Market Outlook – October 25, 2004(A)
Waiting and Watching
During the past three months the price of oil spiked from $38 to $55 a barrel. Job growth slowed after a brief spring surge. The Federal Reserve raised short-term interest rates twice. And Senator Kerry recovered in the polls. The market didn’t like any of it as third quarter declines left stock returns hovering near zero for 2004.
On the brighter side, the mainsail of consumer spending rose a healthy 4% last quarter. Manufacturing activity continued to expand. The overall economy picked up speed after the second quarter’s “soft patch.” And inflation and interest rates remained quite tame. Not that anybody cared, as the items above garnered all the headlines. This selectivity suggests to us a high degree of investor anxiety, no doubt fueled by presidential politics.
For the market to be in a funk this near to Election Day is unusual. Typically stocks are flat during the first six months of an election year and then rise in the second half as election uncertainty wanes. The latter, of course, hasn’t happened this time around. Senator Kerry and President Bush have fallen into a dead heat that has only heightened investor anxiety. As we’ve said many times, the market hates uncertainty more than almost any particular outcome. With the candidates posing such stark differences, investors and corporate decision-makers seem to have taken to the sidelines pending the election’s outcome. (Kerry partisans may take heart from the market’s softness just prior to the election; historically such behavior often precedes a change in Administration.)
Oil Prices, Job Growth & the Economy
The big economic story this quarter was oil prices, about which the most important thing to say is that this is not the 1970s. The economy will not be crippled by $53-a-barrel oil. As services have grown and manufacturing declined as a share of the economy, and as energy efficiency measures have evolved, the impact of rising energy costs has shrunk materially. That said, there are negative consequences to consider. Higher oil prices redirect consumer spending toward energy companies and away from the rest of the economy. And they also raise operating costs for businesses and thus reduce profits (unless you’re an oil company).
More problematic than the direct effects of rising oil prices, however, may be their indirect effect in the area of job creation. Spiraling asset prices–whether up or down–are usually driven by speculation and so involve a large degree of unpredictability. The current spike in oil is no different as by various estimates hedge-fund speculation accounts for as much as $15 of the per-barrel price of oil.
This unnerving spike in oil prices has thus served to compound the uncertainty employers already felt over the deteriorating situation in Iraq, the ongoing threat of terrorism and the outcome of the presidential election. The result has been an extremely cautious approach to hiring, with businesses choosing instead to widen profit margins, pay off debt and build up cash as protection against an uncertain future. Today, corporate cash holdings as a percentage of the national economy are at their highest level in 45 years.
This cautious hiring stance has left the workforce stagnant and largely shut out from the economic recovery. And there’s the rub. Consumers account for 2/3 of all US economic activity; if consumers as workers aren’t participating in the recovery their ability to sustain the recovery may come into question. Or so the more dire version of this argument goes, as told by those who’ve been selling stocks over the past three months. With the US unemployment rate at an unremarkable 5.4% we don’t buy the argument that consumers are about to cave in. We do, however, think its proponents are onto something, a sort of Catch-22, that’s holding back the economy.
The Catch-22 is this: While corporations have beefed up their earnings, their balance sheets and their cash hordes, they’ve done so at the expense of the hiring and capital investment needed to give the economy a full head of steam. They’re waiting to hire and invest, of course, until the economy…gets up a full head of steam.
As we’ve written in the past, the economic engine shifts into high gear when rising corporate revenues are used to hire new employees and make new capital investments. Doing so creates positive feedback loops in the economy that spur more revenues, more hiring, more investment, etc. In the current recovery the business community has yet to engage this “virtuous cycle.” Until it does, the economy will operate at less than full potential.
Animal Spirits Revisited
In our last commentary we underlined the crucial yet unpredictable role of what Keynes called “animal spirits” in every economy. Today the animal spirits are cautious, wary, uncertain. Nowhere is this more evident than in the fact noted above that corporate cash is at its highest level since 1959. Cash is simply monetized uncertainty. What we’re seeing from corporations, mutual funds, individuals is an unusually strong preference for safety and a corollary aversion to risk. In the economy this shows up as weak hiring and big cash hordes. In the markets it shows up as high bond prices and cheap stocks.
Our most basic assumption is that markets revert to the mean; that preferences will return to more normal patterns of valuing risk vs. safety. When such reversion occurs stock prices should rise and bond prices should ease; job growth should resume and capital investment rekindle. The difficulty is predicting when this will happen as geo-politics are a key variable in the equation. In that light November 2nd is the first potential inflection point in alleviating the markets’ anxiety. Whoever wins, investors will have answers to a whole host of questions–on federal spending, tax policy, healthcare–that are wide open until the election.