Where is the US Economy Headed?

I believe that there are two possible courses for the US economy: I will start out with my second scenario, namely a pickup in economic growth which would cause a rise in interest rates sometime later this year to fight off inflationary pressures.

We are seeing this already in the purchasing and supply manager's data for April. The ISM New Orders and Production data both show increases consistent with expanding production and replenishment of low inventories from late last year/early this year. While some of these new orders may go to the export market it is not expected that the export data will rise noticeably since the drop in our currency were only a few percentage points, making only a nominal difference between our goods and goods coming from China or within Europe. The competitiveness factor of American goods will not increase substantially with a small depreciation of the currency. That, in turn, will only increase exports marginally.

Here is where inflation comes into play. Buried in the ISM report is the Prices data. 66% of the manufacturing respondents are reporting an average of 4.9% increase in prices paid and 67% of the non-manufacturing respondents report an increase of 5.5% between what they paid at the end of 2006 and April 2007. These increases will flow through the manufacturing process to the end product and create inflationary pressures along the manufacturing chain.

At some point the additional costs will show up in prices paid at the user level and cause inflationary pressures forcing the Fed to raise interest rates to reign in inflation.

Now onto my first scenario: there are two risks here; one is that inflation fails to moderate while economic growth continues to be weak, causing a recession or stagflation. In fact, while we may not have the high unemployment for a classic stagflation scenario, we do have weak economic growth and stubbornly high inflation so one could argue that we are currently in a stagflationary environment which could turn into a recession.

It is expected that core inflation will moderate as we enter the summer driving season and prices fall. But if the ISM Price data listed above is correct then there are price pressures already in the system that will eventually feed through to the end user level which will mitigate any drop in energy prices.

Now, we are also noticing more corporate layoffs and a decrease in personal income and disposable personal income while personal consumption expenditures are increasing. This means that the average person is feeling a squeeze on their income and may begin to cut back on purchases since the home equity tap has been turned off. They can turn to credit cards to continue their spending but if corporate layoffs continue to increase then consumer confidence levels will begin to decrease and they will retrench.

If consumer confidence begins to wane then the inventory adjustment that is occurring will become a one off event. For production to stay on a steady or increasing level after the inventory adjustment it needs a corresponding increase in sales to keep inventories at the proper level. If sales decrease while inventories increase then businesses will cut back on orders meaning lower production.

Finally, while the market may be doing well in the short-term there will be an adjustment period sometime down the road and when the adjustment period comes, the longer the wait the more painful the adjustment. We are still a long-term bull (for the next 15 months) but the high PE's given the current economic environment temper my bullishness.

Given the high PE's, this is not an environment where we would look to chase stocks. A more defensive posture is more appropriate with overweights to sectors like commodities, where demand will continue to be strong regardless of a US slowdown or structural changes are underway. Overseas markets like Thailand and Taiwan are attractive in this environment.