Fed and Government Firepower is Diminishing

TheUSeconomy will have to gut it out from here without additional help from the Fed or the government. Today’s inflation report shows that the Federal Reserve had little flexibility to lower beyond the quarter of a percent they announced on Wednesday fearing inflation and a falling dollar. As to government actions; early signs are that credit bailout efforts will fall short of easing tight credit. InWashington, political wrestling has already stalled and likely killed relief from the alternative minimum tax. There appears scant hope that a Democratically controlled House and Senate will continue Bush’s tax cuts. So the combined prospects of higher taxes, tighter credit, already high gasoline, falling house prices, slowing consumer demand, and higher prices on everything else if inflation takes hold, almost surely will be enough to stall theUSeconomy. 

The government announced today that the consumer price index increased 0.8%, the most since September 2005, after a 0.3% gain in October. The core rate climbed 0.3% percent, also more than anticipated. The immediate problem is not real inflation but that the threat of it will likely restrain the Fed from dropping rates further to stimulate the economy. The falling dollar also restrain them from further drops until central bankers in Europe and Japan follow suit with lower rates. So that some extent, Fed policy has now near the point of having to wait on the good judgment of our trading partners.

Oil prices may have reached their peaks for the near term. Experts believe the current price does not reflect the decreasing demand of a slowing global economy. TheUSalone consumes a quarter of the world’s oil supply. OPEC announced yesterday that they would increase production to reduce prices. The combined forces of more supply and lower demand will most certainly force prices down in the coming months, winter notwithstanding.

Predicting what the American consumer will do over the last decade has been challenging, to say the least. So far he has generally surprised to the upside. Yesterday’s report by the government on retail sales proved that point yet again. Retail sales in the November increased twice as much as forecast.  The 1.2% increase, the biggest since May, followed a 0.2% gain in October. The report provides further evidence as to why the Fed reduced rates less than markets were expecting.

However, today’s report on US Internet holiday sales conflicts with the government’s glowing results. They show that online sales are growing at the slowest pace on record as shoppers put off purchases ahead of year-end bargains. Sales from Nov. 1 through December 11th increased 19 percent to $20.5 billion, according to ComScore Inc. These results compare to a 26% pace last year. 

A large concern threatening global growth is the seemingly ineffective actions by world central bankers so far to reduce borrowing costs which have reached record highs inEurope. Despite their efforts which include offering $64 billion to financial companies to spur lending, stocks of financial concerns continue to drop as they report declines in their lending operations. 

Caution is indicated in the current environment, but a knee-jerk sale of stocks to raise cash or buy bonds may not necessarily be the best action here, at least on a large scale. Bond yields are very low now with Treasuries ranging from a 2.85% three month Bill to a 4.25% 10-year Note. Yields did not fall much below current levels during the 2001 recession. They did, however fall further in 2003 when the Fed reached its depth of their interest rate cuts in June at 2%. 

When one compares the yield of the earnings generated by S&P 500 companies to bond yields over time it becomes apparent just how cheap stocks really are. The chart is useful in highlighting periods of both high and low valuations. 

Note the crash of 1987 occurred at a time when the yield of the 10-year Treasury at 9.75% was nearly 5% higher than the earnings yield on stocks. Conversely today, the earnings yield on stocks is almost 2% higher than the 4.25% yield on the 10-year Treasury. The question though is will companies be able to maintain their earnings at near the same level if the global economies decline? We believe some will and others will not.

We believe that if theUSdoes go into recession that it will be relatively shallow and short-lived; say a year or less. This view is predicated on the belief that the global economy (parts of it anyway) will continue on momentum. We are not looking for demand for raw materials and commodities to fall off so dramatically as to wreck those economies largely dependent on their sale to other countries, such asBrazil,Russia,China, andLatin America. Further, we expect the credit crunch to ease as banks eventually get a handle on their exposure to bad mortgage paper and government and private money pools begin to liquefy markets. These negative influences should begin to wane by the first quarter of next year. The consumer will likely see house prices stabilizing and oil prices dropping in the coming months boosting confidence. If companies do not begin significantly cutting jobs as a result of the coming slowdown, we just might avoid a prolonged recession. The economies outside theUSare the ones now in the drivers’ seats for global prosperity. Their continued strength or collective collapse will determine the significance of theUSslowdown. If their buying power stays healthy, US exports may be sufficient to maintain the economy while the consumer, housing, and financial sectors recuperate.

Have a nice weekend