The minutes from the March 17-18 Federal Open Market Committee meeting, released this afternoon, seemed like a bucket of cold water over the bull’s head. Anyone with the time and inclination to read this document received a stark reality check with regard to the condition of the domestic and global economies. Investors didn’t appear to like what they read either. After trading firmly in the black for most of the day, the S&P 500 sold off after the release (but recovered with a modest gain). But should we be surprised at all the negative rhetoric being bandied about behind closed doors at the FOMC? After all, the outcome of this meeting was the authorization to buy additional mortgage-backed securities, housing agency debt and, for the first time in this crisis, US Treasury bonds. Obviously, the FOMC must have felt a strong sense of urgency if it was willing to bring this latest weapon out of the arsenal. The Fed is going all out to lower the cost of home ownership and thereby put a floor under home prices.
The minutes of the FOMC meeting were highly negative about the present state of the US economy. While recent encouraging data points (stabilization in consumer spending and better housing data) were seemingly dismissed as anamolies, the preponderance of the text provided a long list of indicators suggesting the economic situation is deteriorating:
“The information reviewed at the March 17-18 meeting indicated that economic activity had fallen sharply in recent months. The contraction was reflected in widespread declines in payroll employment and industrial production. Consumer spending appeared to remain at a low level after changing little, on balance, in recent months. The housing market weakened further, and nonresidential construction fell. Business spending on equipment and software continued to fall across a broad range of categories. Despite the cutbacks in production, inventory overhangs appeared to worsen in a number of areas.”
“…nearly all meeting participants said that conditions had deteriorated relative to their expectations at the time of the January meeting. The slowdown was widespread across sectors. Large declines in equity prices, a further drop in house prices, and mounting job losses threatened to further depress consumer spending, despite some firming in the recent retail sales data and forthcoming tax reductions. Business capital spending was weakening in an environment of uncertainty and low business confidence. Of particular note was the apparent sharp fall in foreign economic activity, which was having a negative effect on U.S. exports. Credit conditions remained very tight, and financial markets remained fragile and unsettled, with pressures on financial institutions generally intensifying this year. Overall, participants expressed concern about downside risks to an outlook for activity that was already weak.”
“Overall, most participants viewed downside risks as predominating in the near term, mainly owing to potential adverse feedback effects as reduced employment and production weighed on consumer spending and investment, and as the weakening economy boosted the prospective losses of financial institutions, leading to a further tightening of credit conditions.”
Obviously, the Fed has a vested interest in making the economic situation appear dour. The central bank has expanded its balance sheet to over $2 trillion and has largely circumvented the legislative process in doing so. This is taxpayer money that is being put at risk without formal authorization by Congress. But Bernanke wouldn’t do something so sinister, would he?
For our part, we believe there are some early indications of modest improvement in the economy, and we are not so sure the FOMC should be so dismissive of these key indicators. For example, we have been saying for quite some time that improvement in credit markets will be one of the key indicators to a bottoming process in the economy. While the signals are few and far between so far, we are hopeful the trend will continue. The FOMC does mention some of these improvements in the meeting minutes:
“Conditions in the commercial paper (CP) market continued to improve, on balance, over the intermeeting period. Spreads on 30-day A2/P2-rated CP trended down further, and those on AA-rated asset-backed commercial paper re-mained at the lower end of the range recorded over the past year. Conditions in repurchase agreement markets for most collateral types improved over the period, but volumes remained low.”
“Gross bond issuance by non-financial firms was very strong in January and February, as investment-grade issuance more than doubled from its already solid pace in the fourth quarter…”
“Participants agreed that the asset purchase programs were helping to reduce mortgage interest rates and improve market functioning, thereby providing support to economic activity.”
“Notably, the low level of mortgage interest rates, reduced house prices, and the Administration’s new programs to encourage mortgage refinancing and mitigate foreclosures ultimately could bring about a lower cost of homeownership, a sustained increase in home sales, and a stabilization of house prices.”
To sum up all of the above, the negatives still clearly outweigh the positives. Despite some early signs of improvement, the credit markets remain highly stressed. Housing prices continue to fall precipitously as the Feds work to bring down mortgage rates and increase bank lending. And the consumer is retrenching as he struggles with high debt, low savings, and the possibility of job loss. These problems were not created over night, and they will not be resolved quickly either. We are going through a process that is likely to transform the economy from one of irresponsible lending, borrowing and spending, to one of financial constraint, higher savings rates and greater responsibility. This transformation means that the recession, already long-in-the-tooth by historical standards, is likely to continue for some time longer.
I suppose my message is that I would be cautious if looking to increase stock allocations after such a sharp run-up in the indices. While we continue to believe that long-term investors are likely to be rewarded if invested at these levels, the economic headwinds remain formidable over the near term. Stocks’ rebound off recent lows suggests a certain level of optimism that may or may not be justified at this stage in the cycle.