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Smart people have more questions than answers Print E-mail

The Economy

A belated Happy New Year to clients and friends. Our year end commentary will serve to review 2006 and preview what we believe will be important issues for your community and your investment objectives in 2007. But before we begin this winding narrative let me share one of the more insightful things my mother said before sending me off to college. Mom said, “Smart people have more questions than answers.”  While that apparent contradiction made little sense to me 30+ years ago it seems to be sinking in today. Questions are tools of exploration and excavation that allow us to chip away at our assumptions and accepted knowledge base. They allow us to uncover ideas yet to emerge, dots yet to be connected. New questions must form to provide an understanding of the changing world around us. Globalization has introduced doubt into many of the assumptions imbedded in our economic models. We must reassess the validity of our models as forecasting tools of economic activity. The development of sound monetary and fiscal policy, community and corporate strategies depends upon it. The problem as we see it at ICM is that it has become difficult to understand our position in the dynamic global economy. Formal economics training has led us to make the following assumptions in the past; Domestic economic activity including growth, employment and inflation influence Federal Reserve   policy. Federal Reserve policy influences bond yields. Therefore if you want to know where the bond market is headed it pays to follow the economy and the Fed. These three factors appeared locked into an unbroken circle of economic life. But the circle has been altered; it is larger and more complicated than ever before. We observe the Federal Reserve battling inflation threats, real and imagined, and the central bankers seems to be pushing on the interest rate string. Overnight lending rates have risen by 425 basis points since June 2004, climbing from 1% to 5.25%. During this two and a half year period the yield of the 10 year Treasury has remained unfazed. (see chart 1.). With short rates marching higher and longer rates quiet the yield curve has inverted. Foreign investors who are also trading partners and our creditors display their financial muscle by depressing Treasury yields by 100 basis points or more, defying Fed intentions. Fed policy certainly has not lost its ability to affect market yields but it is clear that other powerful forces are at work. Consider oil. One of our tried and true economic assumptions is that rising oil prices suppress consumer spending, slow growth and agitate inflation. But as oil has risen to $78 and then retreated to $50 per barrel something interesting has emerged. Core inflation is fairly tame, asset prices (stocks, bonds, precious metals and real estate) have risen and long term interest rates have remained steady and low. Petrodollars from the Middle East, Russia and South America are being recycled into US securities markets depressing interest rates and funneling capital into the US. This source of liquidity is outside the control of the Fed and is stimulating our economy just when the Fed is trying to tamp it down. Our read is that while this glut of petrodollars may benefit the “markets” in the long run it is bad for the US economy. We also see that assets are inflated by a global money supply run wild. This is reminiscent of the “irrational exuberance” of the 1990’s when stocks set records and risks were downplayed. Core CPI may appear tame today as it did in the dot com boom but the real inflation is in asset prices out side the traditional measures. Will the flood of liquidity push values higher and keep market yields and risk spreads low or is there a bubble waiting to pop?  The relationship between capital and labor has been fundamentally changed and thus has undermines the concept of wage inflation. The world’s labor force has doubled, providing employers with cost savings hard to pass up in this competitive world.  In many industries labor’s bargaining power has evaporated. National companies have become international companies and nation state economies have become international economies. Economic models built upon laws of supply and demand for factory and labor capacity, productivity and inflation have been based largely on closed economy assumptions. These suppositions no longer apply. An array of other issues will impact the domestic economy and markets in 2007. Here are few of the things we will follow this year. Will tide of protectionism rise? Globalization has created upheaval in America’s manufacturing heartland. The techno-global revolution has not been an immediate win/win for labor and capital.  Great wealth and profit has been created for the most fortunate Americans while many others find life increasingly difficult. The change in the balance of power in congress will bring the “hour glass” economy front and center. Many see the hollowing out of the American middle class as a function of greed and globalization. To a great degree it is. The social change associated with the techno-global revolution, namely the transfer of US jobs to the lowest bidder has been wrenching for many. Great social change is almost always accompanied by dislocation and pain. It will be difficult for some in congress to avoid the political trap that favors protectionism over evolution. New York Federal Reserve President Timothy Geithner, quoted in a recent speech stated “that sustaining support for global economic integration may be the most important economic challenge of our time.”  