This week we have seen a lot of conflicting stories on the economy: worries about an oil shock leading to a double dip recession and more deflation, a surprise increase in the Producer Price Index but only a slight increase in the Consumer Price Index. Unemployment claims went up, while retail sales were down while the Wall Street Journal says they went up. We examine what these could all mean this year, as my Muddle Through scenario faces some stiff winds. We also look at the long term implications of a recent study on healthcare costs in the US. For my large and growing international readership, this has implications for you as well.
I read about 200 (more or less) articles, e-letters, reports, magazines, newspapers, etc. each week. When I sit down to write on Friday around noon or so, I generally write about a theme that strikes me as something that can help us discern the ongoing puzzle of the direction of the economy, and perhaps suggest some investment themes. I generally try to think about where the economy is headed over the coming years, and rarely on the immediate future. My business is researching investment managers and funds, and not writing. I try to think about how different styles of investing will do, given my view of the economy, and then make investment or consulting suggestions accordingly. Writing this letter is a discipline I use to make me focus on the larger picture. That is why this letter is free.
This week more than the usual number of articles about healthcare crossed my desk, and then the Centers for Medicare and Medicaid Services (CMS) released a study this week that forecasts the costs of health care over the next 10 years. I will provide the links later, but I think we need to examine some of the implications of this study.
In the US in 2002, we spent $5,427 per person on healthcare, almost exactly double of what we spent in 1990. CMS projections estimate that we will spend $9,972 in 2012. Within another year or so after that, our medical bill will have doubled from what they are today. Keep in mind, the Baby Boom did not really get started until 1947, so these costs do not begin to reflect the potentially accelerating rise in costs after 2012 as my generation gets older and begins to need ever more medical care.
In 1990, we spent 12 % of our gross domestic product on health care. Today, that has risen to 14.8% and is projected to rise to 17.8% in 2012. Put another way, that is 3% of our economy or $500 Billion in 2012, that will not be spent on imported goods, cars, etc. Yes, that will pay the salaries of a number of people who will buy those products, but this still represents a huge shift in buying "preferences." It will not happen all at once, but the decade long shift in buying patterns will present significant challenges for many consumer sales products.
The percentage of GDP may be understated, as the CMS uses a higher estimate of US economic growth than I would, and assumes we will have no recessions in the next ten years, which is highly unlikely. However, a recession would do little to slow down the rise in health care costs. They rose 8.7% in 2001, as an example. Also, the CMS assumes that health care expenditures will rise slower in the coming decade than they have the past three years, something they attribute to slower rates of growth in disposable personal income, medical price inflation, and Medicare spending.
In 2001 and in 2002, health-insurance costs were listed as the biggest barrier to adding workers in a poll of 120 chief executives of very large companies by the Conference Board. Almost 82% of 1,017 members surveyed by the Connecticut Business and Industry Association last year said rising health insurance costs were "an important factor" in decisions about whether to hire new workers. Poll after survey shows that small businesses, which typically provide the bulk of new employment in the aftermath of a recession, are increasingly seeing health care as a reason to not hire, or are laying off workers as a result of higher health care costs.
Take an Aspirin and Call Me in the Morning
Think about what this means to the proverbial middle class family of four, making $50,000 today. Today, the total company cost of their insurance is roughly $6,000 or about 12% of their income (using my firm's cost as a rough guideline.) Let's say their salary is going to grow by about 2-3% per year over the next ten years, to about $65,000. Their insurance costs are going to double to about 18% of their income or they are going to have significantly less insurance. Can business absorb $500 billion a year in increased costs? Not without serious impact upon their profits.
Hewitt Associates projects that the average cost for employee health insurance will be $5,134, up 70% just since 1998. Costs rose 14% last year, and will rise by double digits this year. What workers pay will rise even more. Projections are that employee out of pocket expenses will rise by almost 25%, as employers shift part of the rising expenses to employees.
Who Really Owns GM and Ford?
