Economic Update: September, 2009
By Jim Oelschlager
Chief Investment Officer and Portfolio Manager
September 9, 2009
The economy appears to be improving. GDP through the second quarter was at -1%. Now we are two thirds of the way through the third quarter and it appears likely that the GDP for the third quarter will show a positive number, and maybe a surprisingly strong positive number. Productivity is high which is normal in the early recovery stages of an economic slowdown. Manufacturers produce more with the same amount of workforce. Having been beaten up, most companies are slow to add workers back, which is why unemployment is a lagging indicator. Productivity gains in conjunction with very low inventory should lead to continued good earnings reports by companies for the third quarter and should also bode well for results going forward.
We went through a period where analysts were constantly revising downward their earnings estimates for companies. Now we are in an environment where analysts are generally increasing their estimates for companies on a regular basis. This is possibly responsible for the sharp rally we have seen in the equity markets. We are certainly not out of the woods; and, we certainly have problems in the future. Banks which were beaten up with loan losses in the recent past are slow to make any loans at all which are not extremely well collateralized. Reluctance on the part of banks to extend loans to businesses is likely to mitigate the advance of the economy in the near future. The housing market still has significant problems, and foreclosures have not abated significantly. I heard of one project in Phoenix that had 250 homes in a development and 200 of them were on the market for sale. Seems it will take a long time to work through that kind of inventory even with a sharp reduction in prices.
In conjunction with the stock market going up, virtually every commodity, with the exception of natural gas, has also shown a strong increase in price in recent months. Many wonder whether this increase in commodity prices is a function of increase in demand as a result of an improving economy or whether it is a result of inflation fears by people who are trying to hedge themselves for the future. Increased commodity prices may ramp up in the rate of inflation. Many people believe that the huge amount of money that the government is throwing at our economic problems will at some point in time lead to inflation, whether it will occur in six months or three years, nobody knows. But, it is widely feared that this rapid money expansion will eventually lead to higher inflation. That said, it is noteworthy that given the explosion in the monetary base and future concern for inflation, the U.S. Treasury market has been able to stay quite strong even in the face of huge borrowing literally every day -- borrowing of an unprecedented magnitude. There is a lot of talk about the dollar no longer being a reserve currency; and, certainly the dollar’s relevance in the world or dominance in the world is going to be muted from what it was in the past. However, there seem to be a lot of people still willing to buy Treasurys, where yields are relatively low by historical standards. People are buying two-year Treasurys at a rate of about 1%. While we have been through a period of deflation, which makes that modest positive return a little more palatable, it seems likely that the real return will become very minimal or even negative quite quickly if inflation picks up.
It is also possible that some of this money being thrown at the system will not only meet the higher prices for commodities, but also higher prices in equity markets as the money looks for a home. More and more individuals and institutions see very modest returns in the fixed income markets. The equity markets may appear more attractive, particularly in an environment where the stock market is finally, for a change, showing positive returns.
As a general rule, people often get the direction of the markets correct, and they almost always underestimate the magnitude – meaning that as the market went down further than most people anticipated in the recent correction, it may go up a lot higher than people are thinking at this point in time. The wild card, of course, is how much inflation will be created, if any, as a result of the huge injections of money into the system. That is the $64,000-question!
Back to the beginning: are commodity prices going up because of increased demand or because of stockpiling in anticipation of inflation? Probably a little bit of both. Is the equity market going up because of anticipated inflation or because of improving earnings? Again, probably a little bit of both.
One of the reasons for our investment in the energy sector was a possible return of inflation. We are monitoring the inflation situation and will position our clients according to our conclusions.
In the political arena, the general populace seems to be more upset and vocal than anytime I can remember since the Vietnam era. It is probably better for the general populace to get riled up and involved than to treat their government with benign neglect. It will be very interesting to see what comes out of all this. Again, it is a positive for individuals to take more active roles; and, the government is likely to move in the direction of the general populace.
This kind of involvement by the general public tends to keep the government a bit in check and precludes radical change. Radical change is not coincident with the general feeling of the general population. In other words, for a change, the government has to be responsible to the people. I think that is the way it was supposed to be from the beginning.
This manager commentary represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice.