I wrote in my last post about the reversing of the expectations cycle. The expectations cycle is an interesting topic intellectually and also an incredibly useful investment tool. I wrote two weeks ago I expected an imminent reversal of optimism as economic data would come in worse than expected. No indicator demonstrates this better than the new unemployment figures from last week.
The unemployment rate is now up to 9.5% and looks set to break 10% for the first time since the early 80s recession. This data was worse than expected in the same way the May unemployment figures were better than expected. In May, unemployment was 100,000 people less than expected, sending markets higher into June. June's unemployment was 100,000 people more than expected. Ever since that data was released in early July, equities have fallen by about 1% a day. Most interesting however is the effect on commodities, especially oil. Commodity prices have decreased across the board and oil is down to $60 today (already a -3.4% change just for the day). (Oil was also affected by an announcement by the CFTC that it might place limits on positions for some market participants.) The decline in commodities is indicative of greater risk-aversion and negativity on the economy. Most of the upward pressure on commodities came from reasoning that an economic recovery would demand more raw materials and re-inflate commodity prices. In that sense, commodities can be seen as a call option on economic recovery. A good indicator of the new negativity is the marketpsych fear index (the line represents investor fear):
The rise in unemployment has significant political risk for the economy. As unemployment increases, policymakers will be under more pressure to stimulate the economy, especially since Obama said the stimulus package would keep unemployment at 8%. As unemployment surges, Obama will be under additional pressure to enact policies that can really mess things up in the long-run. A large part of this pressure comes from the fact that public opinion of Obama depends almost completely on a recovery. It is hard to imagine how Obama could be re-elected with unemployment above 10%. (A WashPost article from today titled "Obama Stands to Be Judged By the Economic Recovery" argues just that.)
Increasing the budget deficit is a grave risk, especially if you believe Morgan Stanley chief economist Richard Berner, who declared "America’s long-awaited fiscal train wreck is now under way."
We have already heard talk about a stimulus II. Another stimulus would have more long-term negative repercussions than its worth. Sometimes, one simply has to buckle down and take the pain."Depending on policy actions taken now and over the next few years, federal deficits will likely average as much as 6 percent of [the gross domestic product] through 2019, contributing to a jump in debt held by the public to as high as 82 percent of GDP by then — a doubling over the next decade,” Berner writes on Morgan Stanley’s online Global Economic Forum.
"Worse, barring aggressive policy actions, deficits and debt will rise even more sharply thereafter as entitlement spending accelerates relative to GDP. Keeping entitlement promises would require unsustainable borrowing, taxes or both, severely testing the credibility of our policies and hurting our long-term ability to finance investment and sustain growth," he adds. "And soaring debt will force up real interest rates, reducing capital and productivity and boosting debt service."
"Not only will those factors steadily lower our standard of living," Berner concludes, "but they will imperil economic and financial stability."
