“We have met the enemy, and he is us.” – Pogo (Walt Kelly)
Another lugubrious week in the markets, and we are rather afraid that the coming days may not be much better. In a replay of the 1998 financial crisis (which few seem to recall anymore, but the stock market fell 22% in eight weeks, beginning in July), it’s the stock market that is again threatening the economy, rather than the usual order of things.
The downturn in prices that began with the debt-ceiling debacle (calling attention to our political ineptitude and frightening the markets in the bargain) and a series of economic disappointments – GDP data, ISM surveys, S&P’s ill-fated downgrade – have shrugged off the positive news in earnings, retail sales and employment. Neither earnings nor employment have been outstanding, to be sure, but they haven’t been negative, either, a conclusion one might have drawn from looking at valuations.
Alas, it seems that as soon as the markets start to find some footing, we manage to produce another confidence-crusher that saps the market and in turn saps the confidence of business leaders. That leads to another round of weakish data that in turn causes more caution, with the whole thing threatening a negative feedback loop. Mohammed El-Erian, the well-known co-head of PIMCO, did a good job of sketching out the problem in a piece in the Huffington Post.
The economy isn’t as bad as the market is suggesting, but it could get there if confidence continues to break down. The biggest problem around the globe is domestic politics, whether here in America, where a great many of our political leaders seem more interested in jockeying for next year’s election than trying to do anything sensible about the economy, or in Europe, where the Finns and Germans keep trying to carry on as if the houses of their neighbors can burn down while they remain unaffected. They are free to disapprove of the adjacent behavior, but will find out that it takes something more pragmatic than virtue to stop a fire.
It’s a curious situation, and one that isn’t new. In our eponymous film, High Noon, Gary Cooper’s sheriff character is deserted by townspeople desperately trying to believe that if they hide and mind their own business, an invading band of murderous gangsters will for no logical reason leave them in peace after they finish disposing of the sheriff.
Here in America, we have a group of laissez-faire zealots who are bent on destroying the economy in order to “save” it. They remind us of a tag line we read during the days of the Palestinian intifida, to the effect that the streets of Palestine were filled with youths in a state of “permanent exaltation” that their moment was at hand. In their stead, we have group of economic rock-throwers who seem on bent on winning the counter-culture wars of thirty, forty, even eighty years ago.
Rather than addressing the pragmatic problem of our lost productive capacity and concurrent employment problems – ably summed up by Jeffery Sachs in the Financial Times last Thursday (we would like to provide the link, but unfortunately we only read the hard copy and the FT.com’s search capabilities are spectacularly weak) – our exalted ideologues are bent on pursuing an end-of-days showdown on taxes, government, social programs, fluoridated water and evolution. Shades of the 1930s.
In Germany, Chancellor Angela Merkel has again signaled that she will be content to play to the prejudices of frivolity-disapproving German voters until the country – and more specifically, the German banking system – is forced to look over the edge into the abyss. It is quite possible that Merkel has deliberately chosen this course in order to be forced into a decision that she knows is inevitable – either ante up to finance the write-down of the periphery debts and the exposed European banks, or watch the eurozone and its economy collapse. However, the European elite (and especially the Germans) is irrationally determined not to be dictated to by their “inferiors” in the markets (see Michael Lewis’s excellent summary in Vanity Fair).
So we are left with a mindless race to the bottom of chasing deficits with austerity, a race that cannot be won. The biggest cause of our deficit is the economy, and the more governments pursue austerity, the worse the economy will get. We are aware that some believe in a magical world of free markets without structure, but it’s just another euphemism for chaos.
Next week brings a Damoclean sword in the form of the Jackson Hole symposium for central bankers and economic policymakers sponsored by the Federal Reserve. On the one hand, it presents an opportunity for a coordinated round of rational action and policies to stop the bleeding. On the other, the possibility of disappointing already fragile markets is disturbingly large. Yet there is a limit to how far central banks can go in bailing out the weakness of elected leaders.
Markets are oversold, valuations are cheap, but if Jackson Hole produces nothing but signs of indecision and weakness, another ten percent down is in plain view. The silver lining is that like 1998, if things get bad enough it will finally provoke a genuine policy response. High noon approaches, and we cannot afford much longer the notion that getting rid of the sheriff will solve everything – or even anything at all.
The Economic Beat
The report of the week was the Philadelphia Fed manufacturing survey. We don’t think it was the most telling report of the week, but it had the biggest impact on the market. The result of (-30.7) contrasted sharply with consensus expectations of a positive print (somewhere between +1 and +4), though realistically the latter had been discounted. The poor start to the week given by the New York Fed survey (-7.72) had prepared the market for a weak Philadelphia number – but not that weak.
