Stocks continue to show impressive resilience in the face of several seemingly daunting negatives. First is how much they've advanced in the last three months from their 12-year lows. By any measure, stocks are due for a rest.
Second, while the U.S. economy is showing increasing signs of stabilization—that is, a slower rate of deterioration—evidence of actual improvement remains scant. Third on the worry list is rising interest rates (see below) plus the probability of sky-high federal budget deficits for a long time to come.
Nevertheless, the broad market has not pulled back, and the Standard & Poor's 500 is near its high for 2009. Instead, many sectors are merely consolidating, while others are still climbing higher. Among the latter group of market leaders are energy and other commodity-related issues. Oil hit a seven-month high near $73 a barrel today.
Meanwhile, the rally has met with deep skepticism, and the Big Money is dramatically underinvested. Admittedly, a sluggish economy, rising interest rates and higher commodity prices aren't a likely scenario for long-term investment gains.
Yet the quiet strength of the equity market plus the fact of all that low-yield cash on the sidelines burning a hole in investors' pockets is a good combination too.
We advise continued investment in a diversified group of dividend, energy and international equities; high-quality, nongovernment debt; and some inflation protection; plus cash reserves of 20 percent or so.
Rising Rates Pose New Risk
A sharp rise in interest rates is bringing new worries about the housing market, the economy and the stock market.
Rising rates threaten to dampen prospects for a housing recovery. Rates on 30-year fixed-rate mortgages have climbed to 5.75 percent from 5 percent in just two weeks ago. Earlier this spring, mortgage rates had fallen below 5 percent, a 50-year low.
This fueled a new wave of mortgage refinancing and, to a lesser extent, rising home sales, primarily of lower-priced properties. Mortgage refinancing enables homeowners to reduce their interest expense, freeing up cash for other uses.
Mortgage rates generally track 10-year Treasury notes. The yield on 10-year issues hit 4 percent this week for the first time since mid-October. Yields have soared in 2009 from deeply depressed levels under 2.2 percent. This is a positive development in many ways because it reflects a shift back toward more normal credit conditions from the fearful flight to safety of late 2008.
Meanwhile, the Federal Reserve has actively bought both Treasury issues and mortgage-backed securities in 2009. But the financial markets are much bigger than the Fed. If interest rates continue to rise, they will also reduce corporate borrowing and other consumer borrowing, which along with housing are critical to an economic recovery.
Another reason to sell Treasury debt is the huge amount of new supply coming to the market because of the massive economic stimulus. The U.S. government is expected to borrow some $2 trillion in 2009 alone.
That unprecedented economic stimulus, in turn, has led to rising fears of future inflation—yet another reason not to hold long-term Treasury securities.
Spending Less, Saving More
Evidence continues to build that the severity of the recession is abating.
The Federal Reserve's latest report of regional economic conditions (the "beige book") concludes that the economy continued to weaken in April and May, but the rate of decline is slowing.
Also, the number of U.S. workers filing new claims for unemployment benefits has fallen to the lowest weekly level since early January. And a monthly report from the Conference Board said employment trends strengthened in May for the first time in 16 months.
But Americans continue to cut back on their spending while increasing their savings, imperiling the economic recovery.
For the first time since World War II, Americans are spending less than they did a year earlier. The year-over-year figures have been down in every month so far in 2009. Previously, the weakest year-over-year comparison in consumer spending was a 1.8 percent increase in the 12 months through April 1961.
Meanwhile, the national savings rate rose to a 14-year high of 5.7 percent of disposable income in April. How high can it go? Some observers think it will hit 10 percent or more. The highest savings rate on record (since the 1950s) is 14.6 percent, set in May 1975 as the U.S. had just emerged from a severe recession.
The most striking numbers show that spending and saving aren't always mutually exclusive. In fact, both have been in a long-term decline since the early 1980s, when the savings rate and the 12-month growth in spending both touched 12 percent. Why the drop? Gradually slowing economic growth. The national savings rate actually went negative in 2005, reflecting the rising use of credit to fund consumption.
Another obstacle to growth in consumer spending—and the broad economy—is that consumer debt loads remain very high. The main reason is the bursting of two bubbles, housing and stocks, which wiped out an estimated $12.9 trillion of net worth in the 18 months through year-end 2008.
Historically, rising savings and less spending are tied not only to the inability to spend but also the unwillingness to do so because of pessimism about the country’s economic outlook. Enter the "paradox of thrift": Consumers are saving more and spending less just when the economy needs them to spend more. If people save too much and don't spend enough, it's bad for the economy. So the recovery from the current downturn is unlikely to be robust.
