Weekly Economic and Market Review: Sentiment Remains Overly Bullish on Stocks; Bearish on Bonds

Includes: SPY, TBT, TLT
by: Alhambra Investment Partners

“There are limits to what we can do on the monetary front to provide the bridge financing to fiscal sanity.” Richard Fisher, Dallas Federal Reserve Governor

Is there any way we can replace Ben Bernanke with Richard Fisher? There is very little I like about the Federal Reserve but if we are to have a central bank - and as much as I would like to see the Eccles Building go condo, it seems highly unlikely - then it would be nice if the man in charge was as humble about its abilities as Mr. Fisher.

Unfortunately, we’re stuck with Bazooka Ben Bernanke, who is sticking with the script that produced the housing bubble as a response to the collapse of the internet bubble. He told Congress last week that QE II was working as advertised and might create as many as three million jobs. Well, okay, if $600 billion equals 3 million jobs and we need roughly 13 million jobs to get back to where we were, then why doesn’t Bernanke just crank things up and buy $2.5 trillion in long term bonds? How high would stocks go if he did that? What about oil prices? Oh, wait, I forgot, QE only affects good assets.

In a crude sense, Bernanke is correct that monetary ease creates jobs. The problem, as we just discovered in the middle part of the last decade, is that the jobs created in that fashion are not sustainable or in some cases - mortgage brokers come to mind - even socially desirable. Furthermore, expanding the Fed’s balance sheet just encourages Congress and everyone else to spend more money we don’t have. The CBO released figures last week showing that tax revenue in January rose by $20 billion over last year. Unfortunately, outlays rose by $30 billion so the deficit got worse despite higher revenues.

Anyone who thinks we can raise tax revenue faster than Congress can raise spending underestimates the desire of politicians to get re-elected. QE II also appears to be encouraging individuals to increase their borrowing again. Consumer credit outstanding rose by $6.1 billion in December from November and is now up $15 billion just since September. Why save when interest rates are zero?

Fisher is right that there are limits to what the Fed can do and I would argue they’ve done too much already. The differences between what the Fed is doing now versus what it did after the internet bubble burst are in form not function. The goal of monetary policy back then was essentially the same as it is today - force people to take risks and spend now rather than rebuild their savings for future investment. In the early ’00s it was accomplished with lower interest rates. This time, with rates pegged at zero, the method has changed but the goal is the same; force risk taking and expand credit to induce spending and investment now, damn the future.

The problems with our economy cannot be solved by monetary policy alone because it isn’t the sole cause. It is an over reliance on monetary policy over the last thirty years that produced the illusion of stability known as the Great Moderation. Problems that were created by bad fiscal and regulatory policies were papered over with layer after layer of new credit. It is the interaction of monetary, fiscal and regulatory policy that creates the necessary conditions for long term economic growth and all of them will need to be addressed to correct our problems for the long term.

What Fisher means when he says the Fed is providing bridge financing to fiscal sanity is that the inflationary monetary policies that produced the last boom and appear to be producing one now - or at least the beginnings of one - are temporary and have limits. Congress and the administration are being given a window of opportunity to address the real underlying problems of our economy and if they don’t seize the moment, the window could close at any time. The last administration had a similar opening but squandered it through a weak dollar policy and excessive spending.

I actually think there is a decent chance that we’ll get better fiscal and regulatory policy this time. There are tentative signs in the market now that better policy is being anticipated. The dollar has stabilized and may be making a long term bottom. Gold and oil prices have stalled, albeit at high levels. With emerging markets actively trying to deflect capital inflows, a rising dollar could easily gain momentum if policy starts to improve. A dollar rising in response to better US fiscal policy would reduce commodity prices and improve not only US but global economic performance. Bernanke has said that better fiscal policy would have long term benefits from lower interest rates but if he responds correctly with better monetary policy to match better fiscal policy, the real payoff will come from lower commodity prices. Imagine the stimulus to the world economy if oil prices are reduced to $40/barrel. That’s what better fiscal and monetary policy together can create. Let’s hope the politicians jump through the window provided by the Fed before Fisher and the other dissenters are forced to slam it shut.

It was a light week for economic data but what there was mostly continued to show improvement. The Goldman and Redbook retail reports both showed solid growth with year over year same store changes of 2.5%. That isn’t surprising considering the rise in consumer credit outstanding mentioned above. Cold weather or not, it appears folks are in the mood to spend. One area they don’t seem intent on borrowing for is real estate where mortgage applications resumed their downtrend, falling 5.5%. Purchase applications were only down 1.4% though so it wasn’t that bad.

In what is potentially a sign of optimism - misplaced or not we won’t know for a while - wholesale inventories rose 1% in December. That was a bit faster than sales though so the inventory to sales ratio rose slightly to 1.16, which is still low by historical standards. The trade deficit rose slightly to $40.6 billion but that was better than estimated in the 4th quarter GDP report so that might be revised higher. The non oil deficit actually improved by about $5 billion which just shows how much better we could be performing with lower oil prices. Jobless claims again fell below the 400k level to 383K. Let’s hope it stays down this time.

Stocks generally rose last week, at least in developed markets. Emerging market stocks which had been under some pretty extreme pressure, rebounded some on Friday with the Mubarak resignation. Why exactly a military takeover of the Egyptian government should be good for Brazil is a bit of a mystery but what the heck, I’ll take it. Markets aren’t really moving on fundamentals anyway. The elephant in the market is the Fed and QE II and as long as they keep buying bonds, those who sell to them will have to put the money somewhere. US stocks appear to be the asset of choice right now but emerging markets have sold off enough to attract a bid. Whether it lasts has everything to do with US fiscal and monetary policy. If we get a budget deal or tax reform, a rising dollar would solve a lot of problems, from US investment and growth to emerging market inflation.

In real assets, REITs and the commodity indexes continue to rally. Oil and gold though are looking toppy and that is consistent with a long term bottoming of the dollar. If the dollar does continue to improve, expect other real assets to suffer. REIT fundamentals are not compelling and commodity prices despite Bernanke’s protestations to the contrary are a function of the dollar.

Our portfolios still contain a healthy dose of cash and we’re running tight stops. Market sentiment remains overly bullish on stocks and overly bearish on bonds. Munis perked up at the end of last week and long term Treasuries are nearing very long term support. The outcome of QE II does not have to be inflationary so bonds are not necessarily a bad bet here, but realize that bonds are basically a bet that the politicians will do something about the budget. If they don’t, the situation could get ugly. Would the Fed institute QE III if there is no budget deal? Seems unlikely and it would probably be wise to remember last spring when the last QE program wound down. We’re quite a bit higher now than then so a correction from here could be severe. Stay cautious.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.