By The Curmudgeon
Are almost all U.S. economists looking at their world
through rose- colored glasses? We think so. In our view, risky
loans, excessive leverage, stubborn consumer inflation, slow economic growth
and unexpectedly low productivity growth may at some point cause a financial
market crisis. If that were to occur, then all the happy talk and
soothing economic outlooks would be of little help. Having already
commented on the risky loans and leverage in the system, we will deal with
fundamental economic issues in this commentary
We see a number of current problems that could cause
financial market havoc in the future:
1.
Headline
inflation has been accelerating. The Consumer Price Index for all
Urban Consumers (CPI-U) increased 0.2% in June, while the core CPI-U also
increased by 0.2%. The CPI-U was 2.7% above its level in June 2006, but
it has risen at an annual rate of 5.0% in the first half of 2007.
Fed Chief Ben Bernanke seems to be singularly focused
on the core Personal Consumption Expenditures (PCE) deflator, which
has risen 4.4% for the first 5 months of 2007. The core PCE is
an implicit index -- its weights change based on changes in consumer buying
patterns. When prices rise, consumers tend to find lower priced substitutes
and these substitutions help keep this inflation gauge down. Of course,
there are certain items that are not counted in the core PCE, for which
there is no substitution. Those items, e.g. gasoline, heating oil,
milk, food, college or health care are rising sharply. This means
that the Fed's favorite inflation gauge is not measuring true inflation.
Hence, it is broken and we don’t think it should be relied upon anymore.
For further info, please see:
http://bigpicture.typepad.com/comments/2004/12/chart_of_the_we_3.html
So for over one year, Bernanke keeps saying he hopes
inflation will come down, but it has not done so. Yet, the
bond vigilantes are evidently asleep, as they have pushed the yield on
the 10 year T Note under 5% (a negative real return, based on the CPI-U
for this year).
2. Productivity
growth has been well below its historical average since the fourth quarter
of 2005. Second-quarter gross domestic product and productivity figures,
which will be out at the end of July, will probably reflect continued sluggishness.
3. Economic growth has been declining,
mostly because of the deterioration of the housing market. June housing
starts were 19% below the year-earlier period and building permits were
down 25%. Since employment data has been quite strong throughout 2007,
a weak GDP figure will signal abysmal productivity growth.
4. The US dollar is in another leg down- setting
new all time lows against the Euro and 27 year lows against the GBP and
Canadian dollar. No one seems to be paying attention to this.
The declining dollar lowers our standard of living in the U.S. as all imported
goods and services now cost more in dollars.
Conclusions:
If productivity growth is weak, inflation will be
higher than would be historically expected, given the level of economic
growth. Continued high commodity prices will eventually drive consumer
prices higher as the cost is past through to finished products. The
declining dollar will also raise inflation as imports will be more expensive
and competing US manufacturers will have an incentive to raise prices on
equivalent goods and services.
Where are we at in
the economic cycle? Inflation this year is accelerating, productivity
is weakening, the dollar is declining sharply, and a speculative mania
in buyout/LBO/private equity deals has been artificially boosting global
equity markets (but we think that has finally ended- please see yesterday’s
commentary). We see the current period as one of stealth stagflation,
with stubbornly high inflation and low economic growth. We think
that monetary policy is way too easy and should be significantly tightened
– especially in the U.S. and China. In the U.S. and Europe,
too much newly created money has been going into loose loans for buyouts
and leveraged speculation in other asset classes. (For four years, every
asset class has had a positive total return). Such rampant
speculation has always caused economic dislocations and has resulted in
hard landings for the economy and financial markets.
Does anyone remember
when the dot-com bubble burst? And the aftershocks that followed?
Perhaps, we are in an echo bubble now that is just about to burst.
The Curmudgeon
curmudgeon.corner@sbcglobal.net