| | | The Nike Recovery Just Do It
| www.mksense.blogspot.com
Ever since the government's stimulus plans were put into effect the debate gas raged among market participants, economists. politicians and media talking heads (like the have a clue) over what shape the economic recovery will take. Market bulls exclaimed that copious amounts of stimulus and pent-up consumer demand would lead to a sharp V-shaped recovery "as always." Pay no attention to record amount of household debt, depleted investment values and unemployment.
Others believed that we would see a W-shaped recovery. The W represents a steep decline, a sharp, stimulus-driven recovery followed by another steep drop as stimulus is removed which is then followed by another sharp fundamentals-driven expansion. This kind of recovery could happen if the Fed removed stimulus early or quickly. That is obviously not in the cards. The Fed does not want to risk a second recession. Although Wednesday's FOMC statement was somewhat more optimistic than others in the recent past, it was clear that the Fed was not overjoyed by the spectacular progress being made in the way of economic expansion. This is evidenced by no changes to Fed Policy.
Another possibility is a Nike swish-shaped recovery. A chart of U.S. GDP would take the shape of a Nike swish as it measures a steep decline and a long, gradual recover. Recent Economic data and recovery trends experienced during the past two decades point to a swish-shaped recovery.
A V-shaped recovery depends on consumer spending. Consumers are tapped out. The have record amounts of household debt, unemployment is high and underemployment is even higher. Also dragging in the economic recovery is the fact that low mortgage rates, 0% financing and large price incentives by automakers during the housing bubble has resulted in consumers currently own homes and vehicles which meet their needs and are financed at very low if not zero percent (in the case of auto loans) interest rates. The U.S has a mature economy. Mature economies cannot grow at a very fast pace. 3% to 4% is about as fast as we can realistically can expect without excessive stimulus.
However, in a mature economy, consumer demand is like energy or matter. It cannot be created or destroyed. It can only change form. Stimulating the U.S. economy buy dropping rates merely brings demand forward or changes housing demand from renting to owning. When the stimulus is gone, the situation corrects itself.
The Fed is between a rock and a hard place. If it removes stimulus to soon or too quickly it risks either stalling the economic recover or sending the U.S. back into recession. If it keeps rates too low too long it risks weakening the dollar which could cause prices of imported commodities, such as oil, to rise. This would place a heavy burden on consumers.
The removal of the Fed's quantitative easing is also problematic. The prime reason by far for the modest recovery in housing has been due to the Fed buying treasuries, agencies and agency mortgage-backed bonds. The Fed said yesterday that it is going to stick to its schedule of removing its quantitative easing, in spite of the fact that recent housing data has been disappointing. This runs counter to the opinion of many economists who believe that the Fed will not remove stimulus while unemployment remains high. In the 1970s, then Fed chairman, Arthur Burns used unemployment as a determining factor for Fed policy. He resisted raising rates because of high unemployment, in spite of raging inflation. It too Paul Volcker to break the back inflation by raising rates in spite of high unemployment
Fed chairman Bernanke has been derisively called "Helicopter Ben" because of his advocating strong stimulus to avert or soften economic recessions. However, Mr. Bernanke is very intelligent. He knows he cannot keep the economy overly stimulated. Look for quantitative easing to be removed in 2010 and Fed Funds to rise in 2011. Long-term rates should begin to rise again to stay (at least for this cycle) in the second half of this year. However, because of the drag on the economy from high household debt and unemployment which will remain stubbornly high due to technology-driven productivity gains (many displaced workers will not be re-hired, period) inflation and associated long-term interest rates should not blow out. However, long-term rates will creep higher.
This puts investors between a rock and a hard place. If one over allocates on the short end of the curve one receives very little in the way of yield. So little that one is likely to not catch up to yields which currently exist on the 10-year of the curve, at any time during this cycle, never mind as an average yield while rolling maturing money. However, even a rate increase of 100 basis points on the 10-year area of the curve can result in losses in the 8 point area. The best bet for fixed income investors is to ladder or bar-bell a portfolio from two years to ten years. Ten-year bonds should be from companies which are expected to have improving business models which can result in credit spread tightening to offset the rise of long-term rates. Industrials, oil producers and retailers such as Wal-Mart should be avoided except by very risk averse investors. They are rich. JPM and GS bonds and preferreds are becoming rich. Regional Bells, certain utilities and bands such as BAC (along with explicitly-back Countrywide and implicitly-backed Merrill), Fifth-Third and PNC-owned National City offer better values. Callable agency paper offer the best values in the 3 to 7 year belly of the curve.
Have a great weekend.
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