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The gains recognized in the stock market
may be short lived. Despite reactivated liquidity moving into the stock
market, a loss of confidence in discounted future earnings may lead to a
correction in the near term. If rapid growth in the U.S. economy is slow to
materialize, and the ranks of the “long-term unemployed” continue
to swell, the Federal Reserve will become increasingly frustrated in its
mission to achieve “full employment.”
The Fed may have few options
available beyond increasing the money supply to historic levels and reducing interest
rates to below 25 basis points. It is becoming apparent that Fed officials
are now more aware that the increase of the monetary base may be
inflationary. Reticent to go against their Keynesian roots, the Fed will be
adverse to reverse monetary easing or reduce liquidity. This raises the
specter of stagflation, with stagnant growth and above average inflation
ahead, holding gold at historic price levels and benefiting gold producers.
What is Driving the Bull Market?
The recent bull market in equities
has been impressive, but should be balanced against the rapid declines in
2008. The recent enthusiasm seems to be due more to the psychological
relief of not going over a financial precipice rather than confidence in robust
economic fundamentals. Prudence would suggest that the initial signs of
recovery, following the greatest economic decline since the 1930s, should be
approached with a good dose of skepticism or at least cautious curiosity.
The combination of easy monetary
policies and reactivated sidelined cash may have induced “money
illusion,” or economic blindness, that plays into momentum trading of
equities, temporarily pushing stock prices higher. Clearly, relative to
earlier suppressed valuations and to returns on Treasuries, the stock market
is again attractive. On the other hand, inflation, appearing absent in
interest rates between global currencies, may only be reflected accurately in
record gold prices.
Liquidity, sidelined over the last
year, has been coming back into the market following expanding margins and
improving corporate profits. This expansion appears to be a result of
“excess capacity,” primarily through reduced labor and other
costs. These factors lead market pundits and other “smart people”
to conclude that a “V-shaped” bull market in stocks is
foretelling a “V-shaped” economic recovery in the U.S.
Chronic Unemployment May Dull an
Otherwise Potentially Robust Recovery
An increase in unemployment in the
business cycle is generally considered to be positive as it redistributes
labor to its most productive utilization. The academic argument for a robust
recovery in 2009 does not stand up against the tested but folksy definition
that “a recession is when your neighbor loses his job; a depression is
when you lose your job.” Increasing ranks of the “long-term
unemployed” may suppress top-line growth of corporate sales and
eventually corporate profits.
Reported unemployment in the U.S.
is at its highest level since WWII, and one third of those counted as
unemployed have been unemployed for over 27 weeks. This group is now
estimated at about five million. While “unreported unemployment,”
consisting of those who have given up finding work or are underemployed as part
time labor, is likely in the high teens; this extended period of unemployment
for the “long-term unemployed” provides an entirely new dimension
to the U.S. economy.
Those who are “long-term
unemployed” find it increasingly difficult to locate employment in
their field of expertise or at previous pay levels. This underutilized labor
pool, now affectionately regarded as “excess capacity,” run the
risk of becoming a permanent recipient of government support or entitlements.
A compassionate government may actually subsidize and prolong the period of
unemployment. The longer it takes the unemployed to adjustment and return to
productivity in a competitive world economy, the less likely we may see a
“V-shaped” economic recovery.
Stimulus Efforts to Boost Economic
Recovery May Have Little Effect
Government stimulus and other
encouragement have provided questionable benefit to reestablish confidence in
the economy. It is uncertain whether short-term stimulus for first time home
buyers and “cash for clunkers” programs support long-term growth
for the economy. While positive for special interests such as home builders
and the auto industry (and those lucky enough to be in the market for a new
home or car), it is too soon to know how these activities helped or whether
they simply disrupted the market.
The most important message in the
current bull market is that the financial crisis of 2008 is behind
us. Beyond expanding liquidity in the system and propping up
institutions selectively deemed “too big to fail,” confidence by
all others participants, including the unemployed, is essential for a
functioning economy. This confidence is essentially lacking for both
consumers and commercial interests.
Individuals appear unconvinced
that the recession is over. Although economists are anticipating GDP of -2.6%
in 2009 rebounding to +2.5% in 2010, higher reported and unreported
unemployment has cooled both consumer spending and demand for credit.
