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The Economy

 Long ago, shortly after the dinosaurs disappeared but while the world was still thought to be flat I toiled in a New York elementary school. There I learned so many new and exciting things like; the value of a friend, that girls are different from boys and that the pretty ones made me nervous. I learned that the Yankees were great and the Mets were not. I learned about water pistols that fit in the palm of a boy’s hand that could hit the pretty girls without detection from across the room. I learned that if I hit John Palumbo in the face with a paper clip launched by a rubber band that he would cry and I would visit the principal. I also learned that there was a crazy man named Khrushchev living in Russia that banged his shoe on the furniture at the U.N. I learned to ball up under my desk at the sound of the school’s air raid siren and that presidents could be shot and killed right here in America. And while I still dreamed far more often of hitting heroic grand slams than mushroom clouds I got the impression that there was more to the school thing than spitballs and blondes. I began to pay attention when no one was watching, ever cool and aloof, to the story of history. As a young lad I came to the conclusion, in today’s vernacular, that “it’s all about the money.” My earliest recollection of this epiphany came when I coupled the lessons of the great European explorers with those of the “mercantilists”.  These mercantilists were the equivalent of today’s political consultants. They provided economic advice to the Monarchs of England, France, Spain, Portugal and the Dutch. Their ideas regarding exploration were driven not by a thirst for knowledge of far-away lands and peoples but by a lust for gold, colonies, cheap labor and military might. Suddenly I began to realize why Columbus sailed the ocean blue in fourteen hundred and ninety-two. Between trips to see the principal an economist was born. Fast-forward to the pursuits of higher learning where spitballs and water pistols lost their allure, pretty girls still made me nervous and the study of economics became a labor of love and provided a window to the world. As a college boy long on hair and short on knowledge I devoured the ideas of Adam Smith and smiled as the “Father of Modern Economic Thought” deplored the short-sighted greed of the mercantilists and monarchs with their planned economies rife with monopolies, cronyism and protectionism.  Smith’s “invisible hand” swept away the economics of the mercantilists and brought forward a measure of the “Wealth of Nations” we would do well to heed today. Smith judged a nation’s financial might not in terms of colonies, coins or slaves but instead from the perspective of the consumer and the household standard of living. Adam Smith’s thought represents the clearest expression of free markets and the value of invention, innovation and unbridled competition. He most clearly recognized that it is the consumer who drives capitalism.  In today’s global economy it is the American consumer who disproportionately propels growth and profits around the world. The global economy is riding high on the shoulders of American purchasing power. The International Monetary Fund’s Economic Outlook puts global growth above trend at more than 4% for 2005 and 2006.  As growth accelerates the imbalances between America and its trading partners becomes more acute. While America’s current account deficit, the broadest measure of the trade imbalance hovers above 6% of GDP our partners in Germany and China have surpluses of 4% or more. American wealth is being siphoned to our trading partners through our trade imbalance and we have responded by borrowing to support our spending spree. We have logged three consecutive months of negative savings, spending beyond our means even as consumer confidence has plunged to the lowest three month reading since the age of disco. Our most valuable asset, our homes, doubles as an ATM so that we can buy, buy, buy... You have heard this harangue from us before. But now things are different for the American consumer. The ATM is being drained. The Fed is targeting the housing market, raising rates to slow the relentless and unsustainable price spiral. Rising interest rates makes all borrowing more expensive at a time when America has a quite thin financial cushion. The question of how we will weather the rising cost of fuel for autos and winter heating bills will play out against a far tighter monetary background. While all of this would make Adam Smith worry about the American consumer and the sustainability of our nation’s wealth and health he couldn’t have foreseen what may well be the biggest threat to the American consumer, namely the global labor market. The emergence of China, India and Russia in the global economy has doubled the world’s labor force. Fifty percent of that increase is attributable to China. None of these nations brings much capital to the game. The result is, as one would expect, the relationship between capital and labor has shifted dramatically, profits rise as wages stagnate or fall. As Adam Smith recognized more than two centuries ago it is not the profits and wealth garnered by monarchs and merchants that determines capitalist prosperity but the financial well-being of the consumer household. There is much to concern us about the financial health of the American household. And at this point in time, the tools available to the Federal Government and the Federal Reserve are greatly diminished. Our budget deficit may top $400 billion, 3-4% of GDP in 2006, if congress and the administration honor its promise to rebuild the gulf coast. Record deficits will crowd out the private sector, compromising capital formation essential to economic expansion, innovation and investment. So it is not only unlikely that economic stimulation would come from further tax cuts it is highly likely that future tax revenues will need to grow to close the enormous budget gap. With prices threatening to lift off and the miracle of productivity fading the Federal Reserve will not risk a return to the double-digit inflation of the 1970’s. So expect little stimulation or relief from the Fed in the form of lower rates should debt burdened consumers stumble and the economy falters. If we keep in mind that foreign investment funds nearly half our budget deficit and that foreign lending and investment encourages our consumption beyond our means, it is clear that if we do not get our financial house in order we risk losing some degree of control and freedom to determine domestic monetary and fiscal policy.  It seems likely that we Americans will put the brakes on our spending and borrowing before our European and Asian financiers pull the plug on our profligate ways. Even with all the economic uncertainty one thing is most sure, nations and investors will act in their own best interests if we do not act. We should never forget the lessons of history,” it’s all about the money.”