Let's look at how health care costs affects one particular industry. Today, the Big Three auto makers spend roughly $1,200 per vehicle on health care, according to this week's Fortune. Goldman Sachs estimates that the healthcare liabilities are $92 billion for just the three Detroit automakers, roughly 50% greater than their combined market capitalizations. This is three times their unfunded pension liabilities, if you allow them to project 9% stock market returns on their portfolios. A real world analysis would paint a much darker picture.
There are several scenarios for the car-makers, none of them appealing. They could let the health care costs double as a portion of their price. This puts them at significant disadvantage to foreign firms which have established US plants and do not yet have huge numbers of retirees. That means they will have difficulty raising prices to cover the increase in costs, which of course hurts their profits and will result in lower stock prices.
They could pass on more of the costs to employees. That means big fights with their unions, strikes and lost profits (lower stock price). If they honor their commitments, it means less profit and a reduced stock price. As I wrote last year, the effective owners of GM, Ford, et al may be their workers and retirees, or else there will be a massive restructuring of liabilities. Think about the steel industry as an example.
This is an industry I do not want to have in my investment portfolio, and ironically the reason has nothing to do with the quality of their products or service. It is the real uncertainty surrounding their health care and pension liabilities.
What about federal and state expenditures? Of course, their costs double, rising from $700 billion to $1.4 trillion! Federal government costs will rise by almost $500 billion ANNUALLY. That is without any increase in Medicare coverage, a prescription drug program, etc. With 41,000,000 Americans uncovered by health insurance, a growing cohort of retirees who want (and will get) a federally subsidized prescription health care plan, the probability is high that health care costs will rise even more than these projections.
Could things be improved? Of course. Simply passing tort reform will reduce health care costs by about 4% a year. Could we hammer out some increased efficiencies in the system? Sure.
But the main driver behind rising costs is simply the availability of new and better processes, drugs and equipment. Two weeks ago, I was operated on using equipment and procedures that did not exist ten years ago. Did it cost more than the old-fashioned system? You bet, but the cure rate is significantly higher, the procedure was less painful and the results were far more certain. I was offered the choice for the old procedure. I opted for new, better and more expensive.
The point is that costs are going to rise dramatically, no matter how we end up paying for them. This is going to shift consumer spending habits in ways we do not yet understand.
(I do not have time to go into what the study says about the impact of all this on the income of doctors, but it is not pretty.)
You can see the projections, and a whole lot more, at: http://cms.hhs.gov/statistics/nhe/projections-2002/.
This helps set the stage for why I believe earnings are going to be under pressure for quite some time. Yesterday we were told that the Producer Price Index rose 1.9% in January, yet today we find that the Consumer Price Index rose a mere 0.3%, and without energy costs rose only 0.1%. So which is it? Is inflation set to come roaring back, or should we fear deflation?
Oil Shocks and Deflation
One of the economists who I read each week, without fail, is Stephen Roach of Morgan Stanley. I don't always agree, but I always read. This week he reminds us that we are just one recession away from outright deflation. He lays out the case for a deflationary period that would come from a global recession. He closes by saying:
"...it would now take a fairly vigorous recovery in the global economy -- several years of world GDP increasing in excess of 4% -- to tilt the business cycle away from deflation. Yet precisely the opposite now seems to be in the cards. Courtesy of a full-blown oil shock, the world is now flirting with yet another recession. Crude oil prices (as measured on a West Texas Intermediate basis) are now around $37 per barrel. Not only does that represent an 87% increase from levels prevailing at the start of 2002 (an average of $19.69 in January 2002), but today's prices ($36.79 as of the close on 20 February) are nearly identical with the highs hit on 20 September 2000 ($37.20) that played a key role in triggering the recession of 2001. Unfortunately, oil shocks and recessions go hand in hand. That was not just the case in 2001 but also the outcome in the aftermath of the first OPEC shock of late 1973, as well as the result of the spike associated with the Iranian Revolution in 1979. And, of course, the same was the case following the sharp run-up in oil prices leading up to the Gulf War. In other words, show me an oil shock and I'll show you a recession. It's hard to believe that the current oil shock will be the one exception.
