From the preamble of the communique from the G-20 meeting in Pittsburgh:

We meet in the midst of a critical transition from crisis to recovery to turn the page on an era of irresponsibility and to adopt a set of policies, regulations and reforms to meet the needs of the 21st century global economy.

Actually, the transition has yet to begin. Yes, we have the beginnings of a recovery in economic activity and yes the stock market has recovered some of the losses of last year, but both so far are a result primarily of the tsunami of cash emanating from the central banks of the world. Monetary policy is what has gotten us this far, but getting through the real transition will require that the nations represented at the G-20 meeting actually do something other than issue communiques.

While the recovery in economic activity is, in my opinion, primarily due to the monetary manipulations of the Federal Reserve, it is also partially a product of temporary boosts to demand from measures such as cash for clunkers and the first time home buyers tax credit. These temporary measures may have drawn demand forward - or just paid people to do things they would have done anyway - and with their expiration, we are about to find out if the economy can maintain forward momentum in their absence. If you read my update last week, you know that I believe it will, but since some readers accused me of being overly pollyannish, let me be clear. I believe the larger than expected rebound in GDP will be relatively short lived, with short lived defined as “until the mid term elections have safely passed”. It could be longer and permanent, but accomplishing that will require significant policy changes.

Over the next few months, the Fed will be winding down some of its temporary liquidity programs as well as its open market purchases of Treasuries, Agency bonds and mortgage backed securities. Cash for clunkers has already ended and auto sales have fallen back to the anemic pace that prevailed prior to its enactment, but more time is needed to determine the future course of sales. Based on the age of the existing stock, it would not surprise me if sales start to pick up again as we near the end of the year. Although the first time home buyer’s tax credit doesn’t officially end until November 30th, its effects will fade very soon. To take advantage of the credit, the sale has to close by the deadline and considering the time it takes to get a mortgage approved these days, only cash buyers from here on out are likely to qualify. It is possible that the credit is extended, but with intense opposition to more deficit spending right now, I think it is safer to assume that it won’t. Nevertheless, the current pace of homebuilding is too low and assuming even semi normal rates of new household formation, will continue to pick up over the coming months.

The removal of these temporary demand supports will likely engender a lot of anxiety among market participants. Can auto sales revive without government handouts? Can home sales continue to rebound absent significant buyer subsidies? Will Treasury auctions continue to be well subscribed with the Fed unavailable to repurchase bonds from the primary dealers? What will happen to mortgage rates when the biggest MBS buyer drops out of the market? Who will buy Fannie Mae and Freddie Mac paper other than the Fed?

With the Fed continuing to hold interest rates at near zero, I suspect we’ll get through this first transition, but there will be a lot of anxiety along the way. Markets are likely to be more volatile and a correction of stock prices, risky bonds (corporate, high yield, etc.) and possibly long term Treasuries seems a near certainty. But I think we’ll get through it as much of the spending from the stimulus bill of last year actually kicks in during 2010, as I’m sure it was intended, for the mid term elections. It is what happens after those elections that worries me.

The longer term transition the members of the G-20 spoke of in their communique is a much tougher transition that will depend on policies which promote real growth rather than the temporary stimulus variety we now enjoy. We simply can’t continue to spend as we are now and we can’t - and shouldn’t - depend on the Federal Reserve to maintain growth. Monetary policy, as we’ve seen over the last year, is powerful stuff, but printing money is not what causes real growth.

While most of the G-20 communique concentrated on irrelevancies such as limiting bankers pay (bankers bonuses didn’t cause this crisis and limiting them won’t fix it) and global warming, the important parts were left for the annex. After 17 pages of happy cooperation talk, the real challenge is found on page 18:

G-20 members with sustained, significant external deficits pledge to undertake policies to support private savings and undertake fiscal consolidation while maintaining open markets and strengthening export sectors.

G-20 members with sustained, significant external surpluses pledge to strengthen domestic sources of growth. According to national circumstances this could include increasing investment, reducing financial markets distortions, boosting productivity in service sectors, improving social safety nets, and lifting constraints on demand growth.

What this section refers to is what I called the Great Global Rebalancing. In case you don’t know, the US falls in the first category above so our part of this grand bargain includes enacting policies which reduce consumption and raise savings and investment. Of course savings have already moved higher but the rise since last fall was a result of sheer panic and that isn’t a long term solution. We now need to adopt policies which encourage this behavior over the long term. A falling dollar and persistent outflows of private capital are not positive signs that current policy is appropriate to the task.

Fed Governor Kevin Warsh seems to have put the Obama adminstration on notice just last week that better fiscal policy is needed. In a speech at the Annual International Banking Conference, Warsh first warned that monetary policy may not follow the slow and gradual approach favored by Alan Greenspan:

Ultimately, when the decision is made to remove policy accommodation further, prudent risk management may prescribe that it be accomplished with greater swiftness than is modern central bank custom. The Federal Reserve acted preemptively in providing monetary stimulus, especially in early 2008 when the economy appeared on an uneven, uncertain trajectory. If the economy were to turn up smartly and durably, policy might need to be unwound with the resolve equal to that in the accommodation phase. That is, the speed and force of the action ahead may bear some corresponding symmetry to the path that preceded it. Of course, if the economy remains mired in weak economic conditions, and inflation and inflation expectation measures are firmly anchored, then policy could remain highly accommodative. 

