Tuesday, May 5, 2009

How Is The Economic Medicine Working?

The government has been injecting trillions of dollars into the economy, but how has it been working so far? James Picerno looks at recent events and attempts to answer that question in his blog post below. In addition Picerno takes a look at what lies ahead for the U.S. economy, and offers some words of wisdom for investors.

In late-March, we asked: Is the medicine working? By medicine we meant the massive injection of liquidity into the economy as a cure for fending off deflation and laying the groundwork for recovery. At the time, we were mildly encouraged, in part due to the rising inflation forecast as derived from the spread between the nominal and inflation-indexed 10-year Treasuries.

More than a month later, there's still reason for optimism, perhaps more so, thanks to the so-called green shoots that suggest better days ahead. Yet the rate spread, which is to say the market's inflation outlook, hasn't changed much since late-March. The current forecast is for inflation of 1.4% for the next 10 years, just barely up from around 1.3% from the end of the first quarter. In both cases, that's a healthy change from expecting flat pricing, as was the case at the end of 2008. Low inflation as far as the eye can see would be nice, but is that a reasonable expectation?

In the months ahead there will be a thin line between a healthy rise in inflation expectations and the potential for burdensome pricing pressures later on. Deflation is a hazard to be avoided for a number of reasons. Although we can't quite shut the book on the danger, the odds look increasingly in favor of mild inflation for the foreseeable future, as the chart above suggests. Behind this reasoning is the growing sentiment that the recession is at or near a bottom. Is it time for the Fed to begin tightening? Or are the green shoots still too tentative?

"We're seeing more indications of perhaps a bottoming in the economy," Bill O'Neill of LOGIC Advisors tells Dow Jones. "So there is an increasing—and it will continue to increase—concern surrounding inflation potential."

Gold, the perennial inflation hedge, seems to be considering the possibility, although this market hasn't quite made up its mind. The price of the metal has been hovering around $900 for much of this year, just below its all-time high of $1,033, set back in March 2008. The 10-year Treasury yield, meanwhile, has been climbing, recently bumping up against 3.2% on renewed worries that inflation may now be the bigger risk. Even so, a 10-year yield of 3.2% is still quite low.

None of the inflation anxiety is worrying the stock market, which has now reversed the selloff in the first quarter. Indeed, the S&P 500 is now marginally up on the year, as of last night's close, on expectations that by the end of this year the economy will be sitting up and prepared to get out of bed.

The big question is whether all the renewed hope that the worst is over is really just the byproduct of a bear market bounce in markets and inflation expectations? Given the extreme waves of selling last year and into March, a rebound was all but assured if the world economy didn't collapse. As we now know, it didn't. There are still lots of problems, but we'll all be here next year and so it was time to reprice assets upwards to reflect a humbled but otherwise enduring economic climate.

Investors have cheered the signs that the U.S. economy no longer seems to be contracting at an accelerating pace. Given the fears of what could have happened, that's certainly a reasonable response. Deciding that you're not going to fall into the abyss is always encouraging. But that's still a long way from arguing that growth is imminent, or that the economy won't tread water for a year or two.

The first phase of the post-apocalyptic visions that prevailed six months ago may be over. If so, now we're faced with the more difficult chore of deciding how to repair and rebuild the economy to foster growth while containing inflation. The hardest days are yet to come. Unless you're expecting a seamless transition, keeping some cash at the ready still makes sense, albeit less so than in past months. Volatility isn't banished, it's only hibernating, which suggests another round of value-oriented pricing opportunities in the major asset classes.

This post can also be viewed on capitalspectator.com.

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