TFTF

Under the ‘Macro-Scope’

August 9, 2002

This week I have asked Greg Weldon, whom I frequently refer to, to give us a few examples of how seemingly different economic trends actually fit together, like pieces of a puzzle. If you can figure out how the puzzle pieces fit, you can develop ideas to profit from the picture they create. Greg is very good at seeing economic relationships and finding ways to make money from theme.

Every day, Greg gets up at 3 am and starts to work, so that by the time I come in, I usually have my first letter from him. He typically writes 3 investment letters each day, analyzing macro-economic trends and showing his clients how to profit from them. His clients are mostly hedge funds and large institutional traders who pay $400 per month. I find his analysis to be some of the most useful and on target letters I read anywhere.

As part of his examples, I asked him to give you one trend that he sees working today, and a way to invest in that trend, if you agree with his analysis.

I want to thank Greg for stepping in for me this week, and I will be back from vacation next week, fresh and ready to write. Now let's see what Greg is going share with us.

UNDER THE 'MACRO-SCOPE'

* For readers of John Mauldin's Millenium Wave Investor e-letter, we introduce a couple of the secular-macro fundamental trading themes that Weldon's Money Monitor has been, uh, monitoring for the past couple of years. Indeed, a distinct intensification in these secular trends has taken place over the last eighteen months, and then again, more recently, and more intently, over the last two months.

Let's review our premises and theories first.

Deflation/Disinflation REIGNS supreme, as THE dynamic affecting prices. This trend began more than 20 years ago, with the Dragon-Slayer Paul Volcker standing over the body of the inflation-dragon that had breathed fire and burned paper assets during the seventies. His sword came in the form of monetary hawkishness, and punitively high interest rates.

Throw in a good dose of technology in the nineties, and productivity soared, taking stocks along for the ride. Problem is, man-hour labor became (and continues to become) less and less ... necessary ... in terms of output.

Hence, while wealth spiked, income dynamics are just now seriously being affected, with the US posting the lowest six-month YTD annualized growth in average hourly earnings this year ... in over a decade.

Funny, cause the US Administration stated this week, that there will be NO double-dip recession in the US, as they tell us that 80,000 layoffs in July (as per this week's Challenger report) confirms an uptrend has begun in the labor market.

WHOOOAAA, hold on there big fella, 80,000 LESS citizens have jobs. There is NO WAY that this stat is anywhere near eco-bullish, not unless the Payroll data reveals job growth in excess of layoffs. This is just not the case, case closed.

INDEED, we note last week's US Payroll data, which revealed a SIZABLE PLUNGE in the Aggregate Hours Index, which provides a decent proxy for US GDP. Average weekly hours sits equal to the secular low, set last year, at 34.0 hours. So, while income did show its biggest rise of the year (though NOT large nominally, nor historically) if workers earn 2c more per hour, and work less, this does NOT necessarily mean, he is taking home more disposable dough.

In other words, layoffs are still rising by more than job growth ... while hours are at NEW LOWS.

Guess what !!!!

The US Administration was RIGHT, there will be NO double-dip, as the labor market NEVER erased the first dip.

Within all this, we note that one tangent stemming from the productivity gain, is more fierce price competition. Combine that with the income dynamic, the HUGE consumer debt load, and the wealth that has been burnt by equity market depreciation ... and we have what we originally termed, the consumer cocoon.

Without pricing power, margins are hit, usually leading to more debt.

With that scene, comes LESS profit to be doled out via wages, which crimps the consumer even more, forcing companies to continue to seek out ways to cut costs.

Did someone say ... spiral ???

The offshoot of these forces into the global economy cannot be understated, as more and more countries seek an export-way-to-growth, counting on the US consumer to be enabled to consume beyond their income-means ...

... and thus the current account balance blows up.

This was NOT a problem when the collateral base was rising in the US. Clearly, we speak of the equity market. As long as asset inflation fed the US consumer with more firewood, the consumption engine roared.

NOW .. with consumption set to slow (in order for the US savings rate to rise ... and it did, this week to a new cycle high) the current account deficit suddenly DID matter, and does now.

