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US economic revival?

While much of the recent economic gains have been attributed to the actions of the Federal Reserve, the Fed could be harming as much as it is helping. The question will be what happens when the free money disappears? At that time we will finally know the true state of the US economy and it is not promising

Share prices in the US seem to hit record highs every day. The housing market is up substantially over last year and inventories are at an all time low. US consumers are buying cars in record numbers. Last month the Michigan survey of consumer sentiment beat all expectations. It has rebounded from the lows of 2011. The Federal Reserve’s stimulus, known as QE3, is set to continue at least into mid-year and perhaps longer. The OECD forecast for the first quarter for the US economy has been upgraded to 3.5%, a major improvement on the 0.4% reported in the last quarter of 2012. So the US economy has revived and its growth will accelerate for the rest of the year. Or will it?


The main driver of the US economy is the US central bank, the Federal Reserve (Fed), third program of quantitative easing known as QE3. Since the Federal Reserve announced an open-ended QE program last September, the US stock markets have been on a tear. Like the recent Japanese stock market rally, the promise of free money seems to be the cure for all the economic problems of the world. The problem with QE, like any other government attempts to distort markets, is that although it appears to work at least in the short-term, it has longer term unintended consequences that may destroy its purpose. Also QE does not exist in a vacuum. There are many other forces at work within the US and the global economy, which might dilute its potential effects.


One would assume that the US equity markets continue to rise because corporations consistently produce record profits. But that may not be the case. The S&P is up an astonishing 16% since the beginning of this year, but as we enter the reporting season, first quarter profits are expected to rise only 0.7%. If this forecast is accurate, it would be a sharp drop from the 7.7% growth in profits posted in the last reporting season.


The forecasts are also a lot lower than previous predictions. American managers are past masters of controlling analyst sentiment. Over the last four quarters they have successfully reduced expectations to such an extent that when the reports actually came out, they routinely beat the forecasts. The recent data suggests that this season might be different in that positive surprises will be lower than the prior quarter.


The meaning of the earnings has also changed thanks to the Federal Reserve’s stimulus. There are several ways in which corporations can boost their earnings without actual economic growth. Most CEOs’ compensation includes stock options. This gives them a large incentive to at least give the impression of consistent improvement in earnings. Cheap money can help in two ways. The CEO can increase debt and therefore leverage or they can buy back shares and spread the earnings among fewer shareholders. {break}


The process of boosting earnings with debt has been proceeding on a vast scale. Last year American companies borrowed around $400 billion to buy back their own shares. This is equal to about 2.6% of GDP. It is still increasing almost exponentially. In the first quarter America companies announced buy backs had increased 96% over the same period as last year. But this method of increasing earnings is of course limited. Eventually the companies are actually going to have to increase their earnings by growing revenue, which might prove difficult.


The cheap money will impact earnings in another way. Despite gains from stocks, US corporate pension funds are not earning enough interest from their fixed income investments to provide for their liabilities. Despite contributing $60 billion to their pension funds, the top 1,500 US companies finished the year with their highest deficit ever—$557 billion.


The Federal Reserve has not only inflated share prices, many Americans are feeling richer because the value of their homes has increased. By buying mortgage backed securities, the Fed has pushed down the cost of owning a home. Mortgage rates are at historical lows.


Thanks to low interest rates house prices are finally recovering from the disaster of the past few years. Prices of existing homes have risen 10% since last year. Last year sales of existing homes reached 4.66 million which is still below the 5.04 million recorded in 2007 but almost 10% higher than in 2011. With prices and sales rising, so has construction. In February contractors applied for building permits at an annualized rate of 946,000 which is over 30% higher than last year and the highest since before the crash in 2008. Not only has construction increased, but also everything that goes into building a house.  Lumber prices have risen to an eight-year high.


All of this is good news, but there are some caveats. By suppressing interest rates and yields, the Fed has encouraged people to become home owners. It has also encouraged investors to speculate: hedge funds, private equity vehicles and some individual entrepreneurs. Investors are not looking to purchase the home for the long-term. They want to purchase the home for rental income and eventually a sale, preferably quickly, what is known in the US as flipping. Wall Street has even given this asset class a more respectable name, real estate owned (REO) to rental and it is probably quite large. Most of these purchases are for cash, so the exact size of this class is difficult to determine. It is estimated that a third of the recent real estate purchases were by investors. We do know that the number of people who took out mortgages to purchase for investment or as a second home climbed to 13.6% of mortgages. This beat a previous record of 13.4% which was established at the peak of the market frenzy in 2006.


While investors are good news to a housing market that has been in doldrums, they do put extra stress on the system. Housing markets are long-term and are not that flexible. It takes months and possibly years to buy, sell or build a house. Markets cannot quickly adjust to speculative increases in demand. The result is that the inventory of homes available to buy has fallen to a 20-year low. So although sales volumes this year could remain muted, prices could soar.


