Saturday, June 21, 2008

some numbers on inflation

I have been extremely busy and unable to write as much as I have wished. but it's important to address the growing inflationary trends. they're starting to get scary.

as a financial journalist, I read a lot of economic and corporate research. I have noticed a growing number of warnings on inflation from different kinds of analysts... here are a few of the outstanding points raised:

1-morgan stanley warns that the producer price index (PPI, which affects companies) have risen faster than consumer prices (CPI). businesses are reluctant to raises prices because they don't want to lose customers... this is especially worrisome to them when consumers are already feeling squeezed by $4 gas. in the short run, they simply eat the profit margin to keep the revenue coming in.

earnings will collapse and stocks will make another move lower... I have already predicted the S&P500 will fall all the way to the 1000 point area.. this will take about 2 years to happen...

anyway, this chart from morgan stanley does a lot of things, and is pretty interesting overall.

the solid line shows the difference between cpi and ppi.. when it goes up, it means companies are raising their prices faster than their own costs are going up. that makes profit margins (the dotted line) widen, in general. now that they're eating price increases, the process has reversed. I fear the great profit boom of 2004-2007 is over.

2-food and fuel inflation eventually pulls core cpi higher... this one from jim bianco:

the blue line is general, or headline, inflation. the red line is "core CPI", which excludes food and energy. for years it made sense to exclude these because they created a lot of statistical noise and didn't constitute an important part of people's and businesses' budgets. faster headline inflation will pull everything else higher. one thing ironically that's protecting many americans now is the surplus of cheap items such as clothing because stores are shutting down and selling inventory. (apparel is the only thing with negative inflation in the last few months.. in fact, it's accelerating, suggesting that inventory liquidation is underway.)

3-also from bianco.. inflation is faster right now than it's been in years.. here are the annualized rates over different periods of time... you can see it had been stable around 3% until the last 1-2 years.

3mo == 9.64% -- HOT
6mo == 6.22% -- GETTING HOT
12 month == 4.17%
3 yrs == 3.67%
5 yrs == 3.37%
10 yrs == 2.90%
20 yrs == 3.11%

4-from goldman sachs ... this shows what happens to stock mutliples when inflation picks up. -- basically, stock prices take a hit:

overall, as I said here, profits are going to get hurt. steel, ashphalt, etc.. these are the things that will kill the economy by discouraging large scale investment. the integrated financial model makes a lot less sense in an inflationary period. we will see elimination of real economic capacity.. abandoned shopping centers, etc. houses, even ...

5-wage growth adjusted for inflation was already weakening. throw in higher prices and real wages will take a significant hit. here's a chart from credit suisse:

6-people are responding by cutting spending on non-essential items. another chart from credit suisse:

one interesting thing emering from all of this: political discontent.... a credit suisse survey shows that republicans have suffered rapidly declining consumer confidence this year.. democrats already had lower consumer confidence. we're starting to see all the pieces come together for a real national crisis:

1-slowing economy

2-declines in wealth

3-rising unemployment

4-sinking wages

5-rising inflation

6-a sick currency

the economy is beginning a long-overdue process of structural adjustment. it will be extended and painful to varying degrees. we're also at the stage where problems are going to accelerate for the next 1-2 years. why? because most people are only starting to realize how bad it will really become. things will change for the worse as the new reality sinks in.

furthermore, are new inflationary pressures building? one line stood out to me in a recent Situation Room from B of A:

Overall, the results indicated that amid soaring costs, businesses are trimming production and attempting to control inventories.

this is proof that demand outside the USA is now driving many price increases. 10-15 years ago, producer prices could never rise so fast without american companies in growth mode.

this gives me fear in 1-3 years. .. let's consider what I think will probably happen ...

the economy will weaken as the summer wears on. it will be in full-blown contraction as americans hunker down for winter with fuel oil at $4-6 a gallon. (this will hit traditionally democratic northeastern states like NY, MA, CT and VT hard... not sure whether that might have any significance.)

the new president, regardless of party, will be cajoled into a second "stimulus" package. this and other government-mandated programs will at first seem beneficial. but it will soon emerge that retailers and other companies don't have enough inventory to meet demand.

stores have been widdling down their supplies for the previous 1-2 years. the governement money will make them rush out to buy stuff, causing a rapid surge in prices... this will be the icing on the inflationary cake -- almost like afterburners on a jet, adding a splash of fuel to an already hot situation. (this is an example of why inflation is so hard to fight, it creates many coiled up springs ready to explode higher when they get a chance.)