Thus the HUGE decline in the USD in the YTD, measuring up to 15% against some currencies. Notable was the rampant rise in the Asian peripheral currencies. The rally in the Korean Won, Thai Baht, Taiwan Dollar, Singapore Dollar, Kiwi Dollar and Japanese Yen, are notable for two specific, and critical reasons ---

--- these are ALL countries that run a current account surplus, largely tied to trade. While the value of the currency appreciates against the USD, it causes (in theory) prices of goods exported from these countries to rise, as seen in this week's data, revealing a multi-month upturn underway in US import prices.

--- it has caused monetary conditions in these countries to tighten. In places like New Zealand, which is also raising rates, the currency rally was the monetary straw that broke the back of the economic horse. We have noted severe erosion in Kiwi eco-data over the last two months, including a two-year low in consumer sentiment.

HEY, we thought the Kiwi stock market was rallying on an eco-recovery theme.

Indeed, this was NOT the case, as we have, and continue to believe that the macro-secular force of deflation inhibits final demand, in the context of our discussion above. The Kiwi rally had more to do with the USD, and more specifically, capital flow into NZD.

Final demand has failed to appear, as we expected all along, and thus has not picked up the eco-recovery-torch carried this far by simple inventory rebuilding.

We have seen evidence in the last two months that strongly suggests that the inventory rebuild is OVER. The most recent evidence ... HARD evidence ... came this week as US wholesale inventories were reported to have risen 0.3% during June. Aside from that straight-forward fact, we also note the MORE TELLING point ... the inventory rise came against the backdrop of relatively solid sales growth, reported at up 0.6% during June.

Inventories rose DESPITE sales gains.

This is NOT good going forward, in terms of maintaining the output increases seen in the last couple of months.

When sales slow, or fall again, inventories could rise more rapidly, which would likely cause an even deeper decline in

Considering the SHARP decline in ISM new orders, more than ten big figures worth, we might go so far as to say that the inventory-induced recovery in output is exhausted, and this aspect of the economy has just entered its second dip.

Further, and SOLID evidence to support our contention, is the virtual collapse in the Backlog of Orders Index within the ISM report

Note US Factory Orders, which fell 2.4%, in June alone. More importantly, and fodder for our thesis of just "one-big-ongoing-dip", the June decline in factory orders wiped out three months of gains.

Want to hazard a guess as to which way the eco-momentum is flowing ???

The Fed already knows this.

It took the markets ALL YEAR to realize, they were being duped by signs of strength that can ultimately be linked to the depth, and duration, of the first recession-leg.

Indeed, without being ego-centric, we can say we were NEVER duped on this one, as ALL YEAR LONG, we have been vociferously recommending outright purchases of the Dec-02, and March-03 Eurodollar deposit futures. When we went WAY out on a limb during a February appearance on CNBC, we told Street Signs anchor Ted David, that the Fed would NOT tighten at all in 2002, as final demand would fail to justify such a move, making these contracts a "screaming buy".

Indeed, it is us screaming now, as then, the Dec-02 Eurodollar was priced to imply a yield that required a DOUBLING in the Fed Funds rate this year, a whopping 175 'tightening premium"

That premium has been narrowing all year, and finally, last week, completed its convergence with the actual Fed Funds rate..

SO WHAT WELDON ... what have you done for us lately.

Well, the Fed has ALREADY started the easing process, and we will be KEEN to monitor how the markets respond, as the consequences of a continued Fed failure to facilitate growth in consumption carries dire consequences.

Luckily, so far, the US has been blessed at the helm, by hawkishly-erring Paul Volcker's parallel-universe twin ... dovishly-erring Alan Greenspan.

So far, the damage has been contained by his overtly aggressive monetary stimulation, and sub-2% Fed Funds. So far, the housing market, via refi-activity, has softened the blow dealt by the US savings implosion. By that, we mean the destruction of wealth in the equity market, which took over as THE savings bank of the country.

BUT, there are clear signs now, to suggest thoughts of a peak in housing has been reached. Specifically, we note the sudden, and steep, two-month decline in construction spending ... and ... the fact that supply of homes (nominally) is at its highest level since 1996, while house prices have turned to the downside on a yr-yr basis for several months ... DESPITE RECORD SALES LEVELS.

If (when) home sales begin to erode ... prices could deflate rapidly.

Such a scenario would pose a HUGE problem throughout the globe, by pulling the final leg out from under the already-burned and cocooned US consumer.

