A 3F rated environment Featured

1:55pm EDT December 20, 2011
A 3F rated environment

You may recall that in the Selective Service’s armed forces draft ratings, 4F meant physically unacceptable for military service. I doubt that I would get much argument with my contention that 2011 is finishing up as a 4F year for the economy and investors! In terms of explaining what has happened, I will cut one 'F' from the list and concentrate on 3F’s: fears, fundamentals and feedback loops.

Economic cycles are heavily influenced by business and consumer confidence levels. If my personal situation today is satisfactory and I am confident tomorrow will look pretty much like today, I am more likely to invest and consume. For the business manager, that means investing in buildings, equipment, inventories and employees. For the consumer, that means spending on goods and services. This confidence/optimism (absence of fear) shows up as growth in fundamental measures such as capital investment, industrial production and incomes which are driving factors for GDP growth. As fears abate and fundamentals improve, a positive feedback loop forms and strengthens.

We believed a positive feedback loop was in place a year ago. It wasn’t particularly strong, but it appeared durable. So how did it backslide into this 4F year? A quick review shows a confluence of events beginning with the extremely harsh winter experienced in the Northern Hemisphere that not only truncated the positive loop, but reversed it into a negative feedback loop. Japan’s tsunami/earthquake caused havoc for the just-in-time supply chain; the Arab Spring revolutions caused a spike in energy costs; Europe’s banking system/sovereign debt crisis re-emerged as a threat to the financial system and to European economies; the sharply negative revisions to U.S. GDP revived double-dip recession fears; and confidence was further damaged by the fiasco surrounding the U.S. debt ceiling and the S&P downgrade of U.S. government debt. The sharp selloff and continued extreme volatility in global equity markets since this summer seem to confirm the notion that more trouble lies ahead.

Small wonder that consumers, businesses and investors became fearful! And let’s face it, we’ve already had two experiences in this young century when the wise choice between “fight or flight” was clearly the latter. But what about now — how do we rate the strength of the 3F’s?

We will start with fundamentals. Despite skating even closer to the edge this year than last year, we have avoided falling into a double-dip recession. Although we were concerned to see four of our 10 Recession Checklist Signals toggle on this year, economic data has steadily improved since late summer. Jobs are growing, incomes are growing, debt is falling, industrial production is growing and inventories are lean. Early signs point to a solid Christmas season for retailers. Even housing statistics support a modestly positive perspective.

The composition of Q3 GDP was encouraging, even if the growth rate was only 2.5 percent. The largest contributors to GDP were business and consumer spending and, while inventory reductions hurt Q3 GDP, rebuilding them supports higher production levels to meet pent-up demand. The fundamentals for the financial markets are also moderately positive. Falling inflation and a Fed that is determined to suppress interest rates means bond prices should be stable. Although earnings growth is slowing, it is positive and the S&P 500 p/e ratio is an undemanding 12x 2012 estimates.

Unfortunately, we cannot reject the fears, as the decades of hyper-growth in credit require continued deleveraging in coming years. The global GDP growth rate will continue to be impacted by this trend. The fear of the GDP impact of government austerity and tax increases is very rational. Even when (OK, if) the Europeans give in and emulate the actions of the U.S. (bailouts and quantitative easing), it is not clear they could avoid recession in 2012. As large trading partners for the U.S., this would hurt our fundamentals.

I’ll end this piece by noting that it is difficult (impossible?) to predict the outcome of the fears vs. fundamentals debate for 2012. As to the third 'F,' there seems to be no feedback loop at all currently. We will follow up with further thoughts on this topic as we present our 2012 Economic and Financial Market Outlooks in coming weeks.

The opinions and information contained in this message have been derived from sources believed to be accurate and reliable, but FirstMerit Bank, N.A. makes no representation as to their timeliness or completeness. This message does not constitute individual investment, legal or tax advice. All opinions are reflective of judgments made on the original date of publication and do not constitute a guarantee of present or future financial market conditions.

Have a question about investments or investment services? Contact Bob Leggett, Chief Investment Officer, FirstMerit Wealth Management Services, at robert.leggett@firstmerit.com.