In today’s testimony to Congress, Fed Chairman Bernanke again committed to keeping interest rates “exceptionally low for an extended period” to support a “nascent” economic recovery. At the same time, Bernanke seemed to infer that he did not believe the economy was yet growing on a self-sustaining basis. This sentiment, as we have consistently articulated over the past several months in these weekly commentaries, represents our overriding concern. It is simply not clear to us that the economy will be able to grow respectably in the absence of massive amounts of government support. Recent economic data – including weak home sales, continued job losses, shrinking consumer credit, and yesterday’s dismal consumer confidence report – all seem to justify our concerns. The one bright spot we have seen is in manufacturing, which may be benefiting from a temporary increase in inventories. Meanwhile, the stock market continues to anticipate a seamless transition from government-induced economic growth to more sustainable private-sector demand for goods and services. Until the evidence suggests otherwise, we remain defensive. Don’t get us wrong: there is money to be made in stocks, but the momentum play would be inappropriate. We believe that it is more important than ever to own companies with solid balance sheets, low debt-to-equity, organic earnings growth, and experienced management teams. Cautious is cool!
The Consumer Confidence Survey, based on a representative sample of 5,000 U.S. households, was a major surprise to the market. The reading of 46.0 for February was the lowest in ten months and was down from 56.5 in January. Within the overall reading, the “Present Situation” component came in at a 27-year low. Attitudes about employment and income prospects deteriorated significantly from just one month ago. Survey respondents may have also been unnerved by the roughly 8% correction in stocks. In any case, the consumer confidence numbers we received yesterday do not bode well for the near-term future of consumer spending, which accounts for 70% of GDP. We suspect that there may also be a post-holiday season let-down as winter continues, jobs are fragile, and credit card debt remains robust.
In fact, recent earnings reports from a slew of retailing companies suggest that these management teams are at best lukewarm with regard to their sales expectations for the year. Wal-Mart, which reported a same-store sales decline of 1.6% for its fiscal fourth quarter and guided to flat sales in its first quarter, is certainly not knocking the cover off the ball right now. The current consumer spending landscape was perhaps best described by Alan Greenspan yesterday, who said that the benefits of any economic progress to date are accruing largely to the wealthiest Americans. These high-income consumers, who are not representative of the economy at large, have enjoyed a massive increase in stock prices since last March. However, spending by this small group of Americans will not drive a sustainable recovery. According to an article in today’s Wall Street Journal (and based on a survey by Booz & Co), “only 18% of consumers said they planned to spend on clothing and shoes at pre-recession levels in the next 12 months.”
News from the banking front adds pressure to the economic recovery. An FDIC report issued this week said that loans in 2009 at U.S. banks fell at the sharpest pace since 1942. Banks remain reluctant to lend based on fears about unemployment, a second leg down in residential housing, commercial real estate, and new regulation, which may require higher capital levels. Banks also complain that the demand simply is not there for loans to qualified borrowers. Within the same FDIC report, the number of banks at risk of failing hit a 16-year high of 702, and 5.3% of all bank loans & leases were at least three months past due (the highest level in the 26 years the data have been collected).
What do we glean from all this? The most obvious and irrefutable conclusion may be that Chairman Bernanke is clearly justified in maintaining loose monetary policy for the foreseeable future. The trickier interpretation, however, is how these developments should be greeted by stock investors. Is it a good thing that we remain so highly dependent on piles of government cash and low interest rates? What will happen when the government begins lifting its support by ending MBS purchases and tax credits, and ultimately lifting the Fed Funds rate? We have every confidence that the US Economy will recover. It will likely happen in the good old fashioned way that begins with consumers rebuilding their balance sheets, increasing employment and ultimately increasing consumption. The increasing consumption will feed upon itself as manufacturing increases, more jobs are created, and capital formation expands.
Or maybe we don’t need to worry about anything for several months to come. As I write, the Senate has just approved $15 billion in tax credits for companies that hire unemployed workers. And it is an election year. Can’t we expect more and more support from the government as the year progresses? A Wall Street Journal article this week quoted Lowe’s CEO Robert Niblock as saying, “Hiring hasn’t really kicked back in, and the fact is that home prices have not really stopped declining yet. Congress will have to do something before having to face elections.” He is probably right, but at some point the music will have to stop. At this point in the game I would rather see investors cheering signs of an actual economic recovery than hear applause for the promise of continued government support for a weak economy.
High-quality, blue-chip stocks are not expensive by historical measures, especially in this interest rate environment. However, now is not the time to get aggressive on speculative companies with weak financial profiles and uncertain sales outlooks. Stick with quality for now. Multinational blue-chip companies with strong balance sheets typically outperform during difficult periods. Moreover they offer hedges versus currency risk and inflation. A more defensive posture continues to be prudent.
Hang in there,