Interview With Nick Perna: Correction or Sustained Rally?

Includes: DIA, QQQ, SPY
by: Harlan Levy

Nicholas Perna is the economic adviser to Webster Financial Corp. and chief economist and managing director of the consulting firm Perna Associates. He is also a visiting lecturer at Yale University.

H.L.: First-quarter earnings began coming in last week, boosting the stock market until Friday’s crash after the Goldman Sachs suit announcement. Are we getting a correction, or is a rally sustainable?

N.P.: I don’t know the answer to that. I think we are in totally uncharted territory.

If you asked me if there’s a lot of uncertainty for equity valuations I’d say yes, in spite of the fact that we have a recovery underway in the economy.

The betting is that sometime this year that interest rates will rise, and then we have this disturbing concern over sovereign debt. Portugal is now in the headlines after Greece. Who’s next? We don’t know where that’s headed. But it has the potential for getting quite messy.

Another uncertainty is political uncertainty in the U.S. I’ve never seen the Washington scene as fractious as it is today, and financial markets abhor uncertainty.

H.L.: But so far the earnings look good, so don’t they indicate higher stock prices?

N.P.: You’d expect to get a big earnings lift when you have a combination of economic growth and a diminution of many of the problems that plagued us last year at financial institutions. For example, problem loans were down at GE Capital. These are the kinds of things that make up for sizeable profit increases.

But as we go out later this year, there are a couple of things worth pondering. One is the dollar has strengthened, and it’s quite noticeable against the euro. The problem with a stronger dollar is that it means weaker exports for us. Also, translation gains get smaller with a stronger dollar. When a U.S. company repatriates earnings from abroad, that translates into a smaller number of dollars. Plus Gross Domestic Product growth will be slower during the course of 2010 than it was in 2009.

H.L.: Small businesses aren’t growing and hiring more workers, millions of foreclosures are on the way, and first-time filings for unemployment benefits unexpectedly rose. What’s really happening with the economy?

N.P.: We’re clearly off the bottom in terms of GDP, industrial production, and unemployment. Still, we had such a severe recession and such a severe financial crisis that problems still fester. And there’s still this uncertainty among business people and consumers as to how viable the recovery is.

What we’ve got is that the recession is over, but all we mean by that is that GDP has started rising again. We don’t mean that everything has begun to improve. Nor do we mean that we’re back to normal. We’re talking about a recession being over with a jobless rate over 9 percent. Normal is a lot lower than that.

H.L.: Do you think job growth will accelerate more than expected and eliminate a good chunck of foreclosures?

N.P.: The expectation is for a significant rise in jobs this year. It’s quite likely we’ll get at least 150,000 new jobs per month the balance of this year, and we got the first peek at that for March, where only a small part of that was census takers. But with 150,000 new jobs per month we’ll only get a small improvement in unemployment.

This should ultimately be good for foreclosures, but there’s still a lot in the pipeline, but there will still be a very large number of unemployed people in 2010.

H.L.: Banks and other financial institutions seem to be prospering now. Is our financial system getting healthy, and is there more lending?

N.P.: There’s been a noticeable improvement in banking conditions, especially over the last year and a half. The quality of the bank portfolio of loans and securities is improving, and profits are beginning to rise. All of these are what you need to have more loans made. Plus, the banks have really sizeable reserves that can be used for lending.

H.L.: In Congress the Democrats want to tighten regulation of financial institutions, and the Republicans oppose it, claiming that it will destroy big banks and that current plans contain big-corporate bailouts at taxpayer expense. What’s the truth, and what’s needed?

N.P.: It’s absolutely essential that we make changes to the system that got us into trouble. Many experts say that we need ways of dealing with large financial institutions that go far beyond the banks, ways that don't include bailouts. One important proposal is that government authorities be able to seize a non-bank financial institution if it gets into trouble and reopen it to keep it from causing problems for the rest of the economy. This is far different from a bailout, since share owners would likely be wiped out, and much of the board of directors would be gone, and some creditors would get haircuts. This is exactly what the Federal Deposit Insurance Corporation can do dealing with problem banks. What we need is similar authority in dealing with huge non-banks. It directly addresses the “too big to fail” problem, because it allows them to fail while minimizing the fallout.

As for whether this can be done without any taxpayer money, it’s hard to say, but it probably could be done with a lot less than what just happened.

H.L.: Going back to the debt problems in the euro zone with Greece, Portugal, Italy, Ireland, and Spain, are they bad enough that the U.S. should worry?

N.P.: On one level their pain could be our gain. When there are problems in one part of the world, money tends to flow to the good ol U.S.A. for safekeeping, and that brings down our interest rates. The problem is that the more trouble the European zone nations get into, the less demand they have for our exports and everyone else’s.

The more worrisome concern is that sovereign debt problems could spread to other countries and could get people worried about state debt here in the U.S. When investors get very nervous, they get more concerned about the return of their principal than the return on their principal, which means they might prefer to get next to nothing in U.S. Treasurys.

H.L.: Should China loosen its currency’s tight tie to the dollar?

N.P.: What the Chinese do is undervalue their currency to maximize their exports,

but it’s not good to beggar their neighbors. They make all their trading partners that they export to poorer. Increasingly, nations around the world are getting upset with their currency manipulation, especially at a time of high global unemployment rates.

If China makes its currency more expensive it will help reduce the U.S. trade deficit with China, and that would reduce our reliance on borrowing from the Chinese. They’ve already expressed concern about how much they have to lend us.

But they have a yin and a yang over there. It pays to have a cheap currency for creating jobs immediately, but to protect all the money they’ve lent out, you have to have a more reasonably valued currency.

The bigger problem with China is not so much the currency issue, but whether China grow as fast as it wants to without exacerbating already very serious environmental and financial problems. That’s a near-term concern. Some people worry that China could hit a wall during the coming year or two, maybe from excessive speculation in their financial markets.

Disclosure: No positions