Most markets finished down on the week, but the trendless trend of the last two months continues. The economic news was dominated by the worse than expected employment report Thursday, but overall the data continues to indicate a bottoming process in the economy. Employment is generally the last data point to improve coming out of recession (which is why it is classified as a lagging indicator) so while the report was disconcerting it isn’t all that surprising.

Like most weeks recently, we got several economic reports that point to recovery and several that didn’t. On the positive side, factory orders, pending home sales and the ISM manufacturing index improved. On the negative side, mortgage applications, construction spending and employment didn’t. The stock market’s reaction was generally negative but the averages continued to trade in the previous range:

This sideways action will eventually be resolved and while I’d love to say that it will be resolved to the upside, that is far from certain. What’s gotten us this far is monetary policy and I am becoming increasingly concerned that current Fed policy will not be sufficient to offset the uncertainty surrounding fiscal policy. The Fed’s balance sheet expansion, despite all the quantitative easing talk, has come to a screeching halt over the last couple of months:

Meanwhile, fiscal policy is creating the same kind of regime uncertainty as Roosevelt’s policies of the early 30s. Climate change legislation was passed in the House, but the horse trading it took to get it passed means that if anything is passed in the Senate it will have only a passing resemblance to the House version. Healthcare reform is, if anything, more muddled. With no clear picture of how these and other issues will be resolved, it is very difficult for business to make long term decisions. With consumers likely to continue their frugal ways, business spending is the last best hope for a private sector led recovery. Until there is more certainty in the policy arena, businesses are unlikely to make any big decisions. That leaves monetary policy to do the heavy lifting and Bernanke and his fellow FOMC members are walking a tight rope of inflation expectations that limits their options.  

Credit spreads and CDS prices seem to indicate that the improvement in the credit markets may have reached a peak. It seems increasingly likely that the Fed will have to expand their excursion into quantitative easing or their efforts to date may come to naught. Unfortunately, they risk damaging their credibility on inflation if they are seen as merely monetizing the deficit, so this will not be an easy decision.

Spending from the stimulus package passed earlier this year will start to ramp up over the next few months, so it is possible that the Fed can delay any further monetary expansion for a while, but since the stimulus is seen as temporary, it is unlikely to have much effect on the private sector. Businesses will not hire new workers to fulfill demand derived from temporary measures. Consumers also will not expand their spending if they believe the new income derived from the stimulus spending is temporary. All of the rise in last month’s income numbers was stimulus provided and almost all of it was saved. That seem unlikely to change.

For now, there isn’t sufficient reason to make any big changes in our portfolios, but I am increasingly concerned about the uncertainty of both monetary and fiscal policy. Unless there is a change in one or the other soon, the path of least resistance would seem to be for further weakness and a more conservative investment stance. I’ll keep you updated.