No sooner is my Muddle Through 2003 forecast out, than we get a barrage of data which gives cause for concern. Can we still Muddle Through with an increase in taxes (you read that right!), higher oil prices, more medical costs, and a slowing world economy? Is the Fed actually winning the War Against Deflation? We look at all that today, plus I answer a few critics of my forecast.
Who Turned Off the Printing Press?
Last November 21 we were promised by Federal Reserve Board governor Ben Bernanke that the Fed had the problem of possible deflation well in hand. They knew its causes, had the keys to the printing press and were prepared to use it should deflation actually become a problem. More than one analyst has assumed that inflation should now be our concern, as the Fed has committed us to that path. After all, if you can't trust a central bank to destroy a currency when they set their minds to it, who can you trust?
As noted last week, I am not as convinced as some of my more illustrious fellow analysts that the Fed can so easily deal with deflation. Understand, it is not whether they can ultimately win (they can), but whether the intervening period is as smooth a transition to inflation that the large majority imagine.
Let's look at where we are today, and what gives me cause for concern. The Producer Price Index for 2002 was a negative number for the first time since the data began to be collected since 1974. "On a year-to-year basis, core PPI was down 0.4% in December, the lowest calendar year reading in the nearly 30-year history of the data, reflecting mild deflation in underlying goods prices," said David Greenlaw, chief economist at Morgan Stanley in New York. (National Post)
The Consumer Price Index rose a mere 0.1% for a second month in a row. The core rose 1.9 % in 2002, the smallest increase in three years. The economy probably slowed in the fourth quarter to a 1.4% annual rate. This is holding down price inflation because companies have little room to raise prices.
Greenspan spoke last quarter of the economy being in a "soft patch." This was born out yesterday when the Fed released its monthly Beige Book analysis of the economy. The actual report is certainly not upbeat. "Most districts characterized growth as 'sluggish' or economic activity as 'soft' or 'subdued,' " the Fed said in its latest regional economic survey known as the beige book. "Reports on consumer spending were consistently weak, with disappointing holiday sales." (Bloomberg) Nevertheless, the Fed projects the economy to grow at 3% this year.
Art Cashin (of CNBC fame) writes me that he finds it very interesting to look at the contrast between the very positive speeches of the various Fed governors and the actual wording of the Federal Reserve beige book and the minutes of the Fed meetings. There is a significant disconnect.
Let's look quickly at some of the latest pieces of the puzzle: Capacity utilization, one of my Three Amigos, dropped again today. "The Federal Reserve said manufacturers use 75.5% of capacity, well below the average of 80.9 % in 1967-2001. Even during the 1990-91 recession, factories used 77% of capacity to produce goods." (Arizona Republic) This translates into no ability to raise prices. When you couple that with commodity price increases, it means reduced profits for lots of companies, unless they cut jobs and other expenses. Not a pretty picture for the economy. This is a prescription for a continuation of the jobless, profitless recovery.
Industrial production fell 0.2% last month after rising 0.1% in November. This was surprising as the ISM number (an independent measure of economic business activity) was up rather nicely in December. This causes me to suspect one of these numbers. It will be interesting to see next month whether one or the other (or both) come back toward each other.
The University of Michigan U.S. consumer confidence survey "unexpectedly" fell in January for the first time in three months. The university's sentiment index dropped to 83.7 from 86.7 in December. I am not so sure why we can call this a surprise. We find 101,000 less jobs in December, a looming war, and poor Christmas sales. That is not the backdrop for a rise in confidence. But the real kick in the confidence pants is the lack of confidence that a stimulus package will get through congress, with local headlines trumpeting tax increases (see more below).
Same Song, Second Verse
All of this suggests a continuation of a sluggish, Muddle Through Economy. None of this makes me think there is any reason to change that forecast this early in the game. Much of the last quarter of 2001 was just as ugly, and we worked our way through a year long soft patch. There are a lot of positive factors in the way of restructuring that has happened within businesses in the last year.
What does worry me then?
I was very clear (at least I hoped I was) that my belief in a Muddle Through Economy depends upon the short term stimulus from the Fed, the federal government and hopefully a drop in oil prices after the Iraqi crisis. I feel that these should combine to buy us one more year of Muddle Through.
Without this stimulus, it is my belief that we could/will slip into recession in the second half of this year. We are not that far away. Muddle Through does not provide a lot of cushion.
