The party's over, folksMarch 11, 2011: 10:59 AM ET
The U.S. consumer is under attack and the bullish case for equities is becoming less and less defensible.
By Howard Penney, Hedgeye
The rose-tinted view that has driven the S&P 500 to current levels 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 in flux.
With its downgrade of Spain's credit rating earlier this week, Moody's reminded us of the significant problems with the Eurozone's sovereign debt issues. And last night's earthquake in Japan only adds to the global 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 since the period from 1953 to 1955, inflation is derailing the markets -- some to a greater extent than others. 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 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: Gasoline prices can keep rising and 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 US 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 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."
Here in the U.S., the consumer is now under attack as inflation squeezes like it's 2008. Consumers may still maintain a rosy outlook, but mounting costs at the grocery store and at the pump will almost certainly recalibrate their expectations.
After losing some momentum in recent months, the recovery of new vehicle sales regained steam in February. Having said that, GM (GM) and Ford (F) stock can't get out of their own way; GM is down nearly 15% year-to-date 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 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 optimism 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.
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