Globalization is the world’s defining socio-economic system. This will not change in 2007 so America must face this reality through enlightened government and economic directives that do not further alienate the displaced and that provide upside potential to all participants in the capitalist economy. There may be great political hay to be made in “protecting American jobs” but this is certainly not sound economic policy.  Protectionism will gain ground if disparities in opportunity and income are not addressed. A December Bloomberg/L.A. Times poll confirms that the growing gap between rich and poor is on the minds of most Americans regardless of income levels. This fact will not be lost on the newly empowered Democrats in Washington. The corruption that invaded corporate boardrooms and corner offices around America prompted the Sarbanes Oxley legislation aimed to curb it. One of the unexpected results of that legislation has been the growth of the private equity industry. Wealthy investor groups such as the Carlyle Group, Blackstone and Kohlberg, Kravis, Robberts raised $200 billion in 2006 to buy out large public companies, taking them private, shielding them from onerous legislation. These private equity groups charge enormous fees, increase company debt, avoid public and regulatory scrutiny and pay incredible salaries to hand picked loyalists. Many astute financial observers believe that in 2007 the second act for these private companies will be divestiture; carving and selling the target companies assets for additional profits. The immediate losers in this scenario will be displaced employees, pension recipients and bond holders. Under this scenario America’s commitment to the global economy may take a back seat to protectionism. That will only impede our long term economic interests. Private equity groups should come under greater pressure for financial disclosure and greater regulatory scrutiny in lieu of a social conscience.  The United States isn’t the only nation flirting with protectionism. Both Russia and Venezuela are taking advantage of the tripling of oil revenues to put up walls against globalization. Vladimir Putin called the 1991 collapse of the Soviet Union “the greatest geo-political catastrophe of the century.” Mr. Putin views oil as a weapon to “restore the lost greatness of the Soviet Union” according to the December 16th issue of the Economist. Recent actions would seem to bare this out. Putin forced Russia’s large and independent OAO Yukos Oil Co. into bankruptcy and it’s CEO into a Siberian gulag. With this precedent to lean on Mr. Putin has leaned on foreign investors by threatening to revoke operating permits, cut off investment and disrupt oil supply. The hint of asset seizure hangs in the air. The threat is being taken to heart. Despite large investments and larger potential profits Royal Dutch Shell PLC., Mitsubishi Corp. and Mitsui & Company sold half their stakes in promising Russian oil fields to the state run energy company Gazprom recently. Ed Lucas, Eastern European correspondent for the Economist writes,” Where energy dominance is assured clout necessarily follows. Two decades after the Kremlin beat a retreat from the Soviet empire, a new hegemony, based on pipelines rather than tanks is advancing and shows every sign of being durable.” Russia, unlike the US is now a creditor nation. She has $303 billion in currency reserves. Can Russia simultaneously benefit from and thwart globalization for its own ends? This question may be answered in 2007. In Venezuela global oil demand is funding the social reforms of Hugo Chavez to the tune of $50 billion in 2006. Yet Mr. Chavez is threatening to nationalize the nation’s utilities and reduce the clout of foreign companies like Exxon Mobil, British Petroleum and Total SA. In Caracas stock dove 20% on the threats. Chavez relies on US refineries to process his high sulfur crude and yet he mocks the US and particularly the President at every turn. Thailand, Bolivia and Ecuador all wish to insulate their nations from the global capitalist markets. They see only recycled mercantilism. How ironic that the reassertion of Russian hegemony and Latin America’s turn to socialism are funded by global capitalism. In a still greater irony Communist China will continue to power global expansion. We anticipate that China to grow at a 10% rate again in 2007. Look for China to stimulate domestic demand for its own products and to allow the Yuan to float more freely. This may help reduce the politically charged trade imbalance with the US. China’s amazing growth rate comes with huge waste and pollution.  