July 13th, 2009 4:03 PM by Mel Samick
The economy continues down its meandering path to recovery, but the markets are starting to come to grips with the fact that the easy money has been made, and improvements from here will be slow and modest. The S&P 500 Index was off 2.1% for the week and is off 4.5% so far this month. The drop represents a reversal of the second quarter’s strong 15.2% gain, which was itself a reversal of the massive drop the equity markets went through since late 2007. At least each successive wavelet has been decreasing in amplitude! The March-June rally was driven by an expectation that the government’s stimulus program and financial system bailouts, aided by the market’s own self-correcting mechanisms, would ultimately pull the economy out of recession and return corporate America to health. The fundamental case for that outlook hasn’t changed, but it is being tempered by a dose of reality about what the economy will look like when things settle down to a “new normal”.
The International Monetary Fund released an updated economic forecast, predicting that the global economy is on course to shrink 1.4% in 2009 and then grow 2.5% in 2010. That would be a modest and sustainable growth path, but well below the markets' exuberant expectations formed over the past 15+ years of boom times leading up to the recession.
Last week, Laura Tyson, one of Obama's advisors but not formally a member of the Administration, made mention that perhaps another round of economic stimulus would be needed. I’m sure she floated this trial balloon to help the Administration get a reading on how many people would try to shoot it down. The good thing about stimulus plans is that they help prevent us from sinking into another Great Depression. The bad part is that they cost money – money that the government ends up having to borrow.
Government borrowing was very much in evidence last week as the U.S. Treasury conducted four debt auctions (a new record), one on each day from Monday through Thursday. The Treasury auctioned 10 year Treasury Inflation-Protected Securities, 3 year fixed-rate Notes, 10 year Notes, and 30 year Bonds. To its credit, the Treasury was able to auction (and the markets were able to absorb) over $74 billion worth of securities in a short period of time. Of course, in our capacity as U.S. taxpayers we will ultimately pay for it all, with interest.
Or will we? That question has been on the minds of China's finance officials, and they’ve been sharing their thoughts with us rather publicly over the past month or so. Given that China is now the largest external holder of U.S. Treasury debt (followed by Japan as a close second), they are justifiably concerned about whether the U.S. will ultimately have the willingness and ability to repay its debts with real money. Some of the innovative measures the Federal Reserve has recently taken amount to “monetizing” part of the debt, which is the economic equivalent of running the printing presses. This ultimately creates inflationary pressure. The Chinese don't want to end up facing any of three unfortunate scenarios somewhere down the road, either (a) an outright default by a U.S. government that simply can't pay, or (b) a California-style default where the government pays its obligations in some form of funny-money IOU's, or (c) nominal debts being repaid in monetized, hyper-inflated dollars.
So for this week, watch for key inflation measures to be released on Tuesday and Thursday in the form of the Producer Price Index and the Consumer Price Index. Inflation has been quiescent lately, with retail sales down, consumer spending off, and oil prices dramatically lower than they were a year ago. However, this author is of the opinion that once the economy emerges from recession, inflation will be the primary risk facing investors over the next three to five years.
Information provided by Amtrust Bank Capital Markets