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A Critical JunctureJohn Mauldin
This week we once again look at Fed policy, the economy and some very interesting statistics and commentary from some very thoughtful commentators. We are coming to a critical juncture. Future Fed policy making decisions are rather murky at this point, and we examine why, and why it is important to you. Also, last week, in response to some ad hoc comments in my weekly letter about why it took so long to get soldiers into New Orleans, I received a thoughtful, articulate response from Brigadier General Gregory Zanetti of the New Mexico National Guard. I think you will find the full unedited letter to be of some interest. I think this is a letter you might want to forward to your friends, and at least suggest they read the letter at the end. All in all, it should make for an interesting weekly letter. Let me interrupt the regular letter to note we have had a large number of new readers subscribe in recent months. Let me take this opportunity to welcome you. This week is more or less my fifth anniversary of writing this letter. We started with just a few thousand email addresses in September of 2000, and I am pleased to say that well north of 1,000,000 friends get this letter each week. And I mean it when I say friends, as the letters and comments I get from you make me feel like I have friends everywhere I go. Thanks you for your support over the years. I am most humbled. I take the responsibility of coming into your homes and offices very seriously. As background for new readers, I read several hundreds articles, newsletters, books and reports each week. This letter is about the ideas and themes I find to be of the most interest that week, trying to tie them into a theme centered on our investments. Quite often, I seem to find items that fit together like a puzzle, giving us a picture of the world around us. My goal is to try and make the complex simpler to understand. As long time readers know, the subject matter can range far and wide, but the intent is to help us understand how the economic world works and try to peer, however dimly, into the future and the human economic condition. The newsletter started (and still is) a way for me to discipline myself into getting my ideas and themes on paper, and is of enormous benefit in my regular day (and a lot of evenings) job. It is something I should be doing anyway, and thus it is free. That scores of websites and other firms choose to make this letter available to their clients gives me some little satisfaction. Please feel free to forward this to your friends suggesting they subscribe if you think it appropriate, and if you are reading this for the first time, you can become one of my 1,000,000 closest friends by going to www.2000wave.com and subscribing for free. Simply give us your email address. That's it. No long forms and then I come to you each week. And now let's get back to our regular letter in progress. What Will the Fed Do in 10 Days? Last week, I made the case that the Fed needs to pause in its "measured tightening" cycle for at least the September Fed meeting until we can see the full effects of Katrina and the oil shock upon the US economy. We will really not know all that much by September 20, and given the Fed emphasis upon approaching central bank policy as a task of risk management, that seems the prudent thing to do. But that is in the background of the prior week's letter where I discussed Greenspan's pre-Katrina speech at Jackson Hole where he clearly indicated that the Fed is targeting what he feels is an unhealthy rise in asset prices, and specifically the rise in your home values. Even for a Greenspan speech, or maybe especially for a Greenspan speech, it was not subtle. (You can go to www.2000wave.com for past issues.) I pointed out that pausing for 40 days until the November 1 meeting until we had more data on the effect of Katrina and the current potential oil shock would not suddenly send the economy into a dangerous spasm of inflation. If the economy adjusts, and oil, refineries and shipping come back online in good order by then, as it most likely will, then they can continue their tightening cycle with no danger to the economy. But if we do find problems, the downside risk seems to me to be too great. It is not yet altogether clear that Mississippi shipping will be back up in time for the fall harvest. Any other shocks (we are still in the middle of hurricane season, as an example) at this delicate time could be of real concern. Patience, at least for 40 days and 40 nights, is called for. Even God took that long to get things back to normal when things needed cleaning up. Post Katrina, we have had three Fed governors speak. Frankly, they still seemed to be tied to the party line of the potential for a return of inflation. I found no quicker or more on target assessment than that which comes from Dennis Gartman [note: by "hawkish" Dennis means aggressive in controlling inflation, and in this instance by raising rates]: "We think, therefore, the odds are greater that the Fed shall pause and do nothing at the upcoming meeting. We think that is what reasonable people would do under the circumstance. We think that is the right thing to do. But are we certain that is what the Fed will do? On that we are wholly uncertain. "...Having stated our preference, we must admit that the 'hawks' have been rather overtly public in putting forth their position that Katrina is exogenous and that their previous course of action remains the proper course. We noted of course the very hawkish comments made earlier this week by Mr. Moskow of the Fed Chicago. Now