The Consensus
By James J Puplava CFP, January 3, 2005
We live in uncertain times. The Fed is raising interest rates, the dollar
is falling and the U.S. is fighting a worldwide war against terrorism.
U.S. stock market valuations are high, the bond market is overpriced and
most asset classes of all stripes remain overvalued or fairly priced.
Not to worry. That seems to be the message emanating from Wall Street
analysts, market seers, and other clairvoyants for this year. The
panelists of experts promise certainty this year because that is what
markets and investors love. This year's forecasts look more like
last year more of the same: a growing economy and a rising stock
market. The only difference this year is that the forecasts have been
tempered to reflect rising interest rates. The economy will grow, but at
a slightly lower rate. Stock prices will rise, but not as much as last
year. In other words, "I'm okay you're okay" the markets are okay... and
there isn't much to worry about.
Markets abhor uncertainty, so investors naturally look for certainty in an uncertain world. That is why we have forecasts. They are supposed to bring "certainty" into our world when in fact no such certainty exists. We have forecasts for everything. There are forecasts on weather, forecasts on the economy, the financial markets, politics and elections and even the outcome of sporting events. Everyone wants to know what lies in store for the future. The purpose of these forecasts is to lend a sense of assurance in a world that is becoming increasingly unpredictable and unstable. It has been that way throughout all of human history. From emperors and kings to prime ministers and presidents, leaders and those who follow them rely on forecasts to guide them in their decision making. In the ancient world they were known as oracles, soothsayers, and prophets. Today we call them weatherman, pollsters, economists and analysts. Their job is still the same; to make what is unknowable knowable by removing all of the uncertainty.
The financial markets prefer to travel along a straight road and not one that weaves and winds in unpredictable fashion. But that is exactly what markets did last year. Interest rates went up and then they came down and ended the year at exactly where they started. Stocks went up and then they came down before finally going up again. The same held true for the dollar. It went up and then it came down. Throughout last year's gyrations, the economy continued to grow at an above-normal pace as money and credit expanded at above-average rates. The U.S. economy grew 3.9% the first nine months of last year.
More Of The Same
That brings us to this year's predictions. They could be summed up by four words; more of the same. The experts are forecasting strong growth in the economy (3.5-3.6%), a rising stock market, rising bond yields and a lower dollar. Investors will find comfort in that nothing much has changed. Even though last year's script didn't follow the script that was written at the beginning of the year, this years forecast is expected to give us more of the same. In short, our economic seers are giving us another linear forecast, which is nothing more than an extrapolation of last year with a few minor modifications. As shown in the table taken from the 2005 BusinessWeek, forecast market soothsayers see 7% gains for the Dow and the S&P 500. Interest rates are forecasted to rise over 5% for the 10-year Treasury note. On the economic front, the economy grows by 3.5%, the Fed raises the federal funds rate to 3.4%, inflation moderates to 2.2%, and the economy creates more jobs with the jobless rate falling to 5.1%.
| BUSINESSWEEK 2005 FORECAST | ||||
| FINANCIAL MARKETS | ||||
| Dow Industrials | S&P 500 | 10-Yr Treasury | ||
| 11,263 | 1,271 | 5.1% | ||
| THE ECONOMY | ||||
| Real GDP | CPI | Jobless Rate | Corporate Profits | Fed Funds Rate |
| 3.5% | 2.2% | 5.1% | 6.7% | 3.4% |
The reason for such optimism is that most of last year's worries are behind us. The presidential election is over with no job turnover. The other worries of sky-high oil prices, the turmoil in Iraq, rising interest rates, rising inflation, a hard landing for the Chinese economy, a collapsing dollar are all expected to go away as the year wears on. Oil prices will come down along with inflation rates, Iraq will have free elections, the dollar will decline gradually and we will have the best of all worlds. They already have a name for it, "The Goldilocks economy." Not too hot and not to cold. The Fed will make things right by raising interest rates just enough and at a slow enough pace that it will remove all of the risks in the economy that could come from inflation or a collapsing dollar.
This optimism is based on three major assumptions. They are as follows:
- Oil prices decline and then stabilize.
- The dollar declines gradually and improves U.S. competitiveness
- Fed rate hikes are gradual and aren't overdone.
These
are big assumptions. Oil
prices may retreat and in fact may head into the mid $30 before rising
again. These forecasts assume there are no supply disruptions. With OPEC's
spare capacity now at only one million barrels a day, there is no room
for error as we might have with hurricanes, terrorist attacks and the vagaries of
weather. As far as U.S. competitiveness, what will another 10%
devaluation of the dollar do for the U.S. manufacturing sector that 30%
devaluation has not already done? The last time I checked, the U.S. trade
deficit was getting bigger not smaller despite a decline in the dollar.
www.wsj.com
As to that third assumption that the Fed will raise interest rates without harmful effects to the economy and the financial markets a short trip down memory lane would be helpful.
