Tuesday, July 28, 2009

Inflationary Surprises; Rob Parenteau on a Green Shoot Worth Applauding

Celebrating A Decade of Reckoning
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The Daily Reckoning
Tuesday, July 28, 2009

  • We love surprises...but only when we see them coming...
  • If inflation is a distant threat, why protect yourself from it?
  • The Trade of the Decade is still looking good...
  • Rob Parenteau on a green shoot worth applauding...and more!

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    Inflationary Surprises
    by Bill Bonner
    London, England

    We love surprises! But only when we see them coming.

    We're always wondering: how will we be surprised? What will happen that we don't expect?

    It's easy to make money...if there are no surprises. You just put your money in something that is going up and let it go.

    But surprises sink ships, marriages, military campaigns and investment portfolios. Things happen that you're not prepared for...

    A friend told of what happened to a mutual friend:

    "I guess it was the embarrassment that bothered him most. I don't know. He was happily married...or he thought he was. They had three children. They must have been married 10 years. And then, she announced she was a lesbian...and moved in with a woman.

    "I imagine he was devastated. He didn't seem to have any idea. But just think how you'd feel. You'd think that you were so awful you'd turned her off on the whole male sex. She wanted nothing more to do with any of them..."

    Yes, dear reader, you have to watch out for the surprises...

    Stocks have been rising since March 9th. Yesterday, the Dow went up another 15 points... The Dow now looks toppy...like it will go down again soon. But the rally may have further to go - maybe all the way to 10,000, as we originally guessed.

    And yesterday's rain of news brought forth another green shoot. New houses are selling again - with sales up 11% in June. Maybe it's time to buy a house. Better yet...buy a huge house with a huge, fixed-rate mortgage! Sometime between now and the next 30 years a fixed-rate mortgage is bound to lose its bite. What are the odds that inflation won't rise in the next three decades?

    Last week, in Vancouver, we left listeners confused.

    "Should I buy gold or not?" was the question one posed.

    It's a good question... we'll turn to it in a moment.

    First, the background...

    Everyone knows that stimulus leads to inflation. And everyone knows that this is the most daring use of stimulus ever attempted. Ergo, it seems likely that we will soon see the most inflation we've ever seen.

    But it's not that simple. The story is too easy to tell. It's too obvious. Too logical. Too easy to explain and too easy to understand. Under these circumstances, inflation would be no surprise!

    At least...that's been our worry. That too many people understand the inflation threat and are positioning themselves to avoid it. Everybody can't be right. As they say on Wall Street, when everyone is thinking the same thing no one is thinking.

    But is it true? Is it true that people fear inflation and that they are taking investment positions to counteract it? Alas, we don't know...but perhaps not. Neither the yield on Treasuries nor the price of gold signals a panic about inflation. Just the contrary; they seem to be telling us that investors are complacent...that they're aware of the inflation threat. They may be even sure that inflation is coming. But they seem to think that they can take action later - after inflation actually shows up. Seems reasonable, doesn't it?

    The inflation rate is currently MINUS 1.4%. That is, we're experiencing deflation, not inflation. Why try to protect yourself against something that is such a distant threat?

    Our guess is that this is what most investors are thinking: that inflation is coming, but that it isn't here yet. They're watching...they're holding their fire...but they won't be surprised by it.

    But what if they're facing the wrong way? While they're keeping an eye on inflation, what could be sneaking up behind them?

    Ah...keep reading...

    [Be prepared for whatever is sneaking up behind you - we have all the resources you need to get started on your own 'personal bailout' right here.]

    More news from The 5 Min. Forecast:

    "Here's a headline we can't resist," writes Ian Mathias in today's issue of The 5.

    "'Home Prices Rose in May,' trumpets The New York Times this morning. We understand...it's got papers to sell and a hell of a mortgage. But in reality, the US housing market is only decaying at a slower pace. Today's S&P/Case-Shiller home price index reading is par for the course for the last quarter...home prices and sales are still falling, just no longer accelerating into the abyss.


    "May registered a 16.8% annual decline in S&P's 10-City Composite, with its 20-City just a bit worse. Even though that's still a far cry from home price appreciation, May marks the fourth month in a row in annual return improvement. So raise your glass for a toast...here's to four months of, ummm, home prices not registering record annual declines. (Better make it a double.)

