Market Insights – May 24, 2011
“ A simple way to take measure of a country is to look at how many people want in and how many people want out” —- Tony Blair (former U.K. Prime Minister)
Dear Clients and Friends,
The last time we communicated on the 29th of April, I was discussing the reasons behind the powerful profit margin expansion that corporate America is experiencing ( On May 20th, Salesforce.com reported 1st quarter profits +33.7% on increased Y/Y revenue +74%, making them the first cloud computing company to go over $1 billion in revenue in a one year period). While I continue to be amazed at what U.S. companies are doing, I am also scanning the horizon for potential storm clouds that could produce headwinds strong enough to stall the economic recovery. Let me preface my thoughts by first saying I am not a meteorologist (however, I really did take one class on weather & climate in college), but I do not see any economic storms on the radar capable of producing F-5 force winds (winds powerful enough to level entire towns like we saw last month in Mississippi and Alabama and now again in Joplin, Missouri). In other words, economic and corporate fundamentals are strong enough to withstand most disturbances that are currently known to us. I do not expect another recession in the foreseeable future nor do I anticipate lurking on the horizon, another wealth destroying decline in the stock market like we recently went through in 2008-2009. What I do see however are some issues that if allowed to smolder, could take a bite out of growth and profits as 2011 moves into the summer and fall. Prudent portfolio management dictates that we identify these issues, assign a probability of occurrence and then develop a strategy to deal with them if and when they occur.
1.) Residential real estate and homebuilding continues buried in an awful market. I must admit that I am surprised that these markets remain under water. Clearly the bubble of junk mortgages that burst in 2007 was MUCH bigger than anyone ever imagined. Current estimates put the number of bank owned homes at 3 million. Prior to the summer of 2007, 8% of GDP was comprised of home sales, related expenditures and construction. That number has now shrunk to 2% of GDP, the lowest reading in its history. The 6% loss of GDP here is one of the main reasons that job growth remains below 200,000 jobs per month. Existing home sales for April are down 13% year-over-year. Cash offers are king with 31% of all April sales done on a cash basis (in March the number was 66%). These are investors buying distressed properties at distressed prices. Banks are reluctant to lend and require 20% down even on the most conservative of appraisals which continue to come in at lower and lower levels. This risk aversion in turn creates a negative feedback loop requiring lenders to be even more careful as prices fall. According to Zillow, the on-line appraisal service, 28.4% of all single family mortgages are in a negative equity position with the most acute problems in Atlanta @ (55.7%), Chicago @ (45.2%) and Denver @ (41.8%). To paraphrase Doug Kass, “Even though affordability is at a multi-decade high, mortgage rates are at all-time lows, and new home construction is negligible, the domestic housing market will scrape along the bottom for several more years to come. It will be continued to be constrained by weaker prices, tight credit, foreclosures and badly delinquent loans. This is an important headwind to economic growth in the years ahead.”
2.) The cost of agricultural, industrial and raw materials commodities have risen dramatically during the last year. Driven by increasing demand from an increasing middle class of emerging market populations, food and energy inflation has not only decreased purchasing power around the world but in the examples of Tunisia and Egypt, fueled anger that actually led to successful revolutions. In the U.S., 14% of the CPI (Consumer Price index) basket is made up of food and energy where as in China the number is 31%, in India, Indonesia and other South Asian countries the number is a staggering 50%. The price of oil was initially forced higher by the revolutions in North Africa and finally brought in the speculators when civil war broke out in Libya. Because of the relatively low margin requirements for crude oil futures, these markets are now dominated by hedge fund speculators that have no other interest than driving the price hard in one direction or the other. They are non-users of the commodity and crowd out the real user trying hedge his or her economic exposure. Prolonged higher energy prices will begin to, if not already, force the cost for most goods and services higher ultimately weakening demand across most sectors of the economy. The price of crude oil is up $20 per barrel in two months and at these prices, the extra wealth that is going to oil producing nations is greater than the annual costs to run most government agencies. The Energy Information Administration estimates that assuming an import rate of 9.5 million barrels per day, a $20 increase would result in an extra $69.9 billion spent annually on oil imports. Of all six of the non-defense Federal agencies, only the Transportation Department spends more money on an annual basis at $87 billion. The FED estimates that a sustained $20 increase in the price of oil would shave 0.4% off of GDP. Recent economic data suggests that we are already beginning to see commodity cost pressures at the factory level. Both the Empire (New York) and Philadelphia (Pennsylvania, New Jersey and Delaware) FED district surveys on manufacturing have shown significant slow-downs in recent months due to the rising cost of raw and intermediate materials. A couple of words on GOLD here. The rise is real and legitimate. GOLD is becoming more of a currency as other countries looking to invest capital reserves begin to question the fundamentals of the EURO and the amount of debt behind the U.S. Dollar and Treasury bonds. This point becomes clear when The World Gold Council reported this week that China is now the largest buyer of GOLD, surpassing India with an aggregate purchase of 93.5 tons……a 55% increase from the previous quarter. Combine this demand with the supply constraints created by expensive barriers to entry to the mining business (you just don’t go out and start a gold mine) and you can see how fast the price of the “yellow metal” can rise.
