Markets Misread Strength of US Economy? by D Solin

Looking at markets this week there is an unmistaken theme resonating – the US and hence global slowdown is much less a risk than previously believed and inflation is on the move up and demanding higher rates here and everywhere. Looking at markets this week there is an unmistaken theme resonating – the US and hence global slowdown is much less a risk than previously believed and inflation is on the move up and demanding higher rates here and everywhere.

Well I am not buying it. If any misread is happening it is in market participants overestimating the strength of the US economy and its corollary – overstating the inflation risk.

The idea that Q1 GDP growing at a 0.9% pace against 0.6% in the advance release is somehow a confirmation of the economy averting a recession and prepped for a significant acceleration is preposterous. Home prices are falling at a rate faster than the worst decline of the Great Depression based on the latest data from Case-Shiller for home prices in March (down 14% y/y for top 20 metropolitan areas). Incomes after inflation are not rising as the latest data on personal income and consumption show. This is a consumer based economy and without a consumer beset on spending and borrowing, no amount of export growth can offset a consumer heading for the hills when it come to GDP. Be patient – consumers have become accustomed to all sorts of cheap credit to finance current consumption. Habits are hard to break. But tighter lending standards (credit crunch), a (move to) shutting off of the home ATM machines (HELOCS), surging food and energy prices (cutting into disposable income) and falling home values tell me that the consumer has lots more adjusting to go. Poof is what comes to mind when I think of the impact of the Bush/Congress $600 per person economic stimulus for those earning under $200K. Suspect this is the equivalent of offsetting higher food and gasoline bills for about 5-6 weeks. Retailers are not reporting much in the way of accelerated sales now that government tax rebates have been sent out. High debt levels and low morale suggest other uses for the $600 than putting it towards a Nintendo Wii and Guitar Hero.

My guess is that what is happening in commodity prices that helped explain some of Thursday’s move in fixed income (higher rates) was more about deleveraging in the oil market and not related to some major turn in macro environment favoring growth, equities and the dollar. Yes oil prices fell, stocks and the dollar rallied and Treasuries sank. And lower oil prices will translate into greater disposable income…but the real damage to disposable income from rising oil prices is in the run up from $100 a barrel in oil not the difference between $135 and $125 oil. I think this is more a case of the slippery end of the tail wagging the dog.

The US economy is the most challenged it has been in my memory since getting involved in markets in 1987, ahead of the stock market crash. To lose sight of where the risks are because the full burden of proof of a deep recession has yet to materialize at month 10 of the credit crisis is no reason to bail on hard-landing view. Fed easing is having little to no affect on real economic activity, not with banks in lockdown behind soaring write downs and risk of more to come. Even the Fed’s updated economic forecasts for April released earlier this month have unemployment rising ahead.

Plenty of easing and a surge in commodity-generated inflation warrant a Fed-on-hold message, not a Fed tightening message. Dallas Fed President Fisher is not Chairman Bernanke when it comes to inflation and early rate hikes (like October) are all bark and no bite from the likes of Fisher who voted against the last three rate cuts. My read on the Dow Chemical CEO’s dire warning of pass-through inflation from his input costs surging was a call for government action – a real energy policy that addresses soaring oil. His concern is that the consumer is going to fold in the face of soaring finished goods prices, an anything but a message of confidence in future earnings.

Dell computer posted some impressive earnings numbers after Thursday’s close. Foreign sales and cost cutting were the drivers in the performance. The weak dollar and demand holding up in advanced developing nations are supporting PC sales. But foreign demand is at risk if I am right about a much slower US economy and no amount of cost cutting will support PC sales if unemployment is rising and income falling?

I think government bonds (global bonds – Gilts especially) are undervalued in wake of the recent sell-off. I think stocks are overvalued, though also recognize that even letting the air out of oil will draw funds to this market in light of heavy cash holdings and market participants showing greater capacity for taking risk (non-bank participants that is). On the dollar I think we are getting closer to a bottom but I am not quite ready to throw in the towel on the notion the dollar will put in a new low versus the euro, CHF and Aussie – lows are in place versus sterling, NZD and CAD.

If I have any concession to make on the markets it is that the eye of the hurricane is proving much larger than I thought possible…credit officials with restoring elements of confidence to an otherwise hopeless situation. But no amount of Fed easing, liquidity operations or stock market euphoria can prevent the back side of the financial and economic hurricane from hitting asset prices and economic growth ahead.

And next week? I think the euro will likely retrace more of this week’s downside versus the dollar in light of what seems unavoidable – ECB contemplating rate increase at next Thursday’s Governing Council meeting – which should see the light of day in the post-meeting press conference. Don’t get me wrong, I am not forecasting an ECB rate hike, just the consideration of a hike in light of 3.6% HICP in May for the Euro Zone and the single mandate of price stability.

David Gilmore