The box below lists some of the highlights of the most exuberant Fed chairman the U.S. has known since Benjamin Strong and Arthur Burns. "The Maestro" as he is known has created more bubbles in his tenure at the Fed than any other chairman. The Greenspan trademark is flooding the financial markets with money and credit at the first sign of trouble in either the economy or the financial markets. The result is a string of bubbles in either foreign stock markets or U.S. financial markets from stocks and bonds to real estate and mortgages.
Maestro or Mess? Mr. Exuberance
Highlights of Greenspan Fed
1987: Stock Market Crash
1990-91:
1994: Peso & Derivative Crisis
1997: Asian Financial Crisis
1998: Long Term Capital Demise-Russian Debt Default
1999-2002: Bear Market Stocks-Economic Recession
2004-?: New Bear Market-Real Estate Bust-Recession
Greenspan's
modus
operandi is to inflate first, then analyze and ask questions later.
The Fed chairman is apt to change his mind any time a crisis erupts,
which seems to be more frequent under his watch. The result is that
financial imbalances have become ubiquitous. To name just a few: a
disappearing U.S. savings rate, record trade and current account
deficits along with an overvalued dollar, rising budget deficits, record
low interest rates and premium bond prices, an overvalued stock market and record debt levels and a real estate
and mortgage bubble.
These imbalances get larger each year with every Fed interest rate cycle. The markets and the economy are no longer allowed to cleanse themselves of excesses and heal themselves. Instead intervention is constantly pursued with the goal of altering economic outcomes. Recessions and bear markets are no longer tolerated. At the first sign of trouble, easy money is applied to remedy any downturn either in the markets or the economy. The result is that debt imbalances get larger, asset markets get inflated, and the real economy weakens and is hollowed out. The 1991 and 2001 recessions were followed by the weakest job growth on record. The financial economy keeps growing, while the real economy weakens.
As to this year's consensus for a Goldilocks economy, I'm reminded of times past when these same words were used to describe the benefits of another round of Fed rate hikes. Another phrase often used in addition to the Goldilocks economy is a "soft landing." These words were used in forecasts in 1990 and in 2000. The result was recessions in each of the following years. The forecasts usually start out as Goldilocks. When things begin to slow down with each new rate hike, "soft landing" is then substituted for Goldilocks. When you start hearing the words "soft landing" later on this year, you'll know a recession is on the way.
Right
now the financial markets and the economy are on a collision course with
a falling dollar and Fed rate hikes. It is a lot like playing with
nitroglycerine. At some point this year Fed rate hikes are going to
force the financial markets to reprice risk. Right now risk premiums
have been arbitraged away. The spread between 2-year T-notes and the
10-year note has narrowed to 112 basis points in the last year. The long
end of the curve has remained flat, while short-term rates have risen.
This is the result of foreign buying of U.S. Treasuries and hedge fund
arb plays of buying the long end of the curve and shorting the short
end.
In a yield-starved world, speculators have been forced further and further along the risk curve from junk bonds to emerging market debt. The result is that at a time quality is demanded, a yield-starved world has been forced to climb even higher on the risk scale in search of returns. The result is last year's best bond plays--besides foreign bonds--were in emerging market debt and high yield bonds. Both markets out-performed Treasuries and high quality corporates by almost double the margin. The returns on emerging market debt and junk bonds were 11.68% and 11% respectively. Mortgage-backed bonds returned 4.37%, Treasuries had gains of only 3.15%, and high-grade corporate bonds returned less than 5%. Risk has been arbed out of the markets. The only thing holding down yields at the moment is excess leverage and excess global savings from Asia and Europe.
I want to return to the upcoming Fed rate hikes. Eventually, as the Fed raises short-term rates, the yield curve is going to flatten or worse invert. This will remove arbitrage opportunities and cause the markets to reprice risk. I can’thelp but believe that someone or some institution is going to be on the wrong side of a trade. It is highly unlikely that that all parties involved in a derivative transaction, which is mainly interest rate related, will right their books at the same time. Somebody has to lose. The only question is how big they will be.
As to this year's Fed rate hikes, how high and when the Fed will arrive at neutral, that depends on when things begin to break down. By breaking down I mean the stock market or the economy. My guess is that the stock market begins to break down first, thereby signaling a weakening economy. When the economy begins to weaken, the dollar is in for big trouble. One of the main factors holding up the buck is the perception of a strong U.S. economy. If the U.S. economy weakens or even worse heads into recession, foreigners could begin dumping their dollars. Our trade imbalance is so large that all they have to do is absent themselves from the Treasury market and interest rates begin climbing. At the moment, there is plenty of capital to go around. Japan and Europe's economy are moribund with Japan's economy looking like it is heading back into recession again with Europe not far behind. Weak demand globally means plenty of excess savings, which eventually finds its way back into the U.S. With record low interest rates globally there is too much money sloshing around the globe looking for arbitrage opportunities. That is all that holds up the market. When will this money turn and run?
