Deleveraging & the Case for Stagflation

By Chris Puplava, January 16, 2008

The Japanese yen has started rising against all of the world's major currencies as the yen carry trade may be unwinding. Traders have for years borrowed cheap yen at interest rates near 0% to reinvest those funds throughout the world. When the yen rises the carry trade becomes less profitable and traders will have to sell their assets to close their positions. The yen is not just rising relative to the U.S. dollar, nearing an all-time high, but also against strong currencies in commodity-rich countries such as Canada and Australia who are benefiting from high commodity prices.

Figure 1. Yen/USD

Source: StockCharts.com

Figure 2. Yen/Australian Dollar

Source: StockCharts.com

Figure 3. Yen/Canadian Dollar

Source: StockCharts.com

Figure 4. Yen/Euro

Source: StockCharts.com

Figure 5. Yen/British Pound

Source: StockCharts.com

This puts added selling pressure on global capital markets and was seen in last year's sell-off in February and last summer's market swoon. Markets did not stabilize until the yen weakened. It is no coincidence that the S&P 500 is breaking down at the same time the yen is breaking out. There truly seems to be shift in the undercurrents of capital markets, and a rising trend in the yen and VIX seem to be suggesting that this time is different.

Figure 6

Source: StockCharts.com

Some will try to play down the rising yen as stemming from Japanese economic strength instead of from global fears and an unwinding of the yen carry trade, as currencies typically reflect economic strength. Nothing could be further from the truth. For example, Japanese consumer confidence has been plunging to its lowest levels in years. Commentary from Dismal Scientist is provided below:

Figure 7

Source: Moody's Economy.com, Dismal Scientist

November's decline continues a trend evident since the start of the year; however the magnitude of the deterioration in the past two months is quite alarming. A near perfect storm of uncertain global financial market conditions, deteriorating exports outlook, a housing construction industry in disarray, unemployment rising and food and fuel prices surging have decimated consumer confidence in the Land of the Rising Sun.

Stagflation = Stagnation + Inflation

STAGNATION

Stagnation, or economic growth less than 2-3%, is clearly upon us with rising unemployment, decelerating retail sales, and a housing market in complete disarray. The economic sentiment turned sharply lower in the last few months of 2007 as both consumers and businesses became more pessimistic about the present situation and future. The CFO survey for December hit a record low and the CEO survey released yesterday showed a new low for the current expansion. Here was the main headline from the CFO survey along with the summary of findings. (Click here for report). Note the word "stagnate" in the headline and how employees are cashing out 401(k) accounts to pay for mortgages! (Words in bold for emphasis.)

Figure 8

Source: Duke University/CFO Magazine Global Business Outlook survey

SURVEY: CFO OPTIMISM HITS ANOTHER RECORD LOW; CAPITAL SPENDING AND HIRING TO STAGNATE; CREDIT MARKETS, CONSUMERS, PRICE OF FUEL ARE BIG CONCERNS

SUMMARY OF FINDINGS:

-- Optimism reached its lowest point since the optimism index was launched six years ago. Pessimists outnumber optimists by an eight-to-one margin, with 72 percent of CFOs more pessimistic and only 9 percent more optimistic about the U.S. economy than they were last quarter.

-- Weak consumer demand, high labor and fuel costs, and credit market turmoil are the top concerns of CFOs.

-- Credit conditions have directly hurt one-third of companies, most through decreased availability of credit.

-- At nearly one in five companies, employees have increased hardship withdrawals from their 401(k) accounts, in many cases to make mortgage payments or ward off personal bankruptcy.

-- Year-end bonuses will fall by 10 percent relative to last year.

-- Among firms with greater than one-fourth of sales in foreign locations, more than 60 percent have taken actions in response to the depreciated dollar by increasing hedging (expanding the range of investments to reduce risk) or changing the location of investments and outsourced employment.

-- Capital spending is expected to increase only 4.1 percent, and domestic employment will increase only 0.5 percent, though outsourced employment should rise 5.6 percent.

Does this sound like the strong economic growth that Hank Paulson and the Whitehouse are referring to? Hardly! The CEO survey wasn't any better as it fell below 40, an event that has been accompanied by a recession every time since the survey started in the early 1970s, no exception.