Then he warned that the monetary authorities will be watching closely how fiscal policy develops:

Monetary policy is not conducted in a vacuum. The Federal Reserve, and other monetary policymakers, will be keen observers to the judgments made by the fiscal authorities around the world. Central bankers will necessarily take account of these judgments.

What kinds of policies would discourage consumption and encourage savings and investment? Well, part of that would be the normalization of monetary policy of which Warsh speaks. Higher interest rates would certainly help to encourage savings and reduce consumption, but simply raising interest rates and the savings rate is not sufficient and will just push us back into recession. If monetary policy does its part by raising the savings rate through higher interest rates, fiscal policy needs to do its part by increasing investment through policies which raise the long term return of those new investments.

There are only a few policy levers available to accomplish the task of raising investment returns. US corporate taxes are near the highest in the world and need to be reduced. Yes, I know the effective rate is lower, but the mechanisms used to reduce the published rate are inefficient and unfair. Some industries pay the higher published rate while others, with effective lobbyists, get to pay lower rates. Corporate tax rates should be lowered for all companies, not just those with good political connections. Unless we are planning to depend on government for all new jobs, corporations need to be given some incentive - and the means - to hire. Another effective way to increase investment returns would be to lower capital gains taxes. President Obama promised during the campaign to lower capital gains taxes for newly formed businesses, but again I don’t like favoring one class of business - or citizen for that matter - over another.  Capital gains taxes should be lowered across the board.

The final policy lever that should be pulled is to raise and then stabilize the value of the dollar. While enacting policies which favor investment will help in that regard, it wouldn’t seem to be sufficient by itself. The reference to fiscal consolidation in the G-20 communique is a reminder that the federal budget plays a role as well. Balancing the budget entirely by raising taxes would be self defeating as revenue, even at higher rates, would likely not close the gap due to lower growth. We need to finally address our budget woes and spending cuts have to be a large part of the solution. Finally, the Treasury Secretary needs to make it clear that we favor a strong, stable dollar. He can’t accomplish that by bashing the Chinese over their exchange rate policies. 

The fact is that we don’t need the cooperation of the nations of the G-20 to accomplish the rebalancing of the world economy. The US economy is still, by far, the largest in the world and if we enact policies which correct our own problems the rest of the world will have no choice but to follow. Long term economic growth will not be attained by depending on the kindness of foriegners to correct our own shortcomings. We have the means to accomplish the task before us and thanks to monetary policy we have a window of opportunity within which to get it done. Will we seize the opportunity?

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Weekly Economic and Market Review

Economic reports last week were mixed. The Richmond Fed survey indicated growth for the fifth straight month. It even showed a slight improvement in employment. While the Fed surveys continue to show growth, the durable goods report was a warning that the recovery will not be smooth. Much of last month’s drop can be blamed on the volatile aircraft sector, but there were other weak points as well. Inventories fell again and non defense capital goods orders ex-aircraft were down 0.4%. If this recovery is to take hold we will need to see inventories stop falling and capital spending pick up. Evidence of either is pretty thin as yet. Jobless claims fell again and are nearing the point where payroll growth should resume. Because of the depth of this recession and the large resource reallocation needed to sustain recovery, I suspect we will see job growth resume when claims fall below 500,000 so we aren’t far away. Existing home sales fell slightly from the strong pace seen in July, but inventories also fell. New home sales were up slightly but inventories also fell and even at this slow pace represent just 7.3 months of supply.

Stocks fell slightly on the week. Of particular note was the reversal after the FOMC statement on Wednesday. Stocks initially traded higher as there was no change in policy and little change in the language of the statement. As noted above though, investors are nervous about whether the market can continue higher as the Fed backs out markets and sellers gained the upper hand late in the day to push the market lower. Actually, I think it was more a matter of a lack of buyers after the big run up than a signficant pick up in seller activity. The losses on the week were still quite mild. I did take some profits though as uncertainty is rising and valuations are not exactly cheap. Other economically sensitive markets were also under pressure as oil and copper both pulled back. The potential for removal of monetary stimulus also impacted the gold market as the yellow metal fell back below the $1000 level. Sentiment among the gold newsletters is still quite skeptical though so I suspect the pullback in gold will be short.

The transition period we are entering could be quite volatile and while I believe the economy will prove resilient enough to withstand the removal of some of the monetary stimulus, there are no guarantees. My crystal ball has always been a bit cloudy and I am cognizant of the possibility that I am wrong. Investors should be defensive here until growth becomes more evident.

Selected Charts

The uptrend in stocks is still intact, but I would not be surprised to see a further correction:

Copper fell below 275 and as I promised last week, I sold on the break. If economic growth is robust copper may still move higher long term and I will be looking for a new entry point:

Gold corrected some, but based on sentiment, I think the dips can be bought. Look for support in the 970-980 level:

Chinese stocks are looking increasingly toppy and I took some profits last week. I still like China long term but if investors are nervous about US growth, they’ll be worried about Chinese growth as well:

REITs followed stocks lower, but I’m still positive, especially on foreign markets:

The great corporate bond rally continues, but its getting long in the tooth. Buyer beware:

Finally, sugar appears to have worked off an overbought condition and may be ready for another up leg: