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Forex Blog - The Slow Motion Recession Re-visitedThe Slow Motion Recession Re-visited
June 27, 2008
By John MauldinThe Slow Motion Recession RevisitedInflation, Deflation and StagflationAn Update on MyanmarNew York
"We appear to be entering a period
of serious stagflation with sharply rising expected and actual inflation combined with large
downside risks to growth and employment."
"I would argue that what we are seeing is an
acceleration of expected consumer price inflation in the context of a sharp
expansion in global liquidity. It is hardly surprising that the prices of those
commodities, such as oil, for which the short-run price elasticities of supply
and demand are low move upwards strongly when there is a rise in expected
general inflation. The oil market is a very convenient vehicle to speculate on
expectations of higher levels of general price inflation. Hence my view is that
the 40% jump in oil prices that has occurred over the past few months - roughly
the period during which financial conditions have been loosened sharply - is a
reflection of the expectation of either an acceleration of global inflation, or
a depreciation of the US dollar, or some combination of the two."
- Malcolm D Knight, General
Manager, Bank for International Settlements
It was only five years ago that the
central bankers of the world, and especially the Fed, was worried about
deflation. Ben Bernanke was introduced to the world at large with his famous
helicopter speech about how the Fed could deal with a deflationary environment.
Who would have thought that what passed as humor to a group of economists would
be taken so seriously by the rest of the world?
Today the worry on the mind of investors and
central bankers is inflation. It is causing havoc with the markets. In this
week's letter, we look at whether we should be worried about inflation, take a
mid-year check on the economy, muse on the malaise in the stock market and
offer a very contrarian possibility for a positive shock to the world. It
should make for a thought-provoking letter.
But first, a very quick three paragraph commercial.
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And if you have any feedback or comments, feel free to write me. And now, back
to our regular letter.
Inflation, Deflation and
The quote at the beginning of this letter is
from the managing director of the Bank of International Settlements, or the
central banker to the central bankers of the world. (Thanks to Simon Hunt for
Stagflation is a strong word to use, but Knight
is surveying a world that is increasingly looking like it is in trouble. A
Morgan Stanley study suggests that 50 countries around the globe have inflation
running at 10% or more, and that this represents over 3 billion people.
Almost all of those countries have negative real interest
rates, or interest rates that are below inflation (as here in the US).
Central bankers around the world are slowly raising rates and tapping
on the brakes, but they are going to be under increasing pressure to
do so. Thus, Knight suggests that global growth is due to slow down
even as inflation is rising.
A quick sidebar. I am often asked what I think about the
inflation numbers produced by John Williams of Shadow Government
Statistics. His number, using the methodology to figure inflation that
existed in the late 70s and early 80s suggest that inflation in the US
is over 11%. That certainly corresponds to what many of us feel like
as we see food and energy prices rise. If you are bearish, a high
inflation number makes your case easier.
But let me make a few of you mad. I think what Williams'
number actually do is show that the government did not know how to
calculate inflation back then. If inflation were actually 11.8%, then
that would mean that GDP was a negative 6% today, and that the US
would have been in a recession for several years. That is obviously
not the case. You can simply look at corporate profits and tax
receipts to see the economy has been growing the past five
The recovery after 2003 was in fact robust, and corporate
earnings were solid, and tax collections went through the roof after
the Bush tax cuts. That is not something that would happen in a high
That being said, let me make two observations.
Inflation for much of America is much more than the headline CPI of 4%. If you
make $40-60,000 for a family of four, the cost of food, gas, medicine,
insurance, etc. is causing the inflation you personally experience to be much
more than 5%. The CPI reflects the inflation of all items, but your personal
inflation rate depends on what you actually buy. And it seems like a lot of the
necessities are running well north of 4% inflation.
Secondly, there are some of the statistical
methods used to measure inflation which I think are quite suspect, like hedonic
measurements. Just because the computer I buy today is twice as powerful as the
one I bought three years ago does not mean that the price of a computer dropped
in half. I seem to still spend about the same amount on my new computers or
cars. It is still the same percentage of my budget.
If we used the same methodology as
Europe (for instance), US inflation would be somewhat higher. And that is a
number I would find useful for comparison's sake. But let's get back to main
Louis Gave recently wrote a very
interesting essay on inflation. He makes the point I have made often, that the
Fed is not really increasing the money supply. If you look at the growth in
adjusted monetary base, which is the only measure that the Fed actually can
control, it has not been all that much over the past four years. But M2 and
other measures of money supply have skyrocketed. What gives?
