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An American Nightmare

July 28, 2006
Stephen Martin

Stephen Martin

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Untitled Document The rise in U.S. real estate prices has contributed to a positive wealth-effect and growth in both the U.S. and global economy. However, there are signs that this positive wealth-effect is going into reverse with potentially dramatic consequences. As part of my ongoing theme, The Four Horsemen of the Capital Markets, I am attempting to monitor the four biggest risks facing the capital markets. In this article, I will address one of these risks that the market seems complacent about....DEFLATION.

The market and the FED are worried about inflation. Unfortunately, the definition of inflation seems to mean different things to different people. There is inflation in commodities, including soft commodities and energy. These are largely set by global supply/demand conditions. An under-investment in capacity combined with the emergence of China and India have created an imbalance. In an open and global economy, competition for resources exacerbates these imbalances. Prices tend to adjust fairly rapidly. Supply is more constrained and demand-erosion is slow to adjust, particularly where there is little substitution. This drives prices upwards in a seemingly unstoppable trend. In fact, there is some evidence that commodity cycles can last 20 years before supply exceeds demand sufficiently to drive down prices. Furthermore, a fundamentally weak U.S.$ raises the costs of commodities priced in U.S.$. To U.S. importers and consumers this is inflationary, but not necessarily to capital markets and the FED.

Labour costs also feature in the inflation equation. Once again, in an open and global economy, supply/demand conditions drive the price. Unlike the market for commodities, however, the labour market is not naturally global and imbalances take time to adjust. For example, the cost of labour is much lower in developing countries and varying skill levels complicate the adjustment process. The foreign exchange markets are where much of this adjustment occurs providing there are limited currency controls. But, slow as they are, adjustments do take place in an open and global economy. In general, there is an excess of low-skilled labour in developing countries and a growing excess of skilled labour in developed countries. Initially, this creates a transfer of low-skilled jobs to developing countries and acts as a deflationary force to developed countries. Eventually, a process (too complicated to mention here) creates a transfer of skilled jobs (both manufacturing and services) from developed economies to developing economies. This process is also deflationary to developed economies. Again, the currency markets should faclitate this process of adjustment. However, under present circumstances, this is complicated because some key currencies are not free-floating, the U.S. has a huge trade deficit and growing debt to foreign creditors. The American consumer is thus faced with rising costs that he can not control and attempts to raise his wages but is unable to do so. Why? because U.S. employers are also experiencing rising costs but are unable to pass them on to consumers. In fact, sales at retailers are falling even while companies are widening discounts to lure shoppers. The process only acts to accelerate the transfer of jobs abroad. With weak wage-negotiating conditions, a core wage-cost inflationary spiral is not in the cards.

There has been inflation in assets, but this does not show up in CPI. Stocks and, in particular, housing have benefited from cheap and easy money. In fact, housing has been the key driver of economic growth in the U.S. for the past five years. The U.S. consumer, unable to raise his wage, has tapped into the rising value of his home to subsidize his standard of living. The positive wealth-effect has been key to global growth as well since the U.S. consumer represents 70% of the U.S. economy and 20% of the global economy. However, all of this appears to be going into reverse as global liquidity is drying up. Housing Starts, Building Permits and the The National Association of Homebuilders (NAHB) index have all collapsed in dramatic fashion this year and are now well below trend. The NAHB " believes that the FED has been relying on deficient inflation measures to rationalize the interest rate hikes that have been taking a serious toll on the housing sector". Joseph M. Stanton, of the NAHB, goes on to say " Ironically, much of the recent increase in 'core' CPI that the FED is trying to control with higher interest rates is coming from a weakening housing market, which is increasing the demand for rental units. That, in turn, translates into a sizeable increase in the large Owners' Equivalent Rent components of the core inflation measures". CPI, core annualised, is now back to levels where it spent most of the 90's, and well below the inflationary era of the 70's.

In conclusion, it does not look as if there are serious inflationary pressures developing. In fact, the over-whelming evidence suggests that deflationary forces are gaining momentum. The FED, under Bernanke, does not instill confidence that they fully understand the risks or even that they have the ability to be pro-active. The FED's focus seems to be on U.S. core CPI, the Personal Consumption Expenditure (PCE) index and other traditional measures of consumer inflation and expectations at the expense of other large variables that may give a broader picture of developing economic trends. In attempting to maintain price stability, a noted objective of FED policy, the FED may be constantly behind the curve as a result of this focus. This environment, where we seem to be today, raises the dilemma most central bankers find difficult to address...stagflation. Stagflation, a term coined in the 70's to describe the combination of rising inflation amidst a decline in economic growth, is actually quite rare. Inflation is a lagging indicator and slowdown concerns show up in leading indicators. Two different time frames. The optimists see this dilemma as proof-positive that the FED will ease soon and achieve a soft-landing. Stocks would then rally in anticipation of a timely easing in monetary policy. The pessimists (or realists as I prefer to call them), on the other hand, see the FED as being more reactionary and will only shift the focus to economic growth concerns, away from inflation worries, when it is too late. The FED might want to take a look at the policies of the Reserve Bank of New Zealand. They have resisted raising rates in the face of rising inflationary pressures primarily because they view those pressures as transitory. It is a gamble, because nobody wants to release the inflation genie from the bottle. However, a deflationary-spiral would be much worse.

Next week, I will outline another of the Four Horsemen of the Capital Markets risk that is rising ... NATIONALISM.

About the author:

Stephen Martin
Stephen L. Martin has published articles, studies and research on investments over 20 years and has appeared on national television and radio. He currently works for Fairfax I.S., a private U.K. based investment bank. The views expressed are his own and are not representative of his employer.

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