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Wit is educated insolence Print E-mail

The Economy

 “Wit is educated insolence” said Aristotle. Interesting words from a man who wrote famously about ethics and virtue. 42% percent of Americans responding to a Gallup poll said they believed the recent plunge in gasoline prices was the result of a conspiracy by President Bush to help Republicans retain control of Congress. This group of untrusting cynics, referred to as the “grassy knoll crowd” in the October 30 issue of Fortune magazine, perceived more than a coincidence in the temporal relationship between the plunge in prices at the pump and the plunge facing incumbents on November 6th. Let’s recount the path of market prices for oil. For the past 6 months crude oil has averaged $71 per barrel. Crude peaked at $80 per barrel on July 14 and plunged 26% to $58.81 by October 23. Gasoline prices mirrored oil falling like a skydiver searching for his back-up chute. By August hedge funds, speculators (no redundancy intended) and investors had poured billions of dollars into the “energy complex” that includes oil, natural gas and gasoline. Their bet was a simple one; Middle East conflicts, high global demand and the coming hurricane season would continue to support high energy prices. What could possibly spoil such a rosy picture and the bull run in energy profits? Continuing war in the Middle East and strong global demand seemed safe bets. The weather was more a roll of the dice. But one of the paradoxical attractions to investing is that we can deny the existence of something like global climate change and still bet on its influence. The “grassy knollers”, conspiracy theorists to the man, found something fishy about the President appointing Goldman Sachs chief Hank Paulson to the post of Treasury Secretary. Mr. Paulson’s credentials were not a point of contention, quite the contrary. It wasn’t until Goldman Sachs lowered the weighting for gasoline in its commodities index this summer that the “knollers” began to howl foul. You see, investment managers like yours truly are to lesser and greater degrees servants to performance indices. It’s how we are judged. The easiest road to longevity in the investment game is to run portfolios that mirror your index, to change when it changes. You rarely stand out as a hero or a zero. When Goldman dumped gasoline in its closely watched commodity index traders and leveraged hedge funds followed suit reducing holdings from 32 million barrels of gas to 1.7 million. Is it any wonder that gas prices fell fast and hard from August through October? Are the “knollers” being witty or just dim-witted when drawing a connection between the President and Paulson and the index and gas prices? The opponents of the “grassy knoll crowd”, we call them “crude (as in oil) believers”, point to the August 7th meteorologist report downgrading hurricane risk for 2006 as a potential tipping point in the oil and gas plunge. There would likely be no Katrina or Rita to jazz up the party. The “believers” also sight the end of the summer driving  season as a contributing factor in plummeting prices. The perennial end of summer apparently came as a shock to speculators who stampeded for the exits. We are neither “knollers” nor “believers” but we are market observers and we draw two conclusions, first, energy markets are certainly susceptible to manipulation and second, highly leveraged hedge funds have not lost their ability to whip saw markets and magnify risk. To assure that this tale does not leave you worried for the welfare of the “energy complex” please note that Irving, Texas based Exxon Mobil survived the 3rd quarter with net income of $10.49 billion, $37.3 billion in cash on hand and the second highest quarterly profit of any publicly traded company in history.  Be you” knoller” or “believer” plunging prices in the energy complex is good news for consumers and the Fed. The American Consumer appreciates a bit of breathing room in the monthly budget and the Fed appreciates anything that reduces inflation. Let’s start with consumption, the very foundation of the US economy. The American business model depends upon domestic borrowing and consumption; we refer to it as a finance-based economy. Our financial infrastructure supports consumption through a network of consumer and corporate credit which grows more creative by the day. We have such a vibrant web of financial services that we can consume all that we produce and a lot of what everyone else can as well. Our deficits in trade and budgets reflect the world’s recognition of the US as the supreme consumer and borrower. We face higher adjustable loan payments for our homes, businesses and on our credit cards. We will become even more dependent on our wages and savings if inflation fails to slow. Wages are fairly stagnant and savings rates quite low. Let’s consider inflation, the bane of the Federal Reserve. The Fed is in the awkward spot of both creating and suppressing inflation. Since the cigar chomping Paul Volker left the Central Bank the Fed has shown a strong bias toward pain avoidance, aiming for a kinder gentler brand of capitalism. To understand the conflicted role of the Fed regarding inflation a look to history is helpful. From the 1800’s through 1929 US inflation generally rose and fell with war and peace. In that nearly 130 year period net price changes were near zero. The value and supply of money were determined by the “gold standard” until the depression. President Roosevelt, at the urging of both Keynesians and monetarist alike broke the link between metal and paper as a way out of the economic funk of the 1930’s. Money supply was free to grow and borrowing costs to fluctuate subject to Fed Policy. Modern monetary policy and a fiat currency were born. Institutionalized inflation would not be far behind. In the 20 years following the abandonment of the gold standard inflation doubled, and in the next 40 years prices raised five fold. Ironically Alan  Greenspan commented,” Monetary policy unleashed from the constraint of gold convertibility had allowed a persistent over issuance of money”.  I write “ironically” because it was Mr. Greenspan who flooded the markets with cash and lowered borrowing costs in response to each crisis he faced as Fed Chairman. His challenges included the Asian Contagion, the Russian Debt Default, the collapse of Long Term Capital Management and finally the stock market collapse of 2000. While striving for the elusive “soft landing” for each economic downturn or credit crunch Mr. Greenspan encouraged greater speculation with the equivalent of a morning after pill for poor investments. The pill was made of money.  Each time increasing money supply and lower borrowing costs were used to remedy a financial malady it spurred inflation in one market or another. Real estate is in the last throws of a bull market inflated by excess liquidity. The long awaited correction in housing is underway. Prices are dropping sharply; sales are significantly lower and new construction is falling fast as inventories bulge. The key to the severity of the correction and its impact on the economy will depend upon the duration of the downturn and the velocity of price declines. The greatest weakness is seen in metropolitan areas with dimmer employment prospects, places like New York, Detroit and Los Angeles. The good news for our Arizona clients is that although prices are softer, strong job and population growth will soak up your excess inventory and support prices. The flip side would be Naples, Florida where prices are off 20% from a year ago and inventory has doubled. As the air leaves the housing bubble it will inflate another market that will probably not register in the consumer or producer price indices but will be inflation in the truest sense. New Fed Chief Bernanke will voice strong words about containing inflation while pumping up the money supply to support asset values and growth in consumer spending. A peak at September’s Leading Economic Indicators report shows the factors that contributed on the positive side include growing money supply and consumer confidence while the negatives included housing and manufacturing. One thing we can be confident about is our propensity to consume, just add money and point us at the mall. The widening trade deficit hit $639.9 billion and is proof of America’s financial dilemma, our over consumption is being financed by foreign creditors to the tune of $2 billion each business day. To trim our trade and budget deficits America needs to do a 180, reversing course from financed overspending to interest baring savings and investment.  It could happen. The US economy grew at a 1.6% pace last quarter, the slowest in 3 years. This deceleration should lead to lessening inflation pressures and a sigh of relief at the Fed. Sluggish economic performance can be attributed to energy prices, housing and manufacturing slumps. Ford Motor Company exemplifies the plight of heavy manufacturing in the US. For starters kiss the Ford Taurus goodbye. After 21 years of production the car and the plant in Atlanta where it has been built are history. The Atlanta factory along with 16 others is targeted for closure by 2012. 58,000 jobs, the equivalent of 40% of Ford’s domestic  payroll will go away. Go where? Plans for expansion include China, India and Australia. After posting the worst quarterly results in 14 years Ford believes its future lies largely in China. Ford plans to build more cars and parts outside the US with $3 billion in parts coming from China. Which country has the fastest growing auto market in the world? You guessed it, China. The vast majority of China’s drivers have been on the road for less than one year. That’s a frightening thought on many levels. Our aim is to provide more wit than insolence while illuminating the important economic realities of our day.

