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The Techno-Global Revolution Print E-mail
The Economy 
A couple of years ago, we coined the catchy phrase, “the techno-global revolution.”  Like most creative ideas, it came to me in the early morning as a hot shower was rinsing the cobwebs from my cluttered mind.  Albert Einstein once opined that the key to creativity is learning to hide your sources.  The topic of globalization has been on the minds of many economists for some time.  And the concept of technology revolutionizing the production process in factories has been around since the days of Adam Smith and the horse and buggy.  Separately, perhaps, neither the idea of technology nor globalization is particularly great or innovative but I do believe I was alone in combining the concepts into a compelling new hyphenated catch all expression of economic insight and brilliance.  Yes, I’m certain I was alone, in the shower that morning.  My subconscious mind, sensing my need for an ego boosting economic epiphany likely engaged in a bit of Einsteinian self deception, and presto, we have a (not so new, not so creative) idea to kick around.  The Techno-Global Revolution creates a far greater interdependency between national economies, blurring the lines of demarcation.  The explosive growth of multinational companies shifting capital assets, investments and jobs around the globe for maximum competitive advantage dilutes any sense of loyalty to community, state or country.  The focus shifts to productivity, profits and in some instances, a companies survival.  We live and work in a world of intense competition, great change and increasing symbiosis.  We have noted that the techno-global revolution would threaten less efficient business models, particularly where legacy costs inhibited an industry or company’s ability to respond to change.  Steel and airlines jump to mind as industries struggling and failing to navigate in this new era.  The best example of a business model swimming against the tide is General Motors.  Long time readers of our musings about the economy may recall our use of the Big Bang Theory in conjunction with Adam Smith (September, 2002) to help explain the impact of techno-global competition on America’s smoke stack dinosaurs.  The once proud world leader in autos, GM enjoyed nearly 30 years of ‘AAA’ credit ratings, innovative management styles and healthy profits.  But, GM built an inflexible business infrastructure based upon the boom times of 1950’s and 1960’s.  Now, the exorbitant benefits packages that earned the company the moniker of ‘generous motors’ is proving a tremendous obstacle in its attempts to compete with foreign auto makers.  GM’s health care costs ran $5.3 billion last year, up 20% from 2003, offsetting all gains in profits from improvements in productivity.  GM has lost 40% of its market capitalization in the past 10 months.  Its bonds teeter one notch above junk status, values plunging as investors digest news of new losses, falling revenues and rising borrowing costs.  GM’s unions have refused thus far to open talks aimed at restructuring member’s benefits packages to boost the company’s chances of returning to near term profitability.  As the threat of a down grade to junk status looms, GM’s stock has plunged because the company may soon be faced with the loss of several lines of credit with loan call provisions tied to its credit rating.  There is an old saying, “those who can, do and those who can’t, teach.”  In the manufacturing industries it goes something like this, “those who can, produce and those who can’t open a finance division.”  While GM (and Ford for will lose millions on cars, their finance divisions have fed a steady stream of profitable revenue to the bottom line keeping the companies’ North American operations afloat.  Rising interest rates and consumer debt levels now threaten the golden goose.  GM’s finance division is not unique.  The U.S. economy is more reliant on finance company profits that at any time in our history, totaling nearly 40%.  This reality is weighing heavily on the minds of Alan Greenspan and his perplexed contingent of economists at the Fed.  Inflation concerns are rising because growth rates in China, India and re-emerging Asian economies are driving prices for raw material up at alarming double-digit rates.  And, oh, have you noticed the price of oil these days?  But should the Fed boost rates to protect against inflation, it runs the risk of toppling the economic recovery.  The World Bank and the IMF have already predicted a slowing in the global economy.  Stagflation, a term popular in the 1970’s and relegated to the dark recesses of our memories is stepping into the light.  The economy may be downshifting a bit as we enter the second quarter.  Oil prices, rising interest rates and sluggish job and wage growth have consumers backing off a bit.  Retail sales and corporate capital expenditures paused significantly causing department stores, furniture and tech giant IBM to miss profits and sales projections.  It would be very bad news for the interdependent global economy, particularly countries living on exports, if the U.S. consumer curtailed spending.  Between 1995 and 2004, Americans pumped $3.5 trillion into foreign economies and in 1998 single handedly averted a near certain global recession.  We do love to spend.  The World Bank and the IMF have an added concern about “uneven growth” in the global economy, citing strength in the U.S. and China and weakness in Japan and Europe.  The size of the U.S. trade deficit is now beyond 6% of GDP.  The results of this imbalance are clear.  Our trading partners in Asia and our friends at OPEC are accumulating an unprecedented surfeit of U.S. dollars and assets.  Central banks around the world buy our currency and then our bonds, keeping U.S. bond yields and thus borrowing costs artificially low.  And just like Pavlov’s dog, the U.S. consumer hears the ringing bell of low rate loans and begins to salivate, not for puppy chow, but for the latest low cost import.  U.S. consumers face stagnant wage growth, rising borrowing costs and $2.50 gas prices.  The question becomes what will our “creditor” trading partners do with the lemon after they have squeezed all the juice?
