The Calm Before the Storm Comstock Partners, Inc. Thursday, August 17, 2006
In our view this is a deceptive rally that is the equivalent of the calm before the storm. Investors are happy that the Fed has paused in hiking interest rates and that the latest monthly numbers show a small diminution of inflationary pressures. They also interpret the solid evidence of an economic slowdown as indicative of soft landing ahead.
The problem is that soft landings are extremely rare in American financial history and the vast majority of economic slowdowns following a period of rising interest rates deteriorate into full-blown recessions. The weight of the evidence strongly indicates that the economic slowdown is already here, as key factors such as housing, payroll employment and output have been weakening. The National association of Home Builders (NAHB) index has dropped 40 points from its recent peak to its lowest level in 15 years. Housing starts are down 13.3% year-to-year while single unit permits are down 26% from their peak. Statements from the nation’s leading homebuilders mention plunging order rates, excessive inventories and extensive cancellations.
The weakness in housing impacts the economy directly through reduced building activity and indirectly through the wealth effect, the hundreds of billions of dollars raised through mortgage equity extraction, and the negative effect on employment growth. Some studies indicate that as much as 30 to 35% of employment growth in the last few years has been a result of activity in the housing market.
Additional examples of economic weakness are numerous. Employment growth has been sluggish for the past few months and July industrial production would have been up by only 0.1% if not for the heat wave and a jump in mining activity. Both business and consumer confidence have been dropping significantly. July truck sales were down 12.5% year to year while auto sales bounced in July only because of increased incentives to clear out inventory. Ward’s estimates a significant fourth quarter decline in vehicle production.
The odds are high that the current softness in the economy will develop into an outright recession. Interest rate increases impact the economy with a six-to-twelve month lead time, meaning that the last few rate hikes are still in the pipeline. The vast majority of yield curve inversions have been followed by recessions. Furthermore, the Conference Board’s leading indicators for July, released today, show a decline of 1.4% in the annualized six-month rate of change. This has happened only 11 times in the last 52 years, and 9 of them were followed by recessions.
In our view the market is in a no-win situation. Since most investors are looking for a benign soft landing in the economy with little inflation, the onset of a recession would be a severe shock with highly negative consequences for stocks. On the other hand, if we are wrong about the economy and it continues to grow at the consensus forecast of 2-to-3%, inflation would climb above the limits of Fed tolerance, and interest rates would therefore continue to rise. Despite the headline numbers in this week’s PPI and CPI reports, a closer look clearly indicates that there’s still plenty of potential inflation in the pipeline that could show up in finished goods if economic growth doesn’t slow down sharply. On a year-to-year basis, core intermediate goods prices were up 7.9% while core crude goods were up 34.6%. In other words, the Fed will most likely be forced into a choice between recession on the one hand or inflation on the other. Either one would be highly negative for stocks. Of course, anything is possible and there is a chance that we can get both a soft landing and low inflation, but we think the odds of that happening are quite low.
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