Given the rather somber character of the numbers and Federal Reserve reports mentioned above, I decided to go look at how the War Against Deflation was coming at the Fed. Since Bernanke said he knew where the keys to the printing press were located, I thought perhaps we would start seeing some real high-powered money coming into the system.
Maybe they do know where the keys are, but a look at the numbers says they have run out of ink, or at least electrons. Greenspan keeps telling us productivity is up, and this is the reason to be optimistic, but money supply productivity is not up. Maybe the staff had a few extra holidays. Let's look at the numbers.
Money supply is typically measured by a series of statistics called M-1, MZM, M-2 and M-3. Each statistic adds yet another element of money. M-1 is basically cash and demand deposits at banks. M-3 is the broadest measure, and includes time and savings deposits at institutions, money markets, overnight and term euros, repos, IRAs at commercial banks, etc.
M-1 has not grown since the end of July. M-2 is up a miserly 0.3% since November 1, or roughly an annualized 1.2%. Even Nobel laureate Milton Friedman said the Fed should stop manipulating the money supply and simply grow it at 2.5%. M-3 is flat since about the time of Bernanke's speech.
Friedman tells us that inflation is an increase in the money supply. Others talk about inflation/deflation in terms of consumer prices. I have written at length about this in the past, and will not labor the fine details here. The point is that the money supply is not growing of late and at a time when deflation is still knocking at the door.
Although the actual dollar creation at the Fed has been flat recently, in December it was up significantly. What is happening then? Why no gradual increase in the money supply? (I invite you to go to www.stlouisfed.org, click on the Fred database and look at the monetary databases and their components, as well as commercial banking data.)
We have watched commercial and industrial bank lending drop over 20% at large banks and over 10% at all banks since the beginning of 2001, and this steady drop shows no sign of stopping. It is a combination of tighter lending requirements and businesses simply not wishing to borrow.
Lending to individuals has been growing at a steady pace over the past few years, even during the recession which was unusual. The exception was for real estate lending, which is exploding. But total lending to individuals has gone flat in the last few months. Small time deposits are down, as well as retail money funds. This is not too surprising, as they now pay next to nothing. But it suggest the possibility that consumers might not be responding to Fed stimulus and might be paying down debt, or at least not incurring any more.
There is a concept called the velocity of money. Basically, it has to do with how many times the "same" dollar is spent in a given time period. If I spend a dollar with you and you turn around and give it to Bill and he then spends it with Susan, the dollar has changed hands four times. It is important to economists to know how fast this takes place.
Similarly, when a bank loans me $100 and I spend $90 and you spend $81, that puts more money in circulation. Each dollar deposited at a bank allows for more loans to be made and more money to go into the money supply. The faster these dollars move, the more active and growing the economy.
The velocity of money can both affect inflation and be an indicator. I countries where inflation is large, people rush to buy something or invest the cash. In high inflation cash is trash. It is the opposite in deflation.
The concern among some observers is what happens if the Fed leads the economic horse to drink, but the horse isn't thirsty? What if the consumer joins business and starts to borrow less, or spend money more slowly? What if the Fed creates money but other parts of the money supply chain slow down?
The last few months worth of data makes me wonder.
Let's be very clear about something. In Bernanke's now famous speech (which I bet he wish he had not made), he was talking to economists about the hypothetical means to deal with inflation. He certainly was not implying that any of these methods were getting ready to be rolled out.
Let me make two observations: first, an economy in which the Fed felt compelled to move out the yield curve and buy longer term treasury notes in order to increase the money supply and lower rates to provide stimulus will not be a pretty economy.
Secondly, it will probably be one in which the economy is already in or very close to recession. The moves described by Bernanke are fourth quarter, we are down by two touchdowns and our game plan is not working type of moves. The Fed taking such actions would be a signal to the markets that the economy was very weak. It is not clear whether the markets would react positively to a Fed getting with the program or negatively with a realization things must be very bad.
Michael Lewis of HCM reminded me of the following important observation by the famous economist Hyman Minsky in 1984:
"We now have an inflation-prone system in which conventional steps to contain inflation tend to trigger a debt deflation process, which unless it is aborted will lead to a deep depression."
I think the Fed will be reluctant to take any of the moves described in Bernanke's speech because they will worry about unintended consequences. It is not clear the market will rejoice at such moves, because the consequences down the road could be serious. As I have written before, a logical outcome of most of the proposed actions is stagflation. But when push comes to shove, they will be forced to act, because they believe, as do most observers, that Minsky is right. They would rather see stagflation than a depression.
