With US economic data still surprisingly strong – although not as surprisingly as it was a few months ago – and Europe about to “solve” the Greek crisis – again – it might seem a curious time to start worrying about the global economy, but I can’t shake the feeling that all isn’t right with the economic world. Investors have bid stocks up over 20% since the nadir last fall as the US economy proved more resilient than almost anyone – Alhambra excepted – thought at the time. Alas, what saved the world in the ensuing period was nothing more than another round of inflation, this time by an ECB willing to lend against damn near anything offered up as collateral (I hear Greek sheep only get a small shearing at the ECB discount window) by a European banking system starved for capital after discovering for the umpteenth time in history that there is no such thing as a free lunch. And that inflation is what has me worried.
One of the main reasons I remained optimistic about the US economy last fall was the rise in the dollar and the fall in commodity prices, particularly oil. Reduced gasoline prices along with a dramatic fall in natural gas prices were a boon for the US economy that more than offset the potential fallout from a European recession. I also assumed the ECB would be forced, one way or the other, to print enough Euros to prevent a banking crisis and deflation outside the periphery. Unfortunately, I underestimated the degree to which the world’s central bankers would embrace the warmth of their overworked printing presses. It isn’t just the ECB that has resorted to printing press finance. The US Fed has committed itself to easy policy as far as the eye can see, the Bank of Japan recently announced they would buy bonds until inflation hits 1% in a bid to weaken the Yen, China has reduced bank reserve requirements for the second time and most of the emerging markets are also easing monetary policy.
This global easing has had predictable effects. Oil prices are nearing $105 – gas prices $4 – and natural gas, even in the face of a glut of domestic supply, has stopped falling. Gold has risen $200 since late last year and other commodities are also off their lows. Inflation takes time to work its way through the economic system but commodities, the most sensitive indicators of monetary excess, tend to move immediately and often dramatically. Investors seek to protect themselves from further devaluation of their hard earned money by moving to hard assets that can’t be manipulated by central banks. One of the reasons China recently reduced reserve requirements is an outflow of deposits from Chinese banks where rates are held below the rate of inflation, ensuring a loss of purchasing power. It isn’t a stretch to think those deposits will or maybe already are finding their way into the commodity markets. Japan recently announced a record trade deficit – yes, deficit – primarily a result of high energy costs (but also, ominously, due to a 20% drop in exports to China). Why the BOJ believes even higher prices will fix what ails the Japanese economy is a mystery.
Capital tied up in commodities to protect against the depredations of the world’s central bankers is capital not invested productively and not spent on consumption. The recent boomlet in the US economy will burn itself out when either the inflation stops or oil prices rise enough to again choke the economy back into recession. As I said recently, this isn’t the recovery we’re all looking for. That will only come with a major change in fiscal and monetary policy that at present still looks a long way off. In the meantime, enjoy this stock rally while it lasts.
Those higher gas prices may already be having an effect as both the Goldman and Redbook retail reports showed weakness last week. Although the monthly retail report did show a good gain, the weekly reports are more timely. The Goldman report was down 2% week to week although the year over year gain is still 2.8%. That isn’t worrisome yet, but definitely worth keeping an eye on. For now, inventories are lean after rising less than sales in December. The inventory to sales ratio is a low 1.26.
Oil prices also had an outsize impact on import prices which were up 0.3% in January and 7.1% year over year. Export prices were also up but just 2.5% year over year. Producer prices rose a more subdued 0.1% in January but are up 4.1% year over year. Consumer prices also rose, up 0.2% at the headline and core levels. While the Fed now uses the PCE deflator for policy purposes, it should be noted that core prices year over year are up 2.3%, higher than the Fed’s inflation target of 2%. The scope for further easing would seem to be limited if the Fed actually sticks to its target.
Housing continues to slowly heal with the homebuilders sentiment index up another 4 points to 29. Builders’ optimism isn’t yet reflected in housing starts which rose a modest 1.5% in January with most of the gains in multi-family. That might explain the still subdued builder sentiment since most of them are not building apartments. Permits were also up but only by 0.7%. Year over year gains in starts are now running at 9.9% so construction is recovering but with the recent foreclosure settlement, there may be more price pain to come. Housing is better but a long way from good.
The one area of the economy still performing well is manufacturing with both the Empire State and Philly Fed surveys rising in February. The NY Fed survey rose to 19.53 but new orders growth fell somewhat. Employment readings in both surveys were essentially flat. Both surveys showed less optimism about future business, probably due to concerns about Europe. Industrial production was flat in January but that was primarily due to a drop in mining and utilities. Manufacturing of durable goods was up a robust 1.8% although non durables fell 0.2%.
Jobless claims were the star of the week, falling to 348k in a continuation of the pattern we’ve observed since late last year. It will be interesting to see what happens to claims over the coming weeks as higher oil prices work their way through the economy. The high frequency data we monitor continues to show an economy growing at a modest pace but the inflation that is at its root is cause for concern. I would not be surprised at all to start seeing more disappointment in the data over the coming months.
Stocks rose again last week with the S&P 500 up 1.38% and foreign markets up similarly. Sentiment surveys remain overly bullish at both the individual and adviser levels. It is an interesting phenomenon though with only sporadic inflows to equity mutual funds. Investors seem to be saying one thing and doing another. It is also particularly worrisome to see continued robust inflows to bond funds considering the inflationary backdrop. I can only guess that individual investors are looking at last year’s performance and concluding that bonds are the better bet. With the world’s central bankers easing en masse, that is a bet with low odds of success.