The Fed

In preparation for this writing, I took a look back at the recent past.  I pulled up a copy of ICM’s 3rd quarter 2004 Fed commentary to see where we were then to get a picture of where we are going tomorrow.  Back in ’04, we were concerned with the possible emergence of inflation.  “Oil has topped $55 per barrel, gasoline is consistently above $2 per gallon, the cost of heating a house this winter in the Northeast and Midwest may nearly double.  Health care costs jumped an average of 36% from 2000 through 2004 while average earnings rose just 12%.  Employers searching for ways to maintain profit margins are shifting more of this burden back on workers.   The cost of college tuitions have increased at a pace similar to health care.  Inflation is apparent in the industrial commodities markets with the demand driven by China and India.  The Fed recognizes these threats even if they are not accurately reflected in their formulas of choice,” was the tone of our expectations a year ago. Well a year later and oil at $55 a barrel doesn’t seem that significant when compared to post-Katrina oil prices topping $70.  Before Katrina, the U.S. economy was exhibiting all the character attributes of The Little Engine That Could.  The economy that at times seemed as if it would slow continued to be chugging along and had at that point appeared to be moving with a great head of momentum.  Now standing at the doorway to the end of the year, the question on the minds of many is, “Does the U.S. economy have enough momentum to weather high energy prices, two natural disasters in the span of a month and perceived inflationary pressure that has only heightened due to the aforementioned natural disasters?” Heading into the final quarter of 2005, the Fed has raised rates at eleven straight meetings, most recently on September 20th, one month after Hurricane Katrina made landfall in Louisiana and four days before Hurricane Rita would strike just west of the Texas-Louisiana border.  There are two more Fed Meetings scheduled for this calendar year on November 1st and the last on December 13th.  The belief after this latest hike was that if the Fed were going to take a break from raising the Fed Funds rate, the next meeting was likely their best opportunity.  Today, that view seems to be waning, as the market seems to be signaling that the Fed is going to raise rates further than was previously thought. In the October 10th, 2005 edition of the Wall Street Journal, John Hilsenrath makes exactly that claim, “High energy prices, a potential shift in public psychology toward accepting higher prices, signs that businesses are using up spare capacity and a steep federal budget deficit combine to make Federal Reserve policy makers more nervous about the inflation outlook. A pause in rate increases within the next few months, considered a real possibility after the economic disruption caused by Hurricane Katrina in late  August, now looks increasingly unlikely. Indeed, the Fed may raise rates even further than it had thought likely before Hurricane Katrina struck.” The futures market echoes the sentiments of Mr. Hilsenrath, with futures rates signaling Fed Funds rates at 4.50% in mid-2006, up from 4.25% just a month ago.  Going forward, the Fed will be concerned with three primary factors facing the U.S. economy in order to gain perspective on its strength.  Persistently rising energy prices that show little evidence of a reverse in current trends have sparked a fear in the Fed Governors that inflationary energy prices will spill over into “core” inflation which excludes the costs of energy and food.  A second fear among the Fed is that the perception of increased inflation among corporations and workers cause an increase in prices that will result in an increase in demanded wages, thus exacerbating the situation.   The third and potentially most far reaching facet of the Fed’s future is the burden of increased debt that the U.S. government will incur to fund the reconstruction of the areas destroyed by the tandem of Katrina and Rita.  At the end of the second quarter of 2005, we at ICM were looking for the Fed to raise rates to 4% by year end.  Today, (October 11th) the Fed Funds rate is at 3.75%, with two more meetings scheduled in 2005.  Given the current economic climate, we believe that Fed policy will fight inflation at the expense of economic growth.  The funds rate will likely reach 4.25% by year end and 4.50% by the Spring of ’06.  This tightening cycle is at once aimed at tempering the housing market and fighting commodity and wage inflation.  Alan Greenspan walks a knife’s edge as he approaches retirement.  The blowback from overshooting “neutral” policy could be devastating for housing and the American consumer, not to mention the chairman’s legacy.