The Fed
 Where has the time gone?  It seems like just yesterday, we were wrapping up the end of 2004 and praising the Fed for their effectiveness in relaxing monetary policy.  At that time, the economy was humming along quite nicely both domestically and abroad, most notably in Asia.  The general consensus was that tough times were behind us and with the wind in our sails; it was blue skies and gentle breeze carrying the U.S. economy to renewed prosperity.  While we aren’t facing dark skies and rough seas at the present, the forecast might be a little darker than previously thought. 
Since we last spoke, the Greenspan Fed has raised the benchmark Fed Funds rate twice to a level of 2.75%.  While these moves were to be expected, it is worth noting that the Fed seems to be uncertain of where to go from here.  In the most recent minutes release, it was reported that, “many participants indicated that their uncertainty about the intensity of inflation pressures had risen in response to recent developments and that, the distribution of possible inflation outcomes was now tilted a little to the upside.”  While this may not come as a surprise, as we all have felt the pinch of gasoline as high as $2.50, what may be surprising is that the U.S. economy may be slowing as we begin the 2nd quarter.
In the days following the release of the FOMC’s March minutes statement, several economic reports have hinted to the fact that growth domestically and globally may not be as vigorous as previously expected.  Some very recent examples of this are disappointing March retail sales, coupled with slowing job growth and a fall in consumer confidence levels seem to signal the U.S. economy had lost some momentum as the 1st quarter drew to a close.  Globally, the picture may have darkened a bit also.  In its most recent projections, the IMF projected that the global economy would slow to in their estimation, 4.3% from a level of 5.1% for 2004.  The IMF also downgraded U.S. growth from their previous level of 4.4% to 3.6%.  China’s economy which was moving at a torrid pace is only expected to slow a little, from 9.5% growth in ’04 to 8.5% in 2005. It is these developments in the growth of the economy that may pose the biggest threat to Alan Greenspan receiving the restful sleep that he so much deserves.  Where the Fed goes from here may not entirely be under the committee’s control.  It would seem now, that future Fed policy decision will be predicated on the path the economy takes.  The minutes hinted that the Fed thought interest rates might be further from the neutral level (the level that neither restricts nor inhibits growth) than they had anticipated.  While this does not seem to mean increases larger than the 25bps that we have grown accustomed to, the Fed did hint that they may not pause if inflation were indeed to pick up.  On the other hand, it may be faced with a dilemma if growth does not keep pace.  The factors that could attribute to this dilemma would be continuing high oil and the price pressures that would follow.  However, the economy could bounce back if oil prices correct naturally.  In the past, oil shocks were due to a lack of supply which forced prices higher.  Currently, oil prices are being driven by a large demand increase, most notably, from India and China.  If these higher oil prices were to weaken economic growth globally, they would also weaken demand for oil which would bring prices back in line.  This seems to be the market consensus, as oil has eased recently evidenced by the price of benchmark West Texas Intermediate crude settling at a price of $50.22 on April 13th, its lowest close in two months.  This is also in line with IMF projections for the price of oil averaging around $46.50 for 2005.
At ICM, we feel the economic climate is in line with our previous projections for interest rates.  We are still looking for the Fed Funds rate to be at 3% by mid-year, and 3.50% by end of the year.  These projections are of course contingent upon the economy maintaining its current course.  We also believe the yield curve will continue to flatten throughout the Fed’s tightening cycle.  The current yield spread between 2 and 10 year treasuries has contracted to 67 bps, down from 116 bps at the start of the year.  As the curve further flattens or inverts, the market is signaling that an economic slowdown could occur.
