January 2013 Market and Economic Conditions
By Adam B. Landau Permit Capital Advisors, LLC
As we look back on 2012 and ahead to 2013, we must take note of the resiliency to this point that both the economy and markets have demonstrated in the face of ongoing, and increasing, political dysfunction. Today we are saddled with many of the same global issues and concerns that we had at this time last year, though some have moved in a more positive direction than anticipated (European debt crisis), some have continued to confound observers (US fiscal stance), and others have been on a natural glide path to resolution (soft landing in China).
One thing investors and consumers have demonstrated is that they, more so perhaps than their elected leaders, have the ability to recalibrate their practices and decision-making when provided with a degree of clarity about future conditions. In the US, there is not much fiscal clarity to speak of, even with the patchwork solution offered up by Congress at year-end, though we do have an (over) abundance of transparency coming from the Federal Reserve. In hindsight, the fiscal cliff may very well prove to be nothing more than a red herring, as the failure to seize the opportunity to produce a credible deficit reduction plan simply forces a pivot to the next political crisis, whether it takes the form of debate over the debt ceiling, continuing resolution, or sequestration. Failure to answer the bell on any of those issues will be as punishing as the recessionary impact of a sudden and dramatic fiscal contraction that we faced with the fiscal cliff.
Impact on the economy to this point has been somewhat masked, as it appears that 2-3% growth has been pulled forward from the first half of 2013 into the second half of 2012, on the back of an increase in unsustainable government expenditures. These outlays leave government spending at roughly 24% of GDP, relative to an historical average of closer to 15%. At the same time tax revenue as a percentage of GDP sits at 18% relative to an historical average of closer to 20%. Both of these figures must move back towards those averages if a resolution is to have any lasting substance.
The reality of just how difficult of a task that appears to be in the present political climate has caused CEO sentiment to plunge and capital expenditures to weaken. Business expending is extremely important because spending on plants and equipment tends to have a high multiplier effect on labor and the economy. On the other hand, the consumer has maintained a degree of resiliency, thanks largely to an uptick in housing and an accommodating Fed. The extent to which those two variables intertwine cannot be overstated. The Fed recently announced a continuation and expansion of quantitative easing, to the tune of purchases of an additional $45 billion a month of Treasury securities, on top of the ongoing commitment to buy $40 billion a month of mortgage-backed securities, for an annual addition of $1 trillion to the Fed balance sheet in 2013, making it $4 trillion overall. Perhaps more newsworthy was the announcement of official markers relating to employment and inflation that would be instrumental to policy decisions going forward.
Our two questions are: was this level of detail necessary given the clear signs that the Fed has provided to this point in their handling of monetary policy since the Great Recession? Could the level of transparency actually cause more confusion and distortions amongst those it is intended to assist? It has been clear for some time that presented with evidence of adverse financial and/or economic conditions, the Fed is willing to prop up the economy using any tools at its disposal. This clarity comes from both official and unofficial Fed rhetoric, as well as an understanding of inflationary conditions across the G7. Fed efforts to prevent massive negative shocks to the economy have been guided by the belief that aggressive monetary easing is more likely to help prevent deflation than it is to unleash inflation. Of course, these attempts to utilize monetary policy to prevent a punishing recession only delay difficult fiscal actions until a later date,riskinganevendeeper recession down the road. Developed nations around the world are largely in their current straits because of a persistent tendency to delay dealing with financial imbalances.
The unemployment metric selected is a fairly straight-forward application of the Evans rule, named after Chicago Fed President Charles Evans, and involves a pledge to keep rates low until the unemployment rate drops below 6.5%, provided certain inflationary conditions. The inflation component of the guidance is murkier – as stated, the gauge for inflationary compliance for low rates to be maintained qualifies that the indicator must be below 2.5%. The metric selected is core PCE, which can be very different, and heading in different directions, than headline CPI. Further creating potential ambiguity is the caveat that as well, longer-run inflation expectations must remain “well anchored”. How “well anchored” is defined, and whose expectations are relevant is an unanswered source of potential market confusion. The Fed motivation for this strategy likely lies squarely on an effort to ensure continuedrepairtothebadlydamagedhousing market.
It would appear that the Fed’s explicit targets are designed to keep rates low for quite some time. This stems in part from Ben Bernanke’s recognition that many homeowners who purchased 2/1 and 3/1 adjustable rate loans have still not been able to refinance them because they are among the 22% of US homeowners who are suffering from negative equity. Those homeowners have low payments right now, so they are spending. If rates rise too quickly, one of the primary backstops supporting the economy goes away. To quantify the situation, the housing price index is still 15.37% below the level it was at in September 2007, which is when the last adjustable rate loans of that nature were being written. Further, Fannie Mae has $19.23 billion of adjustable rate loans on its balance sheets, or 7.05% of their total single family loan portfolio. It will take a few more years of low rates for that total to decrease to a point where a spike in defaults and/or foreclosures would have a manageable effect on the housing market.
Commercial real estate is another beneficiary of the manipulated interest rate landscape. Opportunistic and value-add properties across a variety of sectors are sitting out there in targeted markets with significant economic benefit waiting to be created through favorable investment conditions, for both stabilized properties as well as those that are neglected and underperforming. Working with professionals who have experience and expertise in identifying, purchasing, and managing such properties provides a distinct advantage in today’s marketplace.
About Adam Landau
Adam Landau is Chief Executive Officer and Chief Investment Officer of Permit Capital Advisors, LLC.
He has 15 years of experience evaluating investment managers, developing asset allocation strategies, and coordinating the process by which the two disciplines are merged.
Visit http://www.permitcapital.com to see how Adam and Permit Capital Advisors, LLC can grow your wealth.
