Quarterly Market Update
At any given moment, there are always some economic conditions that are improving while others are declining. The question is whether or not the improving conditions (glass half-full) outweigh the declining conditions (glass half-empty). Currently, we believe the glass is half-full. In our view, the positives of declining energy prices (although possibly short-term), Japan coming back on-line, improved liquidity, and moderate inflationary conditions slightly outweigh the negatives of persistent above-norm unemployment levels and currency weakness. The housing outlook remains mixed and unlikely to significantly improve in the coming months.
From a current perspective, it is tempting to label the precise condition of the economy. Labels like Goldilocks, Rolling Recessions, Growth Recessions, Double Dipper, Soft Patch have been used to describe the broad U.S. economy. However, domestic economic conditions and trends are rarely such that sweeping generalizations are 100% explanatory. Generalizations have traditionally proven to be less than helpful because many variables exist which can offset each other at any given moment.
To illustrate, consider what has been happening with oil prices. While oil prices were spiking toward $110 per barrel, talk was rampant about $120 per barrel and $5.00 pump prices, creating predictions of sharp reductions in disposable income and consumer spending. The conclusion was that a meaningful reduction in Gross Domestic Product (GDP) growth was imminent for the remainder of 2011. As the quarter progressed, oil prices reversed, falling to mid-$90 levels. Then, unexpectedly, the Obama Administration announced release of oil from its emergency stockpile. Oil prices, West Texas Intermediate crude, dropped to under $90 per barrel, a decline of almost 20% from the highs.
Following the earlier logic, it would appear that consumer spending will now be less constrained, energy prices will trend lower and economic activity will pick up. Certainly, there is merit in each of these. However, keeping current events in perspective, energy prices are now at approximately the same levels as at the at the beginning of the year. Longer term, oil prices will be driven by demand created from economic activity and changes in supply, not short-term measures such as stockpile releases. In our first quarter 2011 outlook, we suggested that oil per barrel prices would likely range between $85 and $110 per barrel, and this remains a realistic expectation. On June 22nd, the Federal Open Market Committee (FOMC) issued the following statement which we have paraphrased:
The recovery is continuing at a moderate pace but less than previously expected. Near-term recent weakness is transitory and the pace is likely to increase gradually. While inflation is no longer subdued, longer term inflationary conditions appear to remain stable. Quantitative Easing II (QE2) is ending but balance sheet adjustments may continue if viewed as necessary.
We are in agreement with this statement.
The Federal Reserve (the Fed) has provided liquidity to the financial system, evidenced by estimates that banks have in excess of $1 trillion in reserves with the Fed. In addition, a recently released Birinyi Associates report stated that companies represented in the S&P 500 have approximately $800 million of cash equivalents on their balance sheets. Over the past two years, corporations have been able to access the credit markets as evidenced by the high level of debt issuance.
The relative issue is no longer one of liquidity but rather the velocity of money. What could improve velocity? Until now, the Fed's monetary policy has been the major force. Now is the time for another catalyst to emerge. The catalyst(s) may come from many sources – regulatory clarity, tax policy or adjustments to fiscal policy are all among the possibilities. Another catalyst is developments associated with the U.S. debt ceiling debate. Given the political undercurrents, we do expect the issue to be resolved prior to the August deadline, but exactly how much meaningful, long-term progress gets accomplished is extremely difficult to forecast. Ultimately, real positive change is needed to boost business and consumer confidence and enable velocity, rather than liquidity, to emerge as the driving force. Until significant movement develops, uncertainty will persist and restrain the rate of economic recovery.
When 2011 began, our broad expectations for growth were based on accommodative Fed policy, relatively low inflationary pressures, stubbornly high unemployment levels and moderate real GDP growth rates. The Fed is committed to its low interest policy and implementation of an "exit strategy" appears to be a 2012 event. We have seen a mild increase in the Consumer Price Index due to increases in food and energy prices.
Near term, both consumer disposable income and businesses' operating margins will benefit from the recent decline in oil prices. Although the unemployment rate continues to hover around the 9% level, we have seen gains in private hiring and declines in public hiring. Both are favorable trends, but the rate of change persists at below historic norm recovery pace. Overall, we remain comfortable with the 2011 real GDP forecast growth rate of +2.2% – +2.8%.
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