On February 14, 2007, U.S. Fed Chairman Ben Bernanke made his semi-annual trip up to Capitol Hill to present the latest U.S. Monetary Policy Report to Congress. Though not omitting the obligatory words of caution, his testimony was taken by investors as a confirmation that the “Goldilocks” economy, not too hot and not too cold, is alive and well.
The Fed sees the U.S. economy making the transition from a rapid growth rate to more sustainable average annual growth of approximately 2.75%. Inflation has abated somewhat following the run-up in the first half of 2006. In his presentation, Bernanke admitted that though core inflation improved modestly, in recent months, it remains somewhat elevated.
He also noted that signs of stabilization in the housing market and robust consumer spending remain the mainstay of the current economic expansion. The business sector is in excellent financial condition, with strong growth in profits, liquid balance sheets, and corporate leverage near historical lows.
That was more than sufficient for stock jocks to hit the buy buttons on their trading stations, giving the tiring eight-month-old rally new legs. All major stock market indices, including the lagging NASDAQ, subsequently made new multi-year highs. Even the bond market liked the Goldilocks story, with 10-year treasuries extending their rebound from their December-January selloff.
Unfortunately, it took only a few days before the new financial data turned out to be less reassuring than Ben Bernanke’s testimony. Reports from home builders and suppliers to the industry showed a continuing slide in revenues and earnings. While this has already been discounted by the market, with builders’ stocks already rallying in anticipation of better days just ahead, the retreat in stocks of sub-prime lenders, including a few top-tier banks, turned panicky.
Release of the core consumer price index (CPI) for January 2007, which strips out food and energy prices, has done little to alleviate inflationary concerns. The CPI rose 0.3% compared to the forecasted rise of 0.2%. On a year-to-year basis, it was up by 2.7%. At the same time, the 0.1% rise in the January index of leading economic indicators was less than Wall Street’s estimate of 0.2%. In response, the already strong gold and silver prices surged to a new seven-month high last week.
The latest data pointing to higher inflation, accompanied by reduced growth in the economy are unlikely to be of lasting concern to investors. What continues to make this geriatric bull market tick, ignoring all historical precedents, is the seemingly inexhaustible cash float looking for alternative investments to the meager bond yields.
The origins of worldwide liquidity are rooted in the expansionary monetary policies of the U.S. Fed and the Bank of Japan (BOJ). They did their utmost to prevent the recession of the early 2000s from sliding into a depression. In fact, the BOJ still maintains its easy money policy. Even after last week’s increase of one quarter percentage, its benchmark interest is still only 0.5%! This near- zero interest rate keeps Japan from sliding back into recession. It also holds the Yen from rising and, in turn, has lifted gold to new multi-year highs.
The complexity and interrelations between global economies, politics, and markets make it increasingly difficult for the central banks to implement just the right monetary policy. With the benefit of hindsight the central bankers were probably a bit too successful at reviving the economy from the last recession. The subsequent years of strong economic expansion generated huge corporate cash flows with record high profit margins.
However, corporations stung by the recessionary experience of the early 2000s held back on capital expenditures and built up excessive cash reserves instead. Growing cash hoards on corporate balance sheets eventually led to massive share repurchases and takeovers of other companies.
Cash hoards also attracted merger and acquisition buccaneers eager to redeploy idle cash for their own enrichment. Privatization of public corporations via leveraged buyouts has gradually deteriorated into a feeding frenzy with ever larger and riskier deals being announced or rumored almost on a daily basis.
When the investment industry starts to peddle IPOs of merger and acquisition firms and they soar like high-techs of old, an example being the recent IPO of Fortress Investment… when GM ponders buying struggling Chrysler, you know that a new financial frenzy has grappled the markets. This financial mania is unprecedented both in terms of the capital involved and the global reach and spread. It makes it next to impossible to estimate when and how this latest bubble will deflate and its aftermath.