The global equity indices benchmark, S&P 500, is back to Dec 1998 valuations, having also closed at a net sum gain in 12-months of 2011 trade. It would seem that Buy-and-Hold investors are in for a repeat of 2011, and many could be looking at 1.5% (three-session) YTD gains and wondering whether to bank now and take the year off.
A large number of market participants are saying that the US business cycle will de-couple from global contraction, and is likely to recover in 2012. It is said the growth will be driven by strong demand now that the US global economy appears to have diminished the pace of contraction, if recent economic releases are not subject to mighty revisions in the future.
That outlook however flies in the face of Federal Reserve Minutes that point to 2013 as the time that interest rate expansion, and therefore sustainable growth, will be seen.
A fundamental question rises for those who see growth coming in the near-term; where is economic demand likely to come from? It is an important discussion for those who still believe in Buy-and-Hold equity positions, because if growth is not actually seen it is very likely that equity indices will not move too far from current valuations.
There are two main groups to pull expectancy from (outside of dreams and hopes); consumers, and from industry, and both seem increasingly unlikely to assist in the expansion phase.
Consumer demand is usually driven by credit. However, credit card and loan/mortgage defaults are holding record highs on both sides of the Atlantic, while, the velocity of money – which speaking from a theoretical point of view, measures the level of economic activity – has reached very low values for the vast majority of developed economies.
The U.S. saving rate increased exponentially, in-line with the drop of available credit, to 7% in 2009, the highest rate seen since 1993, after being at negative rates in 2008. Nothing has changed in that pattern, except that reduced savings rates in 2010 and 2011 may be attributed to the paying down of debt or replacing lost income flows.
This situation points to a consumer that has been forced to start saving for their financial safety, rather than building a pile of unsustainable debt, as in previous decades, that aided economic expansion, but ultimately proved toxic for Wall Street and Main Street.
As admirable as it is that savings have been forced on consumers, and the heady days of Main Street excess look to be partially restrained, the administration will be pushing for an increase in consumer debt to fund the expansion that pays back the stimulus packages. The heady days of Wall Street excess seem not to have been interrupted.
Strike one; the U.S. consumer will not be consuming the economy into growth anytime soon.
The glimmer of hope is that global savings rates eclipse the rate at which Americans save, and as such the overseas savers may be able to spark a consumption rally. That however, remains nothing other than a glimmer, rather than a ray of consumption sunshine.
Industrial demand is in a comparable situation to the consumer driven demand. During the economic downturn a high percentage of factories have been temporarily closed, or have reduced output dramatically, while employees are fired. This means that when the economy picks up and factories see a stronger backlog of orders, they will simply re-open the idled machines, instead of buying or building new.
This economic phenomenon is known as economic slack, and can be measured using the capacity utilization report and detail. Since the US economic slowdown started, the capacity utilization rate has dropped at a very strong pace, and has been far stronger than in previous economic slowdowns.
Due to the economic slack, industrial demand is likely to stay at low rates, until the economy reaches once again the 2007 production levels. That is something that is not likely to happen until the consumer in the U.S. starts to consume.
Strike two: the industrial sector will not be manufacturing its way to economic growth anytime soon.
All this put together shows that the recovery period will be slow and long, and when translated into market momentum will likely transpose itself into a side-ways trend in risk and currency markets over the medium to longer term. Sound familiar? It should, because this is setting up to be a repeat of last year.
Investors and analysts will try to value regional business cycles and local economic growth, and while that is unfolding, divergence will be seen in regional valuations and expectancy. The forex market might come back to life on its own, breaking some of the historical correlations it had with S&P futures over the last year, as the regional debt-to-growth ratios are absorbed and valued.
The easiest way to generate growth, historically, is to cut interest rates, lower taxation, and force credit onto banks. However, as witnessed from 2003 to 2007, there is a harsh price to pay for the famine-to-feast business cycle that the US is travelling, as it goes from contraction to peak, and back down again, in record time.
The troughs get deeper, whilst the cycles get shallower, and that creates a unique US-based conundrum that may, over time, impact negatively the US perception that the consumer will save the day. Just how will the consumer be able to do that? (Rhetorical).
Strike three: the administration may be issuing a new, bigger, better, stimulus package, that covers the interest on the previous package, but that looks to be like a drop in the ocean of what is really required. Economic growth and expansion are a long way off.
The Fed knows it, tenured traders feel it, and the Talking Heads will likely get to see it as 2012 unfolds.
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