September 3rd, 2012
by Jim Welsh, Macro Strategy Team, Forward
Macro Factors and Their Impact on Monetary Policy, The Economy and Financial Markets
Spain and Italy are sinking under the weight of excessive debt. Since they are too big to fail, European policymakers are likely to leveragetheir $600 billion bailout fund, so it can buy distressed Spanish andItalian debt. This will help lower their borrowing costs in the shortrun. But it will increase their total indebtedness, since they will beresponsible for their share of the increased bailout fund. This is arisky structure that may not end well. The gradual slowing in theu.s. economy is likely to continue, with income and job growth remaining weak. The uncertainty about the election and "fiscal cliff" will also restrain business spending and hiring. With Europe remaining in recession, and u.s. growth slowing, China, India and Brazil will struggle just to maintain present growth. Each is also dealing with a distinct domestic problem that could complicate monetary and fiscal policy in each country.
The Federal Reserve and the U.S. Economy
The Forward Macro Strategy Team expected the u.s. economy to slow gradually as 2012 progressed. The modest improvement in job growth and retail sales in July fits the gradual slowing pattern, and does not indicate a reacceleration of growth. The paltry growth in jobs and personal income will continue to keep consumer spending constrained. Recent increases in gasoline and food prices will further squeeze consu mer discretionary spending. Each $.01 increase in the cost of gasoline pulls $1.3 billion annually out of consumer wallets. The $.25 increase over the last month will lower discretionary spending by $32 billion over the next 12 months if current prices hold. Consumer confidence and small business optimism continue at levels only seen during periods of recession during the last 30 years.
While the gain of 163,000 jobs was a welcome relief to the weak numbers of prior months, it was not as strong as the headline suggested. The seasonal adjustment ofthe raw jobs data was the largest for a July in the past 10 years, adding 377,000 jobs to the unadjusted raw data. The Department of Labor estimates small business job growth with their birth/death model, since small business activity is under the normal monthly survey's radar. Their birth/death model added 52,000 jobs. This does not line up with the National Federation of Independent Businesses survey, which shows a dearth of hiring by small businesses. Average hourly earnings were up 0.1% in July, and 2.0% over the last year, which is less than the increase in the cost of living. There are 8.2 million people who have a part time job, but would rather be toiling full time. In this environment, the 15.0% underemployment rate provides a more comprehensive view of the labor market's health.
This chart from Sentier Research (www.sentierresearch.com) compares Median Household Income (MHI) (left scale) and the Unemployment Rate (right scale) from January 2000 through June 2012, using 100 as the baseline for MHl.ln January 2008, MHI was just over 100, indicating that in the prior eight years there was virtually no income growth. As the unemployment rate soared in 2008, MHI dropped and was 96 when the recession ended in June 2009. This means MHI declined by 4% during the recession. Sadly, during the recovery, MHI has declined another 4%, which is why it is at 92. This is unprecedented after three years of "recovery." Weak income growth explains why consumer confidence is so low. Since 1980, confidence readings below 80 have been coincident with recessionary periods. Confidence hasn't been above 80 since the end of 2007,just prior to the ongoing descent in median household income.
As discussed in prior issues of Market Strategy Review (MSR),the Federal Reservewill feel compelled to launch another boutof Quantitative Easing (QE), in response to another chapter inEurope's financial crisis, or clear signs the u.s. economy is slidingtoward recession. We believe the Fed would rather hold off on QE3so they can use it as a response to weakness, rather than use itpreemptively. The looming fiscal cliff next January must also be aconcern, since it could knock 3-4% off of 2013 GDP. According to theCongressional Budget Office, "a significant recession" could occur, unless Congress averts the tax increases and spending cuts set for January 2013. Concerns about the fiscal cliff are likely over blown, and not because Congress will handle it well. Expecting Congress to handle its duties responsibly may be a long shot. But after much posturing by both parties, a compromise of sorts will emerge. Investors are likely to respond with a sigh of relief stock market rally. But eventually they will realize the fiscal cliff will have morphed into the "slippery slope of slowing" as some taxes are raised and a few spending cuts are implemented. Next year's budget deficit will be less, but so will GDP growth.
It is almost certain the 2% reduction in social security taxes will be reinstated. That will lower disposable income for the average family by roughly $1,000 in 2013. Given how tight most family budgets are, that difference in spendable income will make a difference.
Mortgage rates are hovering just above multi-decade lows, so Fed purchases of Treasury Bonds or Mortgage-Backed Securities will only bring rates down a handful of basis points. The Fed's real target is the stock market, and specifically those with the highest incomes and extensive stock holdings. By lifting the stock market, the Fed hopes those with discretionary income will keep spending. The risk is that without generating a self-sustaining recovery, which creates jobs and boosts median incomes, the stock market could become disconnected from the real economy, and that rarely ends well. If investors ever conclude that monetary policy is incapable of stimulating economic growth, the stock market could be especially vulnerable.
One way of gauging the stock market's health is by measuringthe number of NYSE stocks that are above their 200-day movingaverage (MA). A high percentage of stocks above their MA is a signof strength since it reflects broad participation. When marketaverages push higher, while the percentage of stocks above theirMA shrinks, it means fewer stocks are participating. Waning participation is a warning sign that the stock market is vulnerable to negative news. In early 2011, 80% of NYSE stocks were above their MA. In March of this year, only 70% were above their MA even though the S&P 500 was 1,420, versus 1,370 in 2011. This warning was followed by a 10.9% decline when bad news increased selling. On August 21, the S&P 500 reached 1,427, but the percent of stocks above their MA was less than 60%. This suggests the stock market is vulnerable if some bad news appears.