"...Therein lies the risk. In my view, it was the widening of the global output gap in 2001-02 for a low-inflation world economy that led to the subsequent lack of pricing leverage and the close brush with deflation. And now -- courtesy of another oil shock -- that global output gap is set for a sharp further widening. As I see it, that can only intensify the lack of pricing leverage, taking the world all the closer to the brink of outright deflation. In other words, the current oil shock should not be interpreted as an inflationary event along the lines of the outcomes of the 1970s. It is, by contrast, very much a deflationary shock. Prior to this oil shock, I would have depicted the world economy as being only one recession away from deflation. To the extent that recession may now be in the offing, the case for deflation actually looks more compelling than ever."
The commodity price index is up. The producer price index is up. Higher oil prices are partly responsible -- but not completely. Commodity prices from cotton to cocoa to steel scrap have been jumping. The Economist's commodity price index, which excludes energy and precious metal prices, has risen 16.8% in the past year. (CNN)
But prices that businesses can charge are not up. Think about how airlines are getting hit with higher fuel costs but so far have not been able to increase fares, they actually dropped 0.6% in January. Autos are 2.1% cheaper this January than they were a year ago. (Bloomberg)
Many industries have not been able to pass through their increased costs, like health care, the subject that began this letter.
Inflation and Deficits as Far As Kashdan Can See
Andrew Kashdan at Apogee (among many others) argues forcefully for a return to inflation. How could huge government deficits and a Fed committed to print money, along with a dropping dollar, yield any other result?
"Inflation seems like the only way out for a government beset by burgeoning deficits. With the current deficit likely to be just the beginning of a trend, those hard-working public servants in Washington simply don't have a lot of good alternatives to printing more money."
He then says "...economist Hal Varian, writing in The New York Times, quotes a study co-authored by a Berkeley economist that uses somewhat more realistic assumptions than those embraced by the CBO -- for instance, spending growth that is in line with GDP, the extension of current tax cuts when they expire, a fix for the alternative minimum tax problem and the inclusion of Social Security and Medicare obligations that are bound to explode once the first baby boomers begin to retire in the next few years. As you might imagine, we're talking real money here. A $1 trillion surplus over the next 10 years morphs into a deficit of $5.4 trillion. Oops!
"Varian is forced to concede the likely outcome: "Inflation is all too tempting as an 'easy' way to avoid the political pain associated with tax increases or budget cuts." Greasing the inflationary skids may be easy, but we vaguely recall something about the nonexistence of free lunches.
So, who's right? I think both may be, but not of course at the same time. And maybe not just yet.
As bad as everything sounds, there are a number of good things happening. Industrial production is up. The Leading Economic Indicators suggest growth. Unemployment dropped last month to 5.7%. Profits, while less than forecast only a few months ago, are still rising, if slowly. The train has not jumped the tracks. We are continuing to Muddle Through.
The risk, as Roach clearly states, is that oil prices stay high, bringing on a global recession. Oil prices are hostage to Iraq, Venezuela and now a high intensity strike in Nigeria. How long can we go with high oil prices before they push the US and the world into a recession? No one really knows. But certainly not a year. Probably not even a few quarters.
Rising oil prices act like a tax hike, and have come at a very bad time. Rising state and local taxes sap the economy as well. Will we get a federal tax cut giving us some needed stimulus in the short-term to off-set these forces?
If we go into Iraq, or more happily Hussein is forced out and the oil fields stay intact, and if the US can then get the opposing parties in Nigeria and the rest of the world to increase production, there is the real chance we could Muddle Through for the rest of the year.
