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A Masterpiece of Elocution Print E-mail

The Economy

Many variations of this story have emerged over the years, one attributed to Harvey Penick the late great golf instructor, another version is recounted by Harvey Mackey the envelope magnate and business guru. In any event the oft told tale goes something like this: a man gives a speech and feels he has done a more than adequate job. In fact he feels that he may have just delivered a masterpiece of elocution. As he completes his speech the crowd responds with an ovation that confirms his self evaluation. The speaker exits the stage and joins his wife. He beams with a sense of accomplishment and inflated self-esteem. As a smile lights up his face he says to his beloved, in feigned humility, “Boy there sure are some outstanding speakers at this conference aren’t there dear.” As is so often the case for the married man awaiting a compliment from his spouse he receives something else,” probably one less than you think dear” is her reply. As it would seem to be a requirement for those who seek the stage, most speakers possess an inordinate sense of confidence and belief that they have something of value to say to the masses. Many a speaker can suffer from erroneous self-perceptions. While this phenomenon most often occurs in caustic and cocky personalities it occasionally may occur among even the truly modest and tremendously talented. And yes, I must confess that I have fallen prey to this malady. In the absence of my beloved, I was fortunate to have an unwitting member of the audience clip my wings and ego. Following a conference presentation where I shared the profound insights of a portfolio management professional and closet economist, regarding the “techno-global revolution” and its potential impact on the US economy I heard a bond salesman say, “Well, that was entertaining but why would local government officials care about this stuff?” My bride could not have been more proficient in deflating my post performance euphoria. Was my triumph one of style over substance? Had I missed the mark? Had I failed to make the information relevant to my audience?  And in the cruelest blow of all, must I endure the criticism of – a bond salesman!? As a veteran of the venerable institution of marriage I paraphrase the Good Book, “pride goeth before the 5th anniversary”.   I have evolved and now gratefully acknowledge my short-comings. Having ditched my pride I will strive humbly to right the wrong of failed communication. Let me clearly state my case.  There is no escaping the “techno-global revolution” for American industry, American workers and yes, American local governments. Each CAFR our clients painstakingly produce includes a list of Top Ten Tax Payers. In many communities, these businesses are the largest sources of revenue and thus play a major role in the funding of services and salaries.  Few businesses today escape the competitive pressures of globalization. Most have devised ways of coping with it. Outsourcing US jobs has become an accepted method of controlling costs. The digitization of work and the development of cost effective modes of communication and shipping have combined and contributed to the evolution of global companies and global economies. Globalization has knocked down the protective barriers that have insulated US workers and their wages and lifestyles from cheaper labor abroad. And to the point, globalization has arguably created an underappreciated risk to local  government revenues. We have written and preached of the economic theories of Adam Smith and Joseph Schumpeter regarding entrepreneurship in highly profitable industries that generate high wages (and tax revenue). Profits and wages ring a bell that invites the unwelcome guest of low cost foreign competition to the party. The punchbowl has been drained at the automotive industry get-together. The hors devours have gone bad and the party favors are long gone. General Motors is selling off its profitable financing division, GMAC, and offering lucrative early retirement packages to high cost line workers. The company’s goal is to raise cash, cut costs and buy time to restructure, again. Ford Motor Company finds itself in the same death spiral, just at a higher altitude. Success with be measured in “right-sizing”, plant closures and foreign production. But the story deserving the attention of every local government official with an eye on the future is off the radar screens tracking GM and Ford. Auto parts maker Delphi Corp. is employing a unique legal strategy in the bankruptcy courts that could vastly accelerate the outsourcing of US jobs and plant closures. In an attempt to take advantage of laws written before the “techno-global revolution” transformed the competitive landscape Delphi Corp’s CEO Steve Miller has filed for Chapter 11 protection, but only for the company’s US business excluding highly profitable operations in China and Mexico. Delphi’s plan envisions the closure of or sale of 21 of 29 US plants. Domestic revenues would be cut from $17 billion to about $5 billion and the US labor force could drop from 32,000 to 7,000. Miller seeks a 40% reduction for salaried employees that survive the cuts. Meanwhile Delphi employs 115,000 workers in foreign based factories at significantly lower costs. Delphi has already dropped its billion dollar pension liability in the lap of the Pension Benefit Guaranty Corporation. Smith and Schumpeter might exchange high fives in the economist’s corner of heaven as their theories prove out except for the potential devastation the Delphi case represents for the “consumer class”. While many local government officials may say, “glad I don’t have any Delphi plants in my back yard” the truth of the matter is that if successful in this attempt to “dump and run” Delphi will grease the skids for much of the $170 billion per year auto parts industry and its 695,000 jobs to head overseas. Why wouldn’t other cost sensitive industries (read all industries) follow suit? It is a fact in the global economy that Delphi cannot be competitive using antiquated factories and high cost labor. Perhaps it’s too late for the auto parts industry to remain in the US but enlightened tax strategies that encourage capital expenditures on plant renovation and worker education might make domestic production viable for other industries. We may be looking at the tip of the iceberg.  Foreign competition is not going to subside. Protectionism is not the answer. We must recognize that when the plants close, the tax base shrinks and the demand for services balloons. Is it not more cost effective to keep existing businesses and their revenue streams than to recruit new ones with expensive tax incentives? Technological innovation threatens more than the dinosaur industries. None other than Microsoft with its $40 billion in sales, 64,000 employees and  massive tax contribution is feeling the sting of competition. Open source or online applications that rival the programs Word and Excel are pressing the softies to innovate and respond. Windows and Office generate about half the company revenue and are directly in the line of fire. Could a simple technological innovation threaten the existence of an industry giant? That’s a rhetorical question seasoned with a twinge of sarcasm. Social and economic upheaval does not initiate solely due to leaps in technology. Consider the shipping container. We have all seen thousands upon thousands stacked in ports around the world. The metal box that fits on barges and trucks made it possible for globalization to take hold when shipping costs dropped from dollars to pennies per ton. The Longshoreman Union paved the way for the UAW. Dead union walking… It is imperative that each community know who is their GM, who is their Delphi or Microsoft or longshoreman. Knowledge of your tax base and its position in its industry and the global economy is more important than ever. It is equally important to keep Schumpeter’s concept of “creative destruction” at the fore when offering long term financial incentives to attract new businesses. The techno-global revolution will by its very nature make today’s business models obsolete. A final word, I promise. Each of our clients faces some sort of taxpayer rebellion whether its TABOR or some look alike version. Any way you slice it, legislation of this type targets revenue. This is a poor fiscal strategy that has negative implications for bond ratings and debt costs. With unfunded liabilities like OPEBS hitting the financial statements of many local governments the timing couldn’t be worse. Some communities are entertaining the idea of debt financing these liabilities. In our view this strategy merely trades one liability for another at increased cost. When we combine the potential impact of increased liabilities with revenue restrictions, increased borrowing costs and top it off with the uncertainty introduced by globalization the formula for a financial crunch is in the wind.  When I was a boy my mother referred to me as a “bull in a china shop”, suggesting that I lacked subtlety.  She judged me well.  I hope we at ICM have begun to make the “techno-global revolution” relevant to your world and your work. Put away the fine china.

