Economic Commentary -- October 2011By Christopher Bremer, Director, Private Client Services Portfolio Management Quantitative Easing: Destined to Fail? Gettysburg marked the furthest incursion northward that the Confederates had made thus far. In an effort to strike at the center of the Union Armies in the aftermath of several failed attacks, Gen. Robert E. Lee was determined to send Longstreet, Gen. Pickett and approximately 12,500 Confederate soldiers into battle in an effort to decisively turn the tide of the war. Fulfilling Gen. Longstreet’s worst expectations, Pickett’s Charge was a bloody and costly defeat that the Confederacy never really recovered from. It’s an example of a strategy that was destined to fail from the outset, despite thorough planning and clear intentions. The same could be said for the Federal Reserve Board’s fiscal policy of Quantitative Easing 2, or QE2. Unveiled in November 2010, QE2 was designed to spark economic growth by reducing the unemployment rate and increasing gross domestic product (GDP). Not only did the Fed’s policy fail to achieve its stated aims, it also had some unintended consequences that may have actually hurt the economy. In this month’s commentary, we’ll examine Quantitative Easing 2 by identifying what it was intended to achieve, where it went wrong and why it failed. We’ll analyze where the economy is today, where it’s likely to go over the next few months and the implications for the markets. Overview of QE2 For the eight months between November 2010 and June 2011, the Federal Reserve Board purchased hundreds of billions of dollars in treasury bonds in an effort to spur economic growth and lower interest rates on treasuries with longer dated maturities. By ensuring ample liquidity in the financial system and low interest rates, the Fed hoped that banks would lend more money to businesses and consumers, sparking economic growth and employment that’s been lagging since the global financial crisis began in 2008.
These two trends have reinforced each other and are likely to continue to do so in the foreseeable future. Specifically, with unemployment still relatively high and recent mass layoff announcements, consumers aren’t likely to increase their spending. But without consumer spending and the resultant sales, businesses don’t want to hire. And the pace of layoffs has risen: Bank of America announced plans to lay off 30,000 workers across the globe in September, while Cisco, Lockheed Martin and Goldman Sachs reported plans to lay off approximately 14,000 employees back in July. Not only has QE2 actually missed its stated aims, it’s also had some ugly unintended consequences: interest rates remain low and the dollar has remained weak relative to other currencies, contributing to an increase in core inflation measures that negatively impact the average American. Inflation Concerns
Gasoline prices jumped 4.7 percent in July followed by a 1.7 percent increase in August. Food prices didn’t rise as steeply, but they still climbed .5 percent in August and .4 percent in July. Overall, inflation is also increasing – it climbed 3.8 percent year-over-year for the trailing 12 months ending in August. Core inflation for the same period came in at two percent, the highest rate in three years according to the Bureau of Labor Statistics. Because monetary easing tends to encourage factors that fuel inflation, one of the Fed’s major challenges is encouraging economic growth without stoking inflation. And because of lower interest rates – a product of quantitative easing – goods entering the United States via imports tend to carry higher prices than they otherwise would. A lower dollar does confer the advantage of making U.S. goods cheaper for export, but the trade off of higher prices on imported goods tends to hit consumers where they live because of this country’s need to import fuel, food and other goods. The housing sector is so battered that few people who don’t already own homes can qualify to buy homes because of stringent lending criteria. As a result, rents are increasing, only contributing to inflation. Rents were essentially flat in 2010 but were up two percent from July 2010 to July 2011. More recently, rents paid increased .4 percent from July to August, according to the Department of Labor. Besides not being able to qualify for a home purchase, many potential homebuyers aren’t buying because they aren’t convinced that housing prices are finished falling. To add to that, unemployed and underemployed consumers can’t afford to buy, and people who don’t feel secure in their jobs are also out of the home buying market.
