First quarter 2012 was an “Indian Quarter” with the fourth warmest winter in U.S. history coinciding with the best quarter for U.S. equities since the iMac, Palm V and internet IPOs were warming things up back in 1998. That didn’t end well, but I do hear the sock puppet dog is making a comeback. The S&P 500, Dow Jones Industrial Average, and NASDAQ Composite were up 12%, 8%, and 19% for the first quarter of 2012.
European Central Bank long term refinancing operations (LTRO) in December and late February (essentially $1.3 trillion in 1% loans to banks for survival) took a “Lehman event” (i.e., complete financial system freeze up) off the table for banks, lowered Spanish and Italian yields (the rate at which they borrow) significantly, and acted as quasi-QE for U.S. equity markets (providing money supply to fuel risk taking in U.S. equities). The last of these effects is was what caught most market watchers/pundits/investors off guard. Liquidity is liquidity, regardless of where it comes from. The continued “reflation” of markets through U.S. QE and now Euro Zone “quasi-QE” is something to rent, not buy. You need to be in the game, but you can tap the top of your helmet to get out as well (although if you did that when I played growing up in Texas you may never have seen the field again…different game today…but I digress).
Looking at the balance of the year, it will be interesting to see if the Fed tries to get one more stimulus done before mid-year, in the form of QE, a variation of Operation Twist, or some other monetary experiment to keep markets going. The Fed minutes from their most recent meeting say “no”, but minutes are carefully worded posturing. The Fed does what it wants when it wants, except for a brief few months when it gets bitten and has its hands tied by an upcoming presidential election. So, 1H12 would be the time for stimulus if they do it.
Europe as a whole is in recession with the periphery “moles” (of European “Whack-A-Mole” fame) in Depression. It truly is like the 1930s in Greece, Spain, and Portugal with unemployment rates for young adults above 50% and the whole of the Euro Zone hitting 15 year highs in joblessness. Austerity (i.e., tax hikes, wage cuts, pension cuts, cuts of government services) promises years of the same with intermittent hiccups if not outright shocks to the global economic system. All the factors that led to Euro Zone crisis are still there – the structural problems – monetary union without fiscal union causing balance of payments and debt problems for weaker countries, etc. LTRO saved the European banking system for now, but you can’t fix solvency problems with liquidity, and all Europe’s banks and most periphery mole countries are doubly insolvent. There are also signs the problems in the periphery are seeping into the stronger core, namely France and the Netherlands. Soon, Germany may be the only “core” country left. The Euro Zone is a failed experiment and the long-term negative repercussions of how that experiment ends are gaining strength with every kick of the can.
China has been slowing dramatically since the real estate market turned down severely in Fall/Winter 2011. The new Chinese premier recently announced a lowered 2012 GDP target of 7.5%, which would be the lowest in 13 years, and only the third year under 8% (a “China-cession”) in the last 20 years. China is experiencing the aftereffects from the massive state-directed multi-trillion dollar fiscal and monetary stimulus (around 50% of GDP) to avoid recession in 2009/2010. It may have just delayed it. China has more structural problems than the West, including an uneven, unsustainable growth model (70% reliant on fixed investment and exports for growth over the last ten years), a state capitalist system that favors large inefficient monopolies owned by the state to free enterprise, and the largest, most opaque banking system in world history ($15 trillion in “assets”) with some of the riskiest loans on its books. China has issues to deal with and it must go in its corner and deal with them. If it doesn’t, the biggest, best marginal driver of global growth may add to the West’s economic woes.
In the U.S., if you believe the trends in the data (manufacturing, retail sales, auto sales, personal consumption expenditures, etc.), recovery is in full swing. We do see signs of mild recovery, but it has accrued predominately to large corporations and higher income households. Employment, housing, and middle/lower income spend are still not in confirmation of balanced, and thus robust recovery. Confirmation of balanced recovery would come with hiring above 300,000 (200,000 currently), and preferably multiple 300,000-400,000 job gain months in succession. We don’t see that in the near term. And for perspective, at 200,000 job gains per month, it would take nearly 9 years to recoup the remaining 5.3MM jobs lost during the Great Recession and accommodate new entrants into the workforce. Home prices set a new post-bubble low in January, reaching 2003 levels (Case-Shiller Composite). New home sales are lower than at any time during the Great Recession and indeed barely off the lowest levels going all the way back to 1963. While existing home sales have been picking up since mid-2010, sales have been largely to investors (20%, and 50%+ in some areas), and existing home sales do not contribute to GDP, new construction does. In terms of inventory, new and existing homes for sale are down to 2.7MM from 4.4MM at peak in 2007, but home pricing and new construction may be constrained by the estimated 3.95MM in “shadow inventory” (homes in foreclosure process or owned by the banks), and possible addition of 6.5MM additional foreclosures (those currently 30-90 days late + those with negative equity on their homes, Bloomberg). On the consumption front, retail sales and personal consumption expenditures (PCE) are indeed reaching all-time highs, but it is largely on the back of: (i) fiscal stimulus (e.g., payroll tax cuts, extended unemployment benefits, food stamps), (ii) a decline in the savings rate (at 3.7% down from 5.6% in Aug. 2010, ~90% negative correlation between savings rate and retail sales), and (iii) higher income households maintaining spending levels (upper income average daily spend per day is unchanged from March 2008, while middle/lower income spend is down over 26% – Gallup).
If nothing is done in Washington before the end of 2012, we will see the expiration of the Bush Tax cuts, payroll tax cuts, extended unemployment benefits, accelerated depreciation, Medicare doc fix, etc. Combined, if everything is allowed to expire, it may shave a upwards of 1% off of GDP in 2013. This is the so-called “fiscal cliff”, and it is not a pretty view from the edge. The parachute we used from the last cliff is frayed and tattered and would be of little use if we turned down significantly again.
In summary, I think the answers to several questions dictate that prudent investors remain tactical.
Q: How much are U.S. equity markets dependent on monetary stimulus? A: Very.
Q: How much is the U.S. economy dependent on fiscal stimulus? A: Very.
Q: How much is the Euro Zone dependent on IMF/EU/EC/ECB bailouts? A: Very.
Q: How much is the Chinese economy dependent on infrastructure stimulus and fading exports? A: Very.
None of these answers are “very” good.
Nonetheless, let’s enjoy this “Indian Quarter” for what it is, a jet stream and markets that got pushed too far north, appreciate the warm weather and warm returns, but prepare for Winter, for it will come sooner or later.
Just ask the sock puppet dog. He knows.
Jason B. Leach, CFA