This note was originally published at 8am on March 09, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“Nobody ever defended anything successfully. There is only attack and attack and attack some more.”
-General George S. Patton
The rose-tinted view that has driven the S&P to current levels, up 5.1% year-to-date, is becoming more and more difficult to justify. As uncertainty around the Middle East mounts, highly significant factors behind the global economy, such as oil, are becoming more and more of a concern for investors. The revolution sweeping through the Middle East is driving oil prices higher as the timeline, geography, and repercussions of the political turmoil remain uncertain.
Moody’s reminded us on Monday of the significant uncertainty surrounding the Eurozone’s sovereign debt issues. In early trading today, Portuguese 10-year bonds fell for a third day, pushing the yield as high as 7.70% (the most since at least 1997) and the equivalent-maturity Italian yield climbed to 5% for the first time since November 2008.
With members of Ireland’s new government striking a fairly combative tone with respect to a prospective renegotiation of that country’s bailout, and other countries rolling over significant levels of debt in 2011, the media’s glare will shortly become more focused on Europe and her myriad issues. Yesterday, the Euro fell the most in two weeks on all the uncertainty.
Here in the U.S., inflation is a tax on the consumer and, as such, the broader economy. In fact, I would posit that inflation (inclusive of things people actually buy, like gasoline, food and clothes), is a more devastating drag on the consumer than allowing the Bush tax cuts to expire. Inflation is taxation without the consent of the vast majority of those affected.
With the past two years having seen the second largest upward two-year move in equities after the period from 1953 to 1955, inflation is derailing the markets to a greater or lesser extent depending on the market in question. In the end, as in 2008, risk is always on and it is always interconnected. As oil climbs higher, threatening growth at a time the U.S. economy can ill-afford it, the recovery scenario that has been priced into the markets starts to look less impenetrable, less defensible.
Currently, my attention is firmly focused on the consumer. The spread between consumer expectations and present situation sentiment or, as we like to call it, the Hedgeye Optimism Spread, is at peak levels. Employment has been improving on the margin but, as I see it, two factors along the risk spectrum could spoil the U.S. equity market party that has been raging since 2010. First, gasoline prices can keep doing what they’re doing. Second, interest rates can go up. The magnitude of a possibly interest rate increase is unknown but (think Volcker) there is precedent for sharp, short, expedient increases in interest rates when inflationary pressures merit it.
The pressure for the USA to raise interest rates is growing by the day. Jean-Claude Trichet is telling the world that Europe is ready to raise rates and Timothy Geithner (who met with Germany’s Finance Minister in Frankfurt yesterday), no doubt is begging them not to. One small reason Europe needs to raise interest rates is the fact that European gasoline prices are at an all time record of $8.632 per gallon. European Central Bank Governing Council member Axel Weber has stated that, “Inflation may be more sustained and more fundamental than the ECB’s latest projections suggest” and that he sees “considerable future price pressures.”
This divergence in rhetoric between the USA and EU poses an interesting dilemma for investors. We know from experience that any faith in policymakers in Brussels or Washington being able to manage through this situation seamlessly is gravely misplaced. We were reminded of this last week on CNBC when Alan Greenspan said, “The one thing we all pretend we can do but we can't, is forecast."
Recently, a question we received from a discerning client prompted us to overlay the Hedgeye Optimism Spread against the Yield Curve in a chart. The picture certainly tells a story; the escalation of easy money monetary policy in the United States heralded a period of high correlation between the Optimism Spread and the Yield Curve. Apparently, rendering the country “awash with liquidity” instills a belief among consumers that economic circumstances are set to improve. As Keith referenced in the Early Look from Monday morning, according to Jim Rohn, “For every promise there is a price to pay”. Ultimately, a consumer facing mounting costs at the grocery store and at the pump is going to recalibrate expectations. The U.S. consumer is now under attack as inflation squeezes like it’s 2008.
After losing some momentum in recent months, the recovery of new vehicle sales regained steam in February. Having said that, GM and F stock can’t get out of their own way; GM is down 11.2% YTD and is trading below the $33 IPO price. Is consumer pent-up demand supporting the rise in vehicle sales? The stocks of the automobile makers are telling you a different story.
Yes the labor market momentum is building, as expected payroll gains strengthened measurably in February, following the weather-induced weakness in January. The unemployment rate was a surprise at 8.9%, but it is likely an aberration as more discouraged workers than previous months did not enter the labor force. We see an Intermediate term bottom in the unemployment rate.
The gradual improvement in the labor market is benefiting consumer income trends. Real disposable income growth late last year was the fastest since the fall of 2007. The rate of growth is still far from robust; there are two factors that are limiting income: (1) the selective nature of the recovery, and (2) declining government support.
Despite a surge in personal income growth, real spending declined in January. Real personal consumption expenditures slipped by 0.1%, marking the first decline since April 2010. Nominal spending rose by 0.2%, which was about half of the average pace from the previous six months.
The inflation tax will likely erode the Hedgeye Optimism Spread as reality for the US consumer sets in. According to the latest American Pulse™ Survey of 5,224 respondents, 80.3% of registered voters agree that the increase in gas prices is one of the worst problems affecting the United States. The survey asked respondents to list the worst problems currently affecting the United States, and registered voters mentioned in order of frequency: unemployment (80.4%), rising gas prices (80.3%), weak economy (70.6%), national debt (69.4%) and rising food prices (61.9%).
The U.S. consumer is under attack and the bull case for equities to withstand escalating input costs is becoming less and less defensible. We are expressing this view on US based consumption by being short MCD, WMT and TGT.
Function in disaster; finish in style