Continuing high oil prices, or even worse, a further increase in price due to a series of negative events (Hussein blowing up his oil fields, Nigeria disintegrating, Venezuela not coming back as it should, etc.) could bring us to recession. This would bring out the deflationary pressure in full force. The Fed has told us clearly they will not allow deflation. They know where the printing press is, we are told, even though lately it looks like they have lost the key to the press room.
A recession could then bring an initial bout of deflation and then morph into inflation, which would look like stagflation.
The Fed and the government hope to avoid this scenario. Their hope is that we can grow our way out of our debt problems and the trade deficit. The hope is that the Iraqi problem can be resolved quickly and that world oil prices will come back down even more quickly. With the "uncertainty" due to Iraq out of the way, business can once again begin to plan and grow. It could happen.
All of the above is why my investment theme for this year has been "surprise and transition." I continue to "think" that we will Muddle Through. I am one of those who optimistically, and perhaps with some unrealistic expectations, think the war in Iraq will be short and successful. It must be for us to Muddle Through. But I recognize that any of several events could surprise and lead to a recession later this year.
If I am right about a short war, with massive Iraqui defections and hopefully no mass destruction of oil production, you could see a massive short-covering rally in the markets. If I am wrong, the market will head south faster than you can say "I told you so."
Greenspan is Gone
It is becoming increasingly clear that Greenspan is not interested in being re-appointed Fed Chairman next year. The Bank of Japan will appoint a new Chairman next month. These new faces, whoever they may be, will have a significant impact upon the future of the world economy. The uncertainty about the future of the Fed will create more uncertainty in the markets, especially as we get closer to Greenspan's retirement. Before this becomes a real issue, which it well could, I hope he does the right thing and resigns, or Bush announces his new chairman well in advance. Greenspan has had a long tenure. He should exit before his presence becomes an issue.
The Huge Response to My Article on France and Germany
The response to last week's comments on France and Germany was simply overwhelming, and a little unsettling. The comments from the US were by and large very favorable and those from my European readers (while mostly quite polite) simply suggested I don't get it. It was like reading letters from two different planets. As I read articles from over a dozen international papers each week in preparation for this letter, the increased polarization I see concerns me.
I am not quite sure what to make of it all, so will think for some time before I make any comments about potential economic effects from all the tension. I will note, however, that the polarization and viewpoints expressed sometimes border on the theological in intensity and character: beliefs interpreting and selecting the facts, rather than facts giving rise to a logical conclusion. That does not bode well for those who hope for a more common ground solution to the world's problem.
Chirac and Saddam Hussein
Several readers either emailed me or faxed me the following item from www.stratfor.com. Stratfor is one of the premier and most respected of global intelligence services. They report on a history of a very close personal relationship between Chirac and Hussein as possibly contributing to Chirac's stance: read it for yourself at: http://www.stratfor.com/promo/Story.neo?site=usiraq&s=210275&promo=1.
(Since the link says promo I am assuming it is free. They charge modest prices ($50) for their excellent services, and for global political junkies is well worth the price.)
There was so much this week I couldn't get to, but the letter is long enough, and it is getting late. I will note that I have stopped researching new material for my book-in-progress - Absolute Returns - and started to concentrate on writing. I hope to be finished by May.
As noted, the response from last week was huge. I normally like to answer some letters, but simply could not this week. I did read them all, and saved the critical letters to read again and think through. Most of them were quite thoughtful. A few were simply absurd, bordering on idiotic. Apparently, Hitler and World War 2 were a Jewish plot to create Israel and the events of 9/11 were part of the Zionist conspiracy. There are some REALLY confused (mother said be nice) people in this world.
My bride took my oldest daughter away for the weekend, and I predict that there are action movies and lots of meat with my son in my immediate future. You be sure and have a good week as well. I remind clients and prospective clients in Florida I will be in Delray Beach May 7-9 if you would like to meet. Reply to this email with your contact numbers or call my office at 800-829-2773 to arrange for a meeting.
Your really wanting to be finished with his book analyst,