We’re Back!

Just when it appeared that the economy was strengthening, some old bugaboos from 2008 and 2009 found their way back to the US. The Obama Administration’s home purchase tax credit program ended in April, as did the mini-housing recovery. Once again we have to pay attention to foreclosures and the risk of home prices sliding. Four quarters of small gains in employment came to a halt in May. Even though employment is a lagging indicator — it doesn’t recover until several quarters of economic growth — the end to nascent job gains will hurt still-negative consumer confidence. Indeed, a small boomlet in retail spending by consumers petered out in the Spring. And, recent stock market volatility reminds investors of recent events they would rather forget in 2001 and 2008. Is this time different, or are we destined to relive the bad old times?

This time around, we have one important difference: Europe. The size and impact of huge budget deficits in Europe scare investors — not just declining value of the Euro, which is bad enough — but because it seems that “no one’s in charge.” The lack of political and economic leadership in Europe is appalling and events may turn much worse before any major change. The problem isn’t Greece, Portugal or Spain as much as the lack of preparation by Finance Ministers and the European Central Bank. But — and this is a big but — Europe’s problems will have limited impact on the US. Some US exporters will sell less in Europe, and some US companies with European operations will be affected, but most Americans will so no impact. And, as US stocks have moved in lockstep with the Euro’s value, Europe does seem to be 90% of the problem.

However, the other 10% remains US employment. Why only 10%? Investors seem to have already been prepared for slowing job growth. It was unrealistic to expect the US economy to bounce back sharply, as this was the first recession in 70 years based on excessive debt and lower asset prices. Some of the accumulated debt has been repaid, but continued repayment will pressure consumer spending for at least several more years. And, since consumers normally spend us out of recessions, this pressure will limit the speed of any recovery. A new factor this time is added pressure from state & local government budgets, now being pared back sharply, and a new-found reluctance by Congress to add new stimulus programs due to the size of the Federal deficit. Budget cutting slows economic growth in the near term, even as fiscal discipline is positive in the long run.

As for stocks, the market had been getting expensive and had gotten ahead of itself in March and April. That always seems to be a reason for any selloff. I do not see this as “the big one.” Investors continue to avoid stocks, as they have through the entire 60+% rally from March 2009, so there is limited stock to be “dumped” from frustrated holders. Expectations both for the economy and stocks are limited, so negative surprises may be few. There might well be some near term limited downside — maybe even lasting into the Fall — but widespread investor fear and indifference always seems to eventually result in higher stock prices.

My economic forecast remains largely unchanged from earlier in 2010. Unemployment will remain elevated, and could reach 11% sometime later this year. The overall US economy will shrink 1% in 2010, and perhaps grow 3% in 2011. I had expected inflation to remain at low levels, but with weakness in the US dollar preventing actual deflation. Now, with our dollar a pillar of strength against the weak Euro and Yen, we will likely see lower oil and import prices later this year. This will provide some respite to the consumer, especially at the gas pump. That will be a welcome change in an economic backdrop that otherwise reminds us to much of the last time around.

Christopher H. DeVoe CFA is the Chief Investment Officer of Constellation Asset Management, Inc., an investment advisory firm located in Fayetteville, New York. Mr. DeVoe can be reached at (315) 449-1820.