Gold: The 4,000-Year-Old Bubble

On balance it could be said that we’ve seen a continuation of improving but uneven growth in the US economy since our last Harmonic Notes e-newsletter in mid-January, with one rather large wrinkle: Inflation concerns are back in the headlines.

DATA OVERVIEW

• CONSUMER

-        The major negative factor facing consumers remains, of course, stubbornly high un- and underemployment levels. True, the headline unemployment rate fell to 8.9% in February but recent declines have come in part because the “participation rate” fell.  Also, while home sales have recently been mixed, with sales of new homes flat but sales of existing homes rebounding, home prices as measured by the Case-Shiller Home Price Index resumed their decline. A recent reading of consumer sentiment came in sharply lower than expected, presumably a reaction to the recent surge in fuel prices.

+        The broadest measure of un- and underemployment fell to 15.9% in February, its third consecutive monthly decline.  Despite the still-elevated monthly unemployment rate, weekly unemployment claims have recently fallen below the critical 400K level, suggesting a downward bias to the rate in coming months.  Probably influenced by this gradual improvement, retail sales and other measures of consumer spending rose (although the latest readings were taken prior to the recent spike in oil product price spikes). Also, February’s Consumer Price Index showed a moderate +1.4% YoY increase; concerning, however, was the index’s +0.4% month-over-month spike.  More on the CPI and other inflation measures below.

• BUSINESS

-        Participation in the recovery by small businesses continues to be a sore spot; while the NFIB Small Business Optimism Index ticked up in February to a 3-year high, the index remains at very low levels.  Also, January’s Industrial Production report came in lower than expected but the weakness may be short-lived because warmer than expected weather temporarily cut demand from utilities.

+        The ISM Manufacturing and Service Indices, surveys of mostly large businesses, both continued to surge higher and both remain solidly in expansionary territory.

• INTERNATIONAL TRADE

-        Imports rose more than exports in January, widening the trade gap. Import growth was driven dominantly by energy prices.

• GENERAL

+        The +2.8% revised reading on fourth quarter GDP growth was an improvement from +2.6% in 3Q10 but a drop from the initial estimate of +3.2%. The report showed the strongest consumer spending since 4Q06 and received a huge boost from exports. Meanwhile, our favorite coincident macroeconomic indicator, the Chicago Fed National Economic Activity Index, continues to wobble around the neutral mark. And our favorite leading indicator, the ECRI Weekly Leading Indicator, has continued its gradual improvement; after a precipitous decline for about nine months beginning late 2009, it’s risen back into expansionary territory.

GDP growth (white, right scale); Chicago Fed National Activity Index (yellow, left scale); Economic Cycle Research Institute Weekly Leading Indicator (blue, right scale), 5 Yrs ending 3/4/11 {GRAPH: BLOOMBERG}

EMBERS OF ENCOURAGEMENT

Several anecdotal and quantitative pieces of data suggest the economic expansion is becoming self-sustaining¹:

• Respected research firm ISI Group notes that the lower monthly Unemployment Rate has been corroborated by encouraging employment readings from several other sources, including weekly state unemployment claims and surveys by the Richmond and Philadelphia Feds, National Association for Business Economics, the University of Michigan and even the National Federation of Independent Business.
• Tepid wage growth below 2% poses no wage inflation risk. Since wages are typically the largest portion of a company’s expenses, there appears to be little chance of a wage-price inflationary spiral. Because the cost of labor hasn’t risen, the inflation rate of services has remained quite low; this trend is in contrast to that of goods, especially commodities.

Unemployment rate (white, right scale); Average hourly earnings (orange, left scale); Average workweek (yellow, right scale) {GRAPH: BLOOMBERG}

• Manufacturing continues to motor along. The strength in the ISM Manufacturing Index has been one of the US economy’s few bright spots since it rose above the 50 mark in mid-2009 (measures >50 show expansion in the manufacturing economy; >42 show expansion in the overall economy). Strength in this rather small (12%) segment of the US economy is being supported by growing foreign economies; declines in the US$, which aids export prices, may continue to support this segment.
• The ISM Service Index has also showed surprising strength and sits near all-time highs, critical since services comprise about 76% of US GDP.
• The ISI Group’s weekly survey of trucking companies, which they claim to have the highest correlation with GDP, moved into expansionary territory for the first time in 4 years.

ISM Manufacturing Index (orange) and ISM Service Index (white), 13 years ending February 2011 {GRAPH: BLOOMBERG}

• The apartment vacancy rate is declining and rents are rising nationally.
• Manufacturing in the many foreign economies, including Germany and Japan, are on the rise.
• Vehicle production and sales look to be increasing, with total annualized auto sales jumping in February.
• Year-to-date global mergers and acquisition activity is the strongest since 2000.
• Consumer installment debt has expanded for the past four months, indicating that consumers may be feeling more confident about the outlook.

