Weekly Observations: Even with Government Intervention, Deflation Risks Continue 25 comments
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Down profit cycle has more to run
The S&P 500 can still rally another 15% from here without violating any long-term trendline that has defined the bear market. So, who is to say that this upturn does not have more legs? But we are still convinced that the down profit cycle has more to run.
Look at the nearby chart (click to enlarge), which presents National Account profits relative to GDP – a proxy for margins. People who look at the earnings plunge and deem t
his to have been the worst setback ever and note how we have broken all the peak-to-trough declines in the past fail to take into account the starting point – the profit-to- GDP ratio at the 2006 peak hit an all-time high of 10.9% – not once did it ever even cross above the 10% threshold in the 60-year history of the data. A normal peak was typically around 7%, and today it is 6.6% – after the sharp slide this cycle, it is actually close to prior bull market peaks, believe it or not. The average recession trough is 4.6%, so on that basis we are basically two-thirds of the way though the margin compression phase and seeing as we think nominal growth is likely to be flat over the next two years, a complete normalization of this ratio would imply a further 30% downside potential for corporate profits. Applying that to S&P 500 operating earnings would actually put them at risk of bottoming at $35 at some point over the next two years, which in turn means we have a forward multiple of very close to 25x, which is simply too rich for our liking.
Cyclical spending weakened sharply in March
Retail sales came in markedly weaker than expected in March, down 1.1% M/M versus estimates for a modest gain. The results also suggest that the majority of tax refunds (up 15% Y/Y) are being directed toward paying down debt or savings at the expense of spending.
That retail sales decline, while startling based on all the bullish prognostications, was actually a flattering result. The cyclical sectors weakened sharply – vehicles/parts was down 2.3%, furniture was down 1.7%, electronics/appliances fell 5.9%, e-tailing was down 1.7%, building materials dropped 0.6%, restaurants slipped 1.4%, and clothing sank 1.8%. These discretionary sectors declined 2% or at an annual rate exceeding -20% in March. The only areas of the retail sphere that managed to eke out any gains at all were the ones that would ordinarily be associated with an economy knee-deep in recession – food and pharma with 0.4% increases apiece.
CPI deflates for the first time since 1955
Overall CPI fell by 0.1% M/M in March, in line with Bank of America Securities-Merrill Lynch estimates, but below consensus forecasts for a 0.1% gain. As was seen in the PPI report, energy posted a large decline, down 3.0% M/M and partially led lower by seasonal factors. Food prices were also soft, down 0.1% M/M, following a similar drop in February. Outside of food and energy, the core CPI rose by 0.2% over the month, led by an 11% jump in tobacco prices, which alone added 0.1ppt M/M. Higher wholesale prices and a record hike in federal taxes (set to go into effect in April, but started to pass through in March) were reflected in the tobacco index.
Too much spare capacity to be concerned about inflation
There seems to be a lot of market chatter about how the dramatic fiscal and monetary stimulus is going to reignite inflation. Let’s look at the bigger picture. We have a real unemployment rate of nearly 16% and a capacity utilization rate that looks about to decline to 65%. We think there is simply too much spare capacity to absorb to be concerned about what the government is going to do
except prevent an outright deflationary environment from taking hold. The inflation trade is totally an overplayed card, in our view.
The reality is that it is not economists or market pundits on television who determine the pricing of goods and services that go into the CPI and the PPI. As the latest NFIB small business survey shows, the net share of companies intending to raise prices has plunged for eight months in a row to now stand at ZERO. Nada. For the first time ever, the net share of small businesses that are planning price increases over the next six months has totally vanished. NFIB intentions regarding wage increases have also collapsed to zero – again for the very first time. Based on this data, we would have to conclude that even with all the gobs of government intervention, deflation risks continue to trump inflation risks. That the equity market has enjoyed a very sharp and snappy short-covering rally over the past month has not dissuaded us from this viewpoint.
Housing starts at their second lowest level on record
While starts did come in below expected, down 10.8% to 510,000 annualized units, the pundits are claiming that the number was a market-positive on two fronts: (i), the decline in new construction activity is good from a supply perspective since it shows that the builders are making even more headway at shaving the unsold inventory, and (ii) all the decline in March was in multi-family,
which collapsed 29%. Single-family starts actually held on to the February surge and stabilized at 358,000 units. The fact that (i) and (ii) are just a tad contradictory does not seem to matter. While it may well be true that starts have bottomed – they aren’t going to zero – the bottom line is that housing starts are at their second lowest level on record despite the best affordability conditions in over a generation (data going back to 1959).
Sustained deterioration in consumer credit quality
What does not seem consistent with the newly found pervasive view that we are seeing a significant thaw in the credit markets is the sustained deterioration we are seeing in consumer credit quality: Nearly 10.2% of borrowers who took out an FHA-backed loan in the first quarter of 2008 became delinquent in the next ten months. The comparable data a year ago covering 1Q07 loans were 9.4%. In February 2009, 12.3% of the FHA mortgages that were issued in 2007 were seriously delinquent (more than 90 days past due). This was just one development among many that boosted the total FHA default rate to 7.46% in February from 6.16% a year ago. Is this a green shoot or a yellow weed? For the first time in its 75-year history, the FHA is considering a request for taxpayer funds.
