No Man Is an Island - 05/06/10

The strong recovery in the U.S. economy is jeopardized by growing nontraditional headwinds.

No man is an Island, entire of itself; every man is a piece of the Continent, a part of the main; if a clod be washed away by the sea, Europe is the less, as well as if a promontory were, as well as if a manor of thy friends or of thine own were; any man's death diminsihes me, because I am involved in Mankind; And therefore never send to know for whom the bell tolls: It tolls for thee.

-- John Donne, "Meditation XVII"

The bulls have argued for a liquidity-driven advance in the world's stock markets and have pointed to a strong cyclical recovery in corporate profits (2010 S&P 500 profits of $85 a share; $93-plus per share in 2011). Bulls have also cited economic traction seen in improving domestic ISMs, rising leading indicators, a recovery in home sales/prices and an increase in hirings as the ticket to higher stock prices.

I have argued differently. I have argued that no man, including the U.S., is an island.

As the events of the past few weeks have suggested, the last cycle's egregious use of debt and credit has a long tail, and while it favors that the monetary spigots will be turned on for some time to come (a market positive), the aftershock of the last cycle will show up here (in the recesses of our municipalities) and over there (in the too- levered countries around the world). The associated austerity measures (a precondition to municipal fiscal stabilization and sovereign rescue packages) in both corners spell risks to U.S. growth as our state and local governments, as well as Greece, Portugal and Spain resemble walking zombies in the years ahead and become headwinds to economic growth.

While the strong debt deflation headwinds (reflected, in part, in a 10-year U.S. note yield of 3.60%) seem ample reason and justification for the Fed's continued monetary ease and provides some support to the market's reasonable valuation, the key issue for investors is no longer whether a zero interest rate policy will be maintained for the balance of the year (producing ever more liquidity) but whether the strong recovery in the domestic economy is jeopardized by the aforementioned and growing nontraditional headwinds.

It's different this time.