Market Recap
 Our benchmark Two Year Treasury yield followed the Fed Funds rate higher in the first quarter of 2005.  After seven hikes of 25 basis points each, the Fed controlled short term borrowing rate perched at 2.75%.  The Two Year Treasury finished the quarter at 3.78% up 69 basis points from the turn of the calendar year.  This change in yields produced a tough environment, with the Merril Lynch 1-3 year Government Bond Index putting in a negative total return from January through March. Fannie Mae continued to make headlines in the first quarter for accounting irregularities and what its regulator, OFHEO, called “internal control deficiencies.”  It is alleged that Fannie employees manipulated internal accounting programs to alter financial statements and attributed the changes to high level executives.  An inquiry into Fannie’s use of “special purpose trusts” that allows the company to shift $1.4 trillion in mortgage backed securities it guarantees, off the company balance sheet has begun.  Special purpose trusts allows Fannie to move risk off its balance sheet, reducing capital reserve requirements and boosting profits.  Fannie is the trustee.  There is potential for this issue to worsen Fannie’s capital reserve deficiency and cause a further downward revision in profits booked in prior years. Fed Chairman, Alan Greenspan, Treasury Secretary Snow, and congressmen Shelby of Alabama and Baker of Louisiana have become increasingly vocal in their criticisms and concerns about Fannie and its smaller counter part, Freddie Mac.  Change is coming, and none too soon.  Consider that 60% of U.S. banks have at least 50% of their assets in either Fannie or Freddie debt securities.   The concern for a negative credit contagion spreading through the financial markets is understandable while pretty unlikely.  We don’t lump Fannie and Freddie together as credit risks, although the media often does.  The difference at this point appears to be that Fannie manipulated financial statements to boost profits and bonuses while Freddie engaged in financial accounting irregularities aimed at under reporting profits. At ICM, we rarely stray from the familiar confines of the bond market but for illustration purposes we will compare the change in 10 Year Treasury yields with the performance of the Dow, over nearly three decades.  Since stocks are a good proxy for expected economic performance and show such a strong negative correlation with yields, our wanderings into the world of equities while brief, should prove beneficial.  A look at the two graphics that follow this text shows the powerful influence of interest rates on the equity markets and economic expansion. The mathematics of equities relies upon predicting and then discounting the future value of earnings to derive a current price.  Equity analysts accomplish this, in part, by peering into the interest rate looking glass.  For simplicity’s sake, the interest rate looking glass is actually a telescope. When rates are falling on a secular basis over a prolonged period of time, earnings growth appears closer and larger, because it is discounted at lower and lower rates.  This encourages investors to bid up prices in anticipation of a near term windfall  When rates are rising the telescope is reversed, future earnings are discounted at a higher rate and profits appear more distant and smaller, prices decline.  This analogy may help us understand the importance of interest rates in the expansion of equity markets and the economy.
Since we last spoke, the Greenspan Fed has raised the benchmark Fed Funds rate twice to a level of 2.75%.  While these moves were to be expected, it is worth noting that the Fed seems to be uncertain of where to go from here.  In the most recent minutes release, it was reported that, “many participants indicated that their uncertainty about the intensity of inflation pressures had risen in response to recent developments and that, the distribution of possible inflation outcomes was now tilted a little to the upside.”  While this may not come as a surprise, as we all have felt the pinch of gasoline as high as $2.50, what may be surprising is that the U.S. economy may be slowing as we begin the 2nd quarter.
In the days following the release of the FOMC’s March minutes statement, several economic reports have hinted to the fact that growth domestically and globally may not be as vigorous as previously expected.  Some very recent examples of this are disappointing March retail sales, coupled with slowing job growth and a fall in consumer confidence levels seem to signal the U.S. economy had lost some momentum as the 1st quarter drew to a close.  Globally, the picture may have darkened a bit also.  In its most recent projections, the IMF projected that the global economy would slow to in their estimation, 4.3% from a level of 5.1% for 2004.  The IMF also downgraded U.S. growth from their previous level of 4.4% to 3.6%.  China’s economy which was moving at a torrid pace is only expected to slow a little, from 9.5% growth in ’04 to 8.5% in 2005. It is these developments in the growth of the economy that may pose the biggest threat to Alan Greenspan receiving the restful sleep that he so much deserves.  Where the Fed goes from here may not entirely be under the committee’s control.  It would seem now, that future Fed policy decision will be predicated on the path the economy takes.  The minutes hinted that the Fed thought interest rates might be further from the neutral level (the level that neither restricts nor inhibits growth) than they had anticipated.  While this does not seem to mean increases larger than the 25bps that we have grown accustomed to, the Fed did hint that they may not pause if inflation were indeed to pick up.  On the other hand, it may be faced with a dilemma if growth does not keep pace.  The factors that could attribute to this dilemma would be continuing high oil and the price pressures that would follow.  However, the economy could bounce back if oil prices correct naturally.  In the past, oil shocks were due to a lack of supply which forced prices higher.  Currently, oil prices are being driven by a large demand increase, most notably, from India and China.  If these higher oil prices were to weaken economic growth globally, they would also weaken demand for oil which would bring prices back in line.  This seems to be the market consensus, as oil has eased recently evidenced by the price of benchmark West Texas Intermediate crude settling at a price of $50.22 on April 13th, its lowest close in two months.  This is also in line with IMF projections for the price of oil averaging around $46.50 for 2005.
At ICM, we feel the economic climate is in line with our previous projections for interest rates.  We are still looking for the Fed Funds rate to be at 3% by mid-year, and 3.50% by end of the year.  These projections are of course contingent upon the economy maintaining its current course.  We also believe the yield curve will continue to flatten throughout the Fed’s tightening cycle.  The current yield spread between 2 and 10 year treasuries has contracted to 67 bps, down from 116 bps at the start of the year.  As the curve further flattens or inverts, the market is signaling that an economic slowdown could occur.