May 31, 2006
U.S. Economy
As we predicted, the FOMC raised the Funds rate at their May 10 meeting to 5.00 percent. We think they will raise the rate again at the June 28 meeting to 5.25 mostly in response to the May CPI, which we think will spook the markets once again with a rate of about 0.4 percent, since many market observers have been hoodwinked by the Fed and Company into believing that the "core" PCE price deflator is as close to an absolute philosophical truth about the meaning of inflation as we will ever get.
Despite our long-standing difference of opinion with the Fed regarding the definition of inflation, we think Mr. Ben Bernanke has done an excellent job during his initial period as a no-nonsense Fed Chairman. We were recently amused at the attempts by some Congressmen to trap Mr. B by asking him whether he was concerned about the growing fiscal deficit, to which he replied in the affirmative; and was then asked the follow up question of how he would reduce the deficit, to which he deftly reminded them that their jobs as legislators was to manage the budget and fiscal policy, while his as the central banker was to manage monetary policy.
Nevertheless, some financial market analysts continue to read profound coded messages in what Mr. B says. The May FOMC statement has tipped some analysts into a frenzy over the phrase that how the Fed will chart its course "will depend importantly on the evolution of the economic outlook as implied by incoming information". This is simply another way of saying that economists rely on data for their analysis and policy conclusions, just as physicians’ diagnosis is based on lab work and on the examination of their patients. Nevertheless, as a consequence of such Fed language, Mr. B has now been dubbed the data-dependent chairman. Frankly we think "no-speak" is probably better than "Fed-speak," unless Fed officials are allowed to speak what is really on their minds – but that may be considered "inside information." The Fed should just keep the markets guessing.
We recently ran the numbers comparing the CPI 12 month moving average to the so-called "core" inflation index, defined as the Personal Consumption Expenditures (PCE) deflator excluding food and energy. The 25 year average annual inflation for the CPI was 3.5 percent per annum and for the PCE "core" inflation was 3.2 percent. However, the PCE measure of inflation has been lagging behind the CPI measure for the past four years. Now we know why our central bank is so enamored with that index.
Based on historical trends, if the PCE "core" index lagged the CPI during the past four years or so, it will no doubt surpass the CPI measure during the next several years. But not to worry, at a "measured" moment in the future, the Fed will probably issue a statement announcing that the CPI is really the best measure of inflation. Or alternatively, the "core" index will be revised to exclude a few more goods and services whose prices have risen significantly, but are considered to be volatile. Better yet, some day food and energy may find their way back into the "core" inflation index.
In the meantime, financial markets will be asking why is inflation so high? The WSJ survey of economists shows the latest inflation forecast with a sharp drop in the CPI inflation rate from 3.4 percent in May to 2.7 percent November of this year, with the economy steaming ahead. We think there is a disconnect in those forecast figures.
We expect that the moving average inflation rate, based on the CPI, will average about 3.9 percent during the second half of this year. The University of Michigan’s consumer survey posted inflation expectations of 3.3 percent in April, up from 3.0 percent in March. The reason why we think inflation will remain stubbornly high this year is our view that the economy is moving ahead with a stronger momentum than most analysts have projected.
The revised second quarter GDP growth rate of 5.2 percent shows that there is still a good head of steam in the economy during this current expansion. Industrial production picked up strength in April, as the 12 month growth rate accelerated to 4.7 percent from 3.8 percent in March. The housing sector still holds the key to the economy’s performance during the second half of this year. Interestingly, both the demand and supply sides of the economy have been more closely linked to the real estate sector during this business cycle than in previous ones. Barring a burst of the real estate bubble, as opposed to the fizzling of the "regional froth," we think GDP growth will average a robust 3.5 percent this year and then slow down to 3.2 percent in 2007. Thus our view is that the economic slowdown will occur only gradually, it is not easy to stop a large locomotive or an aircraft carrier once they are cruising at high speeds. At the current rate of economic expansion, our inflation forecast could err on the low side, with the index surpassing the 4.0 percent rate.
Our forecast of a $900 billion current account deficit this year is consistent with the continued growth of the economy. Finally, markets have started to focus on what we have been saying for almost two years, that the dollar is due for a sizeable correction (see our previous StratAlerts). We still expect the Euro to reach US$1.48-1.50 before the end of the year, with a consequent upswing in the yield curve. Remember, any sell-off of the dollar in the currency markets will be accompanied by a sell off of U.S. treasuries in the money market. We are also keeping our eyes on the U.S. - China currency match, which could turn into a trade scuffle. When will the Chinese yuan strengthen to a more realistic rate, perhaps 40 percent stronger with respect to the dollar; and how will this affect U.S. inflation – since almost everything we consume has a Chinese-made component?
With increasing inflationary pressures, still robust economic growth, bulging government and external deficits, and the expected dollar tumble we think the long end of the yield spectrum will likely shift up to higher levels, as opposed to another rally as has been talked about in recent weeks. The 10 and 20 year US treasuries could end the year at 5.70 - 5.80 percent and 6.00-6.10 percent respectively.
Latin American Economies
In Argentina, the Kirchner administration has been turning up the heat on producers and retailers in an effort to bring down inflation. A number of agreements have been signed to limit price increases. The government’s campaign turned more confrontational against meat producers, who have resisted price controls on the grounds that higher production costs and brisk demand are driving up prices. The government slapped a ban on meat exports as retaliation, hoping this would increase the supply of meat in the domestic market and thus lower prices.
New Bolivian president Evo Morales made good his promise to nationalize the oil and gas industry. The nationalization has soured Bolivia’s relations with Brazil, Argentina, Spain, Great Britain and France. On the other hand, it has warmed the already cozy relations with Venezuela, that will help manage the nationalized companies and train personnel.
The
Brazilian state-owned company, Petrobras, has been one of the main victims of the Bolivian nationalization, after having invested heavily in the natural gas sector in that country. Brazil currently depends on Bolivian natural gas for its energy needs, but expects to become energy self-sufficient in a few more years. In the meantime, there is no other choice but to bite the bullet, at least until after the October presidential elections.President Alvaro Uribe won reelection with 62 percent of the vote in the first round in
Colombia.The Congressional and local elections in
Dominican Republic resulted in a resounding victory for president Leonel Fernandez, whose party obtained a majority in both Houses of Congress and also won control of most municipal governments.The
United States broke off the free trade negotiations with Ecuador, after the Ecuadorian government rescinded its concession contract with the American-owned Occidental Petroleum (Oxy).In
Mexico, the PAN candidate, Felipe Calderon, has taken the lead in the voters’ preference polls over leftist candidate Andres Manuel Obregon.Leftist candidate Ollanta Humala finished in first place in
Peru’s presidential elections with about 33 percent of the total vote. He must dispute the presidency in the second round elections against APRA candidate and former president Alan Garcia. Recent polls indicate an easy victory for Garcia, who will benefit from an anti-Humala vote.Venezuelan
president Hugo Chavez has been turning increasingly aggressive in his quest to become the leader of Latin America. Bolivian president Evo Morales has said that Chavez is Bolivia’s tutor, while other presidents in the region complain of Chavez brazen intervention on their countries’ internal affairs.