Good Markets, Bad Economy
by Sinclair Noe
DOW + 18 = 15,470
SPX + 4 = 1680
NAS + 11 = 3610
10 YR YLD – .04 = 2.49%
OIL + .59 = 106.59
GOLD – 16.90 = 1275.60
SILV – .72 = 19.29
Let’s start today with a quick rundown of a few earnings reports.
Intel reported second quarter net income of $2 billion, down from $2.8 billion a year ago. Revenue was $12.8 billion, and they expect third quarter revenue around $13.5 billion, both revenue numbers and guidance were below current estimates.
IBM posted earnings of $4.3 billion on revenue of $24.9 billion. Earnings were up slightly from a year ago, while revenue was down slightly.
Bank of America reports net income rose 63 percent, to $4 billion from $2.5 billion in the period a year earlier, while revenue increased to $22.7 billion from $22 billion. The bank benefited from higher revenue from equities sales and trading and a reduction in expenses, but its mortgage unit continued to struggle.
This seems to be a recurring trend for the big banks; more profits from the Wall Street business side, less revenue from the old fashioned loan business, less money set aside for reserves. The concerns are that trading performance tends to be uneven over time, and cutting costs can only go so far, it doesn’t increase revenue.
June housing starts fell 9.9% to an annualized rate of 836,000—the lowest level since August 2012. The drop in housing starts was led by a decline in multifamily construction, which fell 26.2% versus 0.8% for single-family houses.
The Federal Reserve released its Beige Book survey today, and it indicates “modest to moderate” growth. Housing construction and home prices improved, while consumer spending increased in most districts, fueled by rising car and truck sales. The housing recovery is also driving more production of lumber, materials and construction equipment.
The report says hiring held steady or increased in most districts. But employers in some districts were reluctant to hire permanent or full-time workers. Employers have added an average of 202,000 jobs a month this year, up from about 180,000 a month in the previous six months. Still, growth has been weak.
Fed Chairman Ben Bernanke went before the House of Representatives today to deliver his semi-annual testimony, which was also pretty beige. Bernanke said: “We’re going to be responding to the data. If the data are stronger than we expect, we’ll move more quickly” to reduce bond purchases. If data “don’t meet the kinds of expectations we have about where the economy’s going, then we would delay that process or potentially increase purchases for a time.”
The Fed chairman described labor markets as “far from satisfactory, as the unemployment rate remains well above its longer-run normal level, and rates of underemployment and long-term unemployment are still much too high.”
And then we have to realize that the Fed’s economic forecasting is usually a bit more rosy than realistic. Each year for the past 3 years they’ve been forced to revise lower. Already this year, economic growth has dropped below expectations. The Fed’s prediction of stronger growth in the second half will almost certainly be cut from the current level of 2.5%. The recent spike in inflationary pressures, which is almost entirely due to the surge in energy costs, also negatively impacts the economy. The spike in inflationary pressures in 2011 coincided with the peak in economic activity. And increases in energy prices are highly correlated to recessions, as we discussed yesterday.
So, Bernanke’s testimony today confirmed the Fed isn’t going to exit QE or taper off from purchases any time soon. They can’t reduce liquidity without risking the markets tanking, taking down consumer confidence and negatively impacting the economy. Or, the other way to look at it is that the Fed is the only thing holding up the markets as the economy continues to slowly grind along, or more likely, erode.
The Fed is constantly communicating its intentions regarding rates and it just tends to artificially prop up the markets, resulting in an imbalance, or some think a possible bubble. The Fed has controlled the markets in part starting with the Greenspan Put, then the historically low interest rates, and then the nearly constant infusions of fresh cash for primary dealers by way of massive government bond purchases. By pegging money market rates, the Fed has created fertile ground for carry trades; and the carry trades create an artificially bigger and bigger bid for risk assets. In this kind of environment, it seems prices can only go up.
After all, the Fed is providing what amounts to insurance against downside risk. The super cheap money and the idea that Too Big to Fail won’t be allowed to fail, then attracts even more money flowing into even more speculative long positions. The Fed sets near zero interest rate policy well out into the future, and that eliminates any surprises in the yield curve. That, in turn, allows the traders in the money markets to hypothecate and rehypothecate securities without worries.
The monetary policy of the Fed serves to prop up risk assets but it doesn’t do much to drive economic growth. There may be some trickle down effect but not enough to lift economic growth. The old fashioned ideas of credit creation aren’t working. We’ve seen this failure as the big banks have been reporting earnings. The big banks have been reporting remarkable profits, but it comes from their trading desks; gambling in high risk assets; and it comes from setting aside fewer reserves. They just aren’t making traditional loans.
Traditional loans used to get money circulating through the economy. A bank made a loan to a consumer or a business. The consumer or the business then spends the money and that adds to GDP which then increases corporate sales and profits. The money circulates and economic activity increases. But money velocity has dropped, even as the Fed has been shoveling trillions of dollars into the banks; that money hasn’t found its way into the broader economy, it’s been swallowed up by offshore trading in the highly profitable and incredibly dangerous and unregulated international derivatives markets; or what is sometimes called shadow banking, which has now grown to about $70 trillion.
The shadow banking system has grown to such incredible size without providing any real benefit to the broader economy, and represents a far bigger risk than benefit for GDP growth. The Fed’s QE policy, and the reason Wall Street gets it’s panties in a wad at the thought that QE might end, is nothing more than a way for the Fed to raise the reserve levels of banks; which means the banks don’t have to set aside reserves from their own profits. The money remains on the Fed’s books as a credit to the bank, unless the bank chooses to re-invest in some sort of asset purchase; which they typically do; which drives up asset prices, but does nothing for the economy.
So, the economy is not improving, or at the best it is slowly improving, but not enough to reach escape velocity. We’ve seen some job growth but not enough and the quality of jobs is weak; many of the jobs are part-time or temporary, and wages are shrinking; which means disposable income is shrinking; which mean demand is weak and top line sales are slipping; which means that the way corporations keep profits up is by cost cutting, but we’re coming to the end of the rope when it comes to cost cutting. The major market indices are at record highs but the economy is still grinding along in a trough.
So, we’ve got a multi-trillion dollar shadow banking system propped up by credit creation in the form of QE and leveraged for optimal results; and indeed, the banks have been returning optimal results. But remember that leverage is a two-way street. It works great when the trade goes your way, but it can double your losses when the trade turns against you. What happens when the asset you have leveraged into suddenly begins to move in the wrong direction exposing you to substantial loss – not increased profits? More importantly what happens if the sheer size of your positions are so significant relative to market volume that liquidity disappears and you can’t exit the trade without significantly moving the market in the wrong direction? The answer of course is that you are stuck. We’ve seen this before with Lehman Brothers, with LTCM, and more recently with the London Whale. We will see it again.
Bernanke talked today about the necessary economic conditions that would warrant a change in QE policy. Maybe the Fed could exit QE if there was some fiscal policy that actually had the potential to increase GDP and provide jobs and spur demand. We don’t have that. We have a weak economy and highly speculative asset bubbles and all it takes is a blip in liquidity and the whole show could freeze over in a heartbeat.
So for now the market makers will back stop sell offs. Investors will continue to play along because they have no place else to go. And the Federal Reserve will continue with its accommodative policy; they don’t really have a choice in the matter.