November brought with it numerous signs of an improving economy – albeit slow and fairly jobless. Encouraging data came from numerous sources including auto sales (12.25 million Seasonally Adjusted AnnualRate), improving manufacturing and service activity (via the Fed Beige Book), rising consumer confidence (up 4.2 points per the Conference Board), and improving retail sales (including Thanksgiving traffic that initially seems to have outpaced last year). Even considering these improving factors, the Federal Reserve initiated its program of Quantitative Easing in November, which ostensibly would create rallies in stocks and bonds while weakening the US dollar.
Yet, stocks ended the month flat, bond prices fell, and the dollar strengthened. As had been the case during most of 2010, strong cross-currents managed to derail what would have otherwise been a very bullish month for risk assets. Specifically, the appearance that the European sovereign debt crisis was beginning to spread drove investors back to the relative safety of the US dollar. The strengthening dollar managed to hold down the performance of the stock market and spilled over into a sell-off of most fixed income assets.
Beginning in December, however, Quantitative Easing and Permanent Open Market Operations took center stage again. Despite an absolutely awful employment report on December 3, the S&P 500 has gained over 3% in the first three days of the month. Intraday and day-to-day volatility has gotten to the point where it may be described as absurd.
In an interview on December 3, former director of the OMB, David Stockton, had an interesting quote. He said, “”I can’t explain the market… I don’t know what it is pricing today, I don’t think the market discounts anything anymore, it is purely a day-traders’ market that is trading off the Fed, trading off the headlines. One day it is manic, the next day it is depressive, and we can’t draw any conclusions.” This was, and remains the reason we continue to keep our beta at historical lows. Being too long or too short can get you badly wounded while macro factors continue to dominate the scene.
And, if macro issues are dominating, it makes sense to assess the macro risks on an ongoing basis. So let’s take a minute to summarize the biggest risks, as we see them.
First, jobless numbers are resiliently low. The jobless rate remained well above the 9% threshold in November, which marks the 19th month in a row this happened establishing a new (and rather dubious) record for the post-WWII era. I can’t imagine how the economy can materially grow in this environment because employment growth generates income growth which is the basis for spending and saving. And, 2/3 of the job growth we’ve seen has come almost exclusively from the part-time economy. That translates into 35 million jobs in that sector, with an average wage of $20, 000 a year. That is barely enough money to support a family let alone generating liquidity that will become self-feeding into spending.
Second, we remain concerned with housing. There remains a two year overhang of inventory in residential real estate, and real estate values (as measured by Case-Shiller) have gone down three months in a row. It makes me wonder how much of a wealth effect quantitative easing can produce if home prices continue to decline. As it stands, 1 in 7 homes are now delinquent or in foreclosure, so it seems unlikely that declining prices will abate any time soon.
Third, the European sovereign crisis continues to be an issue of major concern. Bond yields across Europe, even in Germany, rose steadily in November. Ireland, Greece and Portugal are basically insolvent and, we will probably find out over time that, while these countries fall into the “too big to fail, ” camp, Spain may be too big to rescue. On November 30, spreads on Spanish bonds versus the German bund reached an historical high of 4.91%. As recently as August, that spread was a mere 1.19%. That’s a 410% increase in 3 ½ months. Oh, and last Friday news was released that German Chancellor Angela Merkel threatened to pull Germany out of the euro zone if her partners didn’t accept demands for a permanent mechanism to deal with the possibility of a sovereign default. Granted, that type of blustering is probably more bark than bite, but is certainly doesn’t give one any solace that the European crisis is in its late innings.
I’ll conclude with a quote from economist David Rosenberg. I quote, “While the recent rally, which has been predicated on hopes of an ECB rescue plan and hopes of a White House-Congress agreement on tax/benefit extensions, the downside growth risks for 2011 should not be so readily dismissed. This has become such a hope-based market that the Dow jumped over 100 points earlier this week on a Reuters news story in Brussels, which reported that the U.S.A. would back an even greater financial commitment to Europe! Hope isn’t typically a very useful long-term strategy, even if it has helped generate another run at the highs, as the remaining shorts get covered in time for year-end.”