Speculators also have better access to cheap money than normal home buyers. The Fed can insure that interest rates are low, but they do not control lending standards. Tighter lending standards, high unemployment, and low savings are preventing would be home buyers from entering into the market. Even well qualified purchasers are having difficulty competing with investors. Investors pay cash and do not have to qualify or get an appraisal. So their bids win even at the same price. But the real problem with someone who is buying for profit as opposed to someone who wants a place to live is that if the possibility of profit should disappear, say with the prospect of higher interest rates, speculators will most likely leave the market as quickly as they entered it.


Another problem with the US recovery is that the Fed’s largesse is not reaching small businesses. Small businesses are the largest creator of US jobs. They generated over 65% of the new jobs over the past 17 years. While they create more jobs, they are getting fewer bank loans. Their share of bank loans has declined from 52% in 1995 to 29% in 2012. Falling bank loans to small businesses has been due to a number of factors. The first has to do with securitization. Over the past 15 years the packaging of loans for sale to third parties has dramatically increased. To be securitized, loans must first be standardized. Small business loans are often unique. Second, banks have consolidated, destroying small local banks, a major source of small business lending. Third, as the banking industry became more competitive, the cost of making non-standard small business loans became less profitable. The result is that even with low interest rates, small businesses and the jobs they create lose out.


The present party going on in shares and housing may be slowed or even stopped in its tracks by the so called sequester. The sequester is basically an austerity program like the ones in Europe. Thanks mainly to the recession and high unemployment; the US deficit has more than doubled in the past few years. It now stands at over $16 trillion possibly more than 100% of GDP. Although the relationship between government debt and real GDP growth is weak for debt/GDP ratios below 90% of GDP, above 90%, growth rates fall by 1%. To rein in the debt, the US government has agreed to cut spending. It also has raised taxes.{break}


The sequester was the spending part of the so called fiscal cliff. The fiscal cliff was a result of an agreement in the US Congress in 2011. It was basically created because the two main parties in the US Congress, the Republicans and Democrats, could not agree on a compromise budget. The Republicans wanted dramatic spending cuts and the Democrats wanted tax hikes.


 Under the agreement as of 1 January 2013, there would be an automatic tax rise and spending would be cut across the board, something both parties disliked. On 1st January at the last minute, the fiscal cliff was avoided. Congress agreed to small tax rises for people earning over $450,000 and spending cuts were delayed until 1st March. This was a strategic mistake for the Democrats. The Republicans might have agreed tax hikes to get spending cuts. But the spending cuts were automatic, and the tax issues were off the table, so the Republicans had no reason to bargain. The sequestration duly took effect on 1st March.


The Republicans also had another advantage. Tax rises went into effect immediately. The political effects were instantaneous and muted. In contrast the effects of the sequester occur very slowly. Staff can be given short furloughs. Investments can be delayed. Vacancies can go unfilled. This can go on until the fall. The US federal government's fiscal year begins on the first of October. By then the temporary cuts will no longer suffice and fundamental restructuring will have to occur. Employees will actually be fired. Programs will be cut. Services curtailed. But until these things occur, there will not be any complaints and politicians will not be under any pressure to avoid the cuts. Although the impact has already started as of 1st April, the full effects will not come into force until the end of summer.


The sequester will increase the level of unemployment, which has not rebounded since the start of the recession. For the unemployment rate to start going down, the economy has to produce at least 300,000 new jobs a month. Over the past two years the economy seems to get going in one month, but then loses momentum the next. Job creation had been steadily increasing since last summer, but has started to decline again. The hope engendered by last month’s increase of 246,000 new jobs was dashed with this month’s creation of only 88,000 less than half the number predicted.


With job creation at low levels, the number of long-term unemployed grows. The US has over 5 million people who have been out of work for more than six months. The unemployment rate this month did drop from 7.7% to 7.6%, but only because more people dropped out of the labour market. The broader unemployment rate which includes people working part-time because they couldn't find a full-time job and people who wanted a job but haven't looked for work in the past four weeks is 14%. As businesses plan for a slowdown in government demand, new job creation has apparently suffered. It will get a lot worse as the year wears on and the real cuts begin to kick in.


The impact of unemployment is especially important to younger workers, usually the most vibrant part of any economy. When younger workers are unable to find jobs or find jobs below their skill level, their future earnings are adversely impacted. In addition, the skills of the long unemployed atrophy along with their finances and prospects, affects mental and physical health. Many of these workers are burdened by student loans. These have risen to more than $1 trillion and act as a drag on every segment of the economy.

First time home buyers usually make up 40% of the market, but this has dropped to 30%. Home buyers are also large consumer of every other type of durable goods. But these potential consumers and their impact on the economy has declined as they have been forced to continue to rent or move back in with their parents perhaps for years to come.


Along with the better job numbers last month, it appeared that consumer sentiment was increasing. The University of Michigan Consumer Sentiment Index had been steadily rising over the first quarter and last month came in at 78 beating the estimated 71. But it did not agree with another consumer index, the Consumer Confidence Index which came in much lower than predicted. Like last month’s job numbers, the University of Michigan Index preliminary fell back to 72.


While much of the recent economic gains have been attributed to the actions of the Federal Reserve, the Fed could be harming as much as it is helping. American companies are sitting on about $1.8 trillion. European companies have $1 trillion. Instead of building factories and creating jobs, it is sitting in company accounts earning almost nothing. The simple reason is uncertainty. What happens to the economy when the free money stops?


