The Key Variables -Unemployment & FED

Unemployment rate is the linchpin for the Fed and the economy. Although there are many variables restraining the FED, such as rising exports from a dropping dollar or high resource prices, we believe the main variable is the low unemployment rate.
The consumer drives 2/3 of the economy. If people stop spending for fear of losing their jobs or trying to keep the purse strings tight during a “job transition”, there is less consumer fuel to keep the US engine moving.Hence, the FED steps in with cheap money (fuel) and primes the pump all over again (Keynesian Economics).In the short term a slight recession is a bit healthy in the eyes of the FED.  If successful, they will have served their purpose to moderate the economic decline and worked toward keeping full employment as high as possible in the long term.

What places the Fed in the drivers seat this round is its ability to regain control of the aggregate money supply.  This particular liquidity flood (tsunami) started with Greenspan in the banks with the 45 year low discount rate and then was picked up by the private capital markets and foreign governments.  We suspect Greenspan did not realize the ability of the US financial system to innovate so rapidly.  The financial community spliced and diced mortgage products, such as HELOCS and ARMS, and sold them off to various institutions in the form of CMO’s and other hybrid financial products.  Obviously, this joined with other foreign central banks lowering their rates only contributed to the massive global liquidity boom.  The difference being the process of money creation was removed from the FED’s hands.  Greenspan’s policy had such far reaching effects.  We surmise that, as many dollars chased to few goods, petro and china dollars just recycled into the grand global money supply.  One of the last legs of the private liquidity infusions has been the recent M&A and LBO boom from our beloved investment banks hard at work.  In short the policies under Greenspan caused the Fed to lose control of the money supply, as the private sector continued to innovate and create new money supply sources. 

Far be it that our lowly RIA operation criticizes the FED and it’s decisions.  On the contrary the effects of deflation are far more reaching and serious than low to moderate inflation.  Remember, this is the specter Greenspan faced at the end of 2000 with a recession at hand and markets working through one of the worst corrections, since the 70’s and further back to the grand daddy of 29.  However, if we take a closer look at the last run in 2000, we saw a similar process at its last stages.  It was coined “the wealth effect“.  Are you ready for the scary part?

The key to avoiding deflation, which often leads to an economic depression, is a strong banking system.  Here we will pause just a moment to reach back in recent and not so recent economic history.  One of the main causes with Japans depression (multi year lack of sustained GDP growth), outside of different consumer behavior, was the banking sectors bad debt and corporate lending practices.  If you focus on the Great Depression, one of the main contributors that made the economic collapse so sever where the regional and global bank collapses.  We don’t think this is even close to happening, but it is important to be aware of the critical and central role banks play in the economy.  Luckily, the FED started to police the banks 2 years by advising them to clean up their lending practices and standards.  Additonally, financial innovation has lead to the ability to spread risk across different sector and economies.  This is evident by pension funds, insurance pools, hedge funds and European banks all reporting exposure to the sub-prime collapse.    

Currently, we are starting to see the private capital market shutter.  As they adjust to the current risk building in both domestic and global credit markets, the rate of capital has started to rise.  This coupled with rate increases by  foreign central banks and the end of the housing wealth effect are causing the liquidity tide to go out.  As the US economy slows, the Fed will be forced to cut rates.  It is not a question of if, but when.  The slowing US economy will ripple though the world economy.  However, we do think there are other growth engines at work, which will soften the blow.  As the financial markets adjust to this new landscape, new investment opportunities arise.  Currently, we like high yield corporate debt, large cap growth and broad based international.  We are avoiding small cap and emerging markets.  As they have a tendency to suffer sharp swift corrections, they are being monitored very closely.  It is our belief that the next few months are a great buying opportunity for the long term investor.   
August 5,2007