Apr 09, 2010

The Healing

On the political front the passage of the health care bill was important.  Almost everyone in favor would agree that it is not what we once hoped it would be, and many believe that it is a step backwards because of its cost, but for those who had lost confidence in the ability of the American legislative system to get anything done, it was a step forward.  The cleavage between the Republican and Democratic representatives in Congress had become so sharp that it seemed to observers abroad that our system of government was dysfunctional.  That was a pretty severe indictment of the country that is still the political, economic and military leader of the world and it was a view that required reversal.  Passing the health care bill with all of its flaws is a start in that process, but it is not constructive to have the two major political parties so at odds with one another.  We have to change the political focus from gaining seats in Congress in the November election to doing what’s right for the American people and I have to believe there is a common ground where both parties can agree on certain issues and act constructively.  The financial service industry regulatory reform legislation may be the next test.

One of my major concerns has been the growing friction between China and the United States and that situation seems to have gotten better as well.  Over the past few months the United States has irritated China by Obama’s meeting with the Dalai Lama, selling arms to Taiwan, accusing the country of “currency manipulation” and pressuring authorities there to join in imposing tough sanctions on Iran in order to reduce that country’s nuclear weapons development program.  Since China is our most important creditor and the United States is going to need significant foreign support to finance our trillion-plus deficits over the next few years, strained relations between the two countries could evolve into an important negative.  The decision of Hu Jintao, the Chinese President, to come to Washington for the nuclear security summit meetings and to meet with President Obama could represent a thawing of existing tensions or at least the possibility of accomplishing that goal.  Treasury Secretary Geithner was right in postponing his report to Congress on the currency practices of our trading partners.  No country, especially in Asia where stature is so important, wants to be badgered.  Patience in letting the Chinese act on their own to revalue the renminbi may be rewarded.

I continue to worry that intermediate term Treasury yields are headed much higher.  Our borrowing needs are huge, our savings rate is low and some of our foreign creditors like those in the Middle East are concerned that they already own too many U.S. government securities and may slow down their buying.  Also the strength of the U.S. and other economies may encourage investors to buy higher-risk assets.  The Federal Reserve may respond to the renewed strength of the economy and begin to tighten.  Tom Gallagher of International Strategy & Investment points out that the underperformance of utility stocks which is happening now usually leads to higher Treasury yields within one to three months.  He also notes that seasonal factors from the end of March to August push yields up 55 basis points.   Many are worried that higher interest rates will choke off the recovery, but rates today are much lower than they have been in earlier recession-recovery periods and momentum in those cycles endured.  I don’t think the economy will stop expanding unless the 10-year Treasury yield exceeds 6%, which I don’t expect.

I had become concerned that China was not an enthusiastic participant in the recent Treasury auctions because of the sharp 30 basis point rise in the yield of the 10-year note.  Yields had remained low so far this year because investors everywhere were alarmed by economic problems in Greece and the implications for the European Union and had sought refuge in U.S. government securities.  This was not a new phenomenon.  Geopolitical instability and economic uncertainty abroad had driven many overseas investors into Treasuries over the past several years.  What was different in 2010 is that foreign investors in the past years had been willing to buy U.S. notes and bonds even though the U.S. currency was weak, and the dollar’s strength this year has added to the nominal yield they were earning.   

During the month the financial crisis in Greece seems to have improved as well.  While it seems unlikely to me that the country will be willing to endure the austerity that would be required to move the country’s budget deficit into a more reasonable range, it now looks like a cooperative effort between the European Union and the International Monetary Fund will provide interim financing for Greece and give the country time to bring its budget deficit into line.  Hopefully Greece will provide a wake-up call for Spain and other members of the European Union with potential deficit financing problems.  Economic conditions in Europe are improving as they are in the United States and it is important that this fragile recovery is not derailed by a series of further financial crises on the continent and in Ireland. 

The positive employment report may finally convince the skeptics that the economy has indeed “turned the corner” in President Obama’s words.  True, the unemployment level didn’t budge from its troubling 9.7% level, but there were other signs that better news was ahead.  Manufacturing remained strong with the March Purchasing Managers Index at a six-year high of 59.6 (anything over 50 indicates an expansion).  The strength in manufacturing is something of a surprise because few expected a revival in this sector, but the decline of the dollar last year has helped exports.  Even vehicle sales are impressive with March showing the industry operating at an 11.2 million unit annual rate. 

The consumer has also started spending again.  March retail sales should show close to a 4% annual growth rate.  Now that the economy has a better tone, people seem more willing to spend and the savings rate has dropped to 3.1%.  It never got to the 10%–12% level it had reached in earlier severe recessions (1973–1974 and 1980–1982) indicating, to me at least, that there may have been a cultural shift from thrift to consumerism over the past several decades.

I still believe that consumer spending, inventory building, exports and capital spending can each contribute a percentage point or more to real economic growth in 2010, causing the final number to be in excess of 4%.  The consensus at the beginning of the year was 2%–3% and it is probably still close to 3% now.  Perhaps more important, you don’t hear much talk anymore about the “double dip” fear of the economy slipping back into recession.  Most economists who were pessimistic at the beginning of the year are willing to admit that the economy has entered a growth phase but believe that the unemployment rate will remain high.  I question that conclusion as well.  Temporary employment numbers are too high and productivity is at a level that cannot be sustained.  Companies were unwilling to add full-time employees until they knew what the health care legislation would look like.  Now that the bill has passed we should see payrolls expand.  I am still expecting unemployment to fall into the 8% range by year-end. 

One cloud that lingers over the market is the threat of inflation.  The zero interest rate policy and the rapid expansion of the money supply are reasons to fear its resurgence.  So far, however, the signs of rising prices are few.  Oil and other commodities remain strong, but wages, a key factor, are not showing significant upward pressure and house prices, while in positive territory, could only be termed “firm,” not rising sharply.  Inflation may develop into a problem at some future point, but it is likely to remain under control this year-end and next.  I believe the Federal Reserve will start to raise interest rates soon for reasons other than inflationary concerns. 

Around the world the economic expansion continues.  The business environment in Europe is showing strong improvement, Chinese exports are expanding and both retail sales and exports are increasing in Japan.  Inflation problems are concerning authorities in India and China and monetary tightening is taking place there, but both economies are expected to show impressive growth this year.  A property bubble may be developing at the high end in China and there are concerns that the banking system has been too lenient in granting loans to developers, but neither of these conditions are deemed to represent a systemic risk to the Chinese juggernaut. 

You will be able to download the final presentation directly from the webcast replay.

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Byron Wien
The Blackstone Group
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