The Pause That Doesn’t Refresh

By Comstock Partners

The Fed tried to thread a needle and ended up satisfying nobody. They confirmed to all the doubters that the economy was indeed weak and that they really couldn’t do much about it without resorting to completely untried and unorthodox measures with unpredictable results. To all intents and purposes the Fed showed to all that the emperor has no clothes. The $200 billion in proposed Treasury bond purchases only compensates for the coming rollover of mortgage bonds, and, in any event, is dwarfed by the measures previously taken with little effect on the economy, although it did succeed in averting a financial meltdown.

The market has suddenly awakened to the fact that the economy is tanking and that the Fed has used all of its conventional ammunition. Interest rates are near zero, the budget deficit is 10% of GDP and the Fed’s balance sheet has tripled to $2.3 trillion. After some $700 billion of TARP funds, $1.7 trillion of Fed purchases of mortgages and Treasuries, untold billions of dollars of guarantees, the auto industry bailout, cash for clunkers, home purchase credits and mortgage workout programs, the economy still cannot stand on its own.

Aside from the Fed’s tentative move, new reports released this week convinced even most of the doubters that the economy has weakened considerably and that the outlook ahead is for more softness at a minimum and, potentially, a renewed (or continued?) recession. For a long time it seemed as if we were the only ones talking about deflation, and suddenly it has virtually become the conventional wisdom After a big June increase in the trade deficit and a slowing increase in inventories, most economists have reduced their second quarter GDP growth estimate to a range of 1%-1.5%, compared to the previously reported 2.7%. Taken together with a sharp rise in unemployment claims, the disappointing payroll employment number, a continually declining housing market, tepid consumer spending and yet another gloomy report from the small business survey, the economic outlook going into the third quarter does not look promising.

Anyone looking for help from the global economy has to be disappointed as well. European industrial production dropped in June and the Bank of England reduced its forecast for economic growth. The ECB warned that much of the European recovery over the last year was due to one-off factors such as the rebuilding of inventories and government measures that are now expiring. Now the austerity measures that are being put into place are likely to result in slower growth or recession. In addition new concerns about the peripheral EU nations have begun to emerge once again after being papered over in recent months. Greece’s growth weakened even more than expected. Ireland’s interest rate has almost doubled in three weeks. According to the Financial Times, the so-called Euribar-Eonia spread, a measure of banking sector risk, rose to its highest level since last September. The cost of insuring against default by European banks has also climbed. At the same time, Chinese imports dropped 5.6% in July while the government reported slower growth in production and retail sales.

As we have pointed out numerous times, the reason for the U.S. and global economic malaise is the enormous overhang of debt that is in the process of being deleveraged. Efforts to cure the debt problem by attempting to add even more debt are doomed to fail as various sectors of the economy are either attempting to reduce debt or are not good credit risks. This is a typical pattern after recessions that are caused by a credit crisis.

The stock market peaked on April 26th at 1219 on the S&P 500 and declined to 1010 by July 1st. The rally to 1129 since then has now abruptly ended, leaving previously bullish traders trapped. We believe that their efforts to get out of their bullish positions will drive the market lower. Furthermore since consensus economists were only recently looking for 2.5%-to-3% growth in the second half, earnings estimates will have to be revised down for this period and probably 2011 as well. It’s also likely that corporations will be issuing a lot more earnings warnings during the current quarter, and that Cisco’s disappointment will not be a one-off event. Near-term S&P 500 support at 1088 has already been violated and 1010 is next. In our view an eventual test of the March 2009 lows is a distinct possibility.

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