Current Economic Outlook: Tough and Realistically Optimistic

Includes: DIA, F, GM, SPY, UUP
by: Convex Strategies

In today's world of constant bombardment from market "gurus," "genius" money managers, and "savvy" hedge fund managers, many members of the investing community forget one thing: If the economic fundamentals are strong, the overall market will do just fine.

Of course, the fundamentals looked pretty good in 2006 to the everyday individual investor. The real estate market was soaring, company earnings and guidance were strong, and crude oil was at a manageable price (the price of crude per barrel in January '06 was about $60.48). However, many were also able to see the bubble in real estate; most telling was the overwhelmingly increased participation in price speculation, which reached 34% in 2006. Members of the Fed began to warn of a bubble forming in real estate. Jack Guynn, president of the Atlanta Fed cautioned that he was "reasonably comfortable characterizing the housing feeding frenzy in some of our markets as being a bubble."

Although there have been various points in time where the U.S. economy has looked great and then fallen off of a cliff, those periods have occurred when economic success was fueled by massive speculation (most notably the Great Depression and the recent Great Recession). This recovery is not being fueled by dangerous speculation, but rather by accommodative economic policy and stimulus from the U.S. Federal Reserve. This has led to the stabilization of unemployment numbers, foreclosures, and lending, and this relative success should remain even with the absence of stimulus, especially when one considers that the markets have almost surely baked-in the fact that stimulus is about to dry-up. In addition, the stock market and individual company earnings have been on a solid uptrend since the bottom in March 2009, despite worries over Greece, the U.S. debt ceiling, and the absence of a recovery in housing. In this article I will explain why these worries will subside, and why housing will begin to recover sooner rather than later. While these issues are in the process of resolution, I believe the market stock market, in the long-term, will react positively to continued strong earnings from companies and news of strategic utilization of the massive cash reserves that U.S. companies currently have (The companies that make up the S&P 500 (NYSEARCA:SPY) currently have a collective $800 billion on their balance sheets).

Recently, the U.S. economy hit an undeniable soft-patch. Manufacturing data in May showed the first national PMI reading below 60 for 2011. However, according to a report from Decision Economics, the Fed has calculated that non-auto manufacturing gained 7% in May, and declined only 1.5% in April. Auto manufacturing declined 55% in April and 16% in May. The two, very basic reasons for this disparity between non-auto manufacturing and auto manufacturing are a surge in crude oil prices (which typically cause car buyers to hold off), and supply-chain disruption due to the Japanese tsunami/earthquake disaster. The second half of 2011 and beyond should show improvement in manufacturing data due to normalization in the supply-chain, and crude prices stabilizing in the 70-90 dollar per barrel range.

I believe crude will stabilize in this price range due to eventual margin requirement hikes imposed on oil speculators, the end of Quantitative Easing, the lack of a risk premium due to MENA disruption, and serious efforts from world governments to calm oil prices. In fact, on June 23rd, the U.S. government, along with IEA, decided to sell 60 million barrels of oil to reduce prices. This is the first of many steps governments will take to lower oil prices. In addition, because oil is priced in dollars, a stronger dollar will send prices lower. Despite the flack that "king dollar" has taken in recent years, steps taken to rein in U.S. spending and debt levels, along with eventual interest rate hikes and certain tighter monetary policy, will lead to a stronger dollar. Although I believe Greece will not default on its debt obligations, the eurozone has other issues to worry about, including Portugal and Spain. Continued distress in Europe will in fact lead to a stronger dollar here at home, and as a result, lower oil prices.

Although there is a great deal of worry that Democrats and Republicans will not reach an agreement before August 2nd, I find that to be highly unlikely. If it does in fact happen, it will most likely set off a chain of events that sends the world spiraling into a colossal economic depression. The reality is that it is not even worth worrying about a failure to reach an agreement, because if there is no agreement, you won't need to worry about investing for a very long time. While It won't be pretty, America will once again find away to figure its problems out and achieve a plan to cut spending and balance the budget.

A common argument is that the Fed has been in collaboration with the U.S. government just to simply delay the collapse of our economic system as we know it. While we certainly have some tough decisions to make in the near and intermediate future, it will not end in the collapse of the global economy. The people that believe this are the same people that are part of the gun and gold buyers club. They believe that once our system inevitably collapses, the only currency will be gold, and there will be a post-apocalyptic wasteland in which to survive. The argument has no real economic merit, and the most likely outcome of our problems right now is eventual pain in the pockets of the poor and middle class, and a tougher, but more efficient and sustainable spending plan. Politicians will first need to warm up to the ideas of raising the Social Security retirement age, cutting entitlement spending, and making government far more efficient, but those issues are for another article.

This Is Just the Beginning

There is an awful lot of talk of interest rate hikes being on the near horizon, but our interest rates will only rise once employment begins a real march toward acceptable levels, and when the risk of inflation is far greater than the risk of deflation. I am sure many will read this and say, "but inflation is running rampant right now." The truth is, while we no longer have the benefit of cheap fuel and food prices like we had during the recession, oil and food prices will stabilize on their own in the near-term.

Core CPI rose 1.5% YoY in May, and was slightly higher than expected which was most likely due to supply-chain disruption stemming from Japan. Also, a great deal of the inflation we have seen is most likely a result of the Fed's bond buying programs, QE1 and QE2. The goal of these programs was to push investors into riskier assets like stocks and commodities (oil, food, etc.). QE2 ends on June 30th and no plans have been made for a third quantitative easing. This is another silent reason why oil and food prices will most likely cut gains in the near future. The Fed sees a stable long-term inflation rate, and cross-referencing these two charts ( chart 1, chart 2) shows that interest rates only rise once Core CPI bottoms and then begins to rapidly rise. We are still in the bottoming phase, and while we may see some moderate inflation for the remainder of 2011, consumers should be able to handle it as food and energy prices are slashed.

This recovery is just beginning. Housing prices are still bottoming out, unemployment is hovering around 9% (the real under-employed level is much higher at 18.2%), policy is still accomadative, and we've hit a rough patch. We'll get through this rough patch, housing will once again recover, and the U.S. economy will continue to grow for the foreseeable future in a climate of nearly 0% interest rates, and will grow (albeit at a slower pace) once rates begin to rise.

As for the stock market, I tend to subscribe to the idea that while in the short-term the market may not reflect fundamentals, in the long-term it will. As I previously mentioned, I feel this current decade will be much more productive for the long-term investor than the last one. Corporations will begin to invest their cash once the U.S. reforms spending and comes up with a plan for its debt, and once the tax code is reformed. Many companies are slightly worried now about blowing their capital before they know exactly what the economic climate will be like in five years. Companies learned a great deal about the importance of efficiency during this last crisis, and should be able to employ their capital in an efficient and productive manner.

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