The Fed

No one ever said being responsible for the monetary policy of the most important economy in the global era was easy.  Dr. Ben Bernanke is learning that lesson as are all of us who follow U.S. monetary policy.  After 18 plus years of the Alan Greenspan era, there is a new sheriff in town.  Just as there is a learning curve for Dr. Bernanke, the market is also learning along with him. Those of us in the fixed income sector had become accustomed to the semantics of Alan Greenspan’s speeches as a tool to understand what the Fed was thinking and what was probably going to happen next.  With the succession of Dr. Bernanke, we have to learn anew what is deemed important and how language is used to convey those ideas.  So far, Fed policy has been dictated by the most current economic data available as it has been released, but we have to ask, what’s next? The Bernanke fed is currently faced with a Goldilocks dilemma.  They have to find the level for interest rates that is just right, while taking time to be sure they are not too soft nor too hard on the expanding economy.  During the first several months of Dr. Bernanke’s tenure as Fed Chairman the course had primarily been established by the departing Alan Greenspan.  At the end of the Greenspan era  in January, most market participants viewed an increase of the Fed Funds rate during Bernanke’s first meeting in March as a technicality.  But after that meeting, certainty of future moves faded and speculation began.  The Bernanke Fed chose to continue using the same verbiage as previous meetings, but they made sure to note that they were approaching the neutral interest rate level they sought. As of this writing, the Fed has raised the Fed Funds rate at 15 consecutive meetings, from a low of 1% in June of 2004 to the current rate of 4.75% on March 28th.  Since our last report at the end of December, the Fed has raised rates twice.  The next meeting of the Federal Reserve is slated for May 10th and another 25 basis point increase is at this point, a forgone conclusion.  But that is where the certainty ends and the crystal ball goes dark.  The fear of some Fed governors is that short term rates are close to the sweet spot they are looking for with the economy near full capacity and stable inflation.  The worry is that if they raise Fed Funds above the sweet spot, interest rates will become too restrictive, thus putting a damper on an economy that is already expected to slow in the 2nd quarter.  However, the economy has been expected to slow for the last three quarterly reports that ICM has written, and like an old Timex, “it takes a lickin, but it keeps on tickin.”  In the third quarter of 2005, the massive damage from Hurricane’s Katrina and Rita was supposed to be the straw that broke the camel’s back.  In the fourth quarter, we saw the impact of those hurricanes in slower than expected GDP growth which everyone forecasted as a prelude to the end.  The first quarter of 2006 was supposed to be the last hurrah for growth, but the economy  rebounded better than anyone expected. For much of the 1st quarter, all signs pointed to an end of the Fed’s interest rate tightening period, and a slowdown in growth.  That isn’t necessarily the case anymore.  Recently, core inflation had its highest showing in a year, posting  a .3% gain excluding the costs of food and energy for the month of March, plus the most recent employment report seems to foretell of a very tight labor market with jobless rates declining week after week.  These factors would seem to be signaling that the economy is not slowing just yet. The recent rise in CPI has pushed inflation to the upper range of the Fed’s comfort level and may be the first glimpse into what happens next. At ICM, we believe that the Fed will raise the Fed Funds rate to 5% on May 10th.  At that point, we feel that the Fed will pause to give itself time to analyze the health and strength of the economy.  Following its May meeting, the Fed has meetings scheduled for June 28th/29th and August 8th.  We believe that the Fed will pause in its tightening of the Fed Funds rate in June and look to economic data for clarity on its ensuing action in August.  Should the economy continue to grow at its current pace resulting in a tighter job market and an uptick in inflation, we believe the Fed Funds rate may hit 5.25% in the third quarter.  However, if inflation remains contained and the economy slows as expected during the second quarter, then the tightening campaign may be over.  Going forward, the Fed’s new sheriff will be light on his feet and quick on the draw, making monetary policy decisions that coincide with the most current economic data available.

