For a brief moment in time it looked like all economic storm fronts were ready to collide to form the Perfect Storm. The markets fell as the equity bubble burst. The economy went into recession. Companies with poor business models failed or went under and corporate scandals abounded and were found everywhere. For the first time since Pearl Harbor, the nation was attacked on its own soil. The nation headed towards war, a war that would be fought differently unlike anything in our past. Gloom was pervasive and it appeared that storm fronts in the economy and the financial markets were heading toward collision. All seemed lost when suddenly the weather changed. The winds calmed, the seas subsided, the rain stopped, and the sun shown brightly again. Optimism returned first to the markets and then to the economy. Consumer optimism rose, while investors became bullish once more.
Is it morning in America or is it the calm before the storm of the century? Washington and Wall Street believe the good times have returned. Investors and consumers are inclined to agree. Investor euphoria has returned. Day trading has made a spectacular comeback and confidence in stock picking is on the rise. In the view of one market seer, “We’ve seen a move from fear to comfort, probably on the way to greed.” Whether it is a new corporate scandal, another terrorist attack [considered by most to be unlikely], the war in Iraq, missed earnings estimates or high priced markets, investors are taking everything in stride. Investors seem to be forgiving as long as markets continue to rise. If Wall Street is optimistic, investors are even more bullish.
What is behind this change in public sentiment? It is supreme belief in the gods of the economy, the stimulus from Washington and the money flowing from the Fed. Americans believe the economy is getting stronger as profits are improving, which will lead to even higher stock prices. It would appear that this optimism is justified. Stimulus is pouring into the economy and the markets as never before.
This year’s government budget will be $2.3 trillion resulting in a $477 billion deficit. Last years deficit was $374.2 and over the next decade that red ink will total $1.9 trillion. In Washington there is no real desire to cut spending because it is believed that government spending creates prosperity.
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The deficits will not enter into a critical stage until foreigners cease to be willing buyers of U.S. government debt.
At the moment Asian currency intervention in support of the greenback continues to accelerate. Foreign accumulation of U.S. Treasury debt has been massive amounting to almost 7½% of all outstanding Treasury debt on an annualized basis. All that stands between sunshine and rain is foreign willingness to finance the U.S.’ twin deficits now over $1 trillion annually and growing. The latest Fed reports show that foreign central bank holding of U.S. Treasuries stand at $1,105 trillion up $247 billion over the last 52 weeks. As high as the U.S. deficits are, they still appear reasonable on a percentage basis when compared to historical standards and with other countries.
If the economy begins to soften, by mid-year fiscal spending could become even more expansionary. This is an election year and our dear politicians are passing out candy to the voters. If the economy softens, Washington knows only one thing and that is to spend more money. So expect fiscal stimulus to be operating at full throttle. It is one of the pillars holding up the U.S. economy.
The other pillar is monetary policy which is also operating at full throttle. The Fed has its foot to the pedal and is doing all that is possible to goose the markets and economy with cheap and abundant credit. Since it began slashing interest rates in 2001 the Fed has managed to bring interest rates down to a half century low and keep them there. The result has been a flood of money into the economy and the financial markets. Low interest rates have spawned a bubble in real estate, mortgages, bonds, and in stocks. The rise in the stock market since the October lows of 2002 has all been liquidity driven.
For the first time in nearly half a century, the yield on the S&P 500 exceeds the 3-month t-bill rate. (S&P 500 yield = 1.5%, 3-month t-bill yield = .9%) The Fed is able to keep rates this low only as long as foreigners continue to finance America’s burgeoning debt burdens. It is an untenable position fraught with much risk.
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Cash is Trash
Money growth, which has fueled these brief moments of sunshine, has fallen sharply. Part of this has to do with last summer's tax rebates and mortgage refi money generated from the May-June interest rate lows. Another reason for the slowdown in money growth is the “cash is trash” syndrome. The returns on savings are at record lows and in fact are negative when compared to inflation rates and taxes. Savers and investors are pulling their money out of banks because of poor returns and seeking higher returns elsewhere. This is what is in part fueling the financial markets.
That has been Greenspan's intention all along. In order to fund consumption and prevent a reckoning of the debt binge of the 90's, it has been necessary to keep the markets or asset bubbles inflated. Consumers, corporations, and the government continue to go deeper in debt requiring reinflating of all asset bubbles. The debt burdens have become so large that it has become unthinkable to consider the consequences of a deflationary debt collapse. The Fed needs to keep interest rates low in order to keep the mortgage refi and housing markets from collapsing. Mortgage debt has become the main props holding up consumer spending and as long as the housing bubble stays inflated consumer debt burdens appear less ominous.
The housing market is dependent on cheap mortgages, cheap mortgages are dependent on low interest rates, and low interest rates are dependent on foreign intervention. This is an untenable situation and will not last.
Besides the intervention of foreign central banks, another critical factor in keeping interest rates low is the bond carry trade. The Fed’s commitment to keep interest rates artificially low has provided the fuel behind the carry trade. Hedge funds and institutions can borrow at artificially low interest rates and invest the difference in longer-dated Treasuries. The difference in yields has ranged between 300-350 basis points making it extremely profitable to borrow. It is one reason why the bond market has been asleep. It is making money ignoring all the visible signs of monetary inflation.
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Real Estate & Recovery
Meanwhile, the real estate market will continue to play a key role in the U.S. economic recovery. The fact that real estate prices keep going up only reinforces that view. In my view there are four critical factors that all support the real estate market remaining strong this year. They are listed below:
Rogue Waves, Fat Tails & Outliers and Other 10 Sigma-like Events
While the Fed has managed to bring interest rates down to levels not seen in over 50 years, it has not been without risk. By lowering interest rates it has created a level of moral hazard that is without precedent. By making the returns on savings worthless, it has discouraged thrift, encouraged the accumulation of debt, and given impetus to speculation. With negative real interest rates, savers have been forced to seek returns elsewhere in the markets. Investors from sophisticated hedge funds to the average Joe have also been forced to take on more risk.
Risk premiums have narrowed considerably as shown in this BCA Research chart. In fact investors are being paid very little for taking on big risks. Interest rate spreads have nearly collapsed on speculative-grade debt and emerging market sovereign debt. One real threat that a storm in the markets is approaching would be for a blow-out in credit spreads signaling a bottom in the interest rate cycle.
While the markets have become highly geared, they also have become highly overpriced
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Investors get very little in return for buying risky debt or risky equities. Dividends are well below normal and P/E multiples remain way above the normal range for the major markets. For investors all that matters now is price and as long as prices keep going up, investors will keep buying. In the back of the minds of most investors is the strong belief that the Fed will bail them out. Forgotten is the fact that the Fed failed to stop the equity bubble from bursting or keep the NASDAQ from losing almost 80% of its value. Likewise the Fed was unable to create a soft landing or prevent another recession from occurring. The latest opinion polls show that investor bullishness is back to levels last seen at bull-market highs of the late 90’s. In the words of Woody Dorsey, “We’ve seen a move from fear to comfort on the way to greed.”
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