Economic statistics continue to disappoint investors. Consumer spending, consumer confidence, housing, industrial production (in China and Europe as well as the U.S.), are all less than expected. Okay, China is a bit of a special case since, being in no danger of recession, it welcomes rather than fears a slowdown in its torrid growth. For the U.S., however, any additional slowdown could have painful consequences.
Let's consider the context. U.S. interest rates have been slashed to near zero. If we need more economic stimulation, it can't come from lowering rates any further. Plus, Congressmen who want to be re-elected this fall can't afford to launch another round of deficit/stimulative spending anytime soon. On top of that, the tax breaks enacted by the previous administration will expire in 2011 – which may help the deficit, but will take away another source of stimulus.
Altogether, the current climate is bad medicine for an economy suffering from 9.5% unemployment.
The one bit of positive news that might offer a lifeline comes from the Federal Reserve's most recent meeting in June. According to the notes, the Fed felt at the time that there was a 50/50 chance it would resort to monetary easing rather than tightening. With all the statistics since that meeting painting a negative picture, we believe the likelihood of easing has risen to more than 50%.
The question is...what method could the Fed use to ease monetary conditions? With interest rates at zero, its only option – as we've said for some time - is to start buying back debt.
We don't know exactly when the Fed will begin such a program, but we think the trigger will be when stock prices fall far enough to strike fear into the Fed governors. That could be anywhere between 900-1,000 on the S&P 500.
Throughout 2009, the biggest sign that an economic recovery was on its way was the rebound in the stock market. The rally seems to have peaked around 1,220 and we’re still off 12 percent from the high, despite the gains in the past few weeks. If the market shows signs of entering a new bear trend, the Fed will have little choice but to begin buying government debt to halt the resulting slide in confidence. Essentially, the Fed will signal companies that they can borrow as much money as they want because the Fed will print it to infinity. It will be Chairman Bernanke's famous “helicopter-drop” approach to injecting cash into the system.
Of course, there will be consequences. We will find ourselves living in a brave new world in which commodity prices will go ballistic. On the one hand, higher prices will constitute inflationary forces the likes of which we have never seen in this country. Yet, at the same time, high commodity prices will put a virtual tax on businesses and consumers that will promote deflation. Over the past 10 years, higher commodity prices have already amounted to a tax increase bigger than any in the history of the U.S. It's taken 10% off the median American income.
Nor will this be the last episode of quantitative easing we will endure. In our brave new world, QE will become the Fed's new recreational drug, and just as addictive.
We took a hit of QE in 2009, and it caused the prices of most assets to rise together. Our guess is that the next round will ignite the markets in a similar way. When people have easy access to money, they tend to spend it on whatever is for sale. Risks seem to disappear, so why not buy a little of everything? A very strong rally that carries most assets with it is the most likely result and will be a welcome relief for many.
Unfortunately, the rally will end once the world realizes the U.S. dollar is being debased and stops buying dollar-denominated securities.
Ultimately, the real winner will be (no surprise to you, dear reader) commodities and especially gold. Gold is not only a commodity but also the currency of last resort. Historically, it tracks commodities most of the time, but sees its strongest gains when other currencies are being debased and investors seek a better store of value. However, you can rest assured that both gold in particular and commodities in general will be the place to be when the QE helicopter arrives.
We wish our long-term message was happier, but we'll have to settle for making money when most investors aren't. Meanwhile, we expect stock prices to weaken until the Fed is convinced to begin QE. Then hold onto your seatbelts and enjoy a strong rally that takes most people by surprise.
Finally, a word on China. The news today is that China has now become the largest energy consumer in the world. We knew the day was coming, but it shows how misguided the world's priorities are. While the West frets about double-dip recessions and government debt, China's biggest concern is making sure it grows as quickly as it can without outstripping available resources. The recession in the West has therefore benefited China, and its next move will probably be to lower interest rates. The coming dip in the S&P will not harm China one bit, provided the Fed responds the way we expect.