Stocks built on the rally with another net gain last week, ending the week with the S&P 500 Index up 46% from this year’s low point. In fact, July was the best month for the Dow Jones Industrial Average since October 2002—the end of the last bear market. On Thursday, the S&P 500 index came just a few points shy of 1,000 during the day—the highest level on the index since November of last year. On Friday, second quarter GDP was reported to have been down just 1%, compared to the 5-6% declines in the prior two quarters, showing us that the recession has faded quickly and a recovery in the economy is now at hand.
Market participants were pricing in another Great Depression early this year as stocks fell an additional 25% from the start of the year to the low point on March 9. Then stocks rallied nearly 40% over the two months following the low point as the markets began to reflect expectations of a mere recession rather than a depression. Our Current Conditions Index tracked a pattern of steady improvement in the factors most critical to economic and earnings growth. While consolidating those gains, the S&P 500 ranged between 880 and 950 for the past two months, until renewing the rally in the past couple of weeks as market participants began to price in the shift from recession to recovery. The move in sentiment from depression to recession to recovery took only five months. But the shift in sentiment is unlikely to end there—next may come fears of inflation and the concerns about the challenging “exit strategy”.
Depression > Recession > Recovery > Inflation?
While enthusiasm over the prospects for recovery may act as a positive for stock and bond market performance, investors may soon turn their attention to the potential threat of inflation and the challenges associated with how the Fed manages that threat by exiting the extraordinary support measures taken to address the crisis in the economy and financial system.
While the Fed may continue the supportive policies until mid-2010, the markets may price in the potentially negative consequences of an exit strategy on the stock and bond market much earlier. China’s exit strategy could come before the United States’. Last week, the People’s Bank of
China, that nation’s central bank, announced that the rate of inflation in China may rebound in the second half of the year, suggesting rising concerns about inflation. In addition, the central bank recently required several commercial banks to purchase new short term bonds worth 100 billion Yuan (about $16 billion) to soak up some of the extra cash that has led to a lending spree. The Chinese stock market fell over 5% that day, as measured by the Shanghai Composite. Fears were sparked that China would begin to exit the policies that led new lending to triple to more than $1 trillion in the first half of 2009 from a year earlier, leading China’s economy to grow at an annualized and seasonally adjusted 14.9% in the second quarter, up from the 8.5% growth rate in the first quarter.
In 2008, the financial crisis resulted in a global recession that led to a plunge in Chinese exports and a surge in unemployment. The Chinese government responded by lowering bank capital requirements and lending standards at state-owned banks while boosting the amount of capital made available for loans. This approach was so successful that they overshot the entire year’s lending quote of 5 trillion Yuan (about $700 billion) in the first few months of 2009. The pace of lending has shown no sign of abating, raising questions related to the long-term health of the financial system; short-term speculation using loaned money to purchase real estate and stocks—the Shanghai composite index is up about 90% this year—is giving rise to concerns of a credit bubble developing in China.
Requiring the banks that have been inflating a credit bubble to purchase bonds with their extra cash is intended to modestly slow, but not halt, the pace of lending. The value of the loans only represents 10-15% of the amount of monthly new loan volume. This is likely the first step of many in an exit strategy designed to wean the Chinese economy off of cheap and easy credit to a self-sustaining path of expansion as global demand for exports improves.
Additional steps to curtail loan growth are likely to be taken in the fourth quarter. The effectiveness and unintended consequences of this stimulus withdrawal will be watched closely, since it will soon be mirrored by the U.S Federal Reserve, although with much more precise tools. As inflation begins to turn positive around the world toward the end of this year, attention will shift toward the magnitude and velocity of the inflation threat and the exit strategy that the Federal Reserve will take in 2010 just as the fiscal stimulus fades. This strategy will test if the recovery is self-sustaining or likely to suffer another bout of recession. We adhere to our 2009 year-end target for the S&P 500 of 1000-1050. However, we believe therecent surge may soon begin to fade, giving way to a sideways but volatile market in the next few months.