A whopping five million homes are either in foreclosure or projected to be foreclosed on in the near future. In fact, financial institutions filed foreclosure actions on 228,098 homes in August alone, according to RealtyTrac, an online real estate data collection tracker. While overall foreclosure filings were down 33 percent from August 2010, they were up seven percent from the previous month. Default notices – the first step in the foreclosure process – were up 33 percent from July to a nine-month high. Unfortunately, the U.S. housing market shows no signs of exiting its foreclosure crisis anytime soon. A poor housing market impacts the economy in many ways besides consumer and direct consumer spending. Because homeowners can’t move to take jobs that may pay more, it can restrain employment. And construction workers and others in housing-related industries have taken a huge employment hit as those industries have contracted. Why Inflation Hurts so Much It’s remarkable that real wages are failing to keep pace with rising productivity and corporate profits. Typically, when these measures rise, wages also increase. The fact that this isn’t happening makes it even harder for consumers to open their wallets and drive any real spending that would increase economic growth. Because inflation hits consumers so hard, it’s akin to an additional tax on them. Even consumers with disposable income are affected by inflation. As long as fear exists in the financial markets, they are also so intent on deleveraging that they aren’t as likely to spend on anything outside of paying down debt and beefing up their savings. Protracted Economic Weakness Deleveraging is a perfect example. The global economy has not seen a sustained period of deleveraging on the part of both consumers and governments since the 1930s. As consumers pull back on their spending and governments cut programs in an effort to trim budget deficits, two engines that the global economy relied on for growth aren’t likely to contribute. In fact, these two trends together could pull the global economy back into a recession. As the world’s global supply chain has become more interconnected due to widespread adoption of just-in-time inventory management, markets and economies have become more correlated. Globalization has had many benefits and many unintended consequences, including this one. In fact, in August 2011, U.S. and international equity markets reached their highest correlation ever – .90 – according to Wolfe Trahan & Company. Interestingly, economists keep missing the boat. Mainstream economists have consistently predicted higher economic growth rates than have actually occurred and have simultaneously underestimated inflation. There’s also disconnect between what economists and the government observe and report and what consumers and businesses observe and report. What gives? Theories abound, including the viewpoint that models and relationships that worked in the past may not be working now, just as what used to be normal behavior in the economy and the markets has changed. The U.S. has officially been out of a recession since June 2009; however for many consumers it feels like the recession never ended. And businesses haven’t seen the type of recovery they’re used to and haven’t developed the confidence needed to hire in a way that creates meaningful job growth. Deleveraging is a major factor driving economic performance. And because so much of U.S. economic growth is focused on consumption – 71 percent – consumers need three factors present to consume enough to generate economic growth: credit, jobs and feeling wealthy – otherwise known as “the wealth effect.” With many consumers unable or unwilling to borrow, the availability and access to credit is as challenging as the job market itself. The official unemployment rate is 9.1 percent, but the real rate is higher because many consumers are underemployed or have dropped out of the job market because they haven’t been able to find a job. Because credit is so problematic, employment numbers become even more important. Basically, the economy needs more jobs to grow when credit is scarce and consumers are unwilling to access it. Job growth has not been on stable footing since the recession officially ended in mid-2009. At the same time that markets are becoming increasingly correlated, market volatility is becoming more pronounced, with bigger intraday and intraweek swings in markets than we’ve previously experienced. Already-jittery investors are likely to get even more disconcerted as markets fail to settle down following these boom-and-bust cycles. Many investors still haven’t recovered from the financial and market shocks of 2008, and yet 2010 and 2011 have produced their own crises, including the “Flash Crash” in May 2010 and the U.S. government debt ceiling crisis of this past July and August. What the Fed Can and Can’t Do The Fed has taken a number of steps to try to get the economy going. Its most recent attempt, QE2, hasn’t revived economic growth and has adversely impacted consumers by increasing core inflation. Other steps the Fed has taken include depreciating the U.S. dollar, lowering interest rates to near zero, controlling the yield on corporate bonds, ensuring liquidity throughout the financial system and increasing the money supply. None of those steps have succeeded in stimulating the economy, so it’s hard to see exactly what else the Fed could be doing that it hasn’t already done. If there was anything else the Fed could do to stimulate economic growth, odds are it would have already been done. When the Fed has embarked on similar policies in the past, it didn’t face such an uphill climb. But in the absence of fiscal policy support in the form of state, local and federal government spending and hiring, the Fed has acted alone. It might have been enough if corporations were hiring and spending, but they aren’t. Corporations continue to focus on increasing productivity and hoarding cash, resulting in a jobless recovery that isn’t sustainable in the absence of credit availability. Since QE2 hasn’t worked and has actually resulted in inflation that’s impairing consumer spending, it’s unlikely that the Fed will embark on QE3, although it will likely maintain interest rates at present levels through next year. As inflation further slows growth, potential deflationary pressures may reoccur. Policymakers have been concerned about the potential for the United States to fall into a Japanese-style deflationary recession that could result in a long period of sub-par growth amid falling prices, a situation that would be extremely perilous for the economy. What to Watch For