China produces 4% of the world’s GDP but consumes 30% of the world’s raw materials. It takes 4.3 times the energy to produce one unit of GDP in China as it does in the US. In 2006 China consumed 15% more energy per unit of GDP than it did in 2002. China’s massive appetite for commodities and stampeding growth will threaten profitability. Wasteful growth drives up raw material costs at the same time that overinvestment creates overcapacity and drives prices down. As a net importer of raw materials and exporter of finished goods China will face challenges to banking and price stability as well. Waste is not confined to industry. China’s banking system faces market driven strains. China is sitting on $1 trillion in foreign currency reserves looking for investment opportunities. Corruption and inexperience in lending has led to a mountain of bad debt. New factories pop up daily pushing production and supply ahead of demand. This is a recipe for debt deflation and loan defaults. Globalization is placing a burden on China’s planned social economy. Globalization may be transforming China’s economy at a blinding speed but many poor communists can still see the wealth being created and hoarded by wealthy communists. Peasant protests drawing tens of thousands are a daily occurrence. The world spotlight will shine on China as host for the 2008 Olympics. Beijing does not want a repeat of Tiananmen Square broadcast on the Wide World of Sports. We see China continuing to prosper in 2007 and cooling a bit in 2008. The rest of the globe appears ready to post solid growth and more than a hint of inflation in 2007. World GDP will come in near 5% with the BRIC nations (Brazil, Russia, India and China), Eastern Europe and Viet Nam showing particular strength and outpacing the US. The Japanese economy will grow again this year but higher interest rates will slow things there. Euro-zone economies will be a bit sluggish but also face rate increases to cool inflation threats. England is raising rates to suppress the recovering real estate boom but should grow at 3%. The United States will be a mixed bag with the slowest growth occurring in the first half of the year. Housing and manufacturing will continue to be the laggards. The difference is that the housing market will slowly rebound; there isn’t as much room for optimism in manufacturing. Weaker home prices should temper consumer spending and may lead to increased savings. It’s true that the big three auto makers are piling into China and India but local manufacturers there hold a nearly 20% market share. Chinese producer Tata manufactures and profits from the sale of cars and trucks costing between $2500 and $5000. What kind of future can Asia provide for Ford and GM? A good section of the country has enjoyed a warmish winter so far and refineries are increasingly processing gasoline rather than home heating oil. Crude prices have declined 25% since November. Call me naïve but I look for gas prices to come down at the pumps through spring baring an escalation of war in oil producing nations. The most meaningful secular economic trend in the US may be driven by demographics. Baby boomers will be retiring in increasing numbers and soon. Unless we see increased productivity from the remaining workforce, increased savings and investment in technology domestic GDP could slow a point or two in the coming years. We could see a smaller piece of the global pie just as our needs for health care and retirement income soar. Now for a look back at last year’s prognostications. Our best predictions were on the economic front. We looked for a slowing in the second half of 2006 and GDP followed our script falling from a 5%+ growth path to 2%. The housing market tumbled on cue from the frothy heights of 2005, slowing equity withdrawal and the unsustainable price spiral. The exotic and sub-prime mortgage markets drew increased scrutiny as defaults began to accelerate. We questioned the validity of the inverted yield curve as an economic indicator when it signaled a year-end recession. We opined that the manufacturing sector could see higher profits coupled with lower employment and wages. We were mostly right but autos did manage to under perform even our meager expectations. We overestimated the drag weaker real estate would have on consumer spending. Our economic calls were pretty much on the button but the markets wandered slightly from our conjecture. ICM’s call for the year end yield of the 2 year Treasury was quite close. We had the two year climbing from 3.5% to a range of 4.5% to 4.75%. The 2 year closed 2006 at 4.81%. The Federal Reserve surprised us with the tenacity of its anti-inflation stance despite a weakening economy. We had the Funds rate up only to 4.75% and missed by 50 basis points. The Fed Funds rate stopped out at 5.25%. Our hits help confirm some of our thoughts about the new rules for a global economy and our misses help refine our inquiries.  What was clear in 2006 was that the American consumer couldn’t be stopped by falling real estate, rising oil prices and interest rates or empty savings accounts. Cheap credit and massive global liquidity abound. It is equally clear that our trading partners are willing to lend us all the money we need to buy what they produce. We agree with New York Fed President Geithner about the importance of America’s commitment to a successful integration into the global economy.  Our research and investment strategies will reflect this profound change for America and its communities.

