Tuesday, June 9, 2015

The Federal Reserve has Painted Itself into a Corner.........Economic conditions are bad and will only get worse!

The Federal Reserve has Painted Itself into a Corner

The Federal Reserve seems to have solved the problem of extricating the U.S. from the terrible "great recession" by employing two major monetary policies.  They started with a "zero interest rate policy (ZIRP) for the past 6 years, and then used three Quantitative Easing's to build-up the Fed's balance sheet from $800 billion (bn) to almost $4.5 trillion (tn).  We however, believe that the Fed's actions will result in an even greater set of economic problems in the near future.

To support our view we will examine various economic data.  We will attempt to go through the various economic data that have just recently been released and show that the U.S. economy is decelerating, even after the loose monetary conditions over the past 6 years. However, we believe that even if the economic data improves, that will only allow the Fed to raise rates at the same time as other major economies (Japan, Euro Zone, and China) across the globe are in the process of copying the same policies we have used for the past 6 years as they reduce rates and lower the value of their currencies.  Finally, we will conclude with a view of our familiar Cycle of Deflation chart to demonstrate where we currently are positioned in the cycle: "competitive devaluations" which is essentially the same as "currency wars" 

GDP growth in the U.S. after 6 years of "off the charts" Fed monetary easing is the slowest recovery on record since World War II.  And just recently the deceleration in economic data has increased. There is deceleration in corporate earnings, capital expenditures, economic growth, consumer confidence, and Federal Reserve monetary easing.  The reason for the slow recovery is the exact same problem that got us into the mess during the "great depression".   It all boils down to too much debt and until the excessive debt is worked down the U.S. economy will struggle with the recovery.

Some of this can be explained by the severe winter weather, the west coast port closings, and the U.S. dollar increasing.  Due to these transitory problems, most investors and economists believe that there will be a rebound from the first quarter's negative GDP report. In fact, they are especially optimistic since the decline in energy prices should be expected to increase consumer spending.

However, American consumers are not spending their gasoline savings, but instead are spending and saving at recession levels. April consumption was unchanged, March was up 1.1%, February was up 0.6%, January up 0.85%, and December up 0.9%.  These are extremely low consumption levels and consumers have continually increased their savings rate from 4.7% in early 2013 to 5.6% presently. Clearly, the U.S. consumer is acting the same way they did after the "Great Depression" as they were afraid to consume and attempted to save as much as possible.  We believe that this will continue because economists cannot anticipate "consumer behavior", and when the consumer is concerned about another financial crisis like they just experienced in 2007 (and even in 2000) there is nothing that will stoke their spending except time and debt reduction. Despite common lore, economists as a whole do not have a great record when it comes to predictions. Recall that in early 2015, polls taken of economists showed unanimous opinion that interest rates in the U.S. would rise. Of course they fell!! So we take no solace that economists currently predict an acceleration of growth.

To make things worse the U.S. dollar has reversed the latest 5 year decline from 2009 to 2014. This will not just hurt the U.S. multinational companies from exporting goods and services to our trading partners, but will also accelerate the "Cycle of Deflation" deflationary conditions compared to Japan, Europe, and China.

We believe that the economic conditions are bad and will only get worse. If this is correct, we believe investors in this country will conclude that the Fed's policies were not as constructive as the world believed, and will act the same way as the U.S. consumer by seeking safety in their investments (said another way –would sell stocks) and act more like the consumer who is not spending but instead saving.

However, if we are incorrect and the first quarter is really a fluke due to transitory conditions, then the Fed will start increasing the Fed Funds rate at the same time our trading partners are lowering their rates.  In our opinion, this will be even more detrimental than the poor economic environment we described above.  So either way it looks to us like the stock market may not perform well this year and probably not for the next few years.    

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