Whether you love them or hate them, Goldman Sachs (NYSE: GS) portfolio managers, traders and advisors are a big part of the market action. So no matter if you think they’re right or wrong it pays to know where they stand. I get their global research reports from time to time. Here’s an excerpt from the views expressed last week to clients by Jan Hatzius, a young German-born economist who is the bank’s chief U.S. economist. I’ve added emphasis in the parts I found the most important:
”The headlines for [recent] first-tier US economic data releases were above expectations. And at least the employment report was genuinely better, with faster than expected private payrolls growth, significant upward revisions to past months, a 0.3% wage gain, and a firm household survey. The trends are still consistent with the gradual slowing in employment and wage income growth implied by our forecast, so the news is far from good in any absolute sense, but at least for now the deterioration in the labor market no longer looks as precipitous as it did after the last report. The somewhat better claims data of the past two weeks send a similar message.”
The ISM picture was much less good, however. Although the manufacturing composite edged up from 55.5 to 56.3, the new orders/inventories gap fell again and taken by itself now points to a composite of clearly below 50 in a few months. Moreover, the non-manufacturing composite dropped sharply, led by new orders, and the all-industry composite showed its largest month-to-month decline since November 2008.”
The numbers over the next few weeks are likely to look decent. That’s partly because of the direct implications of the employment numbers for industrial production and personal income, and partly because the housing indicators are likely to bounce from their extremely depressed current levels, and partly because the bottom-up indications for retail sales — the most important release in the next few weeks — are reasonably firm.”
Overall the news is sufficiently mixed to make a big QE2 [second round of quantitative easing] announcement at the September 21 Fed meeting unlikely. Although we suspect that the Fed will revise down their growth forecasts once more, the size of the revision is unlikely to be large enough to qualify as the ”significant weakening of the outlook” identified by Chairman Bernanke as one key trigger for additional easing in his Jackson Hole speech. (The other was a meaningful drop in inflation and/or inflation expectations.)”
Later this year or early next, however, we do expect a return to unconventional monetary easing. This is because we strongly disagree with the notion that the recent slowdown in activity is a temporary “soft patch” in an otherwise fairly decent recovery, which seems to underlie the Fed’s forecast of a reacceleration in 2011 after a modestly slower period in 2010H2. On the contrary, we believe that the stronger growth of late 2009/early 2010 was a temporary “firm patch” in an otherwise extremely anemic recovery, and there is a sizable (25%-30%) risk of a renewed recession. As this becomes clear, Fed officials are likely to act.”
The most likely policy shift involves purchases of US Treasuries, although changes in the forward-looking language are also a possibility. Ultimately, any new purchases are likely to total at least $1 trillion, though they may start slowly. The advantage of such a policy is that it may be an easier “sell” to skeptical officials, although the risk is that the markets will view it as half-hearted.”
How effective is a return to QE likely to be? The uncertainties are enormous, but [our] analysis of the first round of QE in late 2008/early 2009 concluded that it pushed down 10-year Treasury yields by 25 basis points. … We suspect the next round would be less effective in terms of easing financial conditions, not because of a smaller impact on riskless long rates but because there is much less room for spread compression in the credit markets. … Based on historical linkages, this [could be] worth about half a percentage point on growth. If this is the right order of magnitude, a $1 trillion purchase would not have a dramatic effect on growth, but would not be insignificant either. Of course, Fed officials could buy more and/or supplement the purchases with changes in the Fed statement to reinforce the effect.”
In the run-up to QE2, communications will remain a challenge for the Fed. The problem is twofold. First, the FOMC is far from united, and participants (especially regional bank presidents) who are skeptical of the need for further action will continue to make their views known. This causes confusion in the markets, even if it ultimately has little bearing on the outcome. Second, the leadership wants to signal that more easing is on the table without talking too pessimistically, for fear of “scaring” those market participants who believe that the Fed has a privileged perspective on the fundamental outlook for the economy. ”
Given the range of different opinions and the conflicting objectives, Hatzius sees the risk of further communication hiccups and resulting bouts of bond market volatility is high. And I concur. That doesn’t mean that stocks can’t go higher, only that there will be increased volatility on the way.
For more ideas like this, check out Jon Markman’s Traders Advantage or Strategic Advantage advisory services.
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