Total Consumer Credit, 3/31/05 to 1/31/11 {GRAPH: BLOOMBERG}

DISTURBING DATA DEEP DIVE

Despite the overall improving data trend there remains plenty of things about which to worry; a partial list²:

• The impact of the earthquake, tsunami and nuclear accident in Japan are a sizeable question mark for global growth.
• The residential real estate market remains moribund, with sales rising slowly if at all and national prices turning downward again. According to economist David Rosenberg of investment firm Gluskin Sheff, house prices have about 3 times the wealth effect of stocks, so continuing declines put significant pressure on household net worth.
• The pace of foreclosures has paused only because of technical concerns about correct paperwork, not because the housing market’s stabilized. There are millions too many houses in the US, the absorption of which almost certainly presents a long-term economic drag.

Case-Shiller 20 City Home Price Index (not seasonally adjusted), January 2005 – December 2010 {GRAPH: BLOOMBERG}

• State and local budgets are under immense pressure, without benefit of the fiscal stimulus that blunted the effects of the downturn in 2009-2010. Not only is spending by state and local governments the second largest contributor to GDP but such spending tends to impact individuals more directly than spending by the Federal government. This shortfall is an enormous problem that will remain front-and-center for some time to come.
• The long-term unemployment rate is historically high. Nearly 60% of unemployed Americans were out of work for 15 weeks or more, with nearly 44% of them unemployed for 27 weeks or more.
• Labor underutilization is also a huge problem, with the broadest measure of under-employment still at 15.9%.
• Getting a clear read on unemployment remains a challenge. To wit: One respected research firm, ISI Group, recently stated that they have increased confidence in the reported 8.9% unemployment rate because of the corroborating data noted in the “Embers of Encouragement” segment of this report. However, BMO Capital Markets postulated that if many jobseekers had not given up looking for work – that is, if the participation rate had not fallen sharply – the unemployment rate would be near 12%.

• “Peripheral” Eurozone countries like Greece, Ireland, Italy and Portugal face very real solvency risks because of indebtedness and other imbalances in their economies.
• Competitive devaluations are a risk as exporting nations try to use their currencies as a tool to maintain global competitiveness. The inability of Eurozone members to do this exacerbates their problem substantially.
• While they’ve eased recently, consumer price index statistics for global markets are showing signs of inflation, especially in food and energy prices, which put new pressure on an already weakened consumer.
• Sharply higher food prices act like a global tax and are especially painful for those at the bottom of the wealth ladder. As the world has seen lately, riots and other political unrest are often the result.

{GRAPH: Bloomberg}

• Rising energy prices also act as a tax on consumers, especially those that must make difficult choices in their consumption. At the same time, companies experience margin pressure if they lack the inability to pass along their rising input prices, so the fair value of their stock prices declines.

INFLATION

Maybe it’s biased by our information sources, but it seems like there’s been an increase in the chatter about inflation lately. We noticed an uptick last summer when Bernanke signaled the Fed’s intention to launch QE2 and it’s really caught the public’s attention since gasoline prices spiked higher.  We thought it worthwhile to dedicate a portion of this newsletter to discussing what inflation is, what we’ve experienced in the past, the most recent readings and where we think we may head.

An online search for definitions of inflation will likely confuse a careful reader. Each school of economic thought offers its definition, the most well-known of which is probably Milton Friedman’s assertion that “inflation is always and everywhere a monetary phenomenon”. The difficulty of defining inflation naturally leads to disagreement over how to measure it, and thus whether the US is currently suffering from it. Rather than choosing a side, we’ll simply observe that inflation’s a widespread rise in the general price level in an economy; it’s NOT:

• a localized increase, like home prices skyrocketing in one city but remaining muted everywhere else in the US
• a short-term phenomenon, like gasoline prices rising as each summer driving season commences, only to subside in the fall
• an increase in the price of only a few items when the prices of most other goods and services remain stable.

We’ll focus this discussion on inflation on consumer price inflation so we’ll leave aside a discussion of measures like the Producer Price Index.

The most widely known indicator of inflation is the CPI – the Consumer Price Index. The Bureau of Labor Statistics, which calculates and publishes the Index, reports the CPI with and without the impact of food and energy prices (aka the “core” CPI).  It’s been said that the Fed prefers to look at the core rate since it’s a more stable reading of prices affecting consumers; that may be so, but I don’t know many people who don’t use energy or eat, so I tend to consider both.

Year-over-year change in CPI (orange), “core” CPI (yellow) and PCE deflator (white),

August 1980 to January 2011 {GRAPH: Bloomberg}

The CPI is well-known and broadly used by investors, economists and the media as a proxy for the overall level of inflation in the US economy. In fact, the US government uses the measure to adjust the value of Social Security and other transfer payments. Also, there’s a type of US Treasury bond (which will be discussed in some detail later) that has its principal value adjusted to reflect changes in CPI. However, problems with the calculation of the Index are widely known and include:

• CPI doesn’t include expenditures made on behalf of households (like employer-paid insurance) only those made out-of-pocket
• The “market basket” used to calculate the Index is updated every two years.  This methodology might not take into account recently and broadly adopted goods or services (smartphones for instance).
• The BLS assumes that if the price of a good or service rises, consumers will substitute; for instance, if the price of steak rises sharply, consumers might purchase chicken instead.  This substitution no doubt takes place but consumers might also purchase a smaller amount of steak or simply go ahead with the purchase.
• The cost of rent or mortgage payments has about a 32% weight of the CPI. The flat home prices of the past several years have clearly weighed on the overall measure.