Market Recap

Interest rates rode the roller coaster of consistently strong economic growth, higher inflation, natural disasters and a single-minded Federal Reserve.  The third quarter began with the Fed bumping the funds rate to 3.25% from 3%.  By September 30th, the funds rate stood at 3.75% with the promise of further rate increases of a ¼ point into 2006; despite two powerful storms, $200 million in damages and the loss of an estimated 100,000 jobs.  Our benchmark two year Treasury yield began the quarter at 3.63%, climbed above 4.10%  by early August and shed 40 basis points, dropping below 3.70% in the fog of uncertainty following Hurricane Katrina.  General market consensus was that New Orleans, while a fun place to party, was not particularly vital to the overall health of the U.S. economy and that damaged refinery capacity in the Gulf region would amplify fuel related inflation.  The Two Year’s yield climbed off the deck and closed the quarter at a high yield of 4.16%.  FNMA received more negative press for mostly old news, while the soon to be retire Fed Chairman, Alan Greenspan continued to warn about the size of the mortgage giant’s portfolio and its poorly defined hedging strategies and derivatives exposure.  Spreads on agency and corporate debt remained at historically tight levels.  With interest rates on the rise, the housing market and corporate balance sheets may suffer setbacks in the coming quarters, producing total return performance less attractive than U.S. Treasuries.

Market Outlook

All markets are a function of uncertainty.  If there were absolute certainty that prices would rise for a given security or commodity, all traders would be buyers and markets would seize, ceasing to function as there would be no sellers.  Uncertainty is thus the key ingredient for healthy markets.  One party buys in anticipation of rising prices while another sells out of a contrary belief.  Uncertainty has been running high for interest rate markets.  Home heating costs will be significantly higher than last year and gas prices between $2.50 and $3.00 will impact discretionary spending.  The $64 dollar question is of course, “how much?”  The Fed is clearly raising short rates to accomplish two goals.  The first is to head off the spread of energy inflation to the core economy.  The second goal is to slow housing price inflation before the bubble bursts.  As both forms of demand-pull inflation continue to cause concern and thus continued rate increases, the $128 dollar question for the funds rate is “how high?”  At ICM, we think the Fed will likely pause in the first quarter of 2006 with the funds rate near 4.50%.  Our benchmark 2 Year Treasury yield should top out in the same range.  Should yields drift much higher as a result of an overly aggressive Fed, than we run the risk of harming consumer balance sheets.  The off shoot of this could be to discourage foreign lenders and buyers of U.S. bonds to doubt America’s ability to repay its debts.  Losing the cheap financing of foreign investors would surely sink the dollar and send market interest rates soaring.  The Fed wants to avoid this scenario and the recession that would follow.  The fog of uncertainty is thick at this juncture.