WEEKLY ECONOMIC ANALYSIS: August 14th, 2009

Provided by TEAM Financial Services

"This is like deja vu all over again."
- Yogi Berra

Items for discussion

Just as Yogi would put it, we seem like we’ve lived this before. What do we mean by “this”? Of course, it is our emerging obsession with the “Weekend at Bernie’s” economy, which appears to have turned into a global blockbuster. While we spend most of our time in this commentary discussing the economy and financial markets in the US, we remain focused on global developments in our day jobs. While the US government has been active in propping up various “Bernies” like the auto industry and banks, the Chinese government makes the US look like amateurs.

The funny thing about an authoritarian regime is that it can pretty much get its citizens to do anything it wants – as long as it remains in power that is. Such control has surely been a driver of the speed at which China has built its infrastructure. When the Chinese government tells a couple of thousand of its citizens to build a nuclear power plan, they do it. In the US, it can take 10+ years to get a site chosen and the mountain of regulatory red tape navigated!

The Chinese government engaged in an economic stimulus program over the past year in which it has essentially mandated that banks lend money. State owned banks in many other countries, including India and Brazil, have likewise exploded lending. All this is occurring as privately own banks in those countries retrench.

Not surprisingly, state owned banks have complied very aggressively in China. The investment in productive capacity and infrastructure has been immense. Under free market conditions, these kinds of investments are the kinds we applaud and believe contribute to the long term health of an economy. However, when they are mandated by a government, we believe significant problems are likely.

Chinese industrial production entered the period of stimulus with massive excess capacity. As global consumer demand dropped (lead by the US and Europe), inventories piled up and production was shuddered. In a free market system, price signals would not begin to make additional investment in new capacity worthwhile until most, or even all, of the excess capacity is soaked up once economic activity and demand recovers. This is why we have economic cycles – these things take time to evolve. The political decision to “stimulate” by the Chinese has resulted in massive over capacity becoming even greater. Empty apartment buildings in Shanghai are no discouragement against building yet more building to sit empty.

We find it amazing that politicians, and many economists for that matter, never seem to learn anything from history. The Japanese attempted public works programs throughout the 1990’s in which roads and bridges were built in areas in which the demand for their existence was limited or did not exist – the proverbial bridge to nowhere. Such government spending certainly increases economic activity in the near term, but it does nothing to build long term productivity or wealth for society – i.e. raise living standards. The Chinese are engaged in a grand experiment like none the world has likely ever witnessed.

The now infamous "clash for clunkers" program in the US is another example of central planning. It rings hollow to us, as it reminds us of the broken window fallacy. Intentionally "destroying" productive assets may stimulate activity in the short term, but it does nothing to increase wealth or production long term. If things were so simple, we could simply instruct the Air Force to blow up all the major bridges in the US! That would surely create jobs in the short term!

There is no question one can argue there are non-economic aspects to the program. Increasing the overall fuel efficiency of the US auto fleet can be argued to have both environmental and national defense policy relevance. However, to argue that it is being done to "stimulate the economy" is simply ridiculous - as the broken window fallacy suggests.

This is just one more example we see in which our government leaders implement policies that make no sense to us over the long term, but do provide a false sense of stability in the short term. Another great example has been the shift in policy to allow banks to change their accounting rules to effectively pretend that their assets are worth more than the markets are saying.

We believe all of these shenanigans have contributed to investors having an excuse to take more risk - not only in the US but throughout the world. However, the consumer doesn't appear to be fooled. This is reflected in a very unusual divergence, as investor sentiment has reached a bullish extreme at the same time consumer sentiment is languishing. Typically, these move in tandom. At some point we expect these two to move back into synchronicity.

Market/Economic Climate

The growth rate on ECRI's Weekly Leading Index reached a 26 year high, which suggests that the economic recovery directly ahead is likely to be the sharpest since the US economy emerged from the double dip recession of the early 1980's - though the job market is likely to remain poor. TEAM believes that on a fundamental basis, the stock market is already reflecting this positive outcome. Based on our various valuation metrics, the S&P 500 is around 15% above what we consider long term fair value.

However, as we learned the hard way during the 2004-2007 period, a recovery built on quicksand can cause investors to whip into a frenzy of momentum that drives prices to be detached significantly from fair value. TEAM believes that a significant allocation to hard assets and related companies remains prudent given the chances of a recovery that surprises most with its intensity, and likely stokes up significant concerns that the Federal Reserve is letting the inflation genie out of the bottle.

We continue to maintain some portfolio hedges, which we believe is prudent insurance given the fundamental backdrop. However, we believe any short to intermediate term corrections in the price of commodities and related equities is likely to be transient and an opportunity to increase exposure.

Humor for the Weekend

Weekly Economic Analysis newsletters are provided by TEAM Financial, and are written by TEAM's Chief Investment Officer, James L. Dailey. Visit TEAM's website if you want to receive weekly economic updates right in your inbox - Click here.