The market’s initial reaction to yesterdays’ comments from Chairman Bernanke was mildly negative. I guess he did not give the impression that additional quantitative easing (QE) is in the cards for now. However, a rally soon followed in a continuation of a strange trading pattern that has dominated the year.
What strikes us as strange is the belief that has been in place these last few years over the effectiveness of QE efforts. QE has been viewed as a magic bullet. In reality, looking at the way cyclical stocks have corrected in recent weeks, we would expect major US indices to be 15-20% lower in price already.
We get the clear impression at this point that these divergences are largely the result of the US investors placing all hope that the Fed can prevent our market from acting like those abroad, if only it were to pull the trigger and decide to buy hundreds of billions of dollars of additional treasury bonds. This belief seems strongest at present, just when it appears that we are quite close to a recession. Retail sales have been negative for three months.
We find the market’s faith in the Fed misplaced. We would argue that the hundreds of billions of dollars spent by the Chinese government to prop up growth since 2009 have had more to do with the ebullience of U.S. markets than anything the Fed has done. That stimulus helped keep the earnings picture strong for many U.S. companies that do business there and in other emerging nations that sell to the Chinese. The Chinese built roads, rails, office buildings, and homes under the “build it and they will come” school of thought. Many cities and industries now suffer from massive overcapacity as a result.
Now China is in the midst of a major slowdown. Anecdotal evidence abounds and is more telling than the Chinese government’s economic releases, which cannot be trusted. Christie’s, the auction house, reported that sales in Asia were off 24% for the first six months of the year. Jewelry sales have also slowed dramatically according to retailers both on the mainland and in Hong Kong. Earnings warnings from Chinese companies are abundant and severe as the Shanghai Composite sits at a three-year low.
We find it instructive to look at the world from the perspective that over-levered economies across the planet are fighting massive deflationary forces as they attempt to de-lever. The powers that be use all means available to counter this deflation, but in the end, they just end up forestalling the inevitable debt restructuring that must occur. China is no exception.
Even the news from the muni bond market is troubling. Three California cities have filed for bankruptcy protection, which heretofore has been a rare occurrence. Typically cities would just cut employment or services, but continue to make bond payments. However, these cities, like government entities in Europe and elsewhere, are operating in a new environment in which slow economic growth exposes past spendthrift habits, forcing difficult responses. There are no quick, easy, or painless solutions in spite of investors’ desires at times to believe otherwise.
We expect that markets will learn a difficult lesson as slowing growth in China causes earnings expectations to be revised dramatically lower in the U.S. Perhaps it will be the point when some participants realize that “Emperor” Bernanke has no clothes. Sooner or later many investors will have to return to real work like discounting future cash flows, not gaming central bank activity.
Scott Brown, July 18, 2012