    "'To put it in perspective,' says David Blitzer, steward of the index, 'this is the first time we have seen broad increases in home prices in 34 months. This could be an indication that home price declines are finally stabilizing.

    "'While many indicators are showing signs of life in the US housing market, we should remember that on a year-over-year basis home prices are still down about 17% on average across all metro areas, so we likely do have a way to go before we see sustained home price appreciation.'"

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    And back to Bill, with more thoughts:

    Practically everyone anticipates rising rates of inflation. The adjusted monetary base of the United States has more than doubled in the past year. Deficits are staggering. The price of oil - at $68 - is telling us that inflationary pressures haven't gone away. Gold, too, at $953, seems to be whispering - not shouting - a warning: watch out...

    So, what's the prudent thing to do? Shouldn't you keep an eye on inflation, like everyone else...and participate in the stock market rally at least until it shows up? If you failed to join the rally, you missed an opportunity for a gain of 20% to 40%. Though a correction in the rally is probably at hand, wouldn't it make sense to buy stocks...hold them until the rally ends or until inflation appears...and then jump into gold?

    Yes...that seems sensible.

    But where's the surprise? Here's one possibility: a much deeper and more persistent depression/deflation than people expect. Ben Bernanke told Congress that he had sought to avoid "a second Great Depression." Well...what if he failed?

    Roger Lowenstein in The New York Times:

    "The US economy is not only shedding jobs at a record rate; it is shedding more jobs than it is supposed to. It's bad enough that the unemployment rate has doubled in only a year and a half and one out of six construction workers is out of work...

    "The Federal Reserve now expects unemployment to surpass 10 percent (the postwar high was 10.8 percent in 1982). By almost every other measure, ours is already the worst job environment since the Great Depression...

    "In terms of its impact on society, a dearth of hiring is far more troubling than an excess of layoffs. Job losses have to end sooner or later. Even if they persist (as, say, in the auto industry), the government can intervene. But the government cannot force firms to hire."

    Job losses result in fewer purchases...which result in fewer sales and earnings...and that leads to more job losses and falling prices. That's what a depression is all about.

    Currently, we look at that -1.4% inflation rate as a fluke...an aberration. And most people are sure the feds will stir up the inflation rate soon. But what if the feds are more incompetent than we realize? What if they can't cause inflation? The Japanese couldn't. And they never had deleveraging consumers to contend with. In other words, their households were never so deep in debt that they had to cut back spending in order to pay down debt. But they cut back anyway...and Japanese prices fell.

    Nor did the Japanese have an entire world economy that was deleveraging. Instead, they were able to continue supplying goods to eager consumers in the United States...and making profits.

    [Now that US consumers aren't consuming, who will prop of the economy? Read Rob Parenteau's latest report in The Richebächer Letter.]

    America's economic situation is much more dangerous...and potentially much more deflationary. We could be entering a period of falling prices that will last for many years.

    So, should you buy gold or not?

    Ten years ago, we suggested a simple Trade of the Decade. Buy gold on dips; sell stocks on rallies.

    This was not the best trade you could have done. There were huge run- ups in stocks and in oil, for example. Many investments would have paid off more. Google was probably the biggest hit of the period.

    But the Trade of the Decade looked to us like the safest, surest thing you could do with your money at the turn of the century. Gold was at a record low; stocks were at a record high. What could have been easier?

    And it turned out to be a decent trade.

    The decade is not finished. So, we'll stick with our trade a bit longer. Our guess is that we'll see some additional profit when the stock market turns down again. But gold's big day still may be a long way in the future.

    [But if you'd like to hang on to some of the yellow metal, you're in very good company. And our intrepid correspondent, Byron King, has some interesting insights into where he believes gold is heading...see his full report here.]

    So, if you are looking for quick profits, gold is probably not a good buy. It's a monetary metal. It is fundamentally a protection against paper money and financial distress, not a real investment...or even a speculation.

    Since we rate the risk of financial distress very high, we buy gold - as insurance. But we do not expect a major bull market in gold soon. Later, after deflation and depression have surprised investors and squeezed inflationary expectations out of them, we will buy gold as a speculation. Then, investors will be surprised by how fast inflation comes back.

    Until tomorrow,

    Bill Bonner
    The Daily Reckoning

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    The Daily Reckoning PRESENTS: What is happening in the US economy right now is clearly not your garden-variety recession. And that said, Rob Parenteau points out, below, that operating from the typical 'recession playbook' is not advisable. Read on...