Another government-produced measure of consumer price inflation is the Personal Consumption Expenditure (PCE) deflator. It’s a broader measure than the CPI, capturing expenditures made by others on behalf of households. The PCE deflator’s composition changes from quarter to quarter, so it’s more up-to-date than the CPI. The CPI actually represents about 74% of the PCE deflator, with the balance consisting of other price indices. Because of these advantages it’s understood that the Fed prefers to watch the PCE deflator.

As one can easily observe from the graph above, the PCE, CPI and core CPI all currently are near their lows of the past 30 years. The year-over-year change in these measures was in the low single digits as of the most recent reading; at 1.1%, the core rate remains below the 1.75%-2.0% range indicated by the Fed as their target.

An interesting third, but by no means final, alternative inflation measure is one calculated by professors in MIT’s Applied Economics Group called the Billion Prices Project (BPP). The BPP conducts a daily online survey of about 5 million individual items across 70 countries that provide a nearly real-time measure of goods price inflation. Obvious weaknesses of the BPP are that it doesn’t include services and the surveys are conducted online only. However, given the breadth and depth of the survey, the BPP provides an interesting and potentially useful counterpoint to the government-collected statistics.

Each of the aforementioned price indices is retrospective and so is of limited value in estimating prospective inflation. As we build our outlook on the economy and financial markets, Harmonic reviews short-term estimates from several sources, including the Federal Reserve Bank of Philadelphia, CXO Advisory Group, and BMO Nesbitt Burns Capital Markets.

GRAPH: CXO Advisory Group LLC

The long-term inflation forecast we find most useful is one that’s derived from the financial markets themselves. We’re of the frank opinion that an investor who’s putting money behind their opinion is a more credible source than an economist who doesn’t. Treasury Inflation-protected Securities (TIPS) are a widely traded type of bond that offers a direct view into the market’s inflation forecast; subtracting the yield of a TIPS bond from a nominal (not inflation-adjusted) bond of same maturity provides an estimate of the average CPI for that upcoming period. For instance, the top panel of the graph below shows the 10-year nominal US Treasury note (orange) and corresponding TIPS yield (white); the lower panel shows the spread, equivalent to the market consensus forecast of the average CPI inflation for the next 10 years, at 2.33%.

{GRAPH: Bloomberg}

Understanding inflation is critical to gauging value in the financial markets and it has an obvious and immediate impact on the quality of life of those it touches. Wages that don’t rise enough to offset higher costs put consumers under greater pressure and may result in undesirable purchasing patterns. In its worst form, hyperinflation, consumers may be relegated to bringing large amounts of rapidly depreciating cash for their purchases.

Inflation also has a measurable impact on the level of interest rates. Since the coupon rate and principal of most bonds is fixed, the price an investor is willing to pay should change in direct negative proportion to anticipated changes in inflation; if inflation is expected to rise, the price of a fixed rate investment should decline to compensate investors for the loss of purchasing power of their securities. Since interest rates move in an opposite direction from bond prices, those price declines create rising market interest rates.

Inflation expectations affect stock prices in two ways: First, since the fair value of an investment is simply the present value of its expected cashflows, higher (lower) interest rates translate into higher (lower) discount rate and therefore lower (higher) estimated fair value. Second, from a fundamental perspective an increase in prices that can’t be passed on to consumers will be seen as pressuring companies’ margins. All other things equal, lower margins mean lower company earnings and lower stock prices.

As can be observed in the bottom panel of the graph above, next-10-year inflation expectations are within a rough “normal” zone of 1.30% to 2.65% despite recent spikes in energy and food prices and widespread concerns regarding the inflation-creating potential of monetary policies like QE2.

We believe that inflation pressures may be building. While velocity of the money supply remains quite low, suggesting that the flow-through of liquidity being pushed to the financial system by the Federal Reserve is being restrained from entering the real economy, velocity may be set to rise because, in part, consumers are no longer deleveraging.

{GRAPH: St. Louis Fed}

Current inflation levels and those short-term forecasts by market participants have risen from 2009 but on balance they appear moderate. We worry, though, that the Fed’s focus on the core rate of inflation, ignoring the affect of energy and food prices, causes the central bank to fail to see the larger picture and to maintain an easy-money policy longer than is necessary.  The pressure on consumers caused by rising food and energy prices is a concern, as are rising rents.  It’s worth remembering too that forecasting models don’t handle structural changes well, such as an increase in the Non-accelerating Inflation Rate of Unemployment (NAIRU) or changes driven by foreign economies, like we’ve seen with commodity demand from emerging markets.

¹ SOURCES: Bureau of Labor Statistics, Cantor Fitzgerald, ISI Group, CIA World FactBook

² SOURCES: Gluskin Sheff, Bureau of Labor Statistics, ISI Group, Global Macro Monitor, CXO Advisory Group, BMO Capital Markets, Federal Reserve, MIT Billion Prices Project,