2011 growth surprise & 2012 growth bust?

Now that the FOMC meeting and Bernanke's first press conference is over, one of the questions that has been nagging at me is whether the Fed might over-react to the recent bout of economic growth.

More importantly, is the growth self-sustaining?


Cash for clunkers on steroids
I came upon an intriguing point of view from Lombard Street Research (LSR). I have been very impressed by these folks as top-down forecasters for their non-consensus out-of-the-box thinking. The most memorable, for me, was their call after the Tech Bust to watch China as a source of global growth when few forecasters were even thinking about the Middle Kingdom.

In their Review published February 28, 2011, LSR voiced concerns that a provision for 100% deduction of capital spending in 2011 would pull capex forward from 2012 and create the illusion of growth (sort of a cash for clunkers program on steroids). In addition, the corporate cash that would flow into capex in 2011 would reduce liquidity and end the stock market rally [emphasis added]:

[T]he chief danger is a large boost to 2011 business capital spending arising from 100% first-year depreciation this year only, and then, with its end-year withdrawal, a very sharp downswing in 2012. This Review posits the chance that 2% of 2012 GDP could be brought forward into 2011 to gain the tax break, and that its bunching at end-year could boost GDP growth to 7% in 2011 Q4 from 2010 Q4. But the loss of that spending in 2012 would doubly reduce cap-ex next year, maybe causing recession. In addition, the build-up of accelerated cap-ex this summer could remove much of the cash flow surplus that businesses are currently pouring into financial markets, at the same time as the end of QE2 takes away the current $100 billion/ month of Fed inflows. This liquidity squeeze would end the stock market recovery.

This LSR analysis is highly intriguing. Indeed Mr. Market seems to have recognized the capex story. The ratio of Industrial stocks, the sector where most of the capital equipment companies are, are in a well-defined uptrend relative to the market.

What if the Fed overreacts?
What nags at me is the Fed reaction. What if the Fed interprets this growth spurt as a self-sustaining recovery and ends ZIRP prematurely? The resulting tightening effects would start to bite in 2012 and coincide with the capital spending slowdown.


Market volatility ahead
If the capital markets look ahead 6-12 months, it would start to anticipate a growth slowdown starting about 3Q, which is also the timeframe for the end of QE2 and discussions about the end of ZIRP. I am already seeing worrisome negative divergences in the market, which should concern the bulls. My inner trader believes that there is still some limited upside to stocks, which he wants to stick around for. One of the important "tells" would be to watch for a downturn in the relative performance of the Industrials to the market shown in the chart above. My inner investor, on the other hand, is preparing for the storm to come. Its magnitude is unknown because it is highly policy dependent.

Fasten your seat belts!