Two things. One is the extraordinary growth in
credit offered by banks around the world. We saw a true inflation in financial
assets of all types.
Secondly, and this is less
intuitive, the US consumer has been a large supplier of money to the world by running
a massive trade deficit. We have seen trillions of dollars flow into the world
markets which has to find a home. Those dollars have been part of the growth in
the supply of dollars around the world.
Now, let me offer a hypothetical
series of events which could alter the current environment and maybe even bring
back the specter of deflation.
The US trade deficit is roughly
where it has been for four years, running in the neighborhood of 6% of GDP.
Only a few years ago, less than 30% of that was for oil. Now, that has changed.
Roughly 60% of our trade deficit is spent on oil, much of it sadly going to
countries that are not necessarily our friends.
The US consumer has cut his
spending on non-oil items by almost 40% in terms of GDP over the past few years,
and the trend is clearly down every quarter.
Financial assets are clearly
deflating. Banks are cutting leverage as aggressively as they once expanded
their balance sheets. Even though the data shows that bank assets (lending) are
increasing, it is because they are being forced to take assets that have been
off the balance sheet and put them on the balance sheet. That trend in the data
is going to reverse, and with a vengeance.
We are also watching home values decline, not just here but
in the United Kingdom and soon to be so in a lot of Europe, which will
put European banks under even more pressure. That is serious wealth
I have been pounding the table for over a year that
financial stocks are going to continue to show losses for at least
through the end of this year. Dividends will be cut. More shares will
be sold and further dilution will be a fact for many banks both in the
US and in Europe. Trying to pick the bottom in the financial stocks is
like catching a falling anvil.
And their distress is going to
translate into distress for businesses and individuals who need to borrow
money. All of this is deflationary. It is a strange world indeed in which we
are in the middle of two bubbles bursting and for inflation to be the headline
topic of every financial medium.
The source of the inflation is
clear. One is rising food costs. World demand for grain is growing at 1.2% a
year, yet yield increases are growing at 1.1% a year. The developed world, both
the US and Europe, uses a lot of food for bio-fuels. The major areas where we
could increase production are areas like Africa where the infrastructure and
production methods are poor.
Everyone now believes that food
costs are going to go up, energy will continue to rise and the dollar will continue
to fall. And maybe all these trends continue. But let me offer a very
contrarian thought or two.
Farmers around the world are going
to respond to high food prices and by this time next year we could see a rise
in supply that more meets the rise in demand. Prices might begin to actually
Energy prices have risen so much
that demand destruction is beginning to happen. US drivers are using less gas,
and as Asia takes away its subsidies demand will fall as well. You could see
oil prices drop over the next year.
And if oil prices drop, that means
the US is shipping less of our dollars offshore, which slows the growth of
available dollars, raises the price of the dollar which further lowers the cost
In a world of decreased leverage, debt
and housing deflation, coupled with lower food and energy costs and a higher
dollar, it is possible that inflation drops below 2% by this time next year.
Far-fetched? Maybe. But it is a
possibility that few are considering. In the inflationary commodity boom of the
70's, there was a 30% correction, which most don't remember. Everyone was
convinced that commodity prices could only go one way. And we do not have the
wage pressures and inflation that we did in the 70s.
The cure for high prices is high
prices. High prices stimulate production and reduce demand. I see no reason
that this could not happen again. Over time, I am along term commodity bull. I
think oil could indeed go to $200 or more in the next decade, and as a
developing world increases its need for commodities of all types, I see growing
demand and prices. But that is then long term.
Stagflation on a world wide basis
is going to have an effect on demand in the short term. I would be cautious
about long only commodity funds. While I do not expect anything to change
abruptly, I would be more vigilant and recognize that trends which look so good
now can change. I am not suggesting that you get out, just pay attention to
supply and demand figures coming out of the developing world.
Five years ago everyone was worried
about deflation. A lot can happen in a short time. Ben Bernanke may be dusting
off his helicopter speech in a few years, as deflation once again becomes the
The Slow Motion Recession
Last October 5, I wrote a letter called The Slow
Motion Recession. The basic premise then and in this space since then has been
that we are either in recession or a lengthy period of very slow growth and
that this slow growth will continue for some time. The cause of the lackluster
growth is the bursting of the two bubbles of the housing market and the credit
crisis. These are not problems that can respond quickly to the Fed cutting
interest rates, but will need several years to correct. These deflating bubbles
will put pressure on consumer spending and thus on corporate profits.
