- Despite widespread fears in the financial markets for a double dip, the U.S. economy just completed what is likely to be its eighth consecutive quarter of economic growth, albeit a tepid rate of expansion.
- The latest readings on the factory sector and the moderation in energy costs suggest that the U.S. economy should rebound to at least three percent real GDP growth pace in the second half of 2011 with real GDP growth potentially testing the four percent area in the third quarter
- The European debt crisis and our own budget mess will contribute to market uncertainty, but we still look for the S&P 500 Index to test the 1400-1450 level later this year.
With the calendar turning over to July, the second half of the baseball season is upon us, offering a continuing season of promise to some (including an ever-optimistic Mets fan like me) and disappointment to others (sorry Cubbies). The question for market participants is similar: does the economy’s June swoon (and May-hem) signal the end of a tenuous season of recovery or just a temporary lull before a second half surge?
The last few days of June were a reminder that the economy has plenty of life in it still.
Supply chain disruptions associated with the earthquake, tsunami, and nuclear disaster in Japan, coupled with debt concerns both domestically and in southern Europe, placed downward pressure on the equity markets during May and the first three weeks of June. Accordingly, the eternal doom and gloom prognosticators came out of the woodwork to reignite double-dip fears for the U.S. economy and default warnings for several developed nations. Although we agree that the latest events in Greece merely represent a temporary fix, with the ultimate end result likely to include a Greek “default,” the events in the U.S. are far less troubling. The double-dip fears about the U.S. economy appear to be overblown as the latest factory sector readings suggest that our economy will recover from the soft spot in upcoming quarter. A likely improvement in economic conditions this summer, combined with the end of the Federal Reserve’s price-insensitive buying via QE II, suggest that the flight-to-quality rally in U.S. Treasuries which briefly took the yield for five-year Treasury notes down to 1.40 percent, and pushed the S&P 500 index to a retest of the 200-day moving average around the 1260 area, should prove to be short-lived. Better economic news in 2011:Q3 should provide support to U.S. equities but place selling pressure on U.S. Treasuries.
Despite widespread fears in the financial markets for a double dip, the U.S. economy just completed what is likely to be its eighth consecutive quarter of economic growth. Although the pace of activity was disappointing as real GDP growth struggled to approach a two percent pace in the first half of 2011, the bulk of the deceleration in growth reflected the combination of the supply-challenges from Japan and the temporary spike to $4+ for gasoline. However, we are beginning to see signs that this one-two punch to the U.S. economy is in the process of ending. The latest readings on the factory sector and the moderation in energy costs (discussed below) suggest that the U.S. economy should rebound to at least three percent real GDP growth pace in 2011:H2, with real GDP growth potentially testing the four percent area in the July through September quarter.
Interestingly, for those market participants fearing a double dip in the U.S. economy, history suggests that betting against the U.S. economy in the early to middle stages of the recovery has often been proven wrong. Double-dip recessions in the U.S. are rare, with the last one occurring way back in the 1970s.
Although supply shortages created challenges in recent months, we are beginning to see that the disruptions from Japan are in the process of being alleviated. Industrial production in Japan surged 5.7 percent in the latest months (its strongest gain in almost 60 years), providing an excellent sign that the bulk of the parts shortages will be ending soon. On a similar note, a 1.9 percent rise in U.S. durable goods orders for June, and rebounds in the latest Chicago purchasing managers’ and national industry supply management (ISM) reports (61.1 and 55.3, respectively) strongly suggest that a rebound in industrial production will boost U.S. economic activity in 2011:Q3. Likewise, the spike in energy prices including the $4+ per gallon price for gasoline has begun to moderate. A return to the $90 to $100 per barrel price for crude oil and a close to $1 per gallon drop in wholesale gasoline prices should help to bring retail gasoline prices back down below the $3.50 per gallon area later this summer/early fall. This moderation in energy costs should, in turn, help to spark a pick-up in discretionary consumer spending just as the auto industry is replenishing its depleted inventory position.
Near term the employment report for June might still reveal some supply channel disruptions. However, a sharp pick up in auto production should help to fuel an improvement in the labor market later this summer. Based on current industrial schedules, domestic automobile assemblies should increase by nearly 20 percent in July. In fact, a sharp increase in domestic auto output could add about two percentage points to real GDP growth in 2011:Q3, making a test of the four percent area for real economic growth a strong possibility. Near term, the initial unemployment claims reports released in the late July and early August could be a great concurrent indicator of an improving trend for the labor market. Accordingly, a sub 400,000 reading for initial unemployment filings would be viewed as another signal that the soft patch in the economy is ending.