3.) The amount of U.S. debt outstanding has to be reduced, and how to do it has to be addressed sooner rather than later. Both the debt and the deficit have grown dramatically in recent years, largely as a result of the wars in Iraq and Afghanistan, government stimulus spending during the Great Recession, low tax revenue due to the weak economy and growing spending for entitlements like Medicare, Social Security and the prescription drug program enacted in 2003. Asked to rate the issue’s importance on a 1 to 10 scale, Wharton finance professor, Franklin Allen say that unequivocally, “It’s a 10. Unfortunately, if we don’t get rid of the deficit we are going to have some kind of economic crisis because of the debt.” Getting the deficit under control “is absolutely vital to our long-term economic health,” according to Mark Zandi, chief economist and co-founder of Moody’s Economy.com. Failure to do so he notes, “would eventually lead to a serious rise in interest rates, choking off economic growth and forcing the government to spend more and more of every tax dollar simply to make payments on past debts, leaving less for services and other government functions and dooming economic output (GDP) to become much smaller.” We all know that there are two ways out of the problem, raise taxes or cut spending. We all know that the “elephants in the room” are the entitlement programs of Medicare, Medicaid and Social Security. We all know that no meaningful spending reductions can be accomplished until these “untouchable” programs are “touched”. So …… as predictable as the sun rising in the east and setting in the west, we will see the Republicans battle for massive spending cuts and the Democrats fight for higher taxes to put us back on the right track, hopefully with the goal of reaching a compromise before the 2012 elections. In the meantime, as the deadline for increasing the Federal debt limit nears, look for blustery threats from both parties about the possibility of using a government default as a tool for leverage and reform. The implications of using that “tool” would equate to economic and political suicide and the mere threat would likely cause a sharp decline in the stock market.
4.) Two other issues that bear watching are the economic problems of Ireland and Greece and the end of the FED’s QE2, scheduled for June 30th. Regarding the European Union, there is no way out for Greece and Ireland. Central bank deposits are down 30% year over year in both countries and the needs of the populations of these socially generous countries continues to rise with the commodity and energy inflation discussed in point #2 (it is also interesting to note that over the last 5 years, not a single DOCTOR in Greece has ever paid more than €12,000 annually in income taxes). Look for both countries default and re-structure within the next year. Although the EURO will likely take a hit on the news, France and Germany will come to the rescue and back their debt. The world equity markets will likely take hit on the news but the facts are that Germany, France and Spain’s economies are strong enough to absorb the hit. In fact, a weaken EURO will probably increase export business for the stronger European nations. At the end of June, the FED will complete its purchase of $600 billion of Treasury and mortgage-backed securities known as QE2. The program was designed to keep long term interest rates low in an attempt to re-start the housing market and further stimulate the economy. Naturally there is some concern about what the economy and stock market will do once this stimulus ends. After all, before QE1 the S&P 500 stood at 903.25 and it is now 1334. Disposable household income before QE1 was $10.8 trillion and now it is $11.7 trillion. Household net worth before QE1 was $51.3 trillion and now is $56.8 trillion. GDP before QE1 was ZERO and it is now 2.8%. Consumer Confidence before QE1 was 38.6 and it is now 70.2. Clearly, the plan was successful at rescuing the economy from the edge of oblivion. Speaking of a lifeline, FED chairman Ben Bernanke in my mind, must be commended for his knowledge and understanding of gravity of the housing problem. By keeping short rates near zero and QE2 in place, long rates are low enough to encourage re-financing of both corporate and individual debt, Bernanke has allowed banks to survive and make commercial loans which have offset the losses on their foreclosed and short-sold housing inventory. Is there a QE3 waiting in the wings? Hard to tell for sure but I expect the FED to remain accommodative until housing gets better and the employment picture improves.
In summary……. I do not expect the debt of the United Stated to be downgraded nor do I expect that we will default on our obligations as a result of the failure to lift the debt ceiling. The odds of significant cuts in government spending are growing as we come face to face with need to “clean up after the party.” Commodities speculators are damaged and raising the margin requirements on them now, would allow pricing in those markets to return to a more realistic representation of actual supply and demand. Lower commodity prices will allow the FED to remain in an “easy money” position for longer, put upward pressure back in corporate profit margins and $35 billion back consumers’ pockets (via a $0.25 decline in gasoline prices). Soon tornado season will be over but we will be prepared for hurricane season when it comes around in the fall.
P.S. —- Apparently the behavior of the recently disgraced IMF leader, Dominique Strauss- Kahn, represented the tip of the iceberg when it came to the cultural boundaries of acceptable behavior within the IMF. Clearly time for new leadership at that organization.
Sources: Real Money (Doug Kass and Jim Cramer), First Trust (Brian Westbury), CNBC, Credit Suisse, the Wharton School of Business at the University of Pennsylvania and the Federal Reserve Bank.
Ken Beach, President of Cascade Investment Group, member FINRA & SIPC. Cascade Investment Group is not a tax or legal advisor. You should always consult with your tax advisor or attorney before taking any actions that may have tax consequences.