The minutes of the recent Fed meeting were not encouraging. The Fed has lost its consensus. Member opinions went from stopping QE immediately to keeping it going indefinitely. Meanwhile although the Fed’s goal of kick-starting the US economy has not been successful, its goal of inflating assets all over the world has been. The question will be what happens when the free money disappears? At that time we will finally know the true state of the US economy and it is not promising.


(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)


Industrial production and consumer inflation still paint a bleak picture, says Nomura

India’s industrial cycle is expected to go through a prolonged bottoming out and maintain below-consensus GDP growth forecast of 5.6% y-o-y in FY14 (year ending March 2014), slightly up from an estimated 4.9% in FY13, says Nomura in a research note

Industrial production growth, as measured by the Index of Industrial Production (IIP) eased to 0.6% y-o-y in February from 2.4% in January, above expectations. The positive surprise was largely a sharp uptick in capital goods production and a smaller-than-expected contraction in consumer durable goods output. Notwithstanding the monthly surprises, industrial production growth is expected to remain low in the near-term on weak demand and persistent supply-side constraints, according to Nomura in its Asian Insights report.


Meanwhile, Consumer Price Index (CPI) based inflation eased to 10.4% y-o-y in March from 10.9% in February (analysts’ consensus and Nomura expectations were 10.7%). Core CPI inflation rose to 8.7% y-o-y (from 8.6% in February), while CPI food inflation eased to 12.4% (13.5%). “We see the current growth-inflation-current account dynamics in a temporary sweet spot and we do not expect this to be sustained as an increase in government spending ahead of the general elections (due in the first half of 2014) is likely to worsen the imbalances again. We maintain our below-consensus GDP growth forecast of 5.6% y-o-y in FY14,” said Nomura in its research note.


Industrial production—not a broad-based recovery

IIP grew by 0.6% y-o-y in February from 2.4% in January, above expectations (consensus -1.3%; Nomura: -2%). Nomura had expected a contraction in February because of lesser working days in February and weak demand. The demand-side break up suggests that the positive surprise is not broad based and is largely because of a sharp uptick in capital goods production and a smaller-than-expected contraction in consumer durable goods.

Capital goods are known to be volatile and the uptick in February was likely due to a sharp increase in the electrical machinery and fabricated metal products categories. By contrast, the basic goods and intermediate goods categories posted negative growth. On the supply side, manufacturing sector output growth eased only marginally to 2.2% y-o-y in February from 2.5% in January, while mining output contracted for the fifth month in a row because of the clampdown on mining activity. Electricity output growth contracted in February largely because of the leap year effect, but nonetheless remained weak and is a binding constraint in our view. Plugging in the current IP reading, Nomura estimates Q1 2013 GDP growth at 4.6% y-o-y (4.5% in Q4 2012).


CPI inflation—underlying inflationary pressures persist

CPI inflation eased to 10.4% y-o-y in March from 10.9% in February and was lower than expectations (Consensus and Nomura: 10.7%). On the positive side, food price inflation eased to 12.4% y-o-y in March from 13.5% in February led by a sharp fall in vegetable and edible oil prices. The seasonal increase in vegetable prices that Nomura was expecting did not happen in March, likely because of the delay in the onset of the summer season. However, food price inflation is likely to rebound in the next few months once the seasonal increase happens. By contrast, core CPI inflation (CPI-ex food and fuel) rose for the fourth straight month to 8.7% y-o-y in March from 8.6% in February led by an uptick in the miscellaneous categories (transport services and others).


Implications for WPI: A sustained increase in core CPI inflation indicates that inflationary pressures still persist in the economy and supports the view that the current fall in WPI inflation, though partly due to weaker demand, is largely driven by lagged effects of lower global commodity prices and delays in the revision of coal and electricity prices rather than a meaningful correction in the supply-demand dynamics in the system.


Notwithstanding the monthly surprises Nomura expect industrial production growth to remain weak in the near-term in the absence of any triggers on the demand side and continued supply-side constraints (mining and power). Reports of weaker order inflows for capital goods manufacturers suggest that even the rebound in the capital goods category is driven by a few items and may not be sustained going forward. Further, weak growth in intermediate goods (a lead indicator for final demand) and other lead indicators such as the Manufacturing PMI and auto sector data suggest that final demand continues to remain tepid. While the brokerage expects WPI inflation to moderate to 6.6% y-o-y in March, it expects inflationary pressures to re-emerge in the second half of 2013 because of rising food prices, the release of suppressed inflation, rupee depreciation and continued supply constraints. Nomura adds that the recent improvement in the merchandise trade deficit is also largely seasonal and the current account deficit is likely to widen again in Q2 2013.


The Nomura report states that the current growth-inflation-current account dynamics is a temporary sweet spot and the brokerage does not expect this to be sustained as an increase in government spending ahead of the general elections is likely to worsen the imbalances again. Overall, it expects the industrial cycle to go through a prolonged bottoming out and maintain below-consensus GDP growth forecast of 5.6% y-o-y in FY14 (year ending March 2014), slightly up from an estimated 4.9% in FY13.


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