As I said last week, get ready for some volatility. Stocks most everywhere fell last week but it wasn’t a one way ride. Down Monday, up Tuesday, flat Wednesday, smacked around Thursday and an end of the week rally on Friday. The S&P 500 finished the week down 1.28%. Foreign markets, particularly emerging ones, were generally weaker. Europe was down over 2.5% as Spain got a downgrade and worries continued to mount about the still unresolved Euro debt crises. Australia and Japan were even bigger losers, both down over 4% on the week. And it should be noted that Japan was having a rough week even prior to the devastating earthquake Friday. Monday will likely not be a pretty day for the Nikkei but how it affects other markets is harder to predict.
The earthquake in Japan is a human tragedy and our thoughts and prayers go out to those affected. If you can afford to help, I urge you to visit some of these sites and do what you can:
From an investor’s perspective, the earthquake is a reminder that we can never predict the future. The only protections we have for our portfolios are diversification and a healthy dose of conservative skepticism. While we concentrate on the known unknowns concerning the economy, it is often the unknown unknowns that create the largest dislocations in markets. As if the ongoing revolutions in the Middle East, the newly re-emerging debt crisis in Europe, inflation in emerging markets and here at home weren’t enough to worry about, we now have the ripple effects of the earthquake and tsunami with which to contend.
At this early moment, there is no way to predict the economic consequences of the tragedy except to say that it is never a positive when the productive capacity of a country is destroyed by a natural disaster. I have already seen a number of commentators announce that this will be a "stimulus" for the Japanese economy. Commentators who make such pronouncements should have their economic commentating license revoked. Bastiat wrote the Parable of the Broken Window over 160 years ago and some people still can’t seem to get it through their thick skulls that breaking things and rebuilding them is the path to the poorhouse, not a job creation program.
The simple fact is that the money spent on reconstruction is money that would have been spent elsewhere absent the destruction. Now that capital will have to be devoted to merely restoring the previous status quo and even if the buildings and other infrastructure are new and better, it is still not a net gain. We cannot know what good might have come from the spending and investment foregone. One should also be careful assuming that the damage will be confined to Japan. It is an interconnected world and the capital devoted to rebuilding will have an effect outside Japan. In case everyone has forgotten, the Japanese government is essentially broke and will be borrowing to pay for reconstruction. Even if the funds are all raised internally, there will be a smaller pool of capital available for the world. Japanese investors who fund the increased deficit will not be able to buy things like Australian stocks and bonds not to mention U.S. Treasury Notes.
This may be the beginning of the end for the protracted Japanese malaise but probably not in a positive way. The Japanese government is in debt up to their top knots and this just brings closer the day when they will finally be forced to pay market rates to borrow. James Grant said back in the 90s that shorting Japanese government bonds was the greatest short of all time. It must surely seem like a lifetime for all the macro traders who have made that bet and lost time and time again. But while his timing may have been off, Grant is surely right that the day will come, maybe sooner now, when interest rates rise and the Yen falls ... a lot. How that affects the rest of the world is something only time will tell but it seems unlikely to be a positive in the short term.
The concerns about the world economy seem to grow by the day and I remain extremely cautious. Our exposure to stocks has steadily dropped over the last few months and it dropped a bit more last week. In addition, I took profits on a long held position in high yield bonds, selling half. I have maintained our exposure to commodities so far, but if the economy slows, that will have to be revisited as well. It appears to this observer that the correction is just getting started and while cash doesn’t pay much, it does have the appealing quality of maintaining its value in nominal - if not real - terms. Stocks are not cheap by my measure and could easily surprise to the downside. Our economy, as noted below, is recovering but it is a tenuous, saw-toothed advance at best. I still see no reason to believe that we will get our fiscal house in order anytime soon - absent another crisis - and monetary policy is rapidly becoming a headwind in the form of higher prices. Stay on your toes; this isn’t buy and hold time.
Last week’s economic data continued the mixed performance we’ve come to expect. This recovery has been a tepid affair so far and nothing from last week changes that picture. There was good news on retail sales, inventories and wholesale sales and bad news on jobless claims and consumer confidence.
Early in the week brought decent news about retailers from the Goldman and Redbook reports. Both showed year over year same store sales gains around 2.5%. Those reports were confirmed later in the week by a strong official report on retail sales. Sales were up 1% in February on higher auto sales and price distorted gas station sales. The December and January sales numbers were also revised higher, a pattern we should expect in a recovery. Even excluding autos and gas, sales were up 0.5% so it was a good report despite price increases.
The consumer credit report foreshadowed the retail report, showing a rise of $5 billion, all of which came from the non revolving sector (which is primarily auto related). Revolving credit fell again as consumers continue to shun credit cards by choice or force. Mortgage applications also surged on the week, rising 15.5%. The Mortgage Bankers Association, a preternaturally optimistic bunch, averred that this might be from the improvement in the jobs picture, but I am more inclined to believe it is related to fears that interest rates will continue to rise.
The inventory picture, overall and at the wholesale level, improved in relation to sales. Inventories at the wholesale level rose 1.1% but that was slower than the rise in sales at 3.4%. That reduced the inventory to sales ratio to just 1.13 which would indicate a need to further increase production. Inflation had some effect on the report as non durables, which includes fuel and groceries, rose rapidly. Nevertheless, it appears that the fall in inventories relative to sales is more widespread. Friday’s business inventories report, which includes the retail level, also showed improvement, up 0.9%. Sales were up 2% and the inventory to sales ratio fell to 1.23. Both these reports point to a rise in production and therefore employment.
One more positive report, although a bit obscure, was the Quarterly Services Survey which showed a revenue rise of 3.8% year over year. More importantly, the employment services sector rose 17.5% year over year. With so much of our economy service related this shows the recovery is real if a bit muted.
The bad news for the week came, as it so often does, from the jobless claims. New claims rose 26k to 397k after two weeks of solid declines. Of course, this is the nature of jobless claims which rarely move in a straight line. Continuing claims continue to fall. The trend for claims is still down.
The most disturbing report was the consumer sentiment report which fell rather precipitously from 77.5 to 68.2. Now I don’t usually place much importance on these reports because people often tell pollsters what they think they want to hear while acting entirely differently. But as I noted recently, inflation expectations are rising and that was reflected dramatically in this report. One year expectations for inflation are now up to 4.6%, a full 1.2% rise from the previous report. That is a rather large jump but maybe more importantly was the rise in 5 year expectations to 3.2%. The Fed’s quantitative easing program was intended to raise inflation expectations and it is working in spades. I wonder if the Fed has a clue what that actually means in an economy with 9% unemployment? I suspect not.
There is no denying the improvement in the economic statistics over the last year but this is a very fragile recovery and could reverse at any moment. It is being built on another layer of debt, this time primarily at the government level, but I find it quite disturbing that consumer credit is once again rising as well. I recently saw a commercial for an auto company touting - once again - No Money Down! It appears the Federal Reserve is finding some success in its quest to ensure that Americans continue transferring their wealth to the banking sector one loan payment at a time. We will probably continue to see an improvement in the economy over the coming months, but make no mistake, this isn’t a real recovery anymore than the last one.