July 28, 2005
U.S. EconomyThis Month’s Headline: Chairman Greenspan’s Testimony
Fed Chairman Greenspan’s Testimony regarding the Semiannual Monetary Report to the Congress reveals an upbeat outlook, just as Mr. Greenspan may be starting to fix his sights on his approaching retirement in January 2006, after 18 years of service as Chairman.
In Mr. Greenspan’s words, "Our baseline outlook for the U.S. economy is one of sustained economic growth and contained inflation pressures, realizing this outcome will require the Fed to continue to remove monetary accommodation."
Despite his optimistic outlook, the Fed Chairman pointed to the following risk factors:
1. Future performance of the economy and inflation will depend on the trend in unit labor costs. The Fed had emphasized several years ago that productivity in the U.S. was expected to exceed historical averages for some time; yet productivity growth has slowed in line with historical averages, thus contributing to higher unit labor costs.
2. Energy prices represent a major risk factor. Mr. Greenspan points out that oil prices will remain high for some time.
3. Uncertainty regarding the outlook for long-term interest rates, or what is referred to in Greenspeak as the interest rate "conundrum."
Long-term rates have not risen despite the up-tick in short-term rates, higher inflation, and structural fiscal deficits arising from the retiring baby boom generation with a longer life expectancy (perhaps not yet reflected in the U.S. life tables). Mr. Greenspan offered the following explanations for the aberrant behavior of long-term interest rates.
1. It is a global phenomenon. Major foreign financial markets are also experiencing low long-term rates, because of the connectivity of cross border capital flows.
2. A reduced risk premium due to lower and more stable inflation.
3. A substantial increase in global productive capacity.
4. An excess of intended savings over intended investment.
StratInfo’s Response to the Fed’s Views on the Economy
We think Chairman Greenspan’s view of the economy is clear and well thought out, particularly his statement of the risks to the outlook. Mr. Greenspan’s characterization of long-term interest rate trends as a "conundrum" is just another way of saying that under normal circumstances long-term rates should be higher. In other words, Mr. Greenspan feels that long-term rates have actually moved contrary to basic economic principles. We agree on that. However, we respectfully disagree with some of the conclusions of his analysis. The following are our main differences with the Fed’s view on the economy:
1. Totally absent from the Chairman’s testimony is any mention of the hemorrhaging in the U.S. balance of payments. As we have been saying for quite some time, the runaway external deficits will trigger some unpleasant currency market surprises later this year or early 2006. We think that markets may be mis-pricing the long-end of the curve. Remember the Plaza Accord in 1985, when the Finance Ministers of the Group of 7 publicly declared that the currency markets were mis-pricing the value of the dollar? Well, markets may simply be misreading their tea leaves, we think markets have missed the boat on currency risks.
2. An excess of intended savings over intended investment is simply another way of stating that long-term interest rates are low. The question should be why is there an excess of savings over investment? Mr. Greenspan’s comments indicate the reason is unclear. In our view, one explanation could be a high degree of uncertainty about future trends, which causes a narrowing of the time horizon for savings and investment, possibly leading to lower long-term rates.
3. Connectivity of cross-border capital flows does not explain low long-term interest rates. A 24/7 global money and currency market has been around since the 1980s. Nor are low long-term rates only a recent phenomenon. In the late 1970s, when oil prices surged, long-term rates were also low in real, or inflation adjusted terms.
3. We question the extent to which global productive capacity has increased as implied by the Fed Chairman. In previous
Recent U.S. and Global Economic Trends
The first quarter GDP growth rate was revised up to a robust 3.8 percent. Apparently, the huge increase in oil prices has not yet had a notable impact on consumers’ purchasing power. However, durable goods consumption was up only 1.8 percent during the first quarter. Demand was strongest in residential investment, up 11.5 percent, and exports of goods and services, up 8.9 percent; although the latter was offset by an increase of 9.6 percent in imports of goods and services.
Industrial production has been strengthening, up 3.9 percent in June with respect to the same month in 2004.The Institute for Supply Management index of manufacturing activity rose to 53.8 in June from 51.4 in May. Production of business equipment is on an upswing. Factory orders in May rose 2.9 percent mostly as a result of a jump in aircraft and other transportation goods orders.
Low long-term interest rates continue to fuel the real estate sector. Using Greenspeak, the "froth" in local real estate markets in our view is becoming more like soon-to-burst regional bubbles with unpleasant consequences for the national economy. However, banking regulators and the Fed have not sounded the alarm, so as not to trigger a downward spiral in real estate prices, that could have an adverse impact on the quality of the banks’ mortgage loan portfolios. One signal of impending market adjustment is the ratio of household debt service payments to disposable personal income, which has averaged above 10.0 percent since the third quarter of last year. The only time that ratio has reached a double digit rate was just prior to the 1990 real estate crisis.
