The first half of the year had surprises for just about everyone. The stock market was weak, corporate profits were better than expected, oil remained robust, job growth was anemic, long interest rates continued to perplex.
What might the second half of 2005 hold in store for investors? Barring some new unforeseen crisis, these issues will continue to drive the economy as well as the financial markets.
Energy and Oil
Crude hit a record in the last week of June, closing (briefly) over $60 a barrel. Back when it was under $40, most economists would have told you that $60 oil would grind global growth to a halt. While there's little doubt that oil is having an impact, it's been more far muted than many had expected.
From a market perspective, the influence has been more pronounced. Trying to correlate the day-to-day gyrations of equity prices with crude has been a fool's errand. But consider the first four months of the year: Crude busted out over $50 in February, and has (mostly) been higher ever since; it's not hard to imagine that the stock market's lousy first half was somehow related.
Yet the relationship between oil prices and the market is far more complex than many realize. Since October 2002, oil has more than doubled in price -- and yet so has the
. Where's the inverse correlation so many seem so fond of blaming the market's woes upon?
Recently, I was asked where would the Nasdaq be if oil were still at $25 a barrel? My answer: "probably a lot lower." Why? Many of the same factors that have driven oil higher also have been driving the Nasdaq upwards, including massive government stimulation, ultra-low interest rates and increasing globalization.
But it won't always be that way. So far, the cumulative impact has been somewhat subdued. The impact won't always be this muted. The interrelationship between energy and global growth is nonlinear. There is a tipping point at which oil prices will have more bite, grinding the global economy to a halt. We just haven't hit that level yet.
The justifications for the
tightening cycle have morphed. When it began in June 2004, the rationale was a "measured removal of monetary accommodation" -- i.e., ultra low rates. Since then, the Fed has been quite cognizant of the threat of inflation. "Pressures on inflation have stayed elevated, but longer-term inflation expectations remain well contained," the Fed's policymaking body said on June 30.
The question is not whether there's inflation -- with nearly everything we buy up significantly in price, there can be little doubt inflation is robust. We also know that the inflation rate is significantly understated by government statistics. The key for investors to consider is twofold: How long will the present inflation continue, and when might it reverse and head toward deflation?
Depending upon its source, inflation can be good or bad. When the underlying cause of inflation is increasing demand for goods and services, that reflects healthy growth. We are willing to tolerate a modest amount of this inflation as a natural part of economic expansion. On the other hand, inflation caused by the government -- federal deficits or sloppy monetary policies (i.e. too much liquidity) -- is problematic, with far-reaching consequences.
Interest rates are a corollary to inflation. They are so intimately tied together, we can hardly talk about one without referencing the other.
The story of the 2003-05 expansion is nearly exclusively a tale of rates.
In the aftermath of the market crash, recession and 9/11, the Fed brought rates down to half-century lows. That sparked an entire global refinancing cycle whereby both consumers and businesses cleaned up their balance sheets.
Homeowners have been the key driver of spending, as ever-lower mortgage rates allowed serial refinancing. Some have criticized treating homes as ATMs, and their arguments have some merit. One can hardly find much wisdom in exchanging long-term equity for short-term nondurables. But consider this: A very high percentage of consumer spending, job creation and economic activity has been directly tied to this stimulus. While long rates staying low despite a year of hikes may be a conundrum for Alan Greenspan, there's no argument it's been a windfall for the economy
But we cannot discuss rates without touching upon the yield curve. Initially, we are concerned with the flattening of the curve. Theoretically, that implies less monetary stimulus.
But the major concern is a yield-curve inversion -- when long-term rates are lower than short-term rates. That implies a lack of appetite for capital, investment and expansion. Historically, the major concern about an inversion is recession. An inverted yield curve has a nearly perfect record of predicting economic contractions.
Surprisingly, the impact on the stock market is less certain. Brian Reynolds of MS Howells did a study on market performance post-inversion. The results were surprisingly random. Following the seven true yield-curve inversions since 1978, markets had gone up, down and sideways. It's hardly been predictive of market action.
As the Fed's monetary accommodation gets slowly removed, investors should observe the impact on several areas: the yield curve, consumer spending, housing, global trade, and foreign purchases of U.S. Treasuries.
Quick, name the most robust, significant sector of the U.S. economy. If you said housing, congratulations, you have been paying attention.