there will be a rush of economic euphoria, followed by a troubling sense of dread and fear as prices shoot higher. companies that previously could afford to buy cheap merchandise from asia now are renogiating contracts and finding the price advantages have disappeared. people living in suburban areas full of costs will find their economic conditions increasingly precarious. with gasoline at $1, a lot of things made sense. people could live places like NJ, making $40-60k a year.. plenty of people made livings under those conditions. as prices climb higher, entire ways of life will be questioned. it will cause major transitions in our culture and civilization.

one final set of charts from me to end this panoply of data:

they show how personal consumptions expenditures (PCE) have taken over GDP and how debt has grown.

2 immediate conclusions:

the driving force behind the economy has been consumer spending growth. it has peaked and needs to contract. but millions of jobs and lifestyles are dependent on it. important economic and cultural interests such as governments, school and pensions are linked to it.

adjustments are already clearly underway as some sectors respond with export growth. but overall, the contraction of the consumer will have wide ranging impact on the economy... they're only starting now.

it's interesting to compare the US economy to GM. both grew for years by expanding consumer growth. over time, they took on medical and retirement liabilities. but investors trusted their name so lent to them...

companies tend to add debt as they mature. investors lend to them because their long standing assets are comforting to credit analysts. companies stop growing and use free cash flow to pay dividends or repay debt. this can be seen across the auto industry, the newspapers, telecom, etc.

throughout this process, the borrower is benefiting from the momentum of previous years of greatness. GM was too big to fail, so people felt comfortable to lard it up with social-spending costs. the US is the world's only superpower, so countries willingly pour trillions into treasuries. it's ok because everybody does it.

I fear that we're like GM in 1995 or so. at that time, they knew they had long-term problems. but they still had the balance sheet and size to lever up and take on higher costs and pursue bad SUV-heavy strategies. as a result, I believe the next big thing will be a surging government deficit, followed by huge treasury bond issuance. everyone is writing about how 10 year note yields need to rise and the curve must steepen.

one thing people forget is that the bubble that's bursting was not just a real estate bubble or a mortgage bond bubble. it was a US dollar fixed income bubble -- US dollar/debt

it was attached to anything in US dollars. securites like corporates and mortgage bonds can do great once the treasury market is in place. many bombs have gone off in credit, but none have yet touched upon the foundation: solid US creditworthiness. the crumbling of this institution is the next chapter of the crisis...

this US primacy was manifest in the late 1990s when capital fled asia and poured into the nasdaq. it was clear in early 2001 when the dollar surged to record levels against all other currencies. bubbles are built upon such senses of stabilty. (houses never lose value)

people have trusted in the US dollar (which is backed by US treasuries anyway), and thus been willing to accept US dollars as payment and to lend to our government and our people (via the bond market). that's what drove yields so low in the first place: massive demand for US debt... that's why wall street had to go out and reinvent new kinds of debt instruments like CDOs, etc.

most people don't appreciate that this was a bubble as well. like all bubbles, it will have a period of rampant production of the bubble asset.
let's consider other bubbles:
1-in the late 1990s, people loved stocks. so wall street invented companies to meet that demand.
2-in the 2005-2006 period, builders kept adding structures despite rising inventories of homes.
3-in the 2006-2007 period, lenders satisfied massive demand from credit investors with novel products to finance those homes.

as the new supply floods the market, traditional investors say "screw this" and start selling their holdings. a period of distribution begins -- this is how trends work.

the US treasury market is a very old and established, so this will take decades and play out in subtle ways. and it won't really happen until the final surge of supply as the government spends foolishly to prop up the economy and pay entitlements.

combine extremely low treasury rates (essentially negative real rates, adjusted for inflation), with a second stimulus package. the government will see income taxes plunge in the next 1-2 years. they will respond with huge deficit spending, funded with a big growth of treasury debt.

this surge, and subsequent collapse, has not yet been comprehended by the market. I have not heard anyone else express it, though it must be understood by many. all bubbles are the same. this one comes at the end of a very long multi-decade run. it's a very long-term trend, but it's still a trend. they all end the same way -- with collapse.

one also has to raise real worries longer term for the US as a AAA sovereign credit. the process of credit deterioration is underway. trends of this nature do not reverse quickly. more problems lie ahead.

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