Behind the numbers

According to the report, which is a summary of anecdotal information from each Federal Reserve Bank on its district’s current economic conditions, “economic activity generally continued to expand since the last report,” though it did slow somewhat in four of the 12 districts. In particular, “some slowing in the pace of growth” was noted in the New York, Philadelphia, Atlanta, and Chicago districts. Only Dallas characterized its economy as accelerating, while other districts indicated steady growth.

Other findings of the report were also similarly mixed. Many districts noted that the pace of manufacturing growth slowed and residential real estate markets generally experienced continued weakness, while input prices continued to increase in most districts. In addition, the report noted that while contacts in most districts were generally optimistic about the manufacturing outlook, they were “less so than the last report.”

Still, the report noted that consumer spending was generally slightly up from a year ago and activity in non-financial service sectors continued to strengthen in most districts.

Overall, the report confirms comments from Federal Reserve Chairman Ben S. Bernanke on Tuesday that, as expected by many market watchers, also implied the recovery will be slow and uneven.

Chairman Bernanke’s comments also confirmed that, as expected, there will be no immediate successor to the Fed’s quantitative easing cycle (QE2), the Fed’s asset purchase program scheduled for completion this month. He also said the Fed will maintain the size of its balance sheet and zero-interest-rate policy for an extended period of time.

We believe the most interesting part of Chairman Bernanke’s comments, however, were his statements on the budget. He said that lawmakers should reduce future budget deficits now to enhance long-term economic growth, but noted that they should be careful not to hurt the recovery with “a sharp fiscal consolidation focused on the very near term.”

To us, Chairman Bernanke seemed to be taking a stand against any imminent fiscal austerity. We agree with him that too much austerity too soon will imperil the recovery and that the right way to address the deficit is through addressing the long-term liabilities, i.e. entitlements, that will drive federal spending over the next several decades. To us, a large, near-term tightening in fiscal policy – either through higher taxes or lower transfer payments – will increase the risk of a slide back towards recession.

As for what this all means for investors, slow economic growth is likely to equate with equity and commodity weakness and bond strength, as we pointed out in our most recent Monday Market Calls post earlier this week. In that post, we reiterated our negative view on US Treasuries, but changed our view of emerging market bonds from negative to a neutral stance. Meanwhile, as too much fiscal austerity too soon is a risk for the recovery, mitigating that risk would be a marginal benefit for risky assets like stocks and commodities.