(He is also the economist who told us that economic stability leads to excess and then recessions. Long periods of stability eventually lead to irrational exuberance and bubbles which lead to crashes. He was right.)
And that is why I am not convinced that interest rates are at their bottom. They well could be. Things could be better than I think, and a turn-around could already be on its way. But I want to see some evidence that the War Against Deflation is progressing as planned.
Deflation is not some weak sister dictator like Saddam Hussein against an overwhelming US Army, with more power than the world has ever seen. It is a powerful, vicious force that is enveloping much of the rest of the world. They are deporting their deflation to us. It is not clear that the Fed's printing press is as effective as a cruise missile.
The drop in the dollar I predict could be a help to a Fed bent on beating deflation, as it makes for higher prices in the US. But it is a two-sided coin. It could mean foreign investors pulling dollars from the US, thus putting upward pressure on interest rates and a slowing of a fragile economy.
A slowing economy which turns into recession at this point is clearly deflationary. As I said last week, we will see if the Fed can put their printing press where their mouth is during the next recession. That is when I will be convinced interest rates will rise permanently.
So, the data of the last few weeks, plus the concerns about money supply growth, suggest that it might take a little more effort on the part of the Fed to stimulate the economy to keep us in our Muddle Through world. We will be watching and report back to you.
Your Taxes Will (probably) Increase
The Center on Budget and Policy Priorities did a study on the budget difficulties of 40 states. They found in December there is a deficit for these states for the next fiscal year approaching $85 billion. When you look at the individual states you find the headlines say it is much more. The study shows Illinois with a deficit of $2.7 billion. The governor today said it would be $4.8. They show Texas at $8 billion. I have it from close sources that it will be over $12. California is listed at $25 billion. The Governor says it is $36 billion, although optimists suggest it is a mere $26 billion. (http://www.cbpp.org/12-23-02sfp.htm)
In short, the total deficits for states could well be over $100 billion. Looked at your city and county budgets lately? These are also seriously short. I can find no estimate but it will be in the tens of billions.
The cities and states will make up the difference by cutting expenses and raising taxes. Even in Texas, where the Republicans control both houses and the governor's office for the first time, and ran on a no tax increase platform, my side bet is that we raise taxes. The deficit is now 140% larger than thought publicly just three months ago. By some accounts, you would have to cut 40% of all discretionary spending in Texas to avoid new taxes. By that I mean education and a lot of services most Texans consider vital. Republicans in Texas will be like the dog that caught the car. What they do with it is the question.
This scenario is played out all over the country. Increasing taxes does the opposite of stimulating the economy. Reducing actual expenditures also slows the economy down in the short run.
Whatever stimulus we get from the federal government, it falls far short of any the effects of tax increases and spending cuts by the states. The best we can hope for is an offset of the two. But if congress delays it will have a serious impact on the economy.
Bush recognizes this, and will put his reputation and full power in order to get a significant stimulus package through the congress as soon as possible. If it is delayed, it will seriously jeopardize his re-election chances.
Iraq and the Hidden Oil Tax
Finally, we come to Iraq and oil. I am starting to read reports from serious analysts that oil could easily go to $40 or more if a problem develops in Iraq and does not get resolved in Venezuela. Some say it could rise to $50 in the short term. I think their analysis has some credence. In the long run, oil will come down significantly. But it is the short run that could affect the economy.
Venezuela is the fifth largest producer of oil. Some are beginning to compare the "revolution" there with the overthrow of the shah in Iran. After the shah left, oil production dropped by two-thirds, and is still only 50% of what is was. Revolutions can and will cause serious economic disruption. The proposals by Chavez to re-organize their oil companies to punish his foes and favor his left-wing cronies are a disaster for oil production. The longer this goes on, the more concerned we should get.
A serious increase in the price of oil acts like a tax increase on the economy. It will slow down not only the US, but the economy of the world. It is a serious drag on world growth. While we will see OPEC and other oil producing countries step up production, filling in for a lost Iraq (if Saddam trashes his oil filed as he leaves) and a reduced Venezuela will not happen overnight.
All these factors weigh an economy down.
I believe the flat growth in the money supply is probably temporary. There have been such periods before, although not accompanied by a clear softening of consumer spending and debt. I am betting we will get a stimulus package from the federal government sooner rather than later. The probability is that the crisis in Venezuela gets resolved and Iraqi oil fields are not allowed to be destroyed.
