September 27, 2006
U.S. Economy
The Fed is on a pause mode and apparently no alarm bells are going off, at least for now. Kudos to the Fed Chairman for leading a well paced orchestra as analysts are increasingly whistling its tunes. Fed-speak, led by the eloquent voice of Mr. B, has been echoed by analysts with such phrases as "inflation expectations are well anchored" and "inflation pressures seem likely to moderate over time." While we cannot disagree with those statements, we are not sure of their exact meaning. Are inflation expectations by consumers of 3.8 percent well anchored? How long do we need to wait for inflation pressures to moderate? Regarding consumer inflation expectations as measured by the University of Michigan survey, we have noticed an increase in the volatility of those expectations, meaning that consumers are unclear as to where inflation is headed, not a picture of well anchored expectations.
It appears to be a new theory of inflation, the "kinked" inflation curve. Recently, analysts have concluded that inflation will fall rapidly as a result of lower oil prices; yet they have been touting the view that inflation is not affected by rising oil prices, and that is why energy is not part of the core inflation measure. Thus based on the so-called "core" inflation rate, the theory appears to hold that when it is rising, inflation does so only modestly, but when it begins to decline it falls very quickly. Sticky when rising but slippery when falling. We hold a very different view of inflation, mainly that inflationary momentum does not go away quickly. Our inflation outlook for December of this year – based on the moving average CPI, coincides with consumer expectations of 3.8 percent. On a December / December basis it will reach 4.9 percent.
The economy is slowing, but still moving ahead at a brisk pace. The second quarter GDP growth rate was revised up to 2.9 percent from the preliminary estimate of 2.5 percent. Durable goods consumption weakened noticeably while investment spending slowed. One good sign for the runaway trade deficit, the growth in the volume of imports also slowed during the second quarter. On the other hand, industrial production strengthened in June and is gathering some momentum. We think GDP will post a still healthy 3.6 percent growth this year, followed by 2.6 percent in 2007.
The wild card for the economy is the real estate market. How hard will it fall? We think "regional froth" has been blown away by a rising bubble. Sales of single family homes, the stalwart ingredient of the American dream, were down 21.6 percent in July compared to July 2005. Based on the OFHEO index, prices could fall 10 - 15 percent during the next 18 months, with greater price risk in those markets that have experienced the strongest appreciation in the past five years.
The external front appears to be quiet for now. The trade and current account deficits are still headed for our forecast of $900 billion for this year, and we are continually monitoring foreign investors’ appetite for another $900 billion of U.S. paper, versus sitting on the sidelines until the dollar takes a steep fall. As of March of this year, foreign investors were holding 25 percent of total Federal Government debt, not to mention their holdings of corporate debt. The US dollar is very vulnerable to any sudden portfolio shift by foreign investors.
The good news is on the fiscal front. The Federal budget deficit is now estimated at $260 billion for FY 2006 – of course based on government accounting principles, not GAAP. The improvement in the fiscal accounts is due in large part to a strong increase in tax revenues. However, a slowing economy and rising interest rates could result in a sizeable increase during the next fiscal year.
We think economic conditions are favorable for the Fed to extend the pause in the Funds rate, although another one step increase during the fourth quarter of 2006 or first quarter of 2007 is still possible. On the long end we still think the 10 and 20 year Treasury bonds will peak at 5.50 and 5.80 percent respectively possibly as early as year end or during the first quarter of next year. As we have mentioned, a sharp drop off of the dollar would send yields quite a bit higher, at least temporarily.
Latin American Economies
Argentina -
president Kirchner easily obtained the authority to change budget allocations without previously seeking Congressional approval. Kirchner has been bolstering the powers of the executive branch and is trying to expand the role of government in the economy.Bolivia
- the Constitutional Assembly has been mired in the midst of conflict. Following the dictates of the government, the MAS controlled majority decided to do away with the universally accepted method of approving constitutional issues by a two-thirds vote. The decision to adopt a simple majority vote effectively discards the opposition and assures that Evo Morales will have his own brand of Constitution. It also means that the autonomy recently approved for themselves by the four most important provinces in the nation will not become a reality. The opposition has withdrawn from the Constitutional Assembly and a 24-hour protest strike paralyzed the provinces of Santa Cruz, Tarija, Beni and Pando.The bitter dispute with Petrobras, owned by the
Brazilian government, over the nationalization of the oil and gas industry, has required the intervention of Brazil’s president Lula da Silva and Bolivia’s vice-president Alvaro Garcia Linera. It has also triggered the resignation of the Bolivian Minister of Energy.Brazil -
president Luiz Inacio "Lula" Da Silva comfortably leads the opinion polls ahead of the October elections. We think Lula will easily win the presidency. He has not been personally linked to the corruption scandals involving high officials of his administration. We also think that after the elections, Lula will take a more assertive position with respect to Bolivia’s pretensions and to the attempts of Venezuelan president Hugo Chavez to become the leader of Latin America.Dominican Republic
- the government will soon introduce in Congress a package of laws required for the implementation of the free trade agreement with the U.S. Those laws will cover the protection of intellectual property rights, such as copyrights and industrial patents and licenses. A law will open government procurement to all the CAFTA-DR members. Another set of laws would comply with the requirements of the Stand-by agreement with the IMF. They would reform fiscal budget procedures and management, public investment and would institute a Ministry of Finance and Planning.Ecuador
- Leftist Rafael Correa leads the presidential election opinion polls with 26.4 percent of vote preference, followed by Leon Roldos of the moderate Democratic Left. About 42 percent of voters are undecided. Correa was briefly Minister of Finance and has publicly flaunted his friendship with Hugo Chavez.El Salvador
- Textiles exports have fallen by 10.4 percent in the first seven months of the year and 25,000 jobs have been lost, due to the stiff competition from China and other global producers. However, El Salvador also faces strong competition from lower cost Central American producers.In
Mexico, the PAN conservative candidate, Felipe Calderon, has been officially declared the winner of the hotly contested presidential elections by a very narrow margin of just about 0.6 percent, after the court challenge by the defeated candidate, Andres Manuel Lopez Obrador, did not prosper. Nevertheless, Lopez Obrador staged massive demonstrations and street blockades in the federal district and refuses to accept the results. He has been talking about establishing a "parallel government".We think that Calderon will have a difficult term in office, due to the harassments staged by Lopez Obrador. However, governability will not be in danger. Lopez Obrador’s antics will divide the
Mexican left between his radical followers and the moderates that prefer to work within the institutional framework.Venezuela
- president Hugo Chavez has launched an aggressive international campaign to obtain a temporary seat in the U.N. Security Council. In the process, he has repeatedly insulted U.S. president Bush and has managed to annoy other governments. Chile has officially requested the withdrawal of the Venezuelan ambassador, due to comments considered as an intromission in Chile’s internal affairs.