By I. Bernobul, Esq.
Quite a week! Started with NObama day on Tuesday, bringing 2 years of gridlock to the USA. Senate Republican Leader Mitch McConnell quickly stated the economic agenda:
The Republicans’ top priority should be defeating Obama two years from now!
This experienced politician no doubt was echoing what most Americans saw as a priority 16 months after “the end” of The Great Recession!
Fortunately, there is Uncle Ben, who knows quite well that politicians and their fiscal policies will be of little help in coming years. So Wednesday, he launched his flagship, the QE2, fully equipped with modern day missiles that are sure to sink the US dollar and everything else floating about it. To be sure, he had done the pre-launch at Jackson Hole two months before, testing the machinery and measuring the effects. The pavlonian response was immediate, setting the stage for the official launch, right after election day.
What a launch! He gave everything he had, and everything they wanted, and even a bit more, committing to create as many QEs as might be needed to win the war. Markets were stunned for a couple of hours but soon enough went as expected, paving the way for the wealth effect needed to lure every poor soul into spending us out of the storm. No doubt, if it works, or not, every American will be indebted forever to Ben and … the rest of the world. Mohamed El-Erian explains how the Fed is now on cruise control:
(…) the Fed hopes its injections of cash will lower interest rates, bolster asset prices, increase wealth and encourage households and companies to spend and hire. Moreover, by noting the possibility of doing more if the data disappoint, it is also hoping that markets could price in the institution’s future asset purchases, turbo-charging the direct policy impact before those purchases have even been specified.
Then, Friday morning, the skies parted a little and an unexpected, almost un-hoped for, ray of sunshine appeared. Good grief! US employment rose 151k in October. Not only that, but the ugly August and September stats were revised up to look not so repulsive. A clearly positive news! Or was it?
What about QE2 now? What about all that liquidity that was planned to lift all boats?
All of a sudden, employment looks up, car sales have improved, US chain store sales have stopped falling and the US October ISM boasted good numbers all around. One week ago, things looked so clearly bad and simple and now, these good news!
Speaking of good news, earnings keep rising and surprising. With 80% of companies having reported and a 68% beat rate overall for S&P 500 companies, Q3 EPS look to total about $21.50, bringing the trailing twelve months total to $78.94, up nearly 8% from 3 months ago. On that basis, the S&P 500 Index at 1225 sells at 15.5 times, right on the historical median, pleasing both bears and bulls. However, the more appropriate Rule of 20 says fair value is at 19x EPS (20 minus inflation of 1%), or 1500 on the Index, a big 18% undervaluation.
The broad index has gained 20% since its July trough and 10% overall this year but trailing EPS have gone up as well. Only in the last 6 months, when the bears thought the rally over, trailing EPS have jumped by 19%! A week ago, one could be justified discounting these earnings on the basis of rising odds of a double dip. But today, investors might have the best of all world: a very cheap equity market, rising earnings, no double dip, very low interest rates for as far as the eye can see, reduced probabilities of deflation and, just in case, the Fed illimited QE puts in the back pocket.
But there are a few buts. For starters, QE2 seems to have few friends of a foreign denomination. Central banks, which only a short while ago seem to all speak the same global monetary language, have all become egocentric. As Ben’s monthly missiles keep hitting on the greenback, more and more defense mechanisms like higher interest rates, capital controls and various protectionist measures will be used by our suddenly less friendly world neighbors. Even China is now accusing the US of currency manipulation!
Just as the US seems less vulnerable to it, Europe is giving double dip signals. Eurozone retail sales have declined 0.2% in volume for the second consecutive month in September. German sales dropped 2.3%! The Eurozone manufacturing PMI rose smartly in October but the recent 17% recovery in the euro could kill that trend rapidly. A case in point is the 4% decline in German industrial orders in September, much worse than expectations and currency related as the WSJ explains:
The September drop was led by 6.6% fall in foreign orders, which suggests the euro zone’s recovery is faltering. Orders from countries that use the euro dropped 13.3%, while foreign demand from beyond the euro zone was down a much more modest 1.2% on a month-to-month basis in September. Domestic demand also declined, but at a much lower rate of 0.6% from the previous month.
Japan also looks weaker. Industrial production is now down four months running, and fell at a 7.5% annual rate in Q3 after five consecutive quarterly gains.
China, the world’s engine, is also showing worrisome signals. The PBoC surprised by raising interest rates 25 bps on October 19. People forget that Chinese leaders’ worst nightmare is a return of inflation. On March 15, 2010, when inflation was running at 2.7% YoY, Premier Wen Jiabao clearly stated that controlling inflation is the Communist Party’s top priority:
Wen Jiabao, the Chinese premier, put tackling inflation at the top of the policy agenda on Sunday and suggested that the survival of Communist party rule might depend upon it. (…)
“If there is inflation plus unfair income distribution and corruption, it will be strong enough to affect our social stability and even affect the stability of state power,” Mr Wen said in his annual press conference at the close of the national people’s congress, China’s rubber stamp parliament.
Inflation in China reached 3.6% in September and price pressures are continuing. It thus seems pretty clear that, barring a sudden and unlikely decline in inflation rates in coming months, China’s monetary authorities will keep ratcheting interest rates up towards the 4-5% real rate level. This will surely unsettle equity and commodity markets which will rightly fear a slowdown in China’s growth rate as Western economies continue to struggle. Furthermore, protectionism will return to the forefront as China will want to refrain from letting the renimbi appreciate while it is applying the monetary brakes.
Speaking of inflation, Uncle Ben’s move has boosted commodity prices quite spectacularly. These higher prices will more or less rapidly find their way into consumer prices, in effect negating the intended wealth effect. Gasoline, in particular, is already eroding discretionary purchasing power. Gas prices have jumped 6% at the pump since September but oil prices are up 18% during the same period. And in case you have not noticed, the heating season is just about here. The Browning Newsletter, an authority on weather forecasting if there is one, just warned:
If all of these are combined, then the current La Nina is the strongest in over 70 years. It is almost as intense as the La Nina in the winters of 1955-1956. It is currently almost two standard deviations below normal and most models expect the phenomenon to intensify over the next three months.
To finish, the venerable former Fed Chairman Paul Volcker, one who knows a thing or two about inflation, is doubtful of Uncle Ben’s strategy:
The thought that you can create a prosperous economy by inflating is an illusion, in my judgment. And we should never forget that. I thought we’d learned that lesson and I hope we continue to learn that lesson.
The influence of this kind of action on longer term interest rates, in particular, is ambiguous because the immediate impact of buying bonds ought to be to drive bond prices up and interest rates down. But if people get concerned about longer run inflationary impacts, the effects go in the other direction.
Cheap markets, but caveat emptor!