Opinions Investor's Corner A tale of two economies
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Investor’s Corner
By John W. Gudritz CFA
Principal
Front Street Investment Management LLC
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"It was the best of times. It was the worst of times.” It seems appropriate to quote these lines from Charles Dickens to describe the current U.S. economy, because of the large dichotomy that currently exists between those people who are benefitting from the recovery and those who are not. Wall Street investment bankers couldn’t be happier with how things are going, whereas the 15 million people who are still without a job probably have another opinion.
There is also a large difference pertaining to the financial markets’ opinions of the current environment. The bulls in the stock market see normal cyclical improvements in the economy and, therefore, see a fully sustainable recovery into the future. I (and those who share my opinion) see a different economy with longer-term structural challenges that will limit its growth and even make it vulnerable to another recession by next year when the government stimulus has been taken away.
The bulls remain in the market’s driver seat as the market indices inch up a little almost every day to make a new recovery high. This is happening because most economic indicators and corporate earnings are beating expectations and giving the bulls the impression that this is nothing less than a normal recovery.
There is no doubt that we are in the midst of an economic recovery. The “green shoots” of “less bad” economic indicators of a year ago have actually turned into real positive signs of economic growth.
For example, the draw down of inventories to such low levels during the Great Recession has put many companies in a position to have to increase production to meet rising demand for their products. The need to replenish inventories is usually an important driver of an economic recovery, so it makes this one look absolutely normal.
The employment situation is similar to the inventory experience. We witnessed the greatest job destruction since the 1930s as a total of 8.4 million people were let go from their jobs from the time the recession started in December 2007. The unemployment rate peaked at just over 10 percent and currently hovers around 9.7 percent.
However, we recently learned from the Labor Department that the economy actually achieved job growth in the first quarter of this year. While the monthly job gains were relatively small, they were at least in the right direction and the bulls celebrated that cyclical accomplishment.
So, the bulls see an economic recovery that is unfolding according to the historical script and has become self-sustaining. The fact that corporate earnings have also recovered as rapidly as they have also gives the bulls confidence that the market rally is for real and has further to go before its over.
Despite the huge run up in stock prices I don’t share the bulls’ enthusiasm for this recovery. When I look at the economy and analyze its components I see an economy that is primarily benefitting from the Federal Reserve’s extended zero interest rate monetary policy and the massive federal government deficit spending for the various stimulus programs that will be winding down in the months to come. I think we will see a significant slowdown by the fourth quarter and into 2011. And if that scenario plays out as I expect, the stock market is vulnerable to a substantial decline.
As I have pointed out many times, the private economy is going through a serious credit contraction following the bursting of the bubble in the real estate market. The banks continue to reduce credit lines for households and small businesses as they continue to face rising defaults in their residential and commercial real estate loan portfolios.
To try to offset the declining demand from the credit contraction in the private economy, the federal government has gone on a borrowing and spending spree to the tune of trillions of dollars. The actual total debt level in the U.S. (private and public) is actually increasing from already historically high levels.
The problem with this fiscal policy strategy is that the government does not really have the borrowing capacity to achieve their goals without putting the United States’ credit rating in jeopardy and risking the loss of confidence from foreign investors in our bonds. To avoid future rating cuts, taxes will have to be raised and spending will have to be cut if nothing more than to just pay the higher interest payments. And let’s not forget about the unfunded liabilities for Social Security and Medicare that are lurking out there.
At some point in the not too distant future I believe the contrasting views of the economy will begin to come together as the structural challenges become clearer and the government makes the tough choices to deal with them. When that time comes I think there will be better opportunities to put more money at risk in the stock market for higher potential returns than I see the market offering right now.