we note the comment made recently by Mr. Santomero, the President of the 'Philly' Fed, who said that 'As the expansion matures, the price dynamics at work in the economy will shift [upward].' Mr. Santomero was concerned about inflationary forces at work. "We understand that concern, and there is no question but that Katrina will exacerbate those concerns as the re-building process begins over the course of the next several months and shall continue for several years into the future. But, does that mean that the Fed cannot chose to pause, if only for a while? We think not, but Mr. Santomero may think otherwise... and let us be rather honest: his opinion counts a bit more than does ours. "What really caught us off guard, however, were the comments from Ms. Yellen, now the President of the Federal Reserve Bank of San Francisco, and a former Board member of the Federal Reserve. Ms. Yellen, we would hope, is fully cognizant of the Fed's 'political' situation and so we suspect that her comments are weighed and weighed again before they are made. Thus, we tend to listen to Ms. Yellen quite closely, and she has spoken rather overtly 'hawkishly' in the past day or two. Noting that the effect of Katrina will indeed slow GDP growth in the 4th quarter of this year, Ms. Yellen nonetheless said that the effect of rising oil prices may more easily be passed through to the consumer than they have been passed in recent years. Her tone was one of very real concern, rather than of merely being modestly bothered by that possibility. "So now we have Moskow, Santomero and Yellen staking out the 'Hawk's' position and doing so rather publicly. We are hoping to hear from the 'Doves.' We await someone to take up that position and to do so as publicly as Moskow, Santomero, Yellen & Co. have staked out theirs. The problem is that in the company of central bankers, the 'dove' is always the outcast bird." It is easy to see inflation as a potential problem. The serious rise in housing prices, and Fed concern about them, is well documented. The Fed is getting ready to pump massive amounts of money into the economy. Coffee is up 7% and sugar up 30% due to delivery and shipping problems. The materials needed to rebuild like copper, aluminum, timber and such will be in large demand. As oil rises, shipping prices for products are going to rise. If Yellen is right and price increases imposed by increased costs "stick," one can readily argue that we could see a surge in inflation. And with inflation near the top level of what the Fed is comfortable with, shouldn't the Fed act preemptively to make sure inflation does not come back? The short answer is no. There are forces which combined with Katrina which could change those trends. Let's look at some of them. A Four-Pronged Attack Upon the Economy Let's turn to those smart guys at Cumberland Advisors for an analysis of how much pressure the consumer is under. They think the Fed might come to a full stop as they are concerned the economy will roll into a recession if the Fed continues on its current path. I have noted in past letters that increased energy prices are going to take a toll on consumer spending. But it is not just energy. Increased interest rate costs on mortgages, the new Alternative Minimum Tax and Katrina all make this worse. They put a pencil to the problem to give us an estimate of the cost and the potential hit to consumer spending. "Energy is the largest of a four pronged attack upon then economy.We will compare the size of these 4 prongs with Disposable Personal Income (DPI) to demonstrate the magnitude of the problem and why they may lead to a consumer led slowdown. "Quickly, DPI is about 9 trillion dollars according to the latest Bureau of Economic Analysis (BEA) estimate. It is what the 295 million of us have left to spend after taxes and some other minor adjustments. It is the source of our consumption spending and our debt payments. Fortunately, BEA data break out the energy costs we incur. "Prong 1. In winter 2004 total energy costs in the U.S. were about 4 1/2% of DPI. We define energy as gasoline, natural gas, heating oil and electricity. By early summer 2005 that had climbed to 5 1/2%. For the next year we are estimating post-Katrina energy cost using near term futures prices. We get over 6% of DPI. It's not just gasoline. Consumers will see it in their monthly heating oil bill or natural gas or electric bills. Budget plan folks are in for their first alarm when the September billing statement arrives in the mail. A 1 1/2% shift against a $9 trillion and gradually rising DPI is over $130 billion. That is our conservative estimate. Note: a 12% increase in the price of energy equates to about a 1/2 point of DPI. "Prong 2. Mortgage interest rates hikes are already baked in the cake. See our housing bubble series of a few weeks ago archived at www.cumber.com. About 2 full percentage point increases on about $1 trillion of adjustable mortgage debt will trigger $20 billion of additional mortgage payments on about 5 million households. They will phase in over the next few months. "Prong 3. The Congressional Budget Office (CBO) estimates that 14 million taxpayers will be hit with the Alternative Minimum Tax (AMT) starting January 1st. Unless Congress acts (not deemed likely at this moment) the temporary AMT adjustments from the Bush tax cutting will expire. We guess that will average about $2000 per household. AMT addition is $30 billion. "Prong 4. The ongoing costs of Katrina will continue for the many months; offsetting occurs when the recovery efforts and rebuilding strongly kick in. Eventually a massive amount of new debt will be issued: federal $50 