>The Economy vs The Stock Market

The global financial market rally is now in its 13th month. As we have pointed out repeatedly, it has occurred against an unsettling, uncertain and unbalanced macroeconomic backdrop. There is an array of structural problems that could derail the recovery once momentum from fiscal and monetary stimulus ends. However, slower than expected growth isn’t necessarily a big negative for investment returns. Sustainability, liquidity flows, interest rates and long‐term profit expectations are crucial variables. In this letter we offer a brief review of what we believe will be the weak link in the U.S. recovery and explain how investors should position themselves for it.

Forecasts for the durability of this bull market are wildly divergent, and with good reason. Most signs of recovery are clouded by the influence of government stimulus and reflation efforts. Moreover, year on year comparisons are misleading. Almost anything would look better than the abyss we were in a year ago. However, a common mistake many of the more bearish analysts are guilty of, is the assumption that investment returns are predicated on their near‐term assumptions of the GDP growth rate.

In terms of the negatives, runaway public‐sector deficits and debt growth are the greatest threats, which we will discuss in detail in a coming letter. However, there is likely at least a year or two before this weighs heavily on markets. The reason is that a massive fiscal drag is likely to hit the U.S. and other economies in 2011, in good part from tax increases. While extremely negative from a supply side perspective, it should help cool the angst coming from debt projections at least temporarily. However, the political process is always a wild card when unemployment is high, and it remains to be seen whether the structural deficit will actually shrink on a sustainable basis.

In the U.S., the more immediate threat to the recovery is consumer deleveraging. Housing prices and unemployment have stabilized, but a quick rebound is not in the cards. Years of credit‐fuelled consumption, which was taken to its ultimate stage of excess during the housing bubble, will be a slow and painful process to unwind. There are no shortcuts, and given that domestic consumption is responsible for 70% of economic activity in the U.S., sluggish growth seems inevitable.

Personal consumption expenditures are growing, although only at a 2% rate from last year. Retail sales are up substantially, but must be adjusted for government incentives which have been successful in causing a bulge in current spending, likely at the expense of future consumption. Worryingly, consumer confidence remains low, which is a reflection of weak income growth, high structural unemployment and excessive household debt levels. This is a grim picture particularly if income growth remains anaemic. It is important to keep in mind that the wealthiest 20% of Americans are responsible for 65% of consumption, and that their buying power is more closely correlated with stock market performance than with income.

Recent stock market gains have given this source of consumption a boost, while the lower middle class has had to be more frugal. However, asset‐driven spending is a two‐way street. A sharp break in the stock market and further weakness in housing prices could cause household spending to dry up again. Below, we present some charts that highlight the unbalanced and artificial nature of the recovery.

The case for a weak recovery.....

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