The best outcome for the economy is for Saddam to leave, avoid an expensive war and leave the oil fields intact and even see them allowed to increase production. We need to see a resolution to the crisis in Venezuela. The worst case is that the oil fields get destroyed as Saddam assumes a Samson complex and pulls the walls down with him, while Venezuela deteriorates.
If the worst case Iraq scenario happens, the Fed will find the keys and open the door to the printing press. Just as the stimulus from the last rate cuts made the recession far less severe than it could have been, the Fed will attempt to forestall or lessen the next one. But the damage will have been done, and the stock market will not act kindly.
John, You are a Wimp
The primary reason I write these weekly essays is it forces me to think through the implications of the scores, if not hundreds of articles, reports, essays, chapters, books reports and so on I read each week. It helps me think about what types of investments and funds I want to suggest to clients.
Last week, I outlined why we could get a significant rally in the market, and this week suggest the opposite could happen. That is why I continue to think your investment strategy should not be a short term one-way directional play on the stock market, either up or down. I did not make a prediction for the stock market this year, although I predicted everything else. There were a few who wrote (and a lot of you thought) I was a wimp and simply copped out.
While I said the general trend is down to flat over the next decade, I admitted to not knowing where we would be at the end of the year. That is because there are simply so many variables which have nothing to do with actual stock values as we come to the beginning of the year.
I read a lot of market analysts I respect. There seems to be some consensus that if the Dow moves down below an average of 8250 or thereabouts, we could test the lows of last year. If we move above 8900 (some say 9000) we could have a nice run. We are close to both. What would happen if within the next few weeks Saddam leaves (as rumored) and it becomes obvious Bush's tax cut will pass? What if the war is a real problem, and the tax cut is stalled in endless Senate filibusters?
Graham tells us the market is a voting machine in the short term and a weighing machine in the long run. Could we see a (psychological) relief rally combined with a short covering rally that could be quite strong? You bet. Will it be a return of the bull? No, it will be just another bear market rally. But that is why a prediction of where the market will be is more of an analysis of psychology and less of actual statistics.
As Bill Bonner says, the market "ought" to go down, as it is over-valued. I agree whole-heartedly. But sometimes the length of time between "ought" and "does" can be quite long, and the emotional response of an illogical market not doing what it "ought" can be frustrating to those like you and I who are coldly logical in our investment strategy.
Over the next few weeks, I will make some specific suggestions of investments, funds, managers and programs that are available to the average investor which have the potential for gains in the types of markets in which we find ourselves.
Palm Beach and a Debate on Hedge Funds
Next weekend, I leave for Palm Beach Gardens where I will speak at the Global Alternative Investment Management conference (Jan. 26-29). This is primarily a conference about hedge funds and private offerings.
Last year I delivered the keynote luncheon address, where I suggested that Modern Portfolio Theory is not practical for the individual investor, and the investment industry should stop using this high sounding theory as an excuse for mediocrity and to keep investors locked into poorly performing assets (contrary to my current reputation as a wimp). While the response was generally good, there were some who did not appreciate my rather blunt observations about industry ethics. Generally, they were people employed by those I criticized.
This year, the conference organizers have invited Dr. Harry Markowitz, the economist who won the Nobel Prize for developing Modern Portfolio Theory. I shall listen humbly.
I speak the next day, but on a far different topic: we debate the regulation of hedge funds and whether they should be available to the public. Long time readers know clearly where I stand. Not allowing investors to choose among the hedge funds of which the rich avail themselves is the last bastion of political incorrectness in this country.
If I were to suggest that women should not be allowed to invest in hedge funds, the picket line, if not mobs, would be at my door. I would be accused of blatant and crass discrimination. But the line is now drawn between rich and poor. The average investor can invest in stocks like Enron, mutual funds like Janus 20, options, futures, Amazon and Cisco and a thousand other businesses in which they have no real information and which are clearly risky. But they are prevented from investing in hedge funds and private offerings.
However, the rich and large institutions are pouring large sums into these funds. Presumably, they think there is value somewhere in these investments. I believe if an investor, no matter his net worth, can decide on which stock or mutual fund to buy, then he should be allowed to make up his own mind whether or not to invest in private offerings and hedge funds.
The rules were written in a day and age in which they made sense. They no longer do, and it is my belief they will change by the end of this decade, if not sooner.
I will now get down off the soapbox.
Have a great week.
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