Market Recap


Our benchmark 2 Year Treasury yield rose throughout the first three months of the year. The treasury began 2006 at a 4.40% yield and ended March at 4.82%. As Figure 1 indicates, this increase in yields represents a continuation of a long term trend that began in mid 2003. 15 consecutive rate hikes by the Fed have led short market yields higher. Strength in the European and Japanese economies have led to speculation that global rates are poised to move up too. China, India and the rest of Asia are experiencing strong economic growth that will outpace the US by a factor of two. Global inflation and a spill over into US prices has raised concerns in the bond  market that the Fed may continue to push monetary policy beyond the 5% level previously thought to represent neutrality. Gold and oil gave the market plenty to worry about as did industrial commodity prices. The housing market has become the canary in the economic coal mine. To date it has slowed gradually with inventories growing along with pricing incentives and seller concessions. Agency spreads, the yield pick up versus Treasury securities with similar maturities remained fairly constant and historically low to moderate. As Figure 2 shows, the yield curve remained flat with little difference between yields at 6 months and ten years. All yields moved higher by about the same degree in what is known as a parallel yield curve shift. This indicates that the markets see rates rising uniformly in the near term with few changes to the inflation and growth outlooks. New Fed Chair Ben Bernanke appears to enjoy the confidence of bond investors.
Market Outlook
Preliminary reports of economic growth reflected in the first quarter’s GDP figures show an economy off to a rousing start. In the contrary world of bonds good news is bad news. Inflation fears are also weighing heavy on the minds of bond market players and Fed officials. The funds rate appears to be headed higher than our projections of 4.5% to 4.75%. A 5% Fed Funds rate would appear a lock for the May meeting with the minutes of the latest FOMC meeting suggesting the possibility for a pause. Two year Treasury yields should continue to track the funds rate fairly closely until the market is convinced that policy has topped. At that juncture, Two and Three year yields should begin a slight decline. At ICM, we still look for the end of the rate cycle to be near but surely at a higher level than we anticipated a year ago. Such is the fate of interest rate prognosticators. Portfolio liquidity will run quite high for our clients in 2006 and we are well positioned for the turn in monetary policy from tightening to neutrality. For the first time since mid 2003 we are likely to see price stability in the bond market and thus your portfolios. As you will notice upon reviewing your total returns for the quarter the shortened durations of your portfolios has produced returns superior to the Merrill Lynch 1-3 year index. With some luck and good timing we should be locking in rates near the top of the cycle and may show price gains in the coming quarters. As the Federal Reserve’s new Chairman reminds us regularly, policy will be data dependent. Our man John Kenneke has done his usual good job of dissecting press releases, leaks and the minutes of FOMC meetings while translating such utterances into English in his section on the Fed.  The strength of the American consumer is being put to the test. It is a bit of a triathlon. We are struggling against higher prices at the pump, lower prices in our homes and significantly higher interest costs on our loans. At every turn the consumer has met the challenge and powered ahead. Where is the tipping point? We have written and spoken often about the importance of rising home values and affordable home equity loans to consumer spending. Delinquency rates are on the rise and exotic loans are coming home to roost for lenders and borrowers alike. $70 oil has translated to nearly $3.00 dollar gas. Getting to and from work is getting expensive not to mention the additional cost of getting to the mall to engage in our favorite pastime. It’s hard not to notice the increased number of hybrid auto ads in circulation.   Short market interest rates will follow the Fed as long as the dollar holds up against strengthening foreign currencies. Long rates are increasingly at the mercy of foreign central banks. Inflation fears may also promote the return of the “bond vigilantes”. If you were around in the early ‘90’s you may recall the vigilantes bullied the Fed by selling bonds and increasing yields when they felt the Fed was not standing strong against rising retail prices. In the end rates are near the top of this cycle and two and three year investments should provide the best opportunities for income and price stability in 2006 and 2007.