The Fed

The ascent of overnight lending rates paused in 2006. After 17 consecutive quarter point hikes dating back to 2004 the members of the Federal Open Market Committee decided to stand back and admire their work. As soon as the committee announced the break in policy the Treasury market began anticipating a rate cut or two. The slowing domestic economy and weaker real estate market seemed to support the bond market’s supposition that an easing was in the cards for late 2006 or early 2007.By November yields for maturities two years and longer had dropped 75 basis points from their June highs  of 5.25% to 4.5%. The yield curve inverted and calls for a recession induced by the faltering housing market gained an increasing audience. At times it seemed the only market participant not listening was the Fed.  Chairman Ben Bernanke cast a deaf ear to the doomsayers and reiterated the Central Bank’s commitment to price stability was its priority and reducing inflation its primary objective. The markets argued through the financial publications and over the airwaves that inflation is a lagging indicator that would ultimately follow GDP lower. The rate setting Federal Open Market Committee stood fast and held rates steady at 5.25% in December and even hinted that higher rates might be needed to govern inflation to acceptable levels. One voting member, Virginia Fed Governor Lacker   has taken the unusual step of repeated public disagreement with Chairman Bernanke , saying the pause  is a mistake , favoring higher borrowing costs to battle inflation. Around year end the Fed trotted out three prominent committee members in successive days to guide market expectations firmly away from the idea of imminent rate cuts. Dallas Fed President Fisher said he was “very comfortable” with the current level of interest rates and that economy was poised for a rebound in 2007. Fisher went so far as to say that the inverted yield curve might represent a “vote of confidence” in the economy rather than the traditional indicator of recession. We made the very same point this time last year in our fourth quarter economic commentary but focused more squarely on the impact of foreign investment. Chicago Fed President Moskow promoted the coming rebound in economic activity and said the Fed must remain “vigilant” in its fight for price stability. Fed Vice Chairman Kohn further chilled rate cut enthusiasm saying inflation remains the Fed’s “primary concern” and that fourth quarter softening of inflation could represent one-time events” reflecting lower energy prices and inventory management. Kohn and Fisher hinted that long term rates could jump higher if the markets were disappointed by the Fed’s failure to cut as expected or if foreign investors diversified dollar and US bond holdings. A steepening of the yield curve produced by higher long term rates would certainly be a negative for the housing market. With a renewed focus on the global economy it is important to note that monetary policy seems to be tightening around the globe. The English Central Bank surprised markets in January by raising lending rates to 5.25%. U.K. two year note yields now exceed US notes of the same maturity by 60 basis points. With the dollar falling against other currencies the U.K. notes look attractive on a yield basis. The ECB President Jean-Claude Trichet said rates in the thirteen nation Euro-zone were still low and that the bank needs to “monitor  inflation closely.” Japan is expected to increase lending rates slightly. By the end of January we shall have a clearer picture of international Central Bank intentions. At ICM we expect that the Fed is on hold through the second quarter of 2007. While we do not see a rate cut until summer, if at all this year, we believe the Fed will adopt a “neutral stance” making a rate cut as likely as a hike in the first quarter of 2007.