Northern Trust's economic team has
calculated that nearly half of all post-recession, private-sector job creation has been housing-related. That's an astonishing figure; imagine how morose the economy would be if not for the housing boom.
Let's not debate the real estate bubble (been
there done that). Instead, let's look at what might happen with housing over the second half.
There's little reason to expect a dramatic change in housing sales without a significant rise in mortgage rates. If the so-called conundrum persists, as some think it might, then housing will remain robust.
John Herrmann, chief economist at Cantor Fitzgerald, is one who expects rates to remain low and housing to stay vigorous. He is forecasting a record-setting pace of homes sold in 2005, and expects that in 2006, sales will surpass this year.
If he's correct, that's bullish for a number of sectors: durable goods, homebuilders, banking.
There are some signs, however, that housing may be slowing. Mortgage applications have dropped. Inventory of existing homes for sale has increased. And we see the most marginal of buyers -- the interest-only, adjustable-rate borrowers -- have decreased their frenetic activity. Whether this merely represents a decrease in speculation or a genuine plateau in home sales remains to be seen.
Oil, interest rates, inflation, housing: These are all pretty well known. What other economic issues might have an impact? Here are some lesser-discussed issues worth watching in the second half:
Federal deficits: The initial reduction in deficits this year gave some hope that a bad source of inflation might be getting under control. Commentators have suggested that the deficit will continue to improve over the next few quarters.
There's less to that improvement than meets the eye. No less an authority than Congressional Budget Office Director Douglas Holtz-Eakin, a Republican and former administration economic adviser, dispelled the idea that deficits are going away any time soon. "These are the good ol' days," he told
The Wall Street Journal
. "These are the best of times. After this, it gets worse."
Plus, if the conflict in Iraq gets any messier, we may see an increase in funding -- and that would make the deficit worse.
Return of the long bond: Everyone in America has refinanced at record low rates -- except for the U.S. itself. When the 30-year comes back sometime in the second half of the year, Uncle Sam will finally improve his finances and save money on his interest payments.
This may have some unfortunate side effects, however. Lack of supply has kept demand for long bonds high, and rates low, even spilling over into the 10-year. Once the 30-year re-enters Treasury auctions, don't be surprised if rates perversely start ticking higher.
Employment: Has remained stubbornly intractable. Outsourcing; weak demand; corporations afraid to put quarterly numbers at risk; and uncertainty about next year -- those and other structural issues have caused anemic job creation.
Indeed, out of the past six months' data, the majority of what little good numbers we've seen is courtesy of some financial legerdemain. Sleight of hand hedonics (like the BLS birth/death adjustment) and not actual job creation, have been responsible for occasional stronger data points.
Watch for this to change. Without true, organic job creation, any recovery is doomed.
Trade deficit: With the monthly deficit now topping $50 billion regularly, this year's foreign trade deficit is on target to beat 2004's record $617 billion.
The fundamental issue is one of structural imbalances: How long can any country consume in excess of what it produces? The argument, grossly oversimplified, is whether you can remain solvent if your family's household budget spends more than it brings in.
The political hot potato was put onto the back burner after a recent private meeting between Fed Chair Alan Greenspan, and Sen. Charles Schumer (D., N.Y.) Big Al got Senator Chuck to throttle back his invective, postponing for now the debate on punitive tariff legislation. But this may rear its head again in the fourth quarter.
The U.S. dollar: After a long fall, the dollar has spent the past eight months gradually regaining strength. While all eyes have been on China, it's the economic weakness out of Old Europe that has been the reason for the greenback's firming.
The key is what the Asian powers do. If they decide to replace their massive dollar reserves, then watch out. That's when the dollar will take a big tumble. My personal expectation is that the dollar eventually ends up considerably lower, but the timing is murky.
The big bet by newbie currency trader Warren Buffett may be further upside down before it pays off.
Barry Ritholtz is chief market strategist for Maxim Group, where his research and market analysis are used by the firm's portfolio managers and clients in the U.S., Europe and Japan. He also publishes The Big Picture, his macro perspectives on the economy and geopolitics, entertainment and technology industries, and is a member of the board of directors of Burst.com, a streaming media software company. At the time of publication, Ritholtz had no position in any securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Ritholtz appreciates your feedback;
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