November 18, 2005
U.S. EconomyWe expect the Fed to raise the Funds rate at the December 13 FOMC meeting to 4.25 percent. In view of Mr. Greenspan’s retirement at the end of January, we think they will also raise the Funds rate another quarter point at the January meeting marking Mr. Greenspan’s expected retirement as the quarter point Chairman.
Recent public statements by Fed Governors and regional Presidents echo our own concerns about rising inflation, except that we have been saying this since last year, when the Fed still held the view that there was no inflation since food and energy prices were not relevant factors in determinating the inflation rate. We have consistently held the view that robust economic growth and higher energy prices plus an accommodative monetary policy would result in higher inflation. The only difference in our vocabulary is that we use the consumer price index, the official measure of inflation, while the Fed prefers to use the personal consumption deflator excluding food and energy, which happens to be a lower number. Nevertheless, both measures now point to rising inflation, although our measure predicted the trend sooner. While acknowledging that food and energy prices do matter in their November 1 FOMC statement, the Fed also pointed out that "longer-term inflation expectations remain contained," of course as a famous economist once said "in the long run we are dead."
The preliminary estimate of third quarter GDP showed robust growth of 3.8 percent, despite the havoc created by Hurricanes Katrina and Rita in September particularly in the critical energy supply and shipping hubs. Personal consumption expenditures were up 3.9 percent, with durable goods up 10.8 percent, driven by strong demand for vehicles and furniture and household equipment – as consumers are still cashing in on their accumulated net worth in real estate. Federal spending, influenced by the war in Iraq, was up 7.7 percent. On the other hand, business investment expanded at a more cautious pace of 6.2 percent.
We were surprised by the strength of the economy in the third quarter, although we think it will be revised down. We think the economy will lose some steam in the fourth quarter, which is not good news for the Holiday retail sector. Industrial production weakened considerably in September with a 1.5 percent decline, due in large part to the impact from the hurricanes; nevertheless, the trend since the summer was already showing signs of slower growth. Durable goods orders were also down 2.1 percent in September. The Institute for Supply Management’s survey for October shows that the manufacturing sector has been negatively impacted by rising materials prices and energy costs.
As we had predicted, inflation continues to accelerate. Our 12 month moving average CPI inflation rate was 3.3 percent in September, and we expect that it will end this year at 3.7 percent and then reach 4.4 percent in June 2006. We are intrigued by the WSJ’s recent mainstream economic forecast for the 12-month inflation rate in November of 3.8 percent, even though the September rate was already 4.7 percent, and a forecast of 3.2 percent for May 2006, based on stronger GDP growth than we predict for 2006.On the other hand, inflation expectations of the average consumer as reported by the University of Michigan’s Consumer Survey had reached 4.3 percent in the September survey.
The real estate sector appears to be weakening. We think the bubble could burst in some regional markets, although the Fed Chairman feels it is only a froth. Prices in some of the strongest markets appear to be leveling off. Some analysts point to rising mortgage rates and prospects of overbuilding as the triggers for a downturn. Rising building costs could also dampen market momentum. On the other hand, new home sales were up 2.1 percent in September, which might be an indication that it will take further interest rate and inflation increases to cool off the market.
We think there are significant risk factors in the outlook which are likely to push up long-term rates at a relatively fast pace:
Political uncertainty: a President with sliding standing at the polls facing increasing opposition in Congress and the upcoming mid-term elections in 2006.
A widening trade deficit. We are now projecting the trade deficit will reach 6.5 percent of GDP this year. This huge gap will likely trigger a sizeable correction in the currency market with the Euro reaching as high as 1.45 dollars which will in turn further push up interest rates.
Higher fiscal deficit caused by increased government spending particularly in an election year.
Another disruptive hurricane season in 2006, which will also result in more government disaster relief spending.
The ever present risk of terrorist acts against the U.S.
The third quarter GDP figure showed that the economy has greater momentum than originally anticipated which will in turn add to inflationary pressures. With inflation of 4.5 percent next year, the 10 year bond should average 5.25 - 5.5 percent – and we think the adjustment in the long-end will materialize much quicker than the Fed’s moderate policy of a quarter point adjustment at each FOMC meeting. As interest rates continue to climb the housing market will begin to lose steam and consumers will be less inclined to cash in on their accumulated net worth in real estate and thus dampen consumer spending. We are forecasting GDP growth of 2.8 percent for 2005 versus the WSJ mainstream forecast of 3.3 percent.
At the current pace, the hemorrhaging in the external accounts will likely reach $900 billion in 2006. Foreign investors have so far been willing to finance this huge external gap. Nevertheless, the larger the financing requirements the higher the risk that foreign investors could get nervous about the sheer magnitude of our deficit and temporarily holed back their financing, thus triggering a sizeable depreciation in the value of the dollar. We think the Euro could reach 1.45 - 1.50 dollars during the next six to eight months. The rise in the value of he Euro in the currency market will simultaneously affect interest rates in the money market. The mechanism works as follows: when foreign investors begin to stay way from the dollar, its value in the currency market will fall – or the value of the Euro will rise – and the lower demand for dollars in the currency market will have a parallel impact on the money market where there will be less demand for U.S. Treasuries thus resulting in higher yields (Note: demand for U.S. dollars in the currency market is reflected in demand for U.S. dollar denominated instruments such as U.S. Treasuries in the money market).
Latin American Economies
In
Argentina, president Nestor Kirchner scored a resounding victory in the mid-term elections. His supporters, including his own wife, won decisively at the local, regional and legislative levels.After considerable confusion regarding a reapportionment of legislative seats, presidential elections in
Bolivia are still on track of December 18 of this year. Leftist Evo Morales and Jorge Quiroga of the center-right are likely to go to a second round.The Central Bank of
Brazil reduced its benchmark interest rate to 19.0 percent in October. Exporters and manufacturers have been raising concerns about the strength of the currency and growth prospects.Japan and
Chile have finalized a feasibility study about a free trade agreement between both countries and expect to start negotiations by next year.The
Colombian Supreme Court cleared the way for president Alvaro Uribe to run for a second consecutive term.Costa Rican
former president Oscar Arias is the frontrunner in the campaign for the presidential elections of February 2006.In the
Dominican Republic, the government and the National Association of Hotels and Restaurants reached an agreement for special taxation on tourism activities. The association had complained that new taxes proposed by the government would impose a heavy burden on the tourism industry and would also hinder its competitiveness.Salvadorean
banks have received a substantial investment from foreign banking institutions. One of the four largest Salvadorean banks, Banco de Comercio, has been acquired by the Canadian Scotiabank. Panamanian Banco del Istmo acquired 60 percent of capital of Banco Salvadoreno.Third quarter statistics show disappointing industrial production in
Mexico of just 0.6 percent. Construction output reached a lackluster 2.1 percent, while manufacturing was almost static at 0.2 percent.