New Highs as Great Disconnect Widens: Part I

by The Curmudgeon

Introduction:

While the DJI and several broad stock market indices made new highs today, U.S. and global economic conditions are MUCH worse than they were in October 2007, when the Dow and S&P 500 made their previous all-time highs.  At that time the economy was growing over 3% and unemployment was much lower than it is now.  The labor participation rate was also much higher.

In this two part series, I will first provide evidence that the U.S. and global economy is weakening, despite the Fed's effort to stimulate growth.  Meanwhile, European unemployment is increasing and the Eurozone will likely be in recession this year.  That doesn't augur well for U.S. exports to Europe.

In the second article, I'll provide corroborating opinions that the Fed's zero interest rate and multiple QE programs have not appreciably increased economic growth or lowered unemployment.  Instead, the Fed's reckless monetary policy has created financial asset bubbles that could burst anytime.  And as previously stated, the Fed has no more silver bullets to fight a new recession.

In addition, I'll enumerate the key points made by former Labor Secretary and UC Berkeley Prof. Robert Reich at today's (March 5th) IDC Directions conference in Santa Clara, CA.

Economic Fundamentals:

Bottom Line: We believe that the combination of the 2% payroll tax on January 1, sequestration (forced government spending cuts) as of March 1, sharply higher gasoline prices, sharply higher health care costs, rising food prices, Europe in a recession, and slower growth in China will result in U.S. GDP of at most 1.5% this year and quite possibly an economic contraction.

Data Points:

1.  On March 1 it was reported that disposable income (after tax income), dropped 4 percent after adjusting for inflation.  That was the biggest plunge since monthly records began in 1959.

2. Personal income decreased by $505.5 billion in January, or 3.6%, compared to December (on a seasonally adjusted and annualized basis). That’s the most dramatic decline since January 1993, according to the Commerce Department.

3.  Sequestration -- $85B of forced Federal government spending cuts commenced on March 1.  This will likely reduce GDP by 0.5% and cost 1M jobs.  The sequestration plan forces $1.2 trillion in across-the-board spending cuts over 10 years. Though most entitlement programs are exempted, every other government department will be affected.

4.  The U.S. government is spending $3.6 trillion a year and borrowing just over a third of that (currently at $1.3 trillion).  In one of the greatest Ponzi schemes of all time, the borrowed money is being monetized by the Fed (in other words, the government is printing money to fund its deficit). U.S. government spending rate is increasing at almost 4% a year – about double the rate of GDP growth.  Any austerity plan to cut government spending will result in lower GDP growth and higher unemployment.

5. Our total government debt was at $10 trillion at the end of 2008. It is now at $16.4 trillion. It will be at $17.5 trillion by the end of 2013. This means our debt to GDP by year’s end will be close to 110%. If the deficit is not narrowed, our government debt will be over $32 trillion in 10 years. Barring any recessions our economy will be at $20 trillion. Our debt to GDP will be at 160%.

6.  Gasoline prices (in CA) have risen 58 cents since January 1 for unleaded regular gas which is now $4.12 per gallon (or more). Consider that for every penny increase a billion dollars is taken away from consumers. So, $58 billion is about to hit disposable income hard.

7.  The chart below of “real median household income index” is quite revealing.

Notice, how steeply “real median household income index” fell under Fed Chairman Bernanke’s zero interest rate policy and QE programs. This drop in real income is a result of disposal income getting pinched as food and gasoline prices have soared and the value of the dollar has plunged.

At IDC Directions 2013 today, UC Berkeley Prof. Robert Reich said that median U.S. wages had DECREASED 8% in real terms since the year 2000!

8. Unemployment rate in the Eurozone just hit a new record high of 11.9%. The unemployment rate in Italy has risen to 11.7 %. That was a huge jump from 11.3% the previous month, and Italy now has the highest unemployment rate that it has experienced in 21 years. Italy is an economic basket case and the political gridlock after their recent elections is creating more economic uncertainty. The unemployment rate in Spain is over 25%, while it's reached 27% in Greece. This does not augur well for European economic growth as there's no demand from the unemployed who don’t have extra euros to spend!

9.  China’s State Council has announced a new set of policies designed to cool down its hot housing market.  Economic data released in the last few days has called into question the strength of China’s recovery (Source: NY Times).

10.  Separately, China is prepared for a "currency war." Yi Gang, Deputy Governor of China’s central bank, made that statement after G20 finance ministers last month moved to calm fears of a looming war on the currency markets at a meeting in Moscow. Those fears have largely been fuelled by the recent steep decline in the Japanese yen, which critics have accused Tokyo of manipulating to give its manufacturers a competitive edge in key export markets over Asian rivals. 

These "competitive currency depreciations" are intended to spur exports, but this kind of “beggar my neighbor” policies has always failed to stimulate global growth.

Investment Conclusions:

Corporate profits cannot indefinitely grow much faster than GDP growth or productivity.  The theme of "doing more with less" (i.e. fewer workers doing more of the heavy lifting) is about played out.  Companies won't hire till they sense demand will improve, but that's not likely anytime soon.  Hence, we see profit growth to decline sharply in coming quarters.

Indeed, corporate earnings expectations have been falling, profit margins are unsustainably high (especially when compared to GDP growth of 1.5 to 2%). And investor sentiment is so optimistic that it seems that the risk in all financial markets has been ignored if not forgotten.  It seems that investors don't remember the two huge (>50%) stock market drops in the last decade.  But then again, I've been told we're in a new secular, long term bull market....Hmmmm????

Stay tuned for part 2 of this series. 

Till next time.....................................

The Curmudgeon

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.