Wishful Thinking
As to all of the wishful thinking regarding a lower dollar as a panacea for what ails the U.S. economy, think twice before you are culled into such wishful complacency. The U.S. trade deficit is structural. Most of what the US imports is because we don't make it here anymore. As you recently went Christmas shopping, what did you find in the stores that are manufactured here? Were the shelves at Wal-Mart stocked with U.S. made goods? Were the racks at Nordstroms or Macy's hung with U.S. made clothing? Were the aisles at Best Buy and Circuit City full of U.S.-made electronics? Consumer spending makes up over 70% of the U.S. economy. Today most of the goods the consumer buys are made overseas. Another 10% devaluation of the U.S. dollar isn't going to solve that problem.
In addition to retail outlets stocked with foreign made goods, another factor contributing to the U.S. trade imbalance is America's voracious appetite for energy. Most of that energy (60%) comes from overseas from the Middle East, Russia and South America to natural gas from Canada. A 10% decline in the dollar will not solve America's energy needs. Dollar devaluation will not cause oil production to increase in the lower 48 states or in the Gulf of Mexico. The problem is depletion, which continues regardless of what happens to the dollar or what goes on in Washington and Wall Street. For the U.S. must now compete with Asia for oil and soon natural gas. Asian consumption has now become the single most important factor in energy demand. It shows no sign of decreasing nor has energy demand slackened in the U.S. As to the benign effects of lower oil prices stimulating the stock market and the economy this year, any declines will only be a temporary respite from a decade long climb to $100 oil.
Far from bringing beneficial effects, a falling dollar has strong inflationary implications. If the dollar declines further, raw material costs will rise and along with it inflation. Pipeline pressure is increasing with producer prices trending higher. Businesses in the U.S. are becoming confident enough to start raising prices from consumer goods companies to food processors. A falling dollar is a two-edged sword with more negatives than positives.
Can we get lucky and have another good year and muddle through without any mishaps? Anything is possible. There is an abundance of global savings with nowhere else to go. This works conveniently for the U.S. It enables the U.S. to consume more than it produces, borrow more than it saves and speculate more than it invests. It is an uncomfortable imbalance that hangs like a thin thread over a very sharp sword.
My forecast for the year is simple. Expect the unexpected. The Fed will keep raising interest rates until damage is inflicted upon the financial markets to be followed by eventual damage to the economy. By next year we should be in a recession. I suspect once the markets start to crater and the economy eventually weakens, the Fed will stop raising interest rates unless we are in a full blown dollar crisis. Even then domestic priorities will take precedence over international concerns. As the trend to a weaker economy and financial markets continue, the Fed will then begin to panic.
It is at that time we will have an answer to the inflation/deflation debate. When the financial markets begin to falter and the economy weakens, how likely is it that the Fed will allow nature to run its course? That would mean allowing all debt to be cleansed from the system and the economy and financial markets to be purged from all of its excesses. That's highly unlikely with an economy that carries $37 trillion in debt with $51 trillion of growing unfunded pension and medical liabilities. When we reach the breaking point some time this year, the Fed and the government is going to throw everything but the kitchen sink at the problem. More money will be created than we have ever seen in history. This will be the beginning of The Great Inflation.
Today's Market
It's off to the races and it started with a stumble. The U.S. stock markets ended lower in the first day of trading of this New Year. The Dow Jones Industrials ended down 53.58 points to close at 10,729.43. The S&P 500 fell 9.84 to 1,202.08 and the Nasdaq dropped 23.29 points to finish the session at 2,152.15.
The markets fell despite some encouraging economic news from the Institute of Supply Management. The ISM's purchasing management index rose to 58.6 in December from 57.8 in November. The only negative was the ISM's employment index, which fell to 52.7 from 57.6 the previous month. Also on the economic front the Commerce Department reported a drop in construction outlays of 0.4 percent, the first decline in 10 months.
On the positive side, the markets should have been helped by a drop in crude oil prices. The benchmark February contract fell $1.33, or 3.1 percent to $42.12 a barrel. Gold prices tumbled $8.70 to close at $429.70. Silver prices also headed lower dropping $.33 to $6.507.
Chart courtesy: www.stockcharts.com, Wall Street Journal, Grandfather Economic Report
James Puplava
© 2005 James Puplava
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James J. Puplava CFP
PFS Group
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