Stocks Slide…Politicians InterveneMay proved to be one of the most volatile months in recent memory as evidenced by the worst monthly performance for the S&P 500 index since February 2009. Even worse, the S&P experienced its worst May performance since 1962, falling 8.2%. Equities fought to regain some of the lost ground in the final week, but it was simply not enough, with the S&P rising 0.2%.

Given the heightened volatility, it should come as no surprise that individual investor sentiment is at its worst level for the year. According to the American Association of Individual Investors (AAII), 51% of individual investors are bearish on the 6 month outlook for stocks. Those same investors hit their most bullish point on April 15th, roughly one week before the stock market reached its year-to-date apex.

Contrary to what is being seen in the global equity markets, the Baltic Dry Index, a measure of international shipping prices for dry bulk cargo, is pushing to new yearly highs. Higher shipping prices would suggest that global trade, and thus, global economic activity, is gaining traction. However, the price increase is largely attributable to Capesize vessels, the largest on the ocean, representing only 10% of the global fleet. Despite the smaller fleet size, the enormity of Capesize shipping capability lends them to massive shipments, with the primary cargo being iron ore and coal. Suddenly the pieces fall into place.

Source: Decision Point

Chinese coal imports jumped a phenomenal 212% in 2009 and it looks increasingly plausible that the country will move from the second largest importer of coal to the first by year end. Look at the iron ore markets and we see an almost identical story. The Baltic Dry Index, formerly a reasonable proxy for pending economic conditions, is decoupling from the current economic fundamentals as the Chinese economy continues its ascent.

Source: Reuters

With the global economy showing signs of softening, politicians in the US hit the panic button, cobbling together a proposed $200bln stimulus package. The Economist questioned whether the economy really needs a 10th stimulus considering that more than $1trln has been injected into the economy in the past 2 years. Furthermore, the Organisation for Economic Co-Operation and Development (OECD) recently ratcheted up growth expectations for OECD member nations, including the US, which the OECD now expects will grow at a 3.2% pace in 2010 and 2011, from 2.5% previously.

A vast majority of the stimulus is geared towards transfer payments (unemployment insurance, welfare, etc.), which are proven to provide no lasting benefit to the economy. Even measures that are typically stimulative will be ineffective. For instance, to pay homage to National Small Business Week last week, the bill includes a small business lending program that would cost an estimated $500mln. Unfortunately, a recent survey found that the biggest problem facing small businesses was a lack of sales, not access to credit.

The request for stimulus money came despite the creation of a recent deficit reduction committee by President Obama. Even more laughable, politicians were supposed to follow a “pay-as-you-go” mandate, offsetting spending increases with budget cuts elsewhere. This most recent bill fell under the “emergency” category and will be exempted from such rules.

Stimulus money is entirely necessary under certain scenarios, but current spending is playing a dramatic role in reshaping the overall economy. Data from the Bureau of Economic Analysis shows that private wages are at an all time low while government benefits continue to rise, reaching 18% in the first quarter. That does not even account for income paid to government employees, another 10% of wages.

Source: USA Today

The concern, as economist David Henderson alluded to in the USA Today article, is that the allocation from private to public wages means “people are paid for being rather than for producing.”

The Incredibly Resilient American Consumer

One of the most disheartening aspects of the past several years was the abysmal state of consumer finances heading into the recession. In the first quarter of 2008, the personal savings rate was a meager 0.8% of disposable income and household liabilities as a share of disposable income reached an astounding 130%. Levels that severe suggested that even the mildest recession would spiral out of control given the “quick to disappear” nature of consumer credit.

Surprisingly, consumers shook off the cob webs and made an exceptional comeback over the past 12 months. But, the story has yet to truly change; consumers are tenuously overextended and unlikely to provide the necessary boost to economic growth in the coming quarters without serious improvement in wage or credit growth.

Source: McKinsey Global Institute

The initial phase of the domestic recovery in 2009 was overwhelmingly driven by inventory restocking. That is, businesses needed to replenish historically low inventory levels to restock the shelves. Contrary to what many economists were expecting, that phase gave way to robust personal consumption, which contributed almost 2.5% to GDP growth in the first quarter alone.

Source: Federal Reserve Bank of Cleveland

Somewhat problematic for consumers is the realization that the economic growth of the past several quarters came at the expense of the personal savings rate, falling from a recent peak of 6.4% to 3.6% in April. In order to continue spending at the current pace, indivudals need higher wage growth or easier access to credit, neither of which seems likely in the present economic climate.

Source: Haver Analytics

The other issue which has yet to be resolved is wage growth. In the past 12 months, disposable income is up 2.5%, after rising only 1.0% in all of 2009.

Source: Econoday

Even with the problems facing the consumer, there are several factors working in their favor. The first is lower mortgage rates. For those individuals with the ability to refinance or purchase a home at today’s historically low interest rates, the monthly savings can be sizeable. In recent weeks, the number of homeowners opting to refinance hit a seven month high and as long as the situation in Europe remains unresolved, interest rates will stay low.

Source: Washington Post

Second, retail gas prices are weakening. The tentative situation in Europe is pushing crude oil prices lower, to the benefit of automobile owners. Prices, while elevated, are still significantly lower than the peak endured in 2008.

Although consumer spending may slow in favor of a higher savings rate, this could prove to be a positive for the economy. Higher savings are generally rerouted back to the economy in the form of capital investments. Corporations use those dollars more efficiently and productively than the average consumer, creating sustainable long-term benefits for the economy. Supporting that notion, the Federal Reserve Bank of St. Louis found that GDP growth is the highest when consumer savings is on the rise, not declining, as one might be inclined to believe.

Encouragingly for consumer finances, household debt service payments as a percent of disposable personal income is on the decline. The ratio remains above the long-term average, but is returning to a more appropriate level and indicates that the consumer balance sheet is slowly being realigned.

Source: Federal Reserve Bank of St. Louis

American consumers are notorious for their spendthrift ways. That trend is under pressure following the deepest recession in the post-WW II era and while this is likely to create headwinds for the economy in the near term, the long-term benefits to the economy from more productive and efficient uses of that capital will prove important.

The week ahead

The most important economic release of the week will be the employment report on Friday. Economists are expecting a very robust headline figure, but much of that gain will be driven by Census hiring. Private sector job is the number to watch, with an estimated range between 100k and 200k.

Source: Clusterstock

On Wednesday, professors from the University of Colorado will release their predictions on the Atlantic hurricane season. Given the current situation in the Gulf of Mexico, there is warranted concern that any hurricane to pass through the area would amplify an already devastating scenario. Finance ministers from the G20 meet in South Korea to discuss exit plans for current liquidity measures as well as the state of affairs in Europe from Thursday through Saturday.

Retail stores in the US will report same-store sales in the second half of the week. Sales are expected to be divergent, with retailers such as Target and similar discounters likely to experience the bulk of the gains for the month. Headlines on global economic weakness during the month of May likely played a part in suppressing sales.

Portuguese legislators will vote on austerity measures in the coming week, including higher tax rates and across the board cost saving maneuvers.

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