12 Jan 2011 What Lies Ahead?

Since stocks turned sharply up last September, they have been on a steady rise, with one notable 4% exception during the month of November. Economic news, both at home and abroad, has steadily improved, but not enough to explain the strength and duration of the rally. Likely much of the buying strength is coming as bondholders cash in profits and head for equities. About the same time stocks began rising, bonds began a steep descent on hyped up inflation worries with the 7-10 year Treasury index losing roughly 6%. More recently, domestic stocks have also benefitted from rising international, particularly emerging market inflation. As central bankers in the fast growing economies of China, Russia, and Brazil raise rates to control speculation, stocks in those countries look less favorable than in the US where rates are being held near zero by the Fed. 

Emerging market central bankers are moving in the opposite direction from the US Fed as they tighten the reins on credit to contain inflation. Stock strategists from Goldman Sacs, Blackrock, and Van Eck Associates see the dichotomy as a “sweet spot” for US assets, particularly stocks. These and other analysts project that equities will handily outperform their emerging market counterparts.

The U.S. expanded 2.8% in 2010, according to the median estimate of 84 economists surveyed by Bloomberg, the strongest annual pace since 2005. By most measures, 2011 will be stronger than 2010. In a Tuesday speech Philadelphia Fed President Charles Plosser said he expects growth will pick up to 3 to 3-1/2% annually in 2011 and 2012. He went on to say “monetary policy must be forward-looking because it works with a lag. This means that the Fed will need to begin removing policy accommodation before the unemployment rate has returned to an acceptable level in order to avoid overshooting, which would result in greater instability in the economy.”

Three key price indicators came out this week; import and export prices, the producer price index, and the consumer price index. While the headline numbers and some of the details could be used to make a case for rising inflation, the broader data suggest continued price stability.

The import and export price report showed that inflation pressures for input prices are tangible but eased some in December both for import and export prices. A notable exception was the annualized rate for imported goods, which rose from 3.7% in November to 4.8% in December.

Domestic producer-level core inflation remains tame, but headline inflation is running higher than expected rising to 1.1% in December vs. 0.8% the month before. Core inflation which strips out more volatile food and energy fell from .3% to .2%.

Just like producer prices, consumer prices are a ‘tale of two cities.’  Core inflation, which removes food and energy, is tame due to high unemployment, weak housing, and heavy competition among retailers. But the headline number is rising largely due to strengthening oil prices and commodity prices. Food prices have yet to build a sustainable pattern, but are expected to in the coming months as transportation and production costs rise. The Fed may have to address the dichotomy in prices ahead of falling unemployment.

In his Tuesday speech Plosser noted that “core CPI inflation, excluding food and energy, has been just less than 1% this past year. While inflation is currently lower than the 1-1/2 to 2 percent level many monetary policymakers would prefer, it does not follow that sustained deflation is imminent or even likely. While I do expect that inflation will be subdued in the near term, I do not see a significant risk of a sustained deflation.”

Job growth continues to struggle mightily. Initial jobless claims released this week surged to 445,000, for the worst weekly rise since October. The Labor Department believes the number was due to “special factors” related to the backlog built up during the shortened weeks of the holidays. The smoother four-week average increased 5,500 to 416,500 which is still nearly 10,000 lower than the month-ago comparison, but little evidence of improvement.    The headline report of retail sales came in strong at .06% in December following a 0.8% increase in November. But a closer look shows that autos and higher gasoline prices significantly influenced the number. General merchandise (which includes department stores) fell 0.7% in December after jumping 1.1% in November. Overall though, retail sales on a year-ago basis in December improved to 7.9% from 7.5% the previous month.

The latest confidence drain for investors comes in the municipal bond market. As you can see in the graph to the right, yields on 30-year AAA rated general obligation municipal bonds re-traced in two months the declines made over the last two years. If you own high grade municipal bonds, don’t panic. This move, particularly in high grades was an overreaction. To a certain degree too, the decline is explained by traders moving from over-priced bonds to more-reasonably priced stocks.

But there are serious concerns for the overall economy in the flight from munis. States and municipalities with lower credit ratings will find it harder and more expensive to finance both existing and new projects – in many cases with a declining tax base and less support from the federal government. With out-of-balance state budgets the norm across the country, it is possible that bond ratings on some will fall too, further increasing their rates.

For far too long in this country we have allowed a ponzi-like style of government to grow almost incurably like a cancer. It is incurable politically because our leaders have drugged the voters with promise upon promise of something for nothing. Why would those who believe them vote to work for or pay for something they can get for free? Somewhere along the way the crowd crying ‘do it now because it’s the right thing to’ overwhelmed the crowd that demanded to know how they would pay for it. As they do their good deeds, guaranteeing their ability to continue, the victorious do-gooders simply pass the costs along the next generation of taxpayers.

Last November, enough taxpayers/voters shouted, ‘no more Ponzi.’ They shouted it in federal, state, city and town elections. It was a clear message with passion behind it. But it was just a loud shot at the beginning of a long war. Will those same taxpayer/voters really stand for the tough measures that surely lie ahead? Will they put up with fewer services and promises while paying higher taxes in the hope of a stable and fiscally sound government?

The answers to these questions depend largely on which crowd can hold the majority long enough to see the campaign to a successful conclusion. Americans are very faithful and hopeful. The question is, will their faith in government and hope for prosperity rest on the firm but difficult foundation of truth, or will they rest more comfortably on familiar lies and promises?