At the end of the day, it is earnings which
drive the price of stocks. And if earnings are under pressure, we are going to
see the stock market to continue to be under pressure. In a Slow Motion
Recession, with growth depressed in the latter half of this year, it is going
to be hard for the stock market to gain any real traction. As I have been
writing for some time, in a recession the US stock market typically falls 30%
or more. We are now down almost 20%. It would not be surprising to see the
markets fall another 10%, at least from the perspective of history.
And inflation is not helping. Inflation is often
more damaging to stock prices than a slow economy. Inflation, especially in a
slow growth economy, eats into profits and can be hard to pass on to customers
who are under spending pressure. And while inflation may slowly go away over
the next year, it could be a factor for the remainder of the year.
While we should see some rallies in July and
August, I think the trend is going to be lower, as the earnings projections are
going to come down, and guidance is likely to be soft for many companies.
A Slow Motion Recession, a Muddle Through
Economy, and inflationary pressures are not a prescription for a robust bull
market. Further giving cause for concern, the recent rise in consumer spending
is largely attributable to the stimulus checks being spent. This will be
largely over by the middle of the next quarter. As gas and food prices eat into
more and more of the average US consumer's ability to spend money on other
discretionary items, there will be pressure on almost any company that has
exposure to the US consumer.
An Update on Myanmar
My good friend Ed Artis and a team of workers
are currently in Myanmar helping the victims of the recent hurricane. His
stories are heart- wrenching. My readers have been very generous in helping
provide relief. They are one of the few teams that have been able to get in and
direct help to exactly where it is needed.
They are working to help re-establish an
orphanage, help farmers, supply needed food and medicine to families. The need
is overwhelming. He is going to stay a while longer and asked me to ask you,
gentle reader, if you could send a donation to help purchase more supplies. The
need for food for families is large.
One of the real
needs is for more water buffalo. They cost about $500, but allow a farmer to
feed his family and more. And it is not as easy buying a buffalo as it looks. Ed
tells me that many are in shock. Many of the ones that did not die will not
work because they are scared silly. "I never considered that as a possible
problem but it is BIG TIME," he writes. "Buffalo with Post Traumatic Stress
Disorder just stand there and stare into space."
thru Pay Pal with a credit card are best as they get quicker access to funds.
Go to www.kbi.org
and scroll down till you
find the donate button. Click on it and it takes you to Pay Pal. "We
accept checks made out to Knightsbridge International, PO Box 4394,
West Hills, CA 91308-4394, they just take longer to get funding to us
here in the field."
These are the
good guys. They are there on their own nickel. Not a penny goes to overhead or
salaries. I cannot say too much about them. I can personally vouch for them.
They are a small operation, but their efforts are very large. They get in where
other groups just can't. Pony up some money for a buffalo.
This next Tuesday Tiffani and I go to New York. I will be on the Larry Kudlow show that afternoon and then we will get to have
dinner with Larry and Charles Gave, co-founder of GaveKal. The next morning we
head out early to Philadelphia. My friend Thomas Fischer from Jyske Bank in
Denmark is coming in and we will be going to see Steve Blumenthal and three of
the mangers on the platform that I mentioned above, and another two that
evening back in New York. We will be at the Bull and Bear for Happy Hour so
I am really excited about the
line-up that we have with all the partners. They (and I) all do a lot of work
looking for managers on behalf of our clients and I think it is paying off. I
am proud of the work they do.
As long time readers know, I have an office that
is physically in the Ballpark in Arlington. You can watch the Texas Rangers
game from balcony in right field. My lease is up on my office this time next
year, and if we can get someone to take it before then we will move, as Tiffani
and I could each save about 200 hours per year by not having to commute. But I
will admit that tonight, with the Rangers playing Philadelphia outside while I
write, I will miss it. And tonight, when the two hottest hitting teams in
baseball are in the park, it is fun. Even better when we win 8-6. If we only
had some pitching.
Have a great week.
Your ready for the Big Apple analyst,
Copyright 2008 John Mauldin. All Rights Reserved
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