The wild, wild world of economic forecasting

Nobody said it was going to be easy. Economic and financial market analysis is a tough business, especially these days.

There are always cross-currents to weigh when considering both economic trends and financial market movements. Both positive and negative factors need to be analyzed as to their importance and sustainability. Valuation levels need to be addressed, and economic catalysts need to be examined.

All of these aspects make for a complex business which is why most sane people don’t attempt to deal with these issues. This business is probably similar to forecasting Colorado weather during the spring – who knows what is going to happen.

The central bankers in Europe have launched Ze Tarp following the Grecian market meltdown (the name comes from the fact that Germany is the main source of monetary supply for this effort). In summary, the Grecian government (and overall economy) has been living beyond their means, and authorities there have been using borrowed money to finance an economy which is highly-dependent on continued transfer payments and governmental employment trends.

The officials within the EU have been addressing this issue and the capital markets have been on strike. The question which has been running through the markets has been: Does this problem stop at Greece, or does this problem spread to other more-levered European countries (Portugal and Spain)? The officials in Europe have taken the approach to flood the banking system with money, and guaranteeing Grecian bond payments.

The question which needs to be answered is: Are the markets clear, or do the problems in Greece foretell of further financial woes?

Weighing the Factors

Currently, there are numerous factors on our minds. Below some issues addressed last month:

Reasons to be Positive

 Friendly Fed policy – (Fed is not tightening yet).  Extremely positive earnings momentum.  Consumer final demand appears to be ramping to the upside.  Unemployment appears to have peaked.

Reasons to be Concerned

  Gravity. The S&P 500 is up more than 70 percent from the lows we witnessed in March of 2009.  Greece – the real problems highlight a nation’s weak balance sheet.  China appears to be slowing.  Debt and a changing environment for banking and financial services. We continue to stand behind our position that as long as the nation’s investors are focused on the economy’s income statement issues (GDP growth, improving employment trends, etc), the markets should continue to march higher. However, as we saw last week, if investors’ focus shifts towards “balance sheet” items (i.e. Grecian debt) the markets will swoon.

Income Statement Items – The Good News!

GDP is growing. The data from this year’s first quarter shows the economy grew by 3.2 percent on a real (after inflation) basis. It appears the economy is growing at roughly 3.5 percent for the current quarter – but it is still early. If so, this quarter will mark the 4th quarter of positive GDP growth since the 2nd quarter of 1999.

Now, we agree that the overall growth rate is substantially sub-par as compared to other economic rebounds following severe economic recessions. However, the economy is growing. Those who were at one time calling for the economy to grow for a couple of quarters and fall back into recession were in error.

Friendly Fed. To the degree that money is the fuel driving the economy; the Fed has been very accommodative during the last year and is still in that position. Short-term interest rates remain extremely low (some would say too low – we count ourselves in that camp). However, while supportive, Fed activity is starting to change. M2 (money supply) is actually now contracting – based on 13-week rate of change – by 0.4 percent. While not alarming, this is the slowest monetary growth rate we have seen since 2004.

As a matter of fact, MZM (M2 + small denomination time deposits + institutional money market funds) is now shrinking at an 8.0 percent rate – the most rapid contraction we have seen in more than 30 years. So, while we still count Fed activity in the “positive” column, activity is not as supportive as it once was.

Extremely positive earnings momentum. There is no denying it – corporate earnings are robust. Many analysts are calling for corporate profits to rise by 35 percent for 1st quarter, to be followed by 20 percent gains on average during the 2nd quarter. To put these numbers in perspective, the S&P 500 earnings have risen by 7.0 percent on average since the end of WWII. So, earnings momentum is very positive and should help drive equity values to the upside.

Balance Sheet Items – The Bad News!

Worldwide debt is a problem. There is really no denying the issue, that the measures taken two years ago in the U.S. (TARP) and the measures taken in Europe this past weekend (ZE TARP) are similar, in that the politicians and central bankers have been throwing debt and liquidity at the world’s capital problems.

We live in a world of “have’s” and “have not’s.” This list is changing, and has been during the last 10 years. There has been, and continues to be, a seismic shift from the Atlantic rim countries being the economic dominant powers of yesterday to the Pacific rim countries which will be the economic dominant powers of tomorrow. As this is happening, financial dislocations are occurring.

Debt is a two-edged sword. If used properly and in the correct amounts, debt is a useful tool. If used to excess, debt is very destructive. We have been of the opinion that the world’s major problems are centered on the amount and structure of debt, both in the U.S. and worldwide. The issues in Europe simply show the breadth of this problem extends beyond the U.S. borders.

We believe, on a worldwide scale, there is an endgame to this problem. We need to recognize China is currently slowing their economic growth engine in an attempt to cool rising inflationary pressures. As of the end of April, inflation in China was running at 2.8 percent annually. Price inflation in China has been rising, but appears to be reasonably subdued. However, asset value inflation is running very high.

For example, during the last 12 months, land prices for residential building purposes are up 30.5 percent. Prices for all land transactions in China are up 21.2 percent. The Chinese authorities are attempting to stay in front of these trends. Expect GDP growth in China to cool from the recent 11.9 percent growth rate registered at the end of March. What does this mean to the U.S.? Well, to the degree that China has been acting as one of the world’s true growth engines, it means GDP within the U.S. will probably be lower than would have otherwise been the case. Bond Prices and Interest Rates Since the first of the year, our outlook has been calling for interest rates to rise by the end of 2010.

Due to the deflationary aspects of what is happening in Europe, coupled with the dampening effects we expect due to the Chinese slowdown, leads us to the conclusion that interest rates may not move to the upside as rapidly as we initially envisioned. Indeed, we are now calling for the 10-year Treasury to yield in the 4.0 percent range by the end of 2010, and the Fed to keep interest rate adjustments on hold for the majority, if not the entire year

Final Word

During this time, our recommendation is, as always, to stay with quality in all investment decisions. During times of high anxiety, quality normally does very well.

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