Consumer spending makes up 70% of the U.S. economy, and although consumer
confidence is being reestablished, it remains below half its historic level
and below the lowest levels of the 2001 recession. Savings of U.S. households
swelled to $566 billion in the second quarter, four times the rate at the
beginning of 2008. Even though the market rebound returned $1.1 trillion to
U.S. household net worth, they are still out $10.8 trillion.
Lower demand for credit has been
offset by a reduction on the supply side for available credit by the chilling
effect of increasing regulations on commercial bankers. A clear takeaway from the recent Group of 20 summit
(G-20) is the U.S. push for increased global financial regulation, capping
executive compensation, and increased capital requirements. This emphasis in
the U.S. is contrary to free markets, which include risk taking and
commensurate returns. Clearly, bankers (and regulators) are more interested
in keeping their jobs than taking risks essential for a growing and expanding
economy.
Lack of consumer confidence may be
a drag on a “V-shaped” economic recovery. This may be prolonged
by lower levels of household income and assets with high debt levels and
growing ranks of “long-term unemployed.” In addition, as
regulators move down the food chain from institutions deemed “too big
to fail,” smaller community banks will come under pressure. This
environment of low interest rates, which typifies both low demand and supply
of credit, argues against a “V-shaped” economic
recovery. When queried on when inflation would commence, one banker attending
a regional banking school responded “when I am confident of my
job.”
Confidence is Essential for
Increasing the Velocity of Money
Irving Fisher’s Equation of
Exchange (MV = PQ) again provides some useful insights. The Fed’s
success in increasing the money supply has failed to inspire sufficient
confidence in market participants to accommodate increased liquidity. The
increased liquidity with higher savings has partially found its way back into
the stock market. The slower rate of liquidity moving through the system has
reduced economic output and increased unemployment. What about the remaining
independent variable, inflation?
The Fed’s mission is to
provide for both “price stability” and “full
employment.” Should the money supply remain unchanged and confidence
(velocity) increase, without a commensurate increase in economic growth,
inflation should ensue. Likewise, should confidence stagnate, economic growth
may likewise, which is inflationary as well. The Fed does not appear to
have the antidote for what ails the economy.
In the Fed’s mind, they
would expect that their actions, including increasing liquidity, would
rapidly restore confidence. This would be followed by increased economic
growth, which when combined with surgical monetary policy would hold
inflation in check. Unfortunately, growing ranks of the “long-term
unemployed” are a drag on confidence, and a successful monetary policy
operation has yet to be performed on this scale.
Well intentioned domestic economic
initiatives may have dire consequences for growth of the U.S. economy
essential to sop up liquidity and check inflation. Health Care Reform, even
in its nebulous form, is taking shape as another tax on productivity to be
enforced by the Internal Revenue Service. Environmental Cap and Trade
policies are expected to increase the cost of energy. Recent experience of
$4.00 per gallon gasoline in the summer of 2008 slowed the economy, and
exacerbated loss of household income met with rising mortgage defaults.
Ambivalent policies for lowering taxes and reducing regulation in the U.S.
may lead to lower production of goods and services relative to an increasing
money supply, which is inflationary.
Global Inflation Appears to be
Inevitable
The recent G-20 summit has brought
attention to an increase in global liquidity, which is evidenced by gold
rising against international currencies. How nations individually address the
stability of their currencies and domestic economies is yet to be seen.
Interestingly, China and India continue to grow and are developing their
domestic consumer base with less reliance on exports to the U.S. Germany has
recently tilted to what resembles a more free market economy. Until actions
of this sort take hold internationally, the only stable store of value and
currency is likely to be gold.
Mike Niehuser
Beacon Rock Research.com
Also
by Mike Niehuser
Mike Niehuser is the founder of Beacon Rock Research, LLC
which produces research for an institutional audience and focuses on precious,
base and industrial metals, and substitutes, oil and gas, alternative energy,
as well as communications and human resources. Mr. Niehuser
was nominated to BrainstormNW magazine's list of
the region's top financial professionals in 2007.
Mr. Niehuser was previously a senior equity
analyst with the Robins Group where he was a generalist and focused on
special situations. Previously he was an equity analyst with The RedChip Review where he initially followed bank stocks
but expanded to a diverse industry range from heavy industry to Internet and
technology companies.
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