After a very strong start to 2012, I am seeing signs of a slowdown in economic momentum. The question I have is whether we are in for a repeat of the economic slowdowns (and the simultaneous volatility and decline in the equity markets) of 2010 and 2011. Below is a chart of the Weekly Leading Index from the Economic Cycle Research Institute, an independent forecasting group. While no index is completely accurate, over the past several years the ECRI Leading Index has rolled over (turned downward) just prior to the economy and the financial markets hitting a rough patch. Notice the recent decline in this index.
Source: ISI
In trying to discern whether we are in for a repeat performance, I have identified 2 key similarities and several differences between this year and the prior two years.
The 1st key similarity is the Fed. You may recall that the so-called QE1 (quantitative easing) program the Fed instituted back in Nov 2008 came to an end in at the end of March 2010. The economy slowed and the financial markets tumbled and QE2 was implemented on November 3, 2010. When QE2 ended on June 30, 2011, the economy and financial markets again responded negatively, prompting the implementation of Operation Twist (another form of monetary easing) on September 21, 2011. Operation Twist is due to expire on June 30, 2012 and I wonder if the current signs of slowdown are appearing in advance of that date.
The 2nd key similarity is corporate profits and balance sheets. Corporate profits continue to grow and their balance sheets remain flush with cash. From the WSJ this week “Corporate Cash Levels Spike To All Time High, Up 38% Since 1Q09” The Federal Reserve today reported corporate cash balances spiked to $1.93 trillion – a 38% increase since the first quarter of 2009 – representing $530 billion. This significant increase indicates companies are still accumulating cash rather than redeploying it, according to Treasury Strategies, a treasury consulting firm. We are roughly halfway through the 1st quarter earnings season and so far roughly 72% of reporting companies have beaten earnings estimates and perhaps more importantly, roughly 70% have reported higher revenues. This indicates that companies aren’t having to “save” their way to profitability – their revenues are actually growing. This trend began in 2010 and continues here in 2012.
The key differences this year versus 2010 and 2011 can be divided into positives and negatives:
Positives:
o Global monetary easing – back in 2010/2011 most countries, other than the US, were tightening their monetary policies (raising interest rates) whereas now virtually every major central bank is easing monetary policy so interest rates around the world are quite low.
o Gas prices – while elevated at close to $4/gal., gas prices have stabilized and are slightly below where they were going into peak driving season in 2010/2011, which should continue to help consumer spending.
o US housing market may have turned the corner – all indications are that the US housing market has finally reached a bottom and is showing signs of recovery. The WSJ had a provocative cover story last week, “Stunned Home Buyers Find Bidding Wars Are Back”. What’s back is more employment, record low mortgage rates and great affordability.
Negatives:
o Continued Euro zone problems – in 2010/2011 it was Greece. Now Spain is in the spotlight and is significantly larger than Greece.
o Unemployment claims increasing – after several months of steadily declining new unemployment claims, we have seen a small uptick in new unemployment claims over the last 3 weeks. This may be a timing issue given the unseasonably mild winter which may have moved some jobs into the 1st quarter from the 2nd quarter.
o The US “Fiscal Cliff” – barring action by Congress & the President, on January 1, 2013 virtually everyone will be hit with a tax increase as the current payroll tax holiday will expire, the tax rate on capital gains and qualified dividends will jump and a 3.8% surcharge will be added on investment income for high income taxpayers. Simultaneously, mandatory spending cuts will be implemented as a result of the failure to agree on a deficit reduction plan last year. The combination of reduced spending and higher taxes is estimated to drain approximately $500 billion out of the economy next year or roughly 4% of GDP (gross domestic product). That is scary given that GDP is currently only growing at about 2%.
My sense is that we are likely in for another period of heightened volatility but that the turbulence will not be as dramatic or as deep as in 2010/2011. Having said that, I will continue to watch the indicators closely and let you know if we need to take any action.
As always, I appreciate the opportunity to be of service and will continue to do my best on your behalf. Please feel free to pass this commentary along to anyone you think would benefit from it.
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