What are the Markets Thinking?
Bond markets have been the big winners in the third quarter. Rates have fallen to incredible lows; Pimco, a large money manager, has referred to them as “Eisenhower” lows because they were prevalent in the 1950s. Treasuries are the biggest winners of all with the 2 year yield now at 0.43%, the 5 year at 1.26%, and the 10 year at 2.49%; the 5 year and 10 year yields fell 75 and 58 basis points, respectively, since late June.
Mortgage rates have followed Treasury yields down, with the 30 year mortgage rate down about 50 basis points. I believe that this extraordinary situation is actually a flight to quality because of fears that had been accumulating in the markets – over European debt, the possibility of another recession, the expectation that the Federal Reserve could begin buying bonds again, and sheer uncertainty over what the true health of the economy, fiscal policy, and unknowns, such as the impacts of health care and financial reform legislation and low consumer and business confidence.
Stock markets performed exceptionally well in September after a summer selloff that took the Dow below the 10,000 level again. The index has fallen below or risen above 10,000 an incredible 295 times since first attaining that level in 1999! (Thanks, Doug Ingram). Earnings are improving and the projected price earnings, or “PE” ratio for the Dow is 12.1 (currently 14). For the S&P 500, the projected PE is 12.5 (currently 15). These are not overvalued levels by any means. One fact I noted was that S&P 500 companies are sitting with cash levels of 10.2% of total assets at June 30th. This huge amount of cash “on the sidelines” is the result of risk aversion leading to a classic liquidity trap. As the outlook improves, these companies will seek higher returns through investments. Still, with stock markets having done so well during September, I would have expected rates to rise somewhat. Instead, they barely budged.
Above trend GDP growth will not come until there is job growth and job growth will not come until there is above trend GDP growth. Second quarter real GDP grew at 1.6% after growth of 3.7% in the first quarter. Real final sales are growing ever so slowly at 1.0% in the second quarter and 1.1% in the first quarter. This level of growth is too slow to create sufficient jobs to recapture the 7.6 million jobs still lost during the recession, leading to our catch 22.
So far in 2010, private employers have added 723,000 jobs, well below the pace of prior recoveries. High unemployment is restraining spending but there are signs that employment is improving. Job openings reported by the Labor Department in July were 3.04 million, representing a year-over-year increase of 30%. An August report by Challenger, Gray, and Christmas showed that layoffs have declined dramatically, to a monthly average of 56,000 since June, 2009 and have been below 100,000 for fourteen consecutive months for the first time since 1999-2000. Year-to-date layoffs are down 65% from the same period last year –good news indeed.
The Recession is Over
What if you declared the end of a recession and no one cared? Well, if you are NBER, or National Bureau for Economic Research, and you wait fifteen months to declare that the recession was over in June, 2009 (its duration was 19 months), no one will care. We declared that it was over late last summer, because we saw the strong positive change in the data. Economists certainly are a cautious breed but we should take their declaration as a positive sign that they believe the economy has achieved growth strong enough to continue. Rebuilding of depleted inventories and increased capital spending helped to get GDP growth back on track in the summer of 2009 and into 2010.
Low interest rates and easing actions by the Federal Reserve have aided the recovery, although it is strongly being debated right now whether the Fed should be doing more. Every month, we keep getting their pledge to “keep rates low for an extended period of time” and their promise that, if the economy slips further, the Fed may begin additional purchases of securities in the marketplace to add money to the system. When we needed action in the second quarter, the Fed did not act. We are improving slightly in the third quarter, so I don’t expect any action from them.
What is really needed is an approach to get banks back to lending, which is not helped by increased capital requirements and FASB’s proposal to subject loans to mark-to-market accounting, which could introduce frightening volatility into bank earnings and capital.
But, I digress… Inflation is very low right now and with yearly core inflation at 1.4% and slipping, we are approaching the lower end of the Fed’s target range of 1% to 2%. Some of you Phillips curvers believe that low inflation is one factor behind the high unemployment rate. If you are unemployed, you may not feel that the recession is over. But jobs are slowly being added, as some of the uncertainty is removed from the markets. Improvements in employment will lead to more spending by consumers and businesses, which could ultimately stabilize the housing market. Home prices are improving on a year-over-year basis, according to Case Shiller, by about 4% to 5%. Uncertainty about a housing recovery has been holding back growth. Future tax rates and compliance costs are also causing uncertainty, most notably from the still unresolved situation with the Bush tax cuts set to expire in 2011, health care costs, and financial reform costs.
Putting It All Together
We are looking at low rates for a long time. The Federal Reserve will keep the short term Fed Funds rate at 0% to 0.25% well into 2011 and likely into 2012. 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. This newly created money must ultimately come through the system, into banks, and come out as loans to consumers and businesses. Until this happens and confidence gets a lift out of the doldrums, GDP will continue on its slow growth path.
With short term rates anchored by Fed policy, long term rates will remain in check as well, due to subdued inflationary expectations. I do believe that the bond markets are wrong right now – that longer term rates are too low and that they will make their adjustment with the 5 year Treasury returning to 2% and 10 year Treasury returning to 3% in the next six months. However, even with these adjustments, rates are still incredibly low, and still “Eisenhower” low!
Update on My Favorite Machine – the Large Hadron Collider,“LHC”
The LHC is now speeding protons around its circle at the speed of light and crashing them into each other at total energy levels of 7TeV, which is still only one-half of its planned energy levels of 14 TeV in 2016. They are researching particles generated by the collisions. It took 100 years for scientists to discover all of the known particles in physics and only 4 months for the LHC to rediscover them. Sadly, the recession affected funding to the programs and upgrades have been delayed by one year. The Collider will have planned shutdowns in 2012 and 2013 and is expected to keep running until 2030.
Thanks for reading! DJ 09/29/10