Investor Visions of Gridlock and Newly Printed Dollars Driving Markets Higher

by: Alhambra Investment Partners

The market got exactly what it expected last week and the result was another leg higher in a rally built on two dubious assumptions: gridlock is good and the Fed can fix what ails the economy. The mid term elections delivered control of the House of Representatives to John Boehner and the Republicans while the Democrats managed to hold onto the Senate. Conventional wisdom had it that gridlock was the best outcome and that is likely what was achieved. I suspect that may turn out to be a case of be careful what you wish for but for now the majority of voters has decided that standing athwart Congress yelling Stop! is their best option.

In another example of wishful thinking, the market applauded the Fed’s decision last week to further expand the supply of dollars even though investors don’t seem all that eager to hold the ones they already have; the dollar fell again last week as investors swapped into anything the Fed can’t manufacture more of at zero cost.

In most circumstances I would be happy to cheer the gridlock that emerged from last week’s election. I’ve rarely run across a politician with an idea that didn’t ultimately cost me something either in dollars or freedom so anything that results in a lot of talk and little action is usually just fine with me but in this case I’m afraid we actually need some things to get done. In case all the gridlock lovers out there have forgotten, doing nothing results in a big old tax hike next year which is not exactly a market friendly event. Yes, President Obama said he was willing to negotiate with Republicans on the issue but his idea of compromise is for Republicans to come around to his way of thinking. Gridlock will also not reform Social Security or Medicare nor will it reduce government spending or end the war in Afghanistan. It won’t get rid of the worst bits of health care reform (and forget repeal) and it won’t stop the EPA from imposing carbon emission limits through regulatory fiat. And it most definitely won’t stop the politicians in both parties who seem bent on starting a trade war with China.

Gridlock also won’t prevent the Federal Reserve from financing next year’s budget deficit by purchasing nearly $1 trillion worth of Treasury Notes over the next 8 months. Creative government financing is reckoned by the market to somehow be more beneficial than the creative financing employed by the typical real estate buyer a few years back but I suspect the results may be quite similar. When offered easy credit, the average American said sure and bought a house he couldn’t afford and didn’t need. Lord knows what politicians will spend Uncle Ben’s easy money on but I’m sure they’ll find something we can’t afford and surely don’t need. If you voted to throw the last crop of bums out because they spent too much, I’d keep that outrage handy if I were you. You’ll be needing it again in a couple of years.

What the Fed is betting on is that this run up in stock prices will be enough to get the old animal spirits stirring and Americans back to spending and speculating our way to prosperity. Unfortunately, the oil and other commodity markets aren’t cooperating with Ben’s plan and while the few Americans still left in the stock market may see some benefit, quantitative easing will hit Joe Sixpack right in the gas tank and the grocery cart. Good thing the Fed ignores that silly non core inflation that includes food and energy or we’d never be able to get this economy going again. Gas prices back over $3/gallon will surely give the gridlocked Congress something they can agree on; hearings on commodity speculation are surely right around the corner.

And in the most ironic of all the goings on last week, the economic data continued to improve all on its own. Yes, there are still problems - lots of them in fact - but there is also a faint but detectable improvement in the recent economic releases. Yes, there were some negatives last week (personal income was down, jobless claims rose again and the employment report Friday was mostly fiction) but there were some genuine bright spots as well that can’t be ignored unless you are a Fed Chairman determined to prevent a non existent deflation.

Personal income was down 0.1% in September but that was mostly due to expiring unemployment benefits and a drop in government sector wages and salaries. Private wages and salaries were up 0.1%. Spending rose by 0.2% month to month and by 3.7% over the last year. That isn’t exactly a boom but it is a respectable gain and should not be a source of concern. The Goldman and Redbook reports also showed respectable gains in spending and chain stores generally reported solid same store sales numbers last week.

The ISM surveys both showed solid improvement. The manufacturing survey reported a headline of 56.9 up 2 1/2 points from last month. New orders, which had been falling back toward 50, showed a huge gain of 8 to 58.9. The employment index rose to 57.7 and production came in at 62.7, up six points and back to levels last seen in May. This was a very strong report and indicates the economy is re-accelerating after the summer slowdown. The non manufacturing version wasn’t as strong but also showed improvement. Headline was 54.3 with new orders and backlog also showing strong gains. The production index jumped six points to 58.4 but employment was the one laggard, up just 0.7 to 50.9. Again, though, this was a very strong report and supports the idea that the economy is re-accelerating.

Real estate continues to be a weak point but there was some improvement in construction spending last month, up 0.5%. Unfortunately, that is still down over 10% from last year’s lousy reading so we still haven’t reached the nadir of activity. The rate of decline is slowing though and we’ll probably start seeing year over year positives by the first quarter. Mortgage applications rose modestly last week but are still at a very low rate. The mini refi boom might be over too as refi apps fell by 6.4% for its third straight decline. Pending home sales also fell 1.8% but that was after a big jump in July and August. I still think the bottom for sales has been seen but there is still a long way to go in the housing market.

The factory orders report confirmed the activity seen in the ISM report, rising 2.1% in September. A lot of the rise was due to a jump in aircraft orders which are very volatile but ex-transportation orders were still up 0.4%. Capital goods orders ex defense and ex transportation were down slightly but shipments were up a solid 1%. Inventories rose in line with orders. Like the ISM report, this report shows the manufacturing sector is re-accelerating. Productivity rose by 1.9% in the third quarter while unit labor costs fell by 0.1% so all the factory activity should remain quite profitable. I do wonder how long that can last if the Fed is successful in raising inflation expectations though. At some point, workers will require - demand, and rightfully so - wage hikes to make up for the higher cost of living.

The big reports of the week concerned jobs and while I’d like to just report the headline of the employment report from Friday and say everything is getting better, that is a stretch I can’t do at nearly 50 years old. Yes, the headlines all trumpeted the fact that there was net hiring on the month of +151,000 jobs but that only tells part of the story and only the good part. Not only that but the good part was at least partially due to a change in seasonal adjustments that added roughly 100k jobs to the total. I suppose it is possible that the BLS has improved their seasonal adjustment process but I wouldn’t bet on it. Looking at the household survey reveals a jobs picture that is still pretty damn grim. The number of employed fell by 330,000 last month by that measure and the only reason the unemployment rate didn’t rise is that a quarter million Americans quit the workforce.

New jobless claims rose right back to 457k completely erasing the previous week’s improvement (click to enlarge).

As you can see, claims need to drop roughly another 100k per week to get to a level consistent with decent job growth. Until that happens you can’t say this economy is good even if it is getting somewhat better. Last week’s election doesn’t change that fact and neither does the Fed meeting.

Markets last week rose again. Notice I didn’t say stock market or commodity market or bond market and that is because all of them were higher on the week. With visions of gridlock and newly printed dollars floating in their heads, investors couldn’t see any bad news and bid everything higher. Fed buying more short and intermediate Treasuries? Buy’em before the Fed does. Fed not buying long term bonds? Sell those suckers. What will the Treasury holders do with the newly printed dollars the Fed gives them in exchange? Buy stocks? Buy’em now before they do. Fed printing means more dollars? Sell’em and buy Brazilian reals, Aussie dollars, gold, silver, oil or damn near anything else instead. The only game in town right now is to figure out where the Fed and/or its new cache of dollars is going next and get there before everyone else does. Why invest in a factory? I don’t think those are on the Fed’s buy list.

Disclosure: No positions.