In sharp contrast to the two surveys stood the July Industrial Production report, a ray of bright sunshine that unfortunately is going to be rubbed out by the market headlines and politics. June was revised upward and July put up a rousing +0.9% (consensus +0.5%) increase. Every category but construction put in a strong performance, with even that laggard up 0.3%.
Alas, it will all end in August. Not because there was anything wrong with July production, but the deadly combo of the debt ceiling and the stock market will have everybody take a pause in August, possibly until politicians show some signs of intelligent life. All we can say is the odds seem to be that they won’t, not unless and until the guns are pointed at their heads.
The Fed surveys are not all that accurate, a point we’ve made many times in the past. They don’t indicate levels of change or activity, and more often than not are quickly filled by harried non-senior executives. Headlines matter. All that said, the Philadelphia and New York numbers are too weak to ignore. They can be turned around quickly, but it will require a strong policy response.
Housing didn’t provide any relief, but it really didn’t provide much in the way of surprises either. Starts and permits both fell from June, but were relatively close to consensus, with starts a little better and permits a little worse. Homebuilder sentiment was unchanged at 15 (50 is neutral, but the number has been stuck in a range of mostly 15-19 for a couple of years). There really wasn’t any news in the sector – it remains in a very weak recovery.
Existing home sales fell back as well, which was more of a surprise to markets. We have been making the point throughout the year that pending home sales data haven’t translated into final sales, and that continues to be the case. Banks have gotten ultra-cautious with credit, valuations and paperwork, so while mortgage rates are at record lows, so are approvals.
The inflation data was somewhat confusing. At the core level, producer prices (PPI) rose 0.4% and consumer prices (CPI) by 0.2%. Higher food and gasoline pushed up the total consumer price increase to 0.5%, yet gasoline prices at the wholesale level fell again. Some of this is an effect of seasonal adjustment, as pump prices are supposed to rise in July. The August actual gasoline drop is counter to the historical pattern and should mean a reversal in August consumer prices.
Year-on-year increases are at 3.6% for the CPI and 7.2% for the PPI, which reflects the usual problem we complain about: excessive financial speculation in crude oil. Core increases are 1.8% for the CPI and 2.5% for the PPI, which are probably lower than the Fed would like.
Import-export prices ran counter to this, with export prices falling and import prices rising, due mainly to higher oil prices. However, the sell-off in the stock market that began in late July took crude prices with it, so both will start to reverse with the August data.
The oddball report of the week was the July Leading Indicators, up 0.5%. They need to be revised. The yield spread doesn’t give the signal that it used to, a point we have made often, and the flawed nature of the model means that indicators will be down sharply in August: the flight for safety in Treasuries has compressed the yield curve (that will be a big negative), all the confidence numbers are down, building permits are down, and so on. The July number looks much better than reality, but the August number will look much worse. The dramatic increase in the money supply has many analysts scrambling to divine the meaning and possible consequences.
Jobless claims edged back up, but the drop below 400,000 withstood the revision, as we predicted: 399,000 was the lowest number in many months. However, it edged back up again last week and will likely edge up again this week due to all the negative headlines.
Next week has less data on tap, with the first revision to second-quarter GDP on Friday promising to be the highlight. Many analysts feel that the huge revision to the first quarter was a major error, so eyes will be turned to see if there are any upward marks. The consensus estimate is for a downward revision to the second quarter, from 1.3% (annualized) to 1.1%. That leaves room for an upward surprise if the Bureau of Economic Analysis heeded its critics.
We’ll get the rest of the housing picture, with new home sales for July on Tuesday and federal loan-based price data from the feds on Wednesday. Again, expectations are low for the sector, yet the estimate looks nevertheless outdated. The data shouldn’t have too much of an impact unless the market is particularly agitated.
The other big report of the week is July durable goods, estimated to have risen by 2.0% in July. A rebound is in the cards for the zigzag data, but it remains to be seen how much the late July stock market fall-off hurt orders. Even an increase is likely to be discounted by nervous analysts fearing the August results.
Consumer sentiment will round out the picture on Friday; after the big plunge in the initial reading, expectations are low. Last week’s earnings were lugubrious, in particular the Dell and Hewlett-Packard (HPQ) reports (the latter was stunning). Next week the market will be watching to see what kind of outlook the managements of Heinz (HNZ), Aruba Networks (ARUN) and Tiffany’s (TIF) provide.