The Fed has continued to chant its moderate growth line for some time (recent FOMC statement). I have started to concentrate further on the effects of the trade imbalance (see post) and possible actions required to retool the portfolio. As such, I ran across a somewhat dated working paper from the Fed ”U.S. External Adjustment: Is it Disorderly? Is it Unique? Will it disrupt the rest of the world?”.
Basically, adjustments in the trade deficit in the US are non-disruptive and the effects to foreign economies are typically benign. Exports will help to offset any slow growth in the economy. (see post) Thus, the paper helps to explain why the Fed continues to support its moderate growth thesis. There are a few points that I think should be drawn out here. The author laid out 5 points, which are significant, during an adjustment. Point number 2 stood out to me, so quoted below.
Real domestic demand has grown 2.6 percentage points, more slowly during periods of
trade balance adjustment than during periods of deterioration; most notably, growth of
residential construction plunged at an annual rate of nearly 14 percentage points during
If this is the case, the housing industry has another hurdle to contend with, as it is my belief that the adjustment in the account deficit has begun. Signs of the adjustment can be seen with the most recent rise in rates and the fall in the dollar. The effect has been a rise in exports and reduction in imports. In short, the above notion lends further support to the housing market going through a historically prolonged contraction.
Another point drawn from the article is the relative benign effect on foreign market economies, even during periods of currency adjustment. I think there is a fine line to be drawn here. I continue to believe in investment in [EFA] for our portfolios, but not [EEM].
Should the US continue to slow, resource inputs from all categories will be hit from their current elevated levels. Additionally, fewer exports to the US and continued foreign central bank rate increase campaign will hit the resource sector. As this happens, the time to invest in emerging markets will be at hand. There is just too much risk in the class at this point in time. On the flip side, I still advocate giving over a small percentage to a broad-based commodity fund. Should there be a correction, the allocation to resources would rise in our portfolios.
In summary, what I took away from the paper is that the US will be in a fairly good position during this adjustment. Pundits are now calling for a reacceleration of the economy, with the recent rise in industrial numbers and the latest job report. I differ here slightly, as I think there is still a chance for a shallow recession or prolonged below trend growth. This is why I still advocate large cap stocks. (see post)
Accordingly, I think the US economy will be in fine shape, but the market is a different animal. I think the market has not adjusted for the current state of affairs. I concede the point that our portfolios managed may be a bit overly conservative with 15% cash and 5% short S&P 500 through (SH). (see post)
I am currently waiting for a shock via further market rate rises (not Fed) and or resource input spike (oil $85, gas above $3.00 ect ect). With a correction, I believe the market will have cleared and the way will be clear to sound the battle cry “Damn the torpedoes, full speed ahead!”. (David Farragut)