Friday’s Economic Data: Green Light for QE2

There was no shortage of economic data released today however there were no major moves in the indices as everyone seems to be waiting for the Fed’s announcement next Wednesday. Released today were GDP, Employment Cost Index, Consumer Sentiment and Chicago PMI. Let’s have a look in that order.

GDP

GDP came in at 2.0% growth quarter over quarter (SAAR) which was in line with expectations. Personal consumption showed surprising strength, contributing 1.8% to growth with change in inventory levels also contributing 1.4%. Inventory restocking continues to be a strong contributor to GDP growth since late 2009 and it remains to be seen how long this will last. GDP growth continues, albeit at a rate slower than typical recoveries. For further reading on what the Consumer Metrics Growth Index says about Q4 GDP, see here.

Sentiment Update: Individual and Professional Investor Sentiment Diverges

The NAAIM (active money managers) and AAII (individual investors) sentiment surveys were released Wednesday and Thursday respectively. Individual and professional investor sentiment diverged this week as individuals increase their bullish sentiment while professional investors reported a substantial decline in equity exposure.

This week, active managers have, on average, a 58% allocation to equities. This is down from 72% last week. The median allocation fell to 75% while the top quartile of active managers have an allocation of 96% or greater to equities with the bottom quartile at a 50% or less equity exposure. The eight week moving average continued its uptrend, now at 61%, although the steady increase in sentiment from this past July appears to be slowing.

Krugman Comes Clean?

Unfortunately, no. Not Krugman. In his latest, titled “The Worst Economist in the World” which I read, thinking he finally admitted to it, he says:

“So, how hard is this? Higher commodity prices will hurt the recovery only if they rise in real terms. And they’ll only rise in real terms if QE succeeds in increasing real demand. And this will happen only if, yes, QE2 is successful in helping economic recovery.”

Let examine Krugman’s claims individually.

1. Higher commodity prices will hurt the recovery only if they rise in real terms. Okay, I will give him this one.
2. And they’ll only rise in real terms if QE succeeds in increasing real demand. False. Real prices (price change less inflation) of commodities have increased since QE2 was first rumored, there is no question about this. Has demand increased? Demand for hard assets as a store of value has increased. The Fed admits, this is what it is trying to do. But has real demand increased? Judging by today’s durable good orders it does not appear QE is increasing real demand. Total orders are still 20% below the December 2007 peak and the year over year gains are leveling off.

3. QE2 is successful in helping economic recovery. There is still no evidence of this. Have a look at Japan for a historical example. In fact, just today, Bill Gross who, in-spite of his seemingly cozy relationship to the Fed, said:

We are, as even some Fed Governors now publicly admit, in a “liquidity trap,” where interest rates or trillions in QEII asset purchases may not stimulate borrowing or lending because consumer demand is just not there. Escaping from a liquidity trap may be impossible, much like light trapped in a black hole.

There is no need – as with Charles Ponzi – to find an increasing amount of future gullibles, they will just write the check themselves. I ask you: Has there ever been a Ponzi scheme so brazen? There has not.

Krugman has constructed a circular argument whereby higher real commodity prices can only be due to increased real demand and therefore an improving economy. It appears to me he is conveniently forgetting that the Fed has admitted to encouraging speculation in assets with the hopes that the wealth affect improves the real economy. QE2 is not spurring an improvement in the real economy only rising valuations of financial assets. These higher asset prices are leading to higher inputs costs which cannot be passed along to the consumer; as we examined yesterday.

Is the Recovery in Corporate Profit Margins Over?

QE2 has yet to begin in earnest and yet its effects are already being felt. In the words of the New York Fed’s Brian Sack, it is hoping via QE2 to (emphasis mine):

“keep longer-term interest rates lower than otherwise by reducing the aggregate amount of risk that the private markets have to bear. In particular, by purchasing longer-term securities, the Federal Reserve removes duration risk from the market, which should help to reduce the term premium that investors demand for holding longer-term securities. That effect should in turn boost other asset prices, as those investors displaced by the Fed’s purchases would likely seek to hold alternative types of securities.

In their own words the Federal Reserve is hoping that lowering interest rates and inflating asset prices will encourage business to expand and stimulate consumers due to a wealth effect. But there is a downside; in fact QE2 may already be doing more harm to the economy than good.

Sentiment Update: Moving Higher

The NAAIM (active money managers) and AAII (individual investors) sentiment surveys were released Wednesday and Thursday respectively. Bullish sentiment in both surveys increased from last week.

This week, active managers have, on average, a 72% allocation to equities. This is up from 67% last week. Bullish sentiment is once again nearing “extreme” levels. The median allocation remains at 80%, unchanged from last week’s survey. 25% of active managers have an allocation of 100% or greater to equities with the bottom quartile at a 50% or less equity exposure. The eight week moving average continued its uptrend, now at 60%.

The NAAIM number measures current equity exposure (0% would be all cash, 100% fully invested). Additional detail can be found here.

Individual investors increased their bullish sentiment for the next six months. Sentiment, as measured by the AAII survey, increased from 47% last week to 50% this week. Bearish sentiment also declined from last week (26.8% to 25.2% this week) with more investors moving to neutral (23.2% to 26.1%). The eight week moving average increased to 45%, which is a level last seen in March ‘07.

While neither survey shows “extreme” bullish sentiment both remain above average. For research on subsequent equity returns based on sentiment please see the flowing links. AAII research here and NAAIM research here.