The Fed
The members of the Federal Open Market Committee headed by Ben Bernanke are beginning to look pretty sharp. The bet they placed a few months back looks pretty good right now. If you recall, the Committee decided to hold the Fed Funds Rate at 5.25% in June, after 17 consecutive quarter point rate increases. What made this move a gamble was the fact that the economy was growing at about a 4% clip for the first half of 2006 with an inflation rate above the Fed’s implied comfort zone of 2%. The Committee began to see evidence that the housing market was cooling during what was traditionally the hottest season for sales and construction activity. Four months following the decision to stand pat the Fed’s stack of chips seems safe. The economy slowed dramatically in the third quarter and the all important core inflation rate moved ever so slightly lower and closer to the Fed’s comfort zone. Most academic models tie the growth rate of an economy to the inflation rate it is likely to produce. As demand for raw materials, labor and money rise so too does the price of conducting business. Thus consumer prices are pushed higher to cover increased costs of production. It stands to reason that as economies slow and demand eases consumer prices should move lower. What makes all economic modeling so interesting and assures economists a paycheck is the fact that every economic “cause and effect” works with a lag. Monetary policy affects the economy with a lag. The rate hikes of the past year or two are only now beginning to show up in the GDP numbers. Rate hikes should slow demand by raising the cost to borrow money to finance economic expansion and consumption. It’s the economist’s bag to guess when the slowing will occur and how much slowing there might be. Inflation lags growth. Kindling inflation takes time to ignite as growth accelerates and generally continues to smolder for a period while the economy slows. So when the Fed attempts to slow the rate of inflation by braking the economy through shifts in monetary policy it has to be both prescient and patient. The indirect effect of interest rates on inflation is what economists call a second derivative. Second derivatives produce less predictable results and thus more uncertainty and risk. Globalization introduces even greater volatility to most economic models by introducing more uncontrolled variables. The Federal Reserve policy makers must contend with the world wide glut of money and cheap credit that finds its way into the pockets of American consumers and businesses. The remarkable growth rates seen in China and the rest of Asia also bring a degree of demand driven inflation to the commodities markets that are for the most part immune to the wrangling of the US Central Bank. One only need look at the inverted yield curve to see that short rates set by the Fed are not having the desired effect on long term borrowing rates. Money supply and credit are growing rapidly around the globe and may be fostering a variety of asset bubbles. More central bankers are  beginning to follow money supply numbers again. Unfortunately the US Fed is not among them. Central bankers around the globe are watching money supply numbers because they are making the connection between cheap money and speculative investments. An example may be found in the initial public offering for the Industrial & Commercial Bank of China. Last month’s offering was the largest on record, raising $19.1 billion. What’s even more remarkable is that more than $500 billion in bids were received. There is an enormous supply of money looking for a home. Too much liquidity available at negligible cost leads to over-investment and over capacity. Returning to China in a related story we see that the country produced a surplus 118 million tons of steel this year, more than the out put of Japan, the world’s second largest producer. As we have learned over-investment leads to inflation, excess capacity and then collapsing prices or deflation. This has been the boom and bust cycle of capitalism for centuries. It has been the bias of the Fed and other central bankers around the globe to soften the edges of this cycle through manipulation of the money supply. So while the Bernanke Fed’s gamble looks good for now there are a number of wild cards left in the deck that could put its chips at risk.