Thursday, August 12, 2010

Guest Post: Second Quarter Economic Update

What’s Bothering the Markets?
There used to be an old adage in the stock market: “sell in May and go away.” This year, it certainly seems to be the case. Stock markets did quite well this year into April then began to sell off relentlessly in May; in the meantime, bond markets moved higher, especially Treasuries, as investors sought the safety of bonds. Interest rates have been driven to incredible lows. The month of June has not been much better; after trying to rally from lows, stock markets keep getting battered back. It’s almost as if there is some invisible hand keeping the Dow near 10,000 and the S&P near 1,050. Wait! These were the 1999 levels for these indices. One lost decade later, we are still there. Did you know that since 1999, the Dow has risen above and fallen below the 10,000 mark an astounding 280 times! (Thanks to Doug Ingram for that bit of history).

So what gives? What is wrong with the markets now? We can’t blame it on the Internet stock bubble of ten years ago. We’ve lived through one of the worst recessions and financial market crises of our lifetimes. The stress of September, 2008 to March, 2009 was beginning to be erased by an economic recovery, as signaled by stocks that rallied over 60% from fearful lows to levels that supported growth. Then came this May and June, and it feels like the market psyche is slipping back to emphasizing the negatives. Don’t get me wrong, there are plenty of negatives to go around – Greece and Europe debt crises, China growth issues, a weak employment report for May and unemployment at 9.7%, fear of a “double-dip” recession, weakening data, the BP gulf oil spill, low business confidence, and continued deleveraging by consumers and businesses.

Government and regulators are contributing to the pessimism with financial reform legislation that does not even address some of the causes of the crisis, new FASB proposals to impose harmful mark-to-market accounting on bank loans, and the looming expiration of the Bush tax cuts in 2011. Bummers all. Jim Cramer describes it as a “malaise,” or a general lack of optimism. I describe it as the sound of thousands of vuvuzelas buzzing at a soccer match!

Is There Anything Good Out There?
Now that I have depressed you completely, let’s take a moment to cheer up. Yes! There are positives in the economy and in the markets. In the first five months of 2010, jobs grew by nearly 1 million. Granted, we lost over 8 million jobs since December, 2007, but gaining 1 million pretty quickly is good. (Now I admit many of those jobs are temporary census workers, but these are people working too). Housing prices bottomed based on the Case Shiller indices months ago and are now up almost 4% to 5% on a year-over-year basis. Existing and new home sales fell sharply in May, but this followed the unusually high months of March and April that contained the $8,000 tax credit.

Inflation and expectations for it are both low; inflation is not a serious risk as GDP growth remains steady but below levels (3% to 4%) that can be inflationary. In fact, the battle against the real enemy, deflation, is being fought by the Federal Reserve with easy money. Interest rates, especially Treasury yields and mortgage rates, are at very low levels, which can help consumers and businesses with new loans (if they ever want to add to debt) and refinancing. And our eternal ally, the Federal Reserve, has pledged to keep short term interest rates low for an extended period of time, creating a friendly growth environment indeed. Ben Bernanke has always pledged to print more money, and drop it from helicopters if need be, to kill deflation.

We worry about all of the negatives mentioned earlier. They can lead to a loss of confidence in the economic recovery that is underway. For employers to add jobs, that confidence is essential. For consumers to spend, that confidence is essential. On the positive side, we are now in the fourth consecutive quarter of an economic recovery that started last summer. Most economists believe that the growth momentum will continue at a pace of 2.7% to 3% into 2011. Then we have to worry about federal tax increases, i.e. the Bush tax cuts expire, and state and local government tax increases as these states and municipalities struggle to balance budgets. States are wrestling with reducing projected June, 2011 deficits of $112 billion, according to the Financial Times. Let’s hope the projections of GDP at 3% come true when these tax increases occur.

Putting It All Together
The economy should grow 2.5% to 3% in 2010 and about the same in 2011. This recovery is slower than those we have seen historically, but “slow,” after the crises we have endured is preferable to “no.” Negatives in the markets have been holding us back, in addition to “inventory” issues that I have continued to stress. Two of the inventory issues have been improving – manufacturers adding to goods on the shelves and the pool of available workers declining slightly – while the other two remain weak-houses on the market and bank loans declining.

Short term interest rates are low and can be expected to remain that way until economic recovery is assured and unemployment drops“way” back from its high level near 10%. We are looking at the Federal Reserve holding the Fed Funds rate at 0% to .25% well into 2011 (mid-year at least). Some economic formulas that predict the Fed Funds rate, most notably the Taylor Rule formula, show that this rate should be negative 1.75% right now, making 0% look pretty high. It’s been said that negative interest rates are not an option, thus the Fed must inject money into the system in other ways, such as buying securities. Longer term rates should rise slightly, by .25% to .50%, once the flight-to-safety comes out of the bond market and yields return to where they were before May. But large increases in long term rates are not expected as inflation remains tame for the foreseeable future and the Fed battles the evil of deflation.

Thanks for reading! DJ 06/29/10

Dorothy Jaworski has worked at large and small banks for over 30 years; much of that time has been spent in investment portfolio management, risk management, and financial analysis. Dorothy has been with First Federal of Bucks County since November, 2004.

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