excardog,
Whatever Greenspan and the other Fed governors decide to do with interest rates will have profound impacts on equities. My guess is if the Fed surprises everyone with an unexpected rate cut to provide added liquidity, the markets will explode furiously to the upside, at least in the short-term. The last time the Fed surprised during trading hours was Oct 1998 and the S&P futures rallied about 4% in about 5 minutes, and then never looked back (until now).
I apologize for the length of this, but I think it is worthwhile and would like to hear other's comments on these issues.
The Fed, I think, has a big problem on their hands. The Fed has kept monetary policy quite loose in recent years, and appears to have largely avoided inflationary pressures by their assertion, due to productivity increases, supposedly made possible by the breakthroughs in technology. It is interesting to note that over the last few years the Fed has gone from using the "original" CPI, to the "revised" CPI, to the core revised CPI and most recently to the Personal Consumption Expenditure (PCE) deflator. Each new measure lowered the "inflation rate." As of last August, the original CPI is measuring inflation at over 4% annually! Much of the low inflation environment is an artifact of changing the measure. Furthermore, the US does something that I don't think anyone else in the world does. They have turned to using "hedonic" price adjustments. That is, when they judge the inflationary impact of a personal computer, this years model may cost more than last, but the hedonic adjustments take into account improvements like a faster processor or more memory. Is that inflationary? Well, yes because to someone whose income has not increased, it is harder to buy a computer this year, but the inflation measures do not see this as inflationary. These hedonic price adjustments also figure into the productivity data.
But the real question is: What will the Fed do with interest rates?
Here are excerpts from Greenspan's testimony in July 1999
"Despite the remarkable progress witnessed to date, history counsels us to be quite modest about our ability to project the future path and pace of technology and its implications for productivity and economic growth. We must remember that the pickup in productivity is relatively recent, and a key question is whether that growth will persist at a high rate, drop back toward the slower standard of much of the last twenty-five years, or climb even more. By the last I do not just mean that productivity will continue to grow, but that it will grow at an increasingly faster pace through a continuation of the process that has so successfully contained inflation and supported economic growth in recent years.
The business and financial community does not as yet appear to sense a pending flattening in this process of increasing
productivity growth. This is certainly the widespread impression imparted by corporate executives. And it is further evidenced by the earnings forecasts of more than a thousand securities analysts who regularly follow S&P 500 companies on a firm-by-firm basis, which presumably embody what corporate executives are telling them. While the level of these estimates is no doubt upwardly biased, unless these biases have significantly changed over time, the revisions of these estimates should be suggestive of changes in underlying economic forces. Except for a short hiatus in the latter part of 1998, analysts' expectations of five-year earnings growth have been revised up continually since early 1995. If anything, the pace of those upward revisions has quickened of late. True, some of that may reflect a pickup in expected earnings of foreign affiliates, especially in Europe, Japan, and the rest of Asia. But most of this year's increase almost surely owes to domestic influences."
federalreserve.gov
In this I focused on "the revisions of these estimates (corporate earnings) should be suggestive of changes in underlying economic forces." What is currently happening with earnings estimates? I think they are being revised DOWN. Why are they going down? Either sales are slowing or unit costs (labor-due to tight labor market, or materials) are rising. This suggests to me that either the US economy is significantly slowing (ie maybe recession) or productivity is not as great as it had appeared. I think there is a lot of information that productivity is not that great. The vast majority of the productivity gains, when broken down into components, are due to manufacturing improvements within technology (PC production), and much of that gain is due to hedonic price adjustment. There is a good graph of this in a recent Businessweek article.
If productivity is slowing then inflationary pressures will mount further and rate increases are in the pipeline. If recession is coming (as the bond market is forecasting), then the Fed may consider lowering rates. But here is the problem: again from Greenspan,
"One offset to the decline in household saving out of income has been a major shift of the federal budget to surplus. Of
course, an important part of that budgetary improvement, in turn, owes to augmented revenues from capital gains and other
taxes that have flowed from the rising market value of assets. Still, the budget surpluses have helped to hold down interest rates and facilitate private spending.
The remaining gap between private saving and domestic investment has been filled by a sizable increase in saving invested from abroad, largely a consequence of the technologically driven marked increase in rates of return on U.S. investments. Moreover, in recent years, with many foreign economies faltering, U.S. investments have looked particularly attractive. As U.S. international indebtedness mounts, however, and foreign economies revive, capital inflows from abroad that enable domestic investment to exceed domestic saving may be difficult to sustain. Any resulting decline in demand for dollar assets could well be associated with higher market interest rates, unless domestic saving rebounds."
The message here is Americans as a whole have not been saving, and domestic investment is largely being funded by foreigners. If the dollar starts declining, foreign investment starts leaving the US (not just slowing inflows, but reversal of flows) and our equity and bond markets are in trouble. In this scenario "decline in demand for dollar assets could well be associated with higher market interest rates." Further, stable or falling stock prices lead to lower capital gains revenues which would reduce or erase the budget surplus, adding upward pressure on rates.
My read on the situation is higher rates are more likely than lower, and that is why I think the Fed is in a bad predicament because the economy is slowing now, and I would not discount the idea of a recession sometime next year. Besides, it's good for presidents to take recessions in their first year because it gives voters time to forget before the next election, so long as things reverse.
I think the most important thing to watch, as someone had earlier pointed out, watch the dollar. If it weakens, stocks stand to get beaten up for several reasons.
My thoughts,
Erik |