billion; state and local governments ($10 billion); commercial and housing ($ unknown, could be another $50 billion or more). That money will be spent over the next several years. About $25 billion of insurance proceeds will arrive sooner. We think this rebuilding process is going to take a lot of time. Katrina reconstruction is much more difficult than Florida's 4 hurricane hits last year. Preliminary damage estimates are already over a $100 billion with about 3/4 are uninsured. "Add these up. Without Katrina destruction it is over 2% of DPI. Our numbers are conservative. Add Katrina and the high end is closer to 3%. "Consumers will certainly retrench; the first issue is how much. The second issue is how big is prong 4 and how long until the recovery phase catches hold." Let's hold that thought while we look at housing prices. This point comes from Martin Barnes at Bank Credit Analyst: "The current 11% year-on-year gain in real house prices compares to a 50 year average of only 2%. The current growth is three standard deviations above its mean, and historically, this has broadly been a mean reverting series. The odds are high that the growth in real house prices will fall below zero in the next few years. "The low level of long-term interest rates will provide a cushion for housing, but will not be able to prevent the market from cooling. The main drag on housing may come from the reduced supply of mortgages rather than a more typical interest-rate induced drop in demand. However, regulators are likely to clamp down on the more speculative types of loans and this will constrain housing demand. Moreover, as we have noted in the past, the experience of the UK and Australia suggests that even a leveling off in prices will be sufficient to cause a marked retrenchment in consumer spending growth." Recent data suggests that the housing prices may be under some pressure. There is a very close correlation between housing prices and consumer confidence and consumer spending. Any decrease in consumer spending will be in addition to the decrease noted above by Cumberland. All of this suggests it is time to be cautious. Even if the Fed were to raise rates, they are close to the end of the cycle. Rates are close to where they should be even if you are very hawkish on inflation. There is no need to hurry the process and every reason to wait. In the past, the Fed has tended to go too long and too far in their rate hike cycle. No need to repeat that mistake. In a call with Martin Barnes today, he believes the Fed will pause. Martin is as astute an observer of the Fed as any person I know. When asked about the recent Fed speeches, he says simply that they are continuing with old Fed policy and that things will change when Greenspan decides they will at the next meeting. It is Greenspan's decision which counts. Finally, Martin was forecasting a slowdown prior to Katrina, but he does not think we will fall into recession. He sees it as more like a mid-cycle slowdown like we saw in the mid-90's. There are more and more calls for the Fed to pause in September. Clearly the markets are expecting them to do so, and this has given a boost to the stock market. There is the perfect excuse and a very easy to write reason. They could simply say they wait for more clarity, but barring some new data suggesting a softening of the economy, they will continue on their rate hike path. Yet, there is less, rather than more, clarity as to what they will do. This meeting, barring a comment by Greenspan, is shaping up to be the most interesting in a long time, as everyone has known for the last ten rate hikes that it would be at a measured pace of 25 basis points per meeting. For at least this meeting, there is uncertainty. A Response From a General in the National Guard Last week, in response to some ad hoc comments in my weekly letter about why it took so long to get soldiers into New Orleans, I received a thoughtful, articulate response from Brigadier General Gregory Zanetti of the New Mexico National Guard. I think you will find the full, unedited letter to be of some interest. Feel free to forward it to your friends, as it reminds us of the commitment and training of our National Guard. ******
****** General, thanks for your letter. You need no defense. I and all of America are proud of the work our Guard does, and you once again demonstrate why such pride is justified. Palo Alto, San Diego, Toronto and Houston I will be in Palo Alto next week attending the Accelerating Change Conference (www.accelerating.org) and then on to San Diego for a quick day conference with my partners at Altegris. On September 27 I fly to Toronto for a few days, to be with Canadian partner Stuart McKinnon and his team at Pro-Hedge. I will have time to meet with a limited number of people. There are also tentative plans for me to speak on Tuesday night (details next week). I will be in Houston by Thursday evening and speak at an industry conference on Friday morning. Then the next day off to Europe for two weeks, although it looks like my trip to Bulgaria is postponed. So I will get more time in London to meet with clients and potential clients there.
Come to think of it, I should add Peter Bernstein to that list as well (the author of "Against the Gods" plus his own famous economics monthly letter). Peter (also around 80) tells me they went to the same high school. Maybe something in that water. There are a lot of things we can do to live longer and healthier, and we all need to practice! I have a few things that I need to work on. Have a great weekend! Your 'happy to start another year of Thoughts From the Frontline' analyst,
John Mauldin
321gold Inc |
