Friday, August 10, 2012
In our last report we postulated the Federal Reserve would force the U.S. Government to face reality. Most investors have taken the opposite view, figuring another round of "quantitative easing" will soon be implemented instead. The cover story there is that more money creation will reduce interest rates further, lift economic activity, and propel stock prices higher, reinforcing the uptrend via the so-called "wealth effect." A lot of investors also have gained confidence from the prospect of quantitative easing in Europe. That would entail printing up piles of new cash and using them to finance government deficit spending.
The money printing might be necessary to keep Europe afloat. The Continent certainly is in dire straits. But it won't turn its economy around. The Europeans will have to get serious and restructure away from their welfare states. In the United States, more easy money probably would exert a negative effect. The Federal Reserve appears to be aware of that. While it might have to provide some liquidity if the Government goes off the fiscal cliff in December, chances are interest rates will begin rising later in 2012 no matter what happens. The real world fundamentals just don't exist to support any more declines.
Energy costs have turned back up. Food prices are starting to percolate. Productivity has been declining for a while and that trend is continuing. The Federal Government deficit remains elevated. Medical spending is slated to surge next year as the Affordable Care Act's negative elements start taking effect. Mortgage write-offs, retirement spending, welfare costs, disability costs, and a wide range of other mandated overhead expenses are surging. Manufacturing unit costs are climbing as volume stalls and costs continue to advance. Foreign bank bailouts and other rescue measures promise to strain the capital markets further.
Inflation is set to rise. The demand for money also is poised to increase. And it won't be practical to print endless amounts of new cash any more. That will just make a bad situation worse. The United States, and perhaps Europe, too, is headed for an adjustment process. Chances are it won't be nearly as bad as everybody fears. But it's something we'll have to work through. There's no free lunch.
How the markets will react is beyond prediction. If earnings remain on a downward path, though, portfolio allocations likely will switch towards bonds as long term interest rates become more attractive. Our advice is to remain cautious until evidence develops that the current strategy will succeed; or the adjustment period gets underway. Change creates opportunity. An attractive buying opportunity could emerge.