Soft Landing?
01/31/06
Volatility indeed seems to be on the rise. Right after our last newsletter, the equity markets continued their rollercoaster ride. The Dow Jones rose during the first 7 trading sessions by 363 points or 3.4%. The following 6 trading sessions saw the index fall 386 points or 3.5% and close at the low point of the week. Then just this past week, the index climbed in 5 trading sessions by 271 points or 2.5%. Up 3.4%, down 3.5%, up 2.5%, all within 3 weeks. Wow! What a difference a week makes. They say as January goes so goes the year. If that be the case, buckle up. Odds are that the subdued volatility seen in 2005 will give way to a volatility explosion in 2006.
The Gross Domestic Product (GDP) grew only 1.1% for the last three months of 2005. Forecasters had expected 2.8% growth. This looks like a shocking shortfall, but upon further review it becomes clear that many one-time items may have artificially depressed this number.
Tony Crescenzi explains the reasons for the miss: "For starters, government spending, including spending by federal, state, and local government, was much weaker than expected. It fell at a 2.4% annual pace, shaving a half-point from the headline gain. Expectations were for government spending to add as much as a half-point, meaning that there was a swing factor of one percent due to the unexpected decline in government spending, which was led by a 7% decline in federal spending, a decline that won't likely last. Federal spending will almost certainly rebound sharply in the current quarter."
Another reason why GDP grew less than expected was because the inflation rate was higher than expected. The 1.1% gain, of course, reflects the growth in GDP after adjustment for inflation. The GDP deflator rose at a 3.0% pace, three-tenths of a percentage point higher than expected, thus accounting for three-tenths of the miss. Note that the GDP deflator has an advantage over the consumer price index (CPI) because it automatically reflects changes in consumption patterns and the introduction of new goods and services. These changes are not automatically reflected in the CPI, which is a fixed basket of goods and services.
A third reason for the miss relates to business spending, which rose much less than expected. In particular, the 3.5% gain posted in spending on equipment and software was far below the double-digit gain seen over the past two years, a pace that was expected to have been repeated in the fourth quarter. The economy needs a strong pace of business spending to offset expected weakening in consumer spending in 2006. It did not happen in the last quarter.
All these factors suppressed Real GDP Growth and - with the exception of inflation - might also be the source for renewed growth in the coming quarters.
Government spending, especially in an election year, should start to pick up in the first and second quarter. Particularly defense spending, which somehow slowed down during the fourth quarter, should start to pick up right away. But also the rebuilding effort around New Orleans and the fact that appropriations run ahead of spending should lead to increased government spending this year.
Business spending should also grow above its recent pace in upcoming quarters. Last Thursday's durable goods report might already be the first tangible evidence to that effect. In addition, corporate cash levels are extraordinarily high, order backlogs have increased at a rapid pace, factory operating rates are above their long-term average, the global economy is stronger, and the rates of return on investing in capital equipment remain high.
I do not want to be accused of wearing rose colored glasses, so I will point out that the GDP report also showed that business investment (left chart) rose at the slowest pace in almost three years last quarter. This needs to pick up. The economy can not lose the consumer and the business sector at the same time. Consumers are already coping with high energy prices and a slowing real estate market, which should slow their discretionary spending somewhat. The business sector was supposed to pick up the slack here. Tony Crescenzi says about the slowdown in business spending: "The weakness could reflect the business community's rapid response to the events of the fourth quarter, particularly the slowdown in consumer spending that resulted from the effects of the recent hurricanes. It is further evidence of Corporate America's desire to maintain growth in profits . In a way, this is good news for shareholders. On the other hand, if the weak spending is a harbinger of things to come, then it is worrisome."
But good news was already forthcoming on Thursday last week. According to the December durable goods orders report (right chart) business spending was picking up last month, perhaps setting the stage for a first-quarter rebound -- even if some forecasts of a longer-term rebound may sound too optimistic. Even though I do not like the chart on the left, I can not be but impressed with the chart on the right. It also makes clear why stocks waited until Thursday to discount a soft landing/mid-cycle slowdown. It was Thursday, when the durable goods report showed increased order activity and plenty of business optimism, even in the face of weakening consumer demand. The fact is that this economy still shows enormous resiliency. For the Federal Reserve and Ben Bernanke, however, the durable goods report and the GDP report constitute the worst-case scenario. The economy stays strong even though it is losing altitude while inflation continues to creep slowly but steadily higher. Bernanke's hands are tied. He must continue raising interest rates as long as inflation measures such as the GDP price inflator and others exceed his targets. As we showed last week, the perception of future interest rate levels will determine stock prices more than earnings at this point in the business cycle. The perception of future Fed actions in turn will be determined by economic and inflation reports. The markets might be whipsawed more often depending on what economic report du jour will alter the inflation picture. As I said, if January is any guide "Buckle Up!"
Hermann Vohs
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