Sky high debt levels, both in the US, and abroad, would become a major inhibitor to eco-growth.

BUT, we already stated that the Fed is aware ... and has already reacted.

Yesterday's money growth figures released by the Fed revealed a third straight week of BIG growth, with M-3 alone expanding by more than $44 billion in the latest week. This comes on top of last week's $33 billion expansion.

Note the stirring in the 13-week rate-of-change indicator monitored by the Fed, which stood at a hawkish 1.4% just seven weeks ago ... and today, stands at 5.3%.

The Fed is already easing.

So, the BIG question that it seems is always the FIRST question John Mauldin asks us when we speak ... what do you think of the Bond market ??

Well, CNBC asked that very same question in a viewer poll taken last Friday. The inquiry was worded to extract the "most comfortable" asset to hold.

The answers were eye-opening, as we always believed the US Long Bond was considered by Ma and Pa Kettle, to be the most conservative place to park dough, and the safest.

That is no longer the case, as only 7% replied they felt most comfortable holding bonds,, while 44% still favored stocks, and a HIGH 22% said Gold, while 13% said cash, and 14% said real-estate.

First, IF 22% actually put their money where their mouths are, Gold would be MUCH higher already, as this market is simply not deep enough to handle such a capital inflow in an orderly manner.

But more complexing, is the lack of taste for Bonds. We ask why ???

We come up with a couple of notions as to why.

First, the USD remains at risk of a reconciliation drop, CLEARLY, if the Fed cannot get long-yields lower, and extend the housing floatation-device, the USD will lose more air.

In fact, we believe it is USD-anxiety that is holding bonds down. Why do we say that, when such in not necessarily obvious ???

Note this week's auction of US-10-year indexed notes, sold at a price to yield 3.09%. Then note the straight 10-year auction, and the problematic stats generated by demand figures, as the tail was a whopping 14 bp, and the high yield got bidders 47% of what they wanted in terms of supply-placement.

From that we figure that the bond market is now being inhibited by the current yield level ... amid our dissection of the spread-stats.

The indexed-10-yr spread over Fed Funds ... 134 basis points, or right in line with they yr-yr rate of CPI.

The regular 10-yr Note spread over the indexed bond .... 130 basis points.

So, for this bond market mini-bull to obtain (theoretically, without taking into account the numerous emerging-market landmines that could detonate at any moment) the Fed will NEED to cut rates, or inflation must continue to decline.

In other words, to hold up the US consumer via perpetual-housing-market floatation, the Fed NEEDS to cut rates.

We have been, and remain, bullish on the US fixed-income curve, expecting the long-end to play catch-up to the rally in the short-end over the course of the rest of the year.

The wild card ... OIL.

There is NO Iraqi-war-risk-premium to be found in the current structure of the forward WTI strip, only a widening contango.

Norway and Venezuela have jacked output.

Russian output hit a new post-Soviet high this week.

Algeria just formally petitioned OPEC for a quota increase ... amounting to a near-doubling of daily output, which they forecast could reach 1.3mbd

Note the massive decline in oil-equities, which have plunged in recent weeks, hitting multi-year lows, taking the XOI with it.

A price breakdown in September NYMEX WTI occurs technically, on a downside violation of support defined at $25.

Sizable, and seemingly NOT price-sensitive Cash delivery of products against the NYMEX board ... stem from the fact that Harbor storage facilities are overflowing. .

A price breakdown in WTI, would ease the Fed-heads ... as per going forward with interest rate cuts. So, if WTI takes out $25, we become even MORE bullish on bonds, and even more bearish on petroleum.

Gregory Weldon ----
WeldonFinancial@comcast.net

Once again, I wish to thank Greg for writing this week's letter. Greg also writes a weekly letter for traders and investors. He charges $400 per month for the daily newsletters, and only $450 per year for access to his website. You can get a one month free subscription by going to www.macro-strategies.com. If you are trading in this market, I strongly suggest you look at his letter.

As you read this, I am in Maine, hopefully avoiding the heat and concentrating on my wife and not the markets. It is at times like this when I can get away that I get reminded that relationships are more important than things.

I look forward to being back next week, mentally rested and ready to plunge into really getting my book on investing and hedge funds finished this fall.

Your probably wishing right now he could stay another week in Maine analyst,

John Mauldin

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