    A Green Shoot Worth Applauding
    by Rob Parenteau
    San Francisco, California

    Fears of a relapse in economic activity are stalking professional investors, judging by the fall in Treasury bond yields, the sagging equity indexes and the softening of commodity prices over the past month or so. Our stated position has been that investors got ahead of themselves with all the "green shoots" rhetoric. This is clearly not your garden-variety recession, so operating from the typical playbook is not advisable. Sifting through the volumes of macro statistics, our assessment has been that the economy is still struggling with a severe recession complicated by balance sheet issues, and, at best, we could find some signs of stabilization in spending and activity starting to shape up in recent months.

    To our mind, the twin head winds of private sector deleveraging and impaired financial institutions with unusually high-risk aversion are the larger issue. If the business and household sectors seek to maintain a high net saving position (that is, saving from income flows minus tangible investment expenditures), as was the case in Japan, then barring the political willingness to allow debt defaults and rapid relative price changes to rip through the economy, only a rising trade surplus plus an increasing fiscal budget deficit can deliver US economic growth. As we will show you in a moment, though, we are detecting for the first time some signs of life in business investment.

    Most investors, policymakers and economists appear to be either ignoring the implications of private sector deleveraging or have implicitly assumed any such deleveraging will prove short-lived. The latter is, of course, more consistent with their experience, but as many professional risk managers at hedge funds and other institutions recently learned the hard way, the past is at best an imperfect guide to the future - especially if you do not stop to consider why the past developed the way it did.

    We have expressed the challenges of private sector deleveraging in our work on US financial balances.

    In simplest terms, the challenge of a balance sheet recession is this: In the face of a large drop in asset prices, the private sector reduces spending on goods and services in order to save enough money out of income flow to reduce balance sheet leverage. Unless the trade balance improves and fiscal stimulus is ramped up in a large enough fashion, private income flows will tend to fall as households and firms spend less money to try to reduce debt loads. Realizing that one man's outlays are another man's income, the end result of this process is much like a dog chasing its tail: Private sector income deflation arises as spending is curtailed, and falling income aggravates attempts to reduce debt burdens.

    In a world where Austrian School precepts held sway, the dog would be allowed to exhaust itself and start out fresh, facing less-distorted relative price signals that eventually would lead to a more productive set of behaviors. Debts that could not be supported would be allowed to disappear in default, creditors would gain ownership of any remaining tangible productive assets and prices for products and labor would adjust until growth returned to the trend path dictated by the available supply of productive resources and the willingness of entrepreneurs to search for profitable production opportunities.

    Few nations appeared prepared to take the pain of such unfettered adjustments. Instead of allowing a debt deflation to rip and eventually burn itself out, contemporary policymakers aim to reduce debt-servicing costs, socialize losses and buttress private sector money income flows. Two routes to buttress private sector money flows are available: first, by an improved trade balance (so more domestic and foreign spending is received as income by domestic producers) and, second, by an increased fiscal deficit (so more income is received by the private sector from government expenditures than is removed by taxation). At a global level, until we discover life on another planet, the first exit strategy is, of course, unavailable.
    "...we are finding evidence that business capital spending has been cut so sharply over the prior three quarters that it is reasonable to expect some replacement demand to begin showing up. While fears of a relapse are still building, that is one green shoot we believe Dr. Richebächer would deem worth applauding."

    Balance sheet recessions have distinct characteristics from normal garden-variety recessions, and so it is no surprise that recoveries from balance sheet recessions will tend to have different profiles as well. Consumer durable and home sales usually, along with an abatement in the pace of inventory reductions, lead the charge in garden-variety recessions. Not so this time - or, at least, less so. We anticipate recoveries in these areas are likely to prove shallower than usual, but judging from the move in the S&P 500 consumer discretionary stocks year to date, most investors have been positioning as if we were working with a more garden-variety recession. We suspect this will prove to be a mistake, especially as more of the infrastructure-related components of the fiscal policy come into view as 2010 approaches.

    For example, consumer expectations, as measured by surveys performed by the University of Michigan, have tended to offer a reasonably good guide to the year-over-year growth rate in consumer spending, adjusted for inflation. July results so far display a 9-point decline in expectations, back below the April readings, but still above the recent February lows. The latest reading on inflation-adjusted consumer spending growth is still as bad as it was during the depths of the 1973-5 recession, which we know was the deepest recession of the post- World War II period. While consumer expectations are consistent with real consumer spending growth migrating back to flat year-over-year gains, this is not the usual liftoff that is typical of garden-variety recessions.