Market Recap & Outlook

A review of 2006 reveals a tale of two markets. It was a year of sharp contrasts in sentiment, moribund then elated. Through mid-year inflation warning signals flashed brightly. Oil prices spiked to $77 per barrel and the CRB index of industrial and agricultural commodities climbed more than 20%. Employment markets tightened and wages threatened to move higher. The Consumer Price Index hovered stubbornly above levels acceptable to the Fed, who by the way raised borrowing costs at every FOMC meeting. The bond market was bearish and stocks lacked conviction.  Two year Treasury yields moved from 4.3% in January to 5.28% on June 28th  mirroring the Fed tightening of 100 basis points in the first half of 2006. The domestic economy was growing at a 5%+ clip and our global trading partners were doing even better. The Dow climbed from the year’s low of 10,667 to over 11,500 by early May before giving back the gains in a summer swoon. In May an interesting thing happened. The CRB index turned sharply lower in a move destined to erase all gains from the broad-based inflation index by year end. Housing weakened further and year over year consumer prices began to decline in June. As the calendar prepared to flip from June to July the investment sky turned from gray to broken sunshine, Chairman Bernanke stuck his head out the door of the Federal Reserve Bank and announced that the steady rain of rate increases would pause. The Chairman could not guarantee that it would not rain basis points again but was confident a pause was warranted. Ben’s forecast was not unanimous, some on his staff called for more rain. Like young boys cooped up too long indoors bond and stock investors burst into action seeing only sun and ignoring the threat of future showers. Things were looking up. Oil began its 30% slide from the $70’s to the $50’s.  Traders took the DOW on an 1800 point tear setting records along the way. Two year bond prices rose and yields fell from the early summer peak of 5.28% to 4.5% before settling the year at 4.81%.  Foreign investors piled on, celebrating the fair weather in America looking to park their assets in the sun. But menacing market contradictions were there for all to see. Stocks rose to all time highs even as the yield curve inverted, predicting an economic slowdown just around the bend. Credit risk spreads, the difference between the rates earned on a risk free Treasury and debt issued by corporations, narrowed to historically low levels. This narrowing indicated that investors saw a bright future ripe with golden opportunity for corporations. But why were corporations investing their profits and cash hoards in stocks, bonds and real estate rather than capital equipment, increased capacity and hiring? The Fed’s favorite inflation indicator, known as the Personal Consumption Expenditure Index also remained above target. As the boys in the trading pits partied in the sun Bernanke and Company cautioned that inflation clouds persisted that could produce additional precipitation accumulating up to 25 or even 50 basis points. Enough already with the meteorological metaphor!  As the year came to a close the economy did not to roll over avoiding recession in 2006. It appeared likely to repeat that feat in 2007 as well. The housing market did not fall apart or spread pain to other sectors of the economy. Manufacturing showed slight expansion, replenishing inventories and holiday shoppers pleasantly surprised retailers. The Fed refused to budge on its anti-inflation stance and battled perceptions that a rate cut is baked in the cake. The disparity between market opinion and that of the Federal Reserve leaves stock and bond traders vulnerable to substantial price corrections. It never pays for traders to play chicken with the Fed. Investor sentiment took a sharp turn in December for those who toil in the Fed Funds Futures pits. On the first day of the month traders set the probability of a rate cute by March at 70%. By month’s end all hope of a cut was priced out of the futures market. Futures traders are a notoriously fickle bunch whose minds can literally change with the weather but as of this writing they see little chance of a rate cut for all of 2007. At ICM we are not as likely to be whipsawed as the boys in the pits but we have taken notice of the following at yearend.  Employment and wage growth has been moderate to strong, unemployment claims are dropping, more Americans are entering the labor pool, labor markets around the globe are looking up and wages are following. In short there is less slack in the global labor market to off set US wage pressure. Consumer confidence is on the rise and oil prices are falling fast. CEOs are more upbeat about consumer spending which should lead to greater production and continued moderate hiring. The slumps in housing and manufacturing are contained and not infecting the rest of the economy.  In this environment of global and domestic strength the Fed will not cut rates. Market yields should rise above the overnight lending rate of 5.25% in the US in 2007. Foreign investors will have a say in that but as oil revenues drop with prices the glut of petrodollars flooding the Treasury market will slow allowing prices to drop and yields to increase. We see the two year Treasury yield settling into a range of 5% to 5.75% probably at the high end by December, in 2007 and the Fed moving to a neutral posture. As Jim Cooper wrote in Business Week recently, “The economy seems to be in a sweet spot: decent growth with ebbing inflation and the Fed watching from the sidelines.” War, budget and trade deficits aside, we agree with Mr. Cooper.