The recent announcement by China to create a trading band of about plus or minus 3.0 percent for the Yuan as a function of some as yet unspecified currency cocktail is a play of smoke and mirrors. It is aimed mostly at deflecting recent threats by U.S. legislators who are upset with the bulging U.S. trade deficit with China. Remember: China is not yet a market economy. Sparks have not yet started to fly in this simmering trade dispute, nor has the Chinese currency yet shown its true strength. Stay tuned to this continuing saga. Looking down the road, we think there is an important symbolic meaning to the Chinese currency announcement. This could be the first step in the launching of a new currency kite: over time, the Chinese yuan will become the kite with the other Asian currencies acting as the tail. The Chinese currency will then replay the role of the German DM within the European Monetary System.
The Mainstream View of the Economic Outlook
The latest mainstream economic forecast, published in the WSJ survey, shows a fairly positive outlook, echoing the Fed.
GDP growth this year is forecast at 3.6 percent, versus our forecast of 3.3 percent.
Inflation is forecast at 2.8 percent in November this year and then falling to 2.5 percent in May 2006, whereas the StratInfo forecast calls for inflation of 3.3 percent in November and a shade higher for May 2006.
The Euro is expected to end this year at $1.21 and remain at that rate through June 2006, versus our much higher forecast for the Euro (see our comments below).
The Ten Year Treasury Note is expected to reach 4.84 percent by June 2006.
StratInfo’s View of the Economic Outlook
We continue to predict slower growth of the U.S. economy, due to the impact of inflation – induced by higher energy and commodity prices and by the recent acceleration in unit labor costs - on consumer purchasing power. The possibility of a downward adjustment in real estate prices will also dampen economic activity.
We think inflation will reach 3.2 percent this year and modestly higher in 2006.
Perhaps where we most differ with market analysts is with respect to the dollar. We expect the current account deficit to exceed 6.2 percent of GDP this year, and the severity of the imbalance is likely to trigger a painful correction in the currency market with the Euro reaching $1.45 - 1.50 by the end of this year or early 2006.
Once markets focus on the severity of the external deficits and the less sanguine prospects for the fiscal accounts, then the long end of the yield curve will begin to rise swiftly.
Based on the above outlook, our rate forecast for December of this year calls for the Fed Funds rate at 4.00 - 4.25 percent and the Ten Year Note at 5.00 - 5.25 percent.
Latin American EconomiesThe IMF is ready to start negotiations with the
Argentinian government for a new Stand-By agreement.Presidential elections have been set for December in
Bolivia. A Constitutional Assembly will be elected next year.Brazil
will prepay US$5.1 billion owed to the IMF as part of a Supplemental Reserve Facility, in order to save US$82 million in debt service payments. Those short term funds had been provided by the IMF at a higher interest rate.Chile’s
Central Bank hiked up interest rates again by 25 basis points from 3.25 percent to 3.50 percent. The authorities are concerned about accelerating inflation.High inflation is prodding many companies in
Costa Rica to set prices for products and services in US dollars. Even the government has started to denominate certain payments of fees and taxes in US dollars.Ecuador’s
exports went up by 21.7 percent in the first five months of the year fueled by higher oil prices and export volumes.El Salvador
has received US$1.4 billion in family remittances during the first semester of this year, representing an increase of 14.3 percent over same period of the previous year.Honduras’
trade deficit widened during the January-May period, despite a robust 19.9 percent increase in exports. Imports also expanded strongly by 18.1 percent.Hurricane Dennis played havoc in the
Jamaican agricultural sector this month. It is estimated that 40 percent of the banana crop was ruined. Other crops, including coffee, were also affected by flooding.Mexico
reported a 17.2 percent increase in tourism income during the first five months of the year to US5.4 billion. Net tourism earnings climbed by 23.7 percent.According to the latest opinion polls, 83.5 percent of the
Nicaraguan population thinks that the political pact between Liberals and Sandinistas contributes greatly to the political instability in the nation and works against democracy. The majority of Nicaraguans also reject the Sandinista leader Daniel Ortega and former Liberal president Arnoldo Aleman as potential presidential candidates.Foreign investment in
Panama fell by 24.4 percent in the first quarter of this year.Peru
is set to export natural gas to Chile, Argentina and Brasil, in response to the deteriorating political situation in Bolivia. However, negotiations are still in progress.