Figure 9

Source: Northern Trust, Daily Global Commentary (01/15/08)

It's not hard to see why businesses are so negative on the economy when simply looking at the state of the consumer. It was interesting to note in the CFO survey that employees are cashing out 401(k) accounts to avoid bankruptcy and pay for their mortgages. This is likely a result of homeowners facing ARM resets at the same time credit for refinancing is harder to come by. If a homeowner can’trefinance, they either scramble for cash by selling assets (stocks, mutual funds, bonds, 401 k) or default. This is the consequence of a record low savings rate and record high financial obligation ratio that have put the consumer in its worst financial shape ever.

Figure 10

Source: Moody's Economy.com

Figure 11

Source: Moody's Economy.com

Things will get worse before they get better as homeowners cut back spending as they are now feeling the negative side of the wealth affect from falling home prices. Consumer delinquency rates are likely to continue to rise into the end of the year before cresting late in the fourth quarter and into the first quarter of 2009. These timelines were arrived from the relationship between consumer delinquency rates with the Fed funds rate and employment growth, both of which have correlation coefficients 87% and 91% respectively.

Figure 12

Source: Moody's Economy.com

Figure 13

Source: Moody's Economy.com

The percent of loans past due has already exceeded the rate seen in the 2001 and 1991 recessions, and appears to be headed towards an all-time high as the unemployment rate is just starting to pick up steam, a contributing factor to delinquency rates. Speaking of the unemployment rate, its rate of change is now in recessionary territory as a year-over-year growth rate north of 10% has marked every recession since 1960, no exception and no false signals.

Figure 14

Source: Moody's Economy.com

Figure 15

Source: Moody's Economy.com

INFLATION

On the inflation front, inflation continues to remain elevated above the Fed's comfort zone of 2%. The CPI data released this morning showed headline inflation rising 4.1% from a year-ago and at a 5.6% annualized rate, and core inflation rose 2.4% from a year-ago.

Figure 16

Source: Moody's Economy.com

Energy again took the center stage in the report, as the energy category rose 17.4% from a year-ago and at a 37.1% annualized rate. Likely to worry economists and the Fed is the pass through of the spike in energy prices into the economy through rising transportation costs, which increased 8.3% from a year-ago, with food and beverage prices also rising significantly, up 4.8% on a year-ago basis.

Figure 17

Source: Moody's Economy.com

Figure 18

Source: Moody's Economy.com

Figure 19

Source: Moody's Economy.com

With all of the adjustments made to how the CPI is calculated, the above inflation rates are understated, an issue taken into account by John Williams from ShadowStats.com who calculates the CPI using the methodologies in place in 1980.

Figure 20

Source: Parker and Hart

Figure 21

Source: ShadowStats.com

The difference between the official CPI and the one calculated by John Williams helps explain why gold has decoupled so much from the U.S. Misery Index (unemployment rate + inflation rate), which should be much higher given the true rate of inflation.

Figure 22

Source: Moody's Economy.com

Gold prices are likely to continue to rise as global central banks inflate their economies back towards growth, with the U.S. M3 money supply (reconstructed by John Williams) surging. As highlighted before in a previous WrapUp (The Case for Gold), double-digit money supply growth rates from countries all over the globe are contributing to rising inflation, an environment that is ripe for gold strength to continue, despite short-term pullbacks.

Today's Market

The markets sank in the early morning trading hours after the earnings release from Intel (INTC), whose fourth quarter revenue of $10.7 billion fell shy of the First Call consensus estimate of $10.84 billion. What unnerved investors was a possible crack in the decoupling theory as INTC derives 75% of its revenue from outside the U.S.

The markets staged a rally after the release of the Fed's Beige Book that suggested economic growth increased modestly from mid-November through December. However, these gains proved temporary as the markets sold off in the final hour of trading. The Dow Jones Industrial Average fell 34.95 points to close at 12466.16 (-0.28%), the S&P 500 lost 7.75 points to close at 1373.20 (-0.56%), and the NASDAQ gave up 23.00 points to close at 2394.59 (-0.95%).

Treasuries fell with the yield on the 10-year note rising 1.1 basis points to close at 3.712%. The dollar index put in a decent gain, rising 0.68 points to close at 76.26 (+0.91%). Advancing issues represented 49 and 52% for the NYSE and NASDAQ respectively, reflecting a mixed market.

Chris Puplava

Contact Information

Christopher M. Puplava
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