    However, Dr. Richebächer worked with a model of economic growth driven by business capital spending, not by consumer spending. This approach was consistent with much of the emphasis of the classical economists, who emphasized the importance of capital accumulation to growth. It was also consistent with Austrian School insights and the work of J.M. Keynes (although subsequently forgotten by some Keynesian followers).

    In this regard, the collapse of US business investment spending as a share of GDP over the last two quarters is most striking, and no doubt this is in part testimony to the "lockdown" mentality that spread among corporate CFOs after the Lehman Bros. debacle and the subsequent freeze in credit markets. CFOs went into cash conservation mode and, of course, not just inventories and payrolls got the axe, but capital spending plans were put on ice.

    In a smoothly growing economy, households do not consume all that they produce. They save out of income flows, and businesses mobilize the associated unconsumed output as working capital or in the production of new plant and equipment. With the sharp revival in the personal saving rate in the wake of plummeting asset prices and extremely weak job prospects, it is no wonder that US nominal GDP has tracked a deflationary path in recent quarters. Higher household saving, with no mobilization of that saving into reinvestment in plant and equipment, is bound to short-circuit any economy.


    We believe the extremely sharp retrenchment in business capital spending is important because the gross spending flows are nearly down to estimated levels of depreciation. That is to say net investment is fast approaching zero. If this is correct, replacement demand for capital equipment is likely to arise in some industries, and therefore could play a larger role in any economic recovery than usual.

    We cannot ignore that some industries will be shrinking their available capital stock as the economy adjusts to a reduced private debt growth path. Autos are an obvious case in point. Nor are we ignorant of the extremely low reading on capacity utilization in the manufacturing sector. But we suspect investors and economists may be missing the fact that gross capital spending has dropped so dramatically that replacement demand for capital equipment is likely to kick in sooner than usual. Indeed, perhaps this recognition of the onset of replacement demand is part of the relative performance in tech stocks year to date, as the tech capital stock tends to depreciate quicker than other forms of capital equipment.

    We have previously noted the Institute for Supply Management (ISM) new orders series has been signaling a revival in order flows, and with the usual three-four month lag, Commerce Department orders are, in fact, confirming the ISM improvements. Dollar levels of manufacturing orders are starting to make the turn, and capital goods orders are already showing improvement off levels that marked the end of the last recession. By composition, the order improvement is reported in the industrial machinery, materials handling machinery and nondefense aircraft and parts segments. Recent Boeing announcements call the improvement in the last category into question, but the key point here is that even at historically low rates of capacity utilization in the manufacturing sector, there are signs of life in new orders for capital goods. The initiation of replacement demand for some types of capital equipment may have begun given the sharp plunge in gross business investment to levels close to estimated depreciation.


    We are quite certain Dr. Richebächer would have recognized this is no garden-variety recession, and so we believe he would agree that positioning investment portfolios as if it were, green shoots in the consumer area and all, is unlikely to prove very satisfying. We are also quite certain Dr. Richebächer would have argued any sound and sustainable recovery requires an improvement in business investment. Business investment is the route to lower cost production and product innovation, as well. In the absence of any such improvement, higher household saving rates will simply tend to show up as shortfalls in the revenues of consumer-oriented firms and a weak, if not falling, nominal GDP. What we wish to share with you is that we are finding evidence that business capital spending has been cut so sharply over the prior three quarters that it is reasonable to expect some replacement demand to begin showing up - and indeed, for the first time in months, we can find evidence of higher new orders for capital goods. While fears of a relapse are still building, that is one green shoot we believe Dr. Richebächer would deem worth applauding.

    Best regards,

    Rob Parenteau
    for The Daily Reckoning

    Editor's Note: Rob Parenteau edits The Richebächer Letter, founded by the late Dr. Kurt Richebächer. Each issue provides an examination of the world's currency and credit markets. Previously, he spent 24 years as Chief US Economist and Investment Strategist for RCM Capital Management, an asset management firm. Rob holds a CFA and was appointed a Research Associate at The Levy Economics Institute in 2006. His papers have been presented at the Political Economy Research Institute, the Seventh and Eighth Annual Post Keynesian International Workshop, and the Eastern Economic Association.

    Get Rob's latest report here.

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