with their own discourse.
The Fund had a lot to say about US policy, in brief saying that it needed to be very careful about destabilizing the rest of the globe with notions about dialing back on quantitative easing, as well as the necessity of overturning the sequester. The irony is that Mme. Lagarde seemed to be advising the US not to follow the Europe’s own policy of fiscal austerity with no quantitative easing.
If you read the report, you’ll see the obligatory nods to German sensibilities about fiscal rectitude. But it’s also clear that the rest of the world is alarmed by what might happen if the US markets start to weaken. With Europe still locked in recession (and political gridlock), China in a slowdown and a sudden rush of capital out of emerging markets, the notion that the US might not be the reliable standby that will somehow bail everyone out has plainly rattled a lot of thinking.
Both the World Bank and the IMF cut their outlooks for US growth this week, and financial markets have been shaken. Not so much the mild three or four percent decline in the S&P from its all-time high – less for the Dow – but also because it’s becoming clear that yet again, a lot of leveraged and complex trades have been multiplying that are tied to everything staying the same – in particular, Fed policy. The turmoil in the much of the globe’s fixed income and currency markets, in part also due to the yen’s volatility, seem out of proportion to the revelation that the Fed won’t forever pursue a $1 trillion annual rate of bond purchases – expanding its balance sheet, printing more money.
Countries from Brazil to Thailand to India that had been lowering rates to keep the currency competitive with the yen, suddenly found themselves forced to intervene in forex markets to keep the value of their legal tender from plunging any further. The press and Street communiqués are filled with talk of capital outflows and panicked sellers of bonds and currencies. It’s difficult to say whether this is a routine adjustment or the tip of something much larger, because the latter usually start out looking just like the former.
It’s been “frustrating” to the Fed, as revealed through its chief indirect press source in the Wall Street Journal. The latest leaks and past behavior suggest that the central bank will be trying to be put some of the toothpaste back into the tube next Wednesday, though it remains to be seen whether Mr. Bernanke will reassert the bank’s right to begin “tapering” its bond purchases. But the Fed has some serious problems to confront, and it won’t do us any good for them to imitate our elected leaders in Europe and the United States by burying their heads in the sand about them.
Number one, clearly, is that global markets have become too fixated on quantitative easing. Not only is it an unhealthy state that defeats price signaling in the marketplace, it makes any policy withdrawal difficult. In the central bank’s ideal world, the underlying economy is supposed to grow to a point that the Fed can smoothly hand off the baton to the private sector and quietly fade into the background, first through easing back on bond-buying and much later on allowing rates to rise.
Problem two is that so long as the Fed keeps busy, politicians will want to do nothing, hoping that as time goes by the economy might get better on its own and spare them difficult, and more importantly, unpopular decisions. They’re not so different from the central banks in that respect .
Problem three is implied by the recent cuts in the US outlook. Our economy is slowing down, a point I’ve been making for several months, and lately seconded by the World Bank and the IMF. Wall Street has been chanting its perennial forecasts for a pickup in second-half growth, but the trend in the economy is not in that direction. Right now we are headed for a recession sometime in 2014. I’m not predicting one because the outcome is by no means inevitable, but the Fed is left with the conundrum that if it continues its current policy, it’s very likely that nothing happens with fiscal policy unless and until there is a crisis.
When one looks at the recent experience of the Bank of Japan, it raises the question of what might happen in our own country if we indeed start to slip towards recession in six month’s time – or even if anything else bad happens, like a Middle East war sending oil prices soaring. The Fed is already stretched. If it doesn’t start to reduce its purchases of bonds soon, what will it have left in its back pocket to combat a potential recession in 2014, or any kind of crisis in between?
It’s not a good situation. Yet don’t discount the market’s ability to regain its capacity for looking past it. Right now we’re in June, a traditional month of anxiety about the full-year outlook when the market has been on a rally. Falling prices mean more anxiety, and more anxiety means more media coverage about what could go wrong. The psychology of the market has changed, make no mistake, but a bullish Fed next week could reverse it. Markets rallied Thursday on the retail sales report beating consensus, yes, but also because they were oversold and the Journal writer with connections to the bank and appearing in the video link above blogged that the Fed wasn’t about to reverse course.
Despite the recent weakness and US futures being sharply down Friday night, there is good reason to suspect that markets are more likely than not to be up next week, unless Mr. B. decides to go off the reservation. Going by what was said to the Journal, the Fed will emphasize low rates and try to dampen talk of immediate tapering, perhaps leaving it on the table as a theoretical something that needs to happen in the fullness of time as the unemployment rate declines – whenever that is. They seem to still be afraid of the markets and stocks usually rally up to the meeting anyway.
