The talk about the economy reaching "escape velocity" has turned out to be just another case of Wall Street hype, fortified by a low-volume, four-month moonshine rally in the stock market. But there is a silver lining to all of this, namely that the milder rate of acceleration in the first quarter of 2012 means that there is a good chance there will be a milder slowdown in the second and third quarters.
Last year saw an inventory accumulation episode come to a more abrupt end than it might have otherwise experienced, when the Japanese tsunami hit and severely disrupted the global supply chain, not to mention life and death in Japan. A slowdown was due anyway as inventory levels had refilled, but the supply chain shock made the data dip below trend and incited fears of a double-dip recession.
This year, we are due for another slowdown from the fourth- and first-quarter inventory accumulation, but we aren't dealing with the tsunami this time. The European problems are still there, and China is slowing, so there is as yet risk to the global economy and from the attendant headlines, but while a slowing China will probably prove to be of more import to the economy than the tsunami, it should hopefully unfold more slowly and give us more time to adjust.
A period of overreaction to the let-down from last quarter's hype is likely in store, but the flip side is that the downturn will probably be milder. We are being set up a little too pat for a repeat of the last two years, in particular 2011, so there is a chance that we could escape with less damage to the markets.
We have to emphasize that the chance is very much based upon the "other things being equal" escape clause of every economic outlook, and things could very well not turn out to be equal. It's difficult to predict what will happen in Europe, as so much depends on policy decisions being made during one of the most sensitive times in Europe in decades. The German bloc is pretty set on its Austrian-economics approach of simply waiting out the bad times, and the view has gained additional resolve from the lack of enthusiasm in the stronger countries for using taxpayer money on the weaker ones.
The IMF has a more Keynesian pro-growth approach, especially with Christiane Lagarde at the head, but it can only use the carrot-and-stick approach with its money, as it has no direct political authority. That leaves the European Central Bank, or ECB, and Mario Draghi in the pivot seat. Longer term, Mr. Draghi is quite correct in saying that the ECB can't solve all of the Union's problems, but markets being what they are, they are much more focused on what the bank might try in the short term.
It's a little eerie watching the European markets. There is still a lot of bad debt that needs to be written down: the housing boom-and-bust that nearly ruined Ireland had its counterpart in Spain, with the difference being that many of the bad loans are still held at fictitious values, either because they are in private banks, or at foreign banks not anxious to disclose their fair value. The latest nudges at Deutsche Bank (DB) to raise capital are part of the main European approach to the problem - hope the world looks the other way long enough that they can get rid of the bad stuff in pieces small enough not to scare anyone, and with a little racing luck maybe things will recover enough in time for the rest.
One can't be sure about such matters, but it doesn't look as if the markets are going to give that kind of time. Not without more ECB intervention, and therein lies the rub. The level of quarreling seems to have gone up overseas, and it isn't clear how big of a bat Mr. Draghi can, or will swing. The recession is spreading, yet markets are up around 10% this year. It has a 2007, what-me-worry feel to it.
We wrote last year that the real Lehman moment for Europe would be Spain, and that still looks like a good possibility. The parallel is worth considering. Bad debts and nervous lenders are obvious enough, yet Spain is a sovereign nation, an important difference. The similarity worth thinking about is the policy one: the Bear Stearns rescue was followed by months of grumbling about bailing out rich bankers and government intervention in the marketplace. As a result, when Lehman couldn't borrow in the overnight markets anymore, the government tried to look the other way and send a message.
The Greek bailout wasn't really all that large, but it engendered a great deal of grumbling and Union tension. The stock market rally in Europe that followed has not only cost its financial markets additional credibility in the eyes of voters, it has probably added a good deal of complacency to the mix at the policy level.
Spain might not get help because Greece did and the problem didn't go away. It doesn't help that Portugal, Greece (still) and Ireland are right behind in line, or that Italy lurks on the corner. Austerity programs are under attack in France, the Czech republic and perhaps most importantly, the Netherlands, which have been a stalwart ally of the German approach. The fault lines are spreading, and while bankruptcy isn't really in the cards for Spain, nobody can really say whether or not the EU will be able to hold everything together under the pressure.
Europe has the resources. Its recent passing of the hat for global capital sums up the problem, however: nobody wants to pay for anyone else, and there is no federal government to impose a solution across all actors. Political chances for the best solution, writing down the debts with an all-hands-together recapitalization, were never favored and seem to be fading.
