After Jackson Hole – 4Q 2011 Market Outlook
The financial world eagerly awaited Ben Bernanke’s annual speech from Jackson Hole, Wyoming on Friday morning August 26th, 2011. Market analysts and economists focused on trying to predict what panacea the Federal Reserve Chairman would offer to an ailing economy struggling to grow with unusually decade-high unemployment, low consumer demand, and depressed prices. Of the Fed’s remaining weapons in its monetary arsenal, QE3 was still a viable, though unpopular option. And while the chairman resisted the temptation to initiate another round of monetary stimulus, he did provide a pragmatic framework addressing the economy’s major headwinds. His thoughtful speech, The Near and Long-Term Prospect of the US Economy, among commentary from other market heavyweights serves as a guiding light through the market abyss for the fourth quarter of 2011.
Stall Speed: Bernanke laid out the sobering truth. We just aren’t growing at a fast enough pace of 3-4% per anum needed to shrink the widening output gap and prevent unemployment from rising. “The recession was even deeper and the recovery even weaker than we had thought; indeed, aggregate output in the United States still has not returned to the level that it attained before the crisis.” Bill Gross of PIMCO this month coined the phrase “stall speed” to describe his end of the year real GDP projections of 1-2%. Growth is the ultimate end game and how we achieve pre-crisis growth levels rests in policies targeted at stabilizing falling housing prices and creating more jobs.
The virtuous cycle begins at home: The reason the financial crisis of 2008-2011 is considered responsible for spurring the greatest economic contraction since the Great Depression lies in its roots in bursting one of the biggest bubbles in financial history; that of the housing market. “The housing sector has been a significant driver of recovery from most recessions in the United States since World War II, but this time–with an overhang of distressed and foreclosed properties, tight credit conditions for builders and potential homebuyers, and ongoing concerns by both potential borrowers and lenders about continued house price declines–the rate of new home construction has remained at less than one-third of its pre-crisis level.” Since the beginning of government response in 2008, fiscal and monetary efforts to stabilize housing prices have all but failed. We believe that the pace of economic recovery will pick up once the housing market finds bottom. As of last quarter, there are a total of 18.7 million vacant homes in America, up 2% from 2005. The bigger worry though lies in the shadow inventory of foreclosed homes with 3.8 million vacant and held off the market. There are also 11.1 million of 55.1 million homes with mortgages in jeopardy of default that are on the verge of contributing to the shadow inventory. Clearing up this excess supply will not just shore up housing prices, but also clean up bank balance sheets with huge mortgage exposure, i.e. Bank of America. Ed Yardeni offered a refreshingly creative take on how to achieve such housing price stabilization that aligns with our proposed solutions of wiping up excess inventory: a targeted housing policy that provides a huge matching subsidy to first time homebuyers or a tax exemption to homeowners renting out their homes. We can go one step further and propose allowing homeowners the chance to pay down debt on their mortgages by paying whatever they can afford over an interim period or extending 30 year mortgages to 50, 100 years, an option Geithner and the Treasury considered once before and should revisit. Lastly, major investors especially in the distressed asset industry could buy up much of the shadow inventory in exchange for favorable tax incentives. We will be able to see the housing market turn around once housing market, according to Warren Buffet, currently at 604k units, climb above 1 million to 2007 levels. The 1 million housing starts level as he sees it will be a big indicator of increasing economic activity.
It’s Jobs, Stupid: The costs of unemployment are laid out simply in Okun’s Law, which states that each percentage point of cyclical unemployment is associated with a loss equal to 2% of full-employment output. According to data compiled from the Federal Reserve of St.Louis, the current unemployment rate of 9.2% reduces output by roughly $1.2 trillion per year. “Our economy is suffering today from an extraordinarily high level of long-term unemployment, with nearly half of the unemployed having been out of work for more than six months. Under these unusual circumstances, policies that promote a stronger recovery in the near term may serve longer-term objectives as well. In the short term, putting people back to work reduces the hardships inflicted by difficult economic times and helps ensure that our economy is producing at its full potential rather than leaving productive resources fallow.” The robust recovery of our economy, for which domestic consumption accounts 70%, depends on the return of the consumer. Bringing the economy back to full employment, which the CBO forecasts will happen between 2013-2016, will have allowed households to repair their balance sheets and start reinvesting their disposable income back into the economy.
Don’t Fight the Fed: Rumors of QE3 or forms of stimulus with names such as “Operation Twist 2.0″ are cards still on the table. “The Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools as appropriate to promote a stronger economic recovery in a context of price stability.” We believe the weak economic data for FY2011 will inspire the Fed to offer creative forms of stimulus to achieve its dual mandate of normal unemployment and price stability. Paul Krugman suggests lessons from Bernanke’s old 1999 Japanese Liquidity Trap playbook and that Ben ought to take his own advice: First, the purchase of long-term government debt, which would lower private borrowing costs. Operation Twist would propose to roll over short-term maturities coming due to longer dated Treasury bonds in the hope of lowering long-term rates that most influence credit markets, making it easier for people to borrow. Second, extending short-terms rates to zero for an extended period, which he already committed to through mid-2013. Lowering the rate banks receive from reserves held at the Fed to zero percent would incite banks to no longer hoard cash and start lending. And finally, the announcement that the Fed is seeking moderate inflation of 3-4%, though politically unpopular with strong dollar purist Republicans, would encourage borrowing and discourage people from hoarding cash. A credit markets revival would be the first major step to quickening the pace of economic recovery.
Mr. Bernanke goes to Washington: Mohamed El-Erian, suggested in his most recent FT article, Bernanke must not push QE3 at Jackson Hole, that Bernanke take this rare opportunity to initiate a national policy debate that realizes the limits of monetary policy without much-needed fiscal coordination from Washington. “Accordingly, rather than embark on another policy initiative (“QE3”) with questionable net benefits, it would be better for Mr Bernanke to use his Jackson Hole speech to reframe the national policy debate and, in the process, set the stage for President Barack Obama’s key economic announcements on September 5″. Bernanke did just that. “Finally, and perhaps most challenging, the country would be well served by a better process for making fiscal decisions. The negotiations that took place over the summer disrupted financial markets and probably the economy as well, and similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses. Although details would have to be negotiated, fiscal policymakers could consider developing a more effective process that sets clear and transparent budget goals, together with budget mechanisms to establish the credibility of those goals.” There is not a single doubt that the biggest obstacle to economic recovery rests solely in the inability for Washington to come up with effective, coordinated policies. The debt-ceiling melodrama revealed the fierce partisanship between Republicans and Democrats on a national stage. It then and rightly so, triggered the debt downgrade of the S&P, which bred fear, panic, and a loss of confidence in Washington’s ability to govern. And finally, precipitated a swoon in global financial markets during the first two weeks of August. Bernanke performed most admirably by putting the pressure on Washington to act responsibly and outside of their respective political interests. “The quality of economic policymaking in the United States will heavily influence the nation’s longer-term prospects. To allow the economy to grow at its full potential, policymakers must work to promote macroeconomic and financial stability; adopt effective tax, trade, and regulatory policies; foster the development of a skilled workforce; encourage productive investment, both private and public; and provide appropriate support for research and development and for the adoption of new technologies.” In the final analysis, they must raise taxes, cut entitlement spending, and close tax loop holes plain and simple.
We foresee equity markets will perform mostly based on the likelihood that Washington achieves putting through coordinated policy actions as suggested above. Our base case scenario for the S&P (1,176), which is currently trading at an earnings multiple of 12.25, is 1,250. Our bull case sees the S&P end the year at 1,350, 15% higher from current levels. And our bear case would have the S&P fall another 10% to 1,050.