Another good reason can be found from looking at the open option interest on the iShares Spyder S&P 500 ETF (SPY). It looks to me like a close between 164 and 165 extracts the maximum amount of loss from retail investors, so expect something in that region unless the Feds tips it all over. If bigger trouble does come, it will probably come later in the summer. Not because of any specific events, but because that’s the way these episodes usually play out. The initial fright is followed by anxiety, then reassurance, then another rally, and then a spike in volatility in August when everyone is on vacation. Pass the pickles.
The Economic Beat
The report of the week was May retail sales, as might be expected, seeing as it’s typically one of the top three monthly reports for market impact (the other two being FOMC statements, which aren’t quite every month, and the job reports).
As noted above, the market’s reaction was probably a mix of relief and being oversold. The headline number of 0.6% was slightly better than the consensus estimate of 0.5%, and that factoid alone, given the dominance of robot and high-frequency trading, was probably responsible for half the gain (“buy the beat”).
The ex-autos number was a tenth light, coming in at 0.3% versus consensus of 0.4%, but the ex-autos ex-gas number of 0.3% did match consensus. That’s a lot of ways at looking at the data, and you may well wonder what they really mean.
The shortfall in sales excluding motor vehicles got a pass because autos are one leg of the magic triumvirate that will rescue the US economy, and by extension, the globe: Autos, housing, shale energy. In fact, auto sales juicing a beat of the consensus for overall sales was one of the best possible outcomes for bulls (big beats across the board would not have been great news, as it might have reinserted fears of Fed withdrawal back into the conversation).
When looked at in depth, however, the retail sales report confirms what just about every other indicator I track confirms – the economy is inexorably slowing in every category. One month doth not a trend make, as most of us know (granted it can make a quick trade, but that’s another story), so I tend to look at year-on-year changes use rolling 12-month periods. Here is a look at retail sales for the last quarter-century or so:
In case you can’t quite make out the exact levels, the last two recessions were preceded by the rate of annual change in 12-month sales dipping below 3.5%. Since inflation is around 2% (retail sales data aren’t adjusted for inflation) over the period, that suggests that the change in unit demand has fallen to somewhere around the 1% level. In other words, demand is weakening to a point where it is vulnerable to being tipped into contraction. In May, the rate fell to 3.8%. In May of 2007, the rate was at 3.7% and fell below 3.5% by August.
I could show you similar data for wholesale sales (see my Seeking Alpha article from this week) or business investment spending. They’re all trending towards the negative, though we aren’t there yet. If and when we do get there, we will be in a recession. The business inventory-to-sales ratio is at its highest level since late 2009, which is going to mean a drag on GDP for a while as inventories get pared back. Even employment, which is usually a lagging indicator and thus tends to rise into a recession and decrease as the economy reaccelerates, is consistent with this pattern.
So far, the rate of job growth in 2013 is slower than 2012, at least according to BLS statistics. Perhaps revisions will later reveal that it was higher, but we sure ain’t hitting it out of the park. The latest JOLTS survey (labor turnover) showed that the hire rate at the end of April 2013 was 2.9% vs. 2.8% a year earlier, and the quits rate 1.7% vs. 1.6% a year ago (the adjusted and unadjusted data were the same, if you’re curious). Last month the year-year rate was the same. That is a very small improvement for the fourth year of a recovery – in fact it suggests that the recovery leg of the cycle may be ending soon.
Weekly claims have been stable, though we may get an uptick again next week or the week after from California. Wholesale sales in April were up 0.7% from a year ago, meaning that they are down in unit terms (the year-year PPI core was 1.7% through April). The small-business optimism indicator rose (though hiring plans did not) and the University of Michigan sentiment reading eased back slightly, probably due to stock market volatility. Global financial sentiment seemed to be another story, as yields shot up around the globe.
Next week has above all the FOMC monetary policy announcement Wednesday afternoon. The whole financial world may be watching, in particular the press conference afterwards. That in itself suggests the precariousness of the current situation, stock market rally or not. Will the bank focus on industrial production data, unchanged in May and down 0.03% through the first five months of the year, or will it focus on housing, with the latest homebuilder sentiment index coming on Monday and housing starts on Tuesday? I’ve commented lately on little housing bubbles popping up, as evidenced in this article from Forbes.
The New York Fed’s manufacturing survey comes out Monday, and the Philadelphia version on Thursday (usually industrial production comes between, I don’t know what happened). The Consumer Price Index (CPI) also comes out Tuesday morning, which might give the Fed some ammunition for whatever it does end up saying. Existing home sales are on Thursday, and Friday is the quarterly “quadruple witching” event.