U.S. Economy: Climbing a Man Made Wall

by: Jeffrey Frankel

Two weeks ago we said that investors were climbing the traditional "Wall of Worry" and we hypothesized that the only really big problem that could de-rail this bull process was a lack of fiscal responsibility in the U.S. This week we are using a hybrid analogy liking the progress in the market to investors moving up a climbing wall.

A climbing wall is man made and allows climbers to train for the perils involved in real mountain climbing. Hand holds, incuts, and protrusions are built into the wall so that climbers can simulate what to watch for and what to grab onto when they go up a mountain. The real protection to those in training comes from a very reliable simulation of using belay ropes. Using a belay rope involves a partner. The partner applies pressure when the climber is not resting so that he does not fall and if he does he does not fall far. The partner removes pressure as the climber climbs allowing him to go higher.

Investors have in the United States have been climbing with the Federal Reserve managing the belay. Zero interest rates and QE 1 and 2 have provided true safety on how far things can fall. When you look around the globe it’s obvious that other governments are also providing support to their climbers. China quickly moved from their own TARP to supervising substantial wage increases for most of their workers. No doubt this is inflationary and the government has responded with beginning to tighten monetary policy. In Europe, the Eurozone had to create a PIIGS bailout fund of massive proportion, but as of this morning they are also starting to raise rates. Japan which has been besieged by problems connected to the Tsunami is still massively increasing liquidity, but their country’s high savings pool will most likely need to be more and more directed toward rebuilding rather than investing in our bonds. None of these fact patterns, by themselves, are show stoppers for the worldwide economic expansion. They do each, however, put some pressure on the U.S.

In the last two weeks the U.S. government has shown itself to be amazingly inept at attempting to reconcile this year’s budget. If we can’t solve the bid $10 billion ask $61 billion cost cut problem that may now bring our government to a shutdown, how can we possibly tackle the trillions of dollars that must be cut out over the next several years? Our incompetent Congress has focused on meeting in the middle at $35-40 billion dollars of cuts but cannot agree on what the cuts are or what idiotic riders need to be attached to the bill.

The hand holds, and incuts on the climbing wall in the U.S. stock market have been made of earnings. Earnings first came from productivity popping, but now EPS is clearly coming from top-line growth. Moving up the climbing wall of worry will continue on the back of earnings. However, investors need to know there is some belay rope holding them from a huge fall. The Federal Reserve has spent most of its rope. The only way to replenish the rope is to make progress on controlling the debt. If the hope for a return to fiscal responsibility is seriously challenged we may have a correction in this market. Hopefully, Washington can get its act together today and keep hope for bigger progress intact. Otherwise we could disturb the market in a serious way. Even if there is a correction, we would still be buyers because the economy will continue to recover. However, for this bull to last several more years budget cutting and revenue raising need to become serious goals of our representatives in Washington.