Retail sales, especially during the critical holiday season, will tell us a lot about whether the consumer is confident enough to spend. If consumer spending increases and stays at a decent level, companies may decide to hire more which could result in a virtuous cycle of spending and hiring. But if the numbers stay anemic, the economy could very well slip back into a recession. Events in Europe will impact the U.S. economy as well. Greece’s debt crisis is nowhere near a resolution, and if Greece defaults, U.S. and European banks will be adversely affected. Growth in Germany, the economic engine of Europe, is already slowing, and a further deepening of the European sovereign debt crisis could bode ill for the U.S. economy. If, on the other hand, Europe finally comes to grip with the crisis and takes meaningful steps to resolve it, the markets will likely respond positively, removing a major source of uncertainty that has been unresolved for more than a year and a half. Where We Are Headed The problem was that the markets not only perceived this policy as ineffectual but were also concerned with a single sentence within the text of the Fed’s statement: “… Moreover, there are significant downside risks to economic outlook, including strains in global financial markets.” Current market movements appear to be driven by fear and uncertainty at the macro level. However, balance sheets are still strong and companies are flush with cash. A recession in corporate earnings does not seem as likely as a recession in the consumer economy. With 10-year U.S. Treasurys yielding less than two percent, the “flight to quality” can result in negative real returns after considering inflation. Therefore, we see an opportunity to add to underweight equity positions. While the next 12 to 18 months will present challenges not only in the U.S., but in Asia and Europe too, we do not advocate changing one’s investment strategy. When asked to regroup his division for a potential counter-attack by the Union, Major General Pickett replied, “General Lee, I have no division now.” European policymakers are now being asked to regroup. What the reply will be remains to be seen. Christopher Bremer is the Director, Private Client Services Portfolio Management with The Northwestern Mutual Wealth Management Company. The opinions expressed are those of Christopher Bremer as of the date stated on this report and are subject to change. There is no guarantee that the forecasts made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment or security. Information and opinions are derived from proprietary and non-proprietary sources. Northwestern Mutual Wealth Management Company, Milwaukee, WI is a subsidiary of The Northwestern Mutual Life Insurance Company, Milwaukee, WI (NM) and a limited purpose federal savings bank authorized to offer a range of financial planning, trust, fiduciary, investment advisory and investment management products and services. Securities are offered by Northwestern Mutual Investment Services, LLC, subsidiary of NM, broker-dealer, registered investment adviser, member FINRA and SIPC. Please remember that all investments carry some level of risk, including the potential loss of principal invested. Bond or debt investors should carefully consider risks such as interest rate risk, credit risk, securities lending, repurchase and reverse repurchase transaction risk. Greater risk is inherent in investing primarily in high yield bonds. They are subject to additional risks, such as limited liquidity and increased volatility. There is an inverse relationship between interest rates and bond prices. Government debts are guaranteed by the full faith and credit of the U.S. government as to the timely payment of principal and interest when held to maturity. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Diversification and strategic asset allocation do not assure profit or protect against loss. All index references and performance calculations are based on information provided through Bloomberg, a provider of real-time and archived financial and market data, pricing, trading, analytics and news. The gross domestic product (GDP) is the amount of goods and services produced in a year, in a country. The Bureau of Labor Statistics of the U.S. Department of Labor is the principal Federal agency responsible for measuring labor market activity, working conditions, and price changes in the economy. The U.S. Department of Labor Consumer Price Indexes (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services. The S&P/Case-Shiller Home Price Indices are designed to be a reliable and consistent benchmark of housing prices in the United States. Their purpose is to measure the average change in home prices in a particular geographic market. RealtyTrac is an online marketplace of foreclosure properties, with more than 1.5 million default, auction and bank-owned listings from over 2,200 U.S. counties, along with detailed property, loan and home sales data. The company’s mission is to make it easier for consumers, investors and real estate professionals to locate, evaluate, buy and sell properties. Wolfe Trahan & Co. is a research firm specializing in equity and macroeconomic research. The Economic Policy Institute (EPI), a non-profit, non-partisan think tank, was created in 1986 to broaden discussions about economic policy to include the needs of low- and middle-income workers. 92-0381 (1011) |
Higher costs for food and energy products directly affect consumers by paring their ability to purchase other goods and services. And when consumers pay higher prices for fuel, food and housing, they have less leftover for the discretionary spending that has driven economic growth in the past. In August, consumer prices – including food and energy – rose .4 percent following a .5 percent increase in July, according to the Bureau of Labor Statistics. Even when stripping out these two categories, core inflation increased .2 percent in August and .2 percent in July (Fig. 2).
During past recoveries, housing led the way out of a recession. But this time, held back by millions of foreclosures, the housing sector is keeping the economy down rather than giving it life. Home prices have fallen to 2003 levels, according to the S&P/Case-Shiller home price indices (Fig. 3).
Employment, housing, consumer spending and consumer and business sentiment will all provide signs to indicate whether the economy is improving or stalling. One positive sign that economic growth isn’t completely stalling would be unemployment claims staying consistently below 400,000 – and the unemployment rate beginning to fall as a result (Fig. 4).| Jim Coopersmith : Northwestern Mutual |
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