August 1, 2003
It All Comes Back To Bonds
By Brady Willett & Todd Alway

Backed by the strongest jump in federal defense spending since the Korean War, U.S. GDP increased by 2.4% in the second quarter of 2003. The initial GDP estimates from the BEA may prove to be off the mark in future revisions.  Nevertheless, the headline number was significantly better than expected, and helped spark a stock market rally early in yesterday’s session.

Also out yesterday was weekly jobless claims (which remained below 400K for the second week in a row), and a better than expected reading in manufacturing (ISM).  When combined with the GDP results, this economic news suggests than an economic rebound is at hand.  However, in the background -- growing increasingly ominous by the day -- sits the bond market debacle...

GDP Internals Do Not Foretell Future

Backed by a 22.6% rise in durable goods purchases, consumer spending logged a 3.3% increase in 2Q03 versus only a 2% increase in 1Q03. Given that President Bush’s tax cuts are expected to give the consumer some extra money to throw around in the coming weeks, many economists (especially those raising their GDP estimates yesterday) expect the consumer to continue spending strongly in 3Q03 and 4Q03. However, with mortgage rates trending higher, the upcoming shortfall in refi activity adds a considerable amount of haze to this forecast. 

Real nonresidential fixed investment (aka ‘Business Investment’) increased by 6.9% in 2Q03 versus a 4.4% decline in 1Q03. While this resurgence in business spending could mark the beginning of an uptrend, it is worth remembering that the cost of capital for many businesses (again, trending higher with long-term interest rates) has increased sharply since mid-June. Is better than expected GDP and an improvement in consumer spending enough to compel businesses to increase spending?   Probably not. The GDP price deflator – which rose by 1% versus a 2.4% increase in 1Q03 – still suggests that deflation (and/or rates of profitability) is a threat.

In short, investors were able to completely ignore all the ‘worse than expected’ economic statistics from March-June because these statistics were not ‘forward looking’.  Thus, it is nonsensical to argue that a dated GDP report is everything stocks need to mark the beginnings of another rally. Those that herald 2Q03 GDP as a turning point for the markets should remember this.  They should also remember that if you exclude defense spending, GDP was up a mere 0.7% in 2Q03.

No Bombs in Beijing

When Saddam was an ally the United States awarded him with weapons of mass destruction in order to fight Iran. However, and as was the case with Bin Laden, a U.S. puppet quickly morphed into a madman when his interests became disjointed to that of the United States.

When China was ‘exporting deflation’ into the U.S. during the 1990s, the communist country was awarded entry into the WTO.  However, and as the U.S. consumer loses its ability to keep the U.S. economy humming and deflation beckons, a once amicable currency/trade relationship is becoming a growing menace.

Obviously the Saddam, Bin Laden, China situations cannot be fully comprehended using the above points of view alone.  However, what vacillating U.S. support for these regimes indicates is that the U.S., like every nation, is looking out for their own interests: the U.S. is willing to help ruthless leaders, and trade with those that have deplorable human rights records because the U.S. is likely to benefit by doing so. 

In the case of China, if the U.S. economy was growing strongly enough (where inflation was thought to be more of a threat than deflation), few policy makers would be voicing concerns about the price of the Chinese Yuan today. However, since China is growing rapidly while the global economy is suffering through a period of anemic growth, the ‘China must revalue’ argument is picking up steam. 

China, unlike Saddam and Bin Laden, isn’t an enemy of the U.S. Rather, by keeping its currency pegged to dollar China is simply looking out for their own interests inside of a supposedly ‘free enterprise/global economy’.  With Japan spending more than 9 trillion yen during the first half of 2003 manipulating currency prices, and the U.S. using rhetoric and, at times, manipulative schemes to determine the price of the dollar, the argument that China should allow its currency to ‘freely float’ is somewhat ridiculous. It is kind of like telling a puppet master to stop pulling strings and start pushing levers because the latter is more conventional, forgetting that each action is undertaken with the explicit purpose of manipulation.

In sum, the U.S. is gathering allies to pressure China to revalue. However, if you want to know why the U.S. has yet to drop anything but rhetorical bombs look no further than the fact that China is the second largest holder of U.S. Treasury debt -- this is more ammunition than Saddam and Bin Laden ever possessed…it all comes back to bonds.

 

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