Yet the timing and nature of the eventual policy decisions remain uncertain. So does the eventual clearing of the Chinese property bubble. One thing stock markets like to do is rally on the deferral of crises, even if it's given back later. Today's worries can easily turn into next week's rally. If Europe simply stumbles along a bit longer, or the ECB takes another dramatic stab at stealth recapitalization with another LTRO variant, then equities will benefit, at least for a time. The focus is back on the U.S. this week, because our news is better.
Sort of. The housing data last week missed on all three reports. The homebuilder sentiment index took a pretty sizable dip, housing starts fell instead of rising, and so did existing home sales. They are both still up year-on-year, but it wouldn't be unreasonable to attribute those modest increases to the weather as well. A positive pending home sales report set off the usual reflex of "buy the homebuilders today, ask questions later," though increases haven't come close in recent years to being realized as actual sales. Pending deals actually fell in the Northeast and Midwest, suggesting the warm weather pulled some sales forward. We would also be willing to attribute all of the year-on-year gain in March new home sales (32K actual vs. 28K actual) to the weather, and if that isn't enough for you, it was the 3rd lowest March in fifty years, as Dave Rosenberg pointed out.
Guesses and chatter about a bottom in housing are seemingly endless. We do see the market as slowly clearing and healing, but it's a slow, painful, and uneven process. A shock from Europe would set the sector back, because the banks would immediately slam the lending windows shut. Even without one, given the onerous credit conditions, shadow inventory and reluctance of sellers to accept depressed prices, it's difficult to make a case for more than very slow.
Weekly claims have been rising instead of falling, with some hefty revisions along the way. It's not so much evidence of a slowdown, but that the warm weather wiggled the underlying trend into appearing better than it really was. Bloomberg immediately tried to come to the rescue by pointing out that unadjusted claims fell and muttered about the Labor Department having confused seasonals, but the reporter should have done a little more homework first.
Actual claims always rise around the end of a quarter and in particular the end of a year, then recede again. Businesses run on quarters and years; it's why we have seasonal adjustment factors. Using the adjustment factor from a year ago would have produced a number over 400k, so be careful about complaining. A late Easter was partly responsible for 2011's factor, but the gap between the two actual numbers narrowed significantly, implying only minor improvement. The reporter might have also learned that a lot of those sunny weekly numbers we read in February and March have gone away - Labor has quietly been adding back 10K a week to its revised data.
The employment market looks like housing to us: the recovery goes on, but at a maddeningly slow rate. The monthly change in year-on-year claims totals, a good leading indicator, is steadily shrinking.
The market this week has been kept afloat partly by Apple (AAPL) earnings on Tuesday, partly by the FOMC statement on Wednesday, and mostly by the fact that we are coming into the end of the month. Yes, the end of the month. You may read that pending home sales caused the Thursday rally, but forget it. Volume was about 20-25% below average on the "investors' rally." Claims rose, the Chicago Fed activity index dipped sharply, but some number would have been found, even if it was weekly candy sales in Topeka.
As for Fed Chairman Bernanke, he said that the Fed could act again if necessary. Imagine that - as if any Fed chairperson would ever say there were no options left. But when the market wants to go up, any remark will do.
The last hurdle to cross is Friday's GDP print. The consensus we are looking at today, 2.5% annualized for the first quarter, looks too high to us. People are being lazy about the 3.0% fourth-quarter print and factoring in a slowdown of half of a percent, but that was a bogus print: annual inflation has been running between 2.5% and 3.0% by every measure but the fourth-quarter GDP report, which had it running at 0.8% annually. If growth slowed by a half-percent and the deflator returns to a more normalized rate (it averaged 2.6% in the prior three quarters), say 2.2%, markets would get a nasty surprise.
We aren't making predictions, though. One thing we do know is that the markets largely ignore the deflator, and another lowball wouldn't matter to them so long as the headline looked good. And even though new orders for durable goods were down sharply in the March report released Wednesday, that's the second quarter's problem, as shipments - which rose in March - are what's counted in GDP. Much of the decline in recent survey numbers have been about falling new orders, and the damage may not show up until this quarter.
If the first quarter number comes in at consensus or better, then it's 1425 here we come on the S&P 500. Monday is the last day of the month, Tuesday the first day of the new one, and those are two of the most powerful bull fundamentals known to the Street (we might not actually rally on Tuesday if the ISM manufacturing number is a dud, but traders will be perfectly happy to borrow on it beforehand). We can start worrying about jobs again on Wednesday, when ADP payrolls come out; until then, there's money to be made and positions to be marked up.
What about the Street being a forward-looking mechanism? It still is. In fact, right now, we reckon it's looking forward to selling the first quarter's equity inventory to the retail pigeons rushing forward to get in on the "new highs." It works every time.
Additional disclosure: We have a small bear straddle position in Apple.