19 August 2009

Reflation Contemplation ~ Nolan

Stock prices traditionally lead economic recoveries. Securities markets tend to react swiftly to loosened monetary conditions, while it takes some time for loose Credit to work its way through to the bowels of the real economy. Highly speculative markets react haphazardly, sloshing liquidity out and about. As is commonly understood, employment conditions are a somewhat lagging economic indicator. Most analysts have been content to read nothing of significance from ongoing poor jobs and housing data. Overwhelmingly, the bulls rely on faith - and history - that surging stock prices are discounting the usual “V” rebound.

Data this week should have those of the bullish persuasion on edge. July retail sales were much weaker-than-expected (down 0.1% vs. expectations of a rise of 0.8%). Retail Sales excluding auto sales were down 0.6% for the month (down 8.1% y-o-y), the largest drop since March’s 1.1% fall. Looking back, there was no mystery surrounding first quarter consumer weakness. But even after a dramatic stock market recovery, July’s Department store sales were down a dismal 1.6% for the month (down 9.6% y-o-y). Even Wal-mart management commented that their customers were “selective” and remained keenly focused on value.

Today’s preliminary report on August University of Michigan Consumer Confidence was also a big disappointment. The consensus called for this confidence reading to jump three points to 69. The actual report came in down to 63 - to the lowest level since those dark days of March. Readings on both “Economic Conditions” and “Economic Outlook” dropped to five-month lows.

Yesterday, RealtyTrac reported that U.S. foreclosures jumped to a record 360,149 in July. This was up almost 7% from June and 32% higher than the year ago level. And there’s no relief in sight. American Bankruptcy Institute data had 126,000 Americans filing for bankruptcy in July, up 34% from a year earlier. It is now expected that 1.4 million will file for bankruptcy this year.

Meanwhile, the economic optimists take comfort from this week’s readings on Non-farm Productivity, Wholesale Inventories, Industrial Production, and Capacity Utilization. Positive data out of Europe and Asia also seem to confirm that some type of global economic recovery has taken hold.

From my perspective, this week’s data confirm important aspects of Credit Bubble analysis. First, ongoing headwinds will restrain rebounds in U.S. housing markets and household consumption - for an extended period. Second, the overall U.S. consumption-based economy will lag those of most of our more manufacturing-oriented trading partners. In short, we are witnessing anything but typical reflation dynamics, and those expecting a typical U.S. recovery will be disappointed. Our economy remains overly exposed to U.S. consumption, while having insufficient manufacturing capacity (and resources) of the type to benefit significantly from heightened global demand.

Returning to the stock market, I see nothing typical going on there either. With the Morgan Stanley Retail Index and the Morgan Stanley Cyclical Index up 56% and 49%, respectively, the marketplace apparently has no issue with the recovery. I suspect these gains have been inflated by short covering. Indeed, market dynamics likely explain much of the divergence between ongoing weak underlying economic fundamentals and robust stock prices (especially in the consumer arena).

Unusually large bearish hedges and bets had been placed against the (consumer-driven) U.S. economy. Unprecedented fiscal and monetary policy crisis response stabilized the Credit system, setting in motion a self-reinforcing unwind of “bearish” positions. In the past, such a reflationary dynamic would have seen stock prices for the most part accurately discount the future direction of economic activity. Stated differently, the reversal of bearish positions (and resulting short “squeeze”) would traditionally have (reflating) stock prices portending recovery and a return to the previous trajectory of economic performance. In general, a rejuvenated Credit system - and the resulting recovery of financial flows - would ensure that the “bear” case was proved wrong.

This time may be different. I would not be surprised if the confluence of unusually large bearish positions, unprecedented policy response, and a resulting major “squeeze” created a backdrop where the stock market was turned into a rather poor foreteller of future prospects. From my vantage point, I certainly don’t believe stock prices today generally provide an accurate reflection of underlying company fundamentals. And from an economic perspective, I suspect the stock market is missing some key underlying dynamics that will shape future economic performance.

In particular, equities seem to be discounting a return to business as usual when it comes to the U.S. economy. Retail and the “consumer discretionary” sectors have been among this year’s stellar performers. And, yes, this does fly in the face of my analysis of new economic realities and a permanently downsized role for household consumption in the U.S. economy. At this point, I view this as an anomaly at least partially explained by the hastened reversal of bearish positions. But I also recognize that massive fiscal and monetary stimulus has been implemented with the policy goal of sustaining the existing economic structure. The market has been content to play this dynamic expecting policymaker success.

As I attempted to explain last week, I view the impairment of the stock market discounting mechanism as a key facet of Monetary Disorder. The reversal of bearish plays not only created huge buying power throughout the markets, it decisively reversed The Greed and Fear Factor. Notwithstanding today’s sell-off, the bulls are greedy and the bears are on the run. And the more that inflated stock prices entice shorting, the more games that can be played to “squeeze” the timid bears.

The end result is a highly speculative stock market increasingly detached from reality and vulnerable to wild swings in sentiment. Yet I don’t expect the emerging global reflation to this time disprove the U.S. bearish thesis, although it will no doubt be a wild market ride.

The bond market was happy with this week’s developments. The Fed confirmed it will be especially unhurried in raising rates and ending quantitative easing. Weak U.S. economic data was seen as confirming the bullish bond view. To be sure, low market yields at home and abroad are imperative for global reflation to gain a head of steam. And I would argue that (over-liquefied) bond markets are subject to their own pricing anomalies. In contrast to stocks, bonds have been fixated on U.S. economic vulnerabilities and the Fed, while content to downplay reflation risks. This week’s data doesn’t have me second-guessing the thesis of bond market vulnerability to global reflation dynamics. For bonds as well, the backdrop is set for a wild, speculative market ride.


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