The international markets breathed a sigh of relief as Greece passed an austerity plan. However, with economic activity in Greece declining at a 4 percent annual pace and the unemployment rate north of 16 percent, the Greeks may still be caught in a never-ending spiral of cutting spending and raising taxes that increases the unemployment rate and places added downward pressure on economic activity. Tax evasion remains a major issue in Greece and with resources being cut it is doubtful that tax collection will improve enough to save Greece from its debt burdens. Moreover, even if Greece were to meet its austerity goals, its debt to GDP ratio is approaching 150 percent. This heavy debt burden, combined with the likely continuation of double-digit interest rates, will force Greece to remain dependent on European entities and the IMF for funding and debt service. We continue to hold to our longstanding view that Greece will ultimately not be able to pay back its obligations and Portugal might not be far behind the Greeks. Although French and German entities are attempting to restructure Greece’s obligations, which include a discounted rollover of Greek bonds maturing over the next three years into new 30-year obligations, the rating agencies are likely to declare this plan a default event. Standard & Poor’s cast an added degree of appropriate uncertainty to the euro-zone efforts to rescue Greek by warning that “It is our view that each of the two financing options described in the (French bank’s) proposal would likely amount to a default under our criteria.” With Greek debt still hovering at around 50 percent of its par value, it will only be a matter of time before investors in Greek debt face the reality and take a significant haircut to their holdings on Greek debt.
The battle of the U.S. debt ceiling negotiations hit a roadblock in late June as Eric Cantor and Jon Kyl withdrew from the discussions. The Democrats are insisting that tax increases be included in the negotiation while the majority of Republicans are still touting that a tax increase of any kind will not be acceptable. Despite the disappointing actions by both sides, this is merely reminiscent of the bad politics that have dominated debt negotiations for the better part of the last 70 years. We believe that the politicians will live up to precedent and make the process extremely painful, possibly taking the U.S. to the edge of default (like what unfolded in late 1995/early 1996) before this debt ceiling episode is put to rest. Given the current inability of the leaders to work on a compromise, the likely outcome may be a “watered down” deficit reduction agreement that tables significant entitlement program cutbacks or tax increases until after the 2012 elections. This will likely not sit well with the bond market vigilantes.
As we have stated in a past InSite commentary, the August 2 date does not have to represent D-day for the debt ceiling – it merely marks the day that the Treasury will need to shift from conventional to unconventional measures to avoid breaching the debt limit. The debt managers could get past this date by reducing cash balances, adjusting auction schedules, delaying payments, and conducting asset sales. While unlikely, this could include creative financing actions such as the conversion of assets from the non-marketable portfolio to marketable securities by selling bills and coupons from the social security trust fund rather than the U.S. Treasury. A last option that might be available for the President is that he could break the debt limit by using section 4 of the 14th Amendment and challenging that the President has the leeway to avoid a debt default as a matter of national security arguing the “validity of the public debt…shall not be questioned.”
On the monetary policy front, the Fed officially ended its QE II program last week and with that the $600 billion price-insensitive buying of U.S. Treasuries by the Federal Reserve is now complete. During the last six months the Fed purchased about 85 percent of the net U.S. Treasury issuance, which we believed helped to artificially support the Treasury market. The ending of QE II may prove to be a game-changing event that will bring rationality back to the U.S. Treasury market. Lost in the excitement of last week’s rebound in the stock market was a sharp sell-off in U.S. Treasuries that included three poorly attended Treasury coupon auctions and 35+ basis point back-up in the yield on 5-year notes to the 1.75 percent area.
Later this month, baseball general managers will have to decide whether they are buyers and contenders into the fall, or sellers, resigned to re-tool rosters and to “wait until next year.” This is the same decision investors face today: risk on or risk off? Our view is that despite the recent slump in the U.S. economy, the good significantly outweighs the bad and by the time the World Series rolls around, talk of a double dip will have subsided. Near term, further signs that the “soft spot” in the economy is ending and that the debt limit battles in Washington and Europe remain, are likely to push investors back into equities and away from government securities.
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