***
Of course none of this is relevant in a market trading on technical factors. But it will be once the unwinds end and the speculators leave the casino.
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Inflation is just a composite of the individual prices of individual goods and services. Creating overall consumer price inflation must be done by increasing the price of all (or most) individual goods and services.
If the federal, state and local governments as well as the federal reserve, treasury, are all united to increase the price of real estate, and are failing, how can we expect them to succeed at raising the price of anything else?
That is my current doubt about inflation.
On Apr 17 05:33 PM Mistrofan wrote:
> Great stuff. but David R. is missing one teribly important point.
> The level of leverage that we have in the system now by comparison
> with the previous decades. I would gladly liek to look at the graph
> on a leverage adjusted ration. Then, my guess is that this downturn
> will look extremelly similar to the one from 1974.
lets make it 7 weeks in a row of gains!
NEW YORK (Dow Jones)--Banks posted stellar first-quarter results from their
fixed income businesses amid signs of economic improvement, but there's another
trend that also bears watching: loss provisions coming in under expectations.
Loss provisions are the amount of money banks put aside to cover what they
expect to post in future losses. Some analysts suspect banks aren't putting
enough aside in case today's rays of sunshine are followed by more rainy days
later this year. Several analysts have noted that banks' loss provisions
came in less than they expected this quarter. Wells Fargo & Co.'s (WFC)
first-quarter loss provision of $4.6 billion was only about three-fourths what
Paul Miller of FBR Capital expected, while Fox-Pitt analyst David Trone noted
Citigroup's (C) first-quarter loss provision of $2.7 billion was only
two-thirds his expectation
(Dow Jones Newswires 03:57 PM ET 04/17/2009)
So far that avalanche has hit bank coffers only and no matter what those austrians tell you about base money supply blown up and whatnot - the velocity of money in the economy is slowing. Companies cutting down on costs, laying off people.
Helicopters of money flying above insolvent banks who raise credit fees and rates = ZERO inflation effect. World derivatives iceberg is melting. I don't think governments will ever have the balls to reset the system - forgive mortgage debts and totally restructure the current banking system. After all, banks own governments and countries in some way or another. So for them deflation is the way to slowly soft-pedal it into "we-tried-but-failed" state of economy. Dollar will still hold, governments will still hold. Until the current elites feel they are "too big to fail", they will always try to hold on, be it financial or political sphere. Sure the could be a new phase of growth or something in a few years' time. But how do you get there from here? Gotta make a hat-tip to austrians tho. Not the one you'd think - screw gold :) But banks are and always the cause of the crises. Whether it was Dark ages or 1930's.
Oh yeah and there's a good read - Olduvai theory. Are we going there?
I don't know if I fully agree with this. Industrial capacity nowadays is largely high-tech. Being such, it's subject to quick obsolesce and replacement cycles, and with such cycles may come a quicker return to growth a couple years down the road. I look to what happened in the Silicon Valley back in 2000 as a baseline for what's happening now. I find more parallels than one would expect considering the difference in scale and complexity of the events, caused by the same acceleration of the technology development cycles.
Of course, this may prove to be a very technocrat-optimistic point of view, and even then not a particularly probable scenario. I guess we'll see in a couple years.
see The Worldwide DEBT is the problem.
allencharlesreport.blo...
For the time being--maybe through 2010--I think deflation is a significant possibility as the article above points to. I don't think we're talking a huge deflation, but even the threat of moderate deflation brings out an aggressive response from the Fed in rate cuts (done that) and "QE", or expanding the money supply. And I'm actually very concerned that the Fed will go overboard to prevent even mild deflation.
The effect as we actually begin to recover ca. 2011-2012 from a long trough could be very serious inflation. Indeed, count me among the many who do not think the Fed will respond either quickly or strongly enough to prevent serious inflation (5% or more) when we begin a serious economic recovery. Aside from the direct adverse effects of inflation, the Fed will also have to contend with some new asset bubble that could be the source of the next recession.
From an investor perspective, this makes it rather difficult to decide where to put one's money. I think the key may be in keeping the investment liquid so one can react (or--better yet--anticipate) when the economy moves from deflation or inflation.
So, yes, I think everyone's right (or wrong) on the deflation/inflation argument. Just keep your capital powder dry!
On Apr 17 06:15 PM prudentinvestor wrote:
> My thinking is that the Fed will not only prevent deflation, but
> impose inflation via force-feeding the system with an avalanche of
> created money. They have stated this very clearly, and there is no
> reason to doubt that they can and will do it, and the evidence so
> far is that they are succeeding, as some of this newly minted money
> must surely be behind the stock market climb. The alternative of
> doing the right thing and letting incompetent businesses and irresponsible
> consumers fail, and letting competent and responsible people pick
> up the pieces, is not politically palatable.
>
> I am not saying I agree with the Fed's approach, which I think is
> disastrous in the long-term, but the thinking is always short-term.
> Just kick the can down the road one more block, one more time, and
> let the next guy pick it.
Mathematically, can you get to the trough ratio through the following nominal GDP growth rates (inflation rates), while holding corporate profits constant:
2010 -- 4% (3% inflation)
2011 -- 5% (4% inflation)
2012 -- 6% (5% inflation)
2013 -- 7% (6% inflation)
Just wondering if there is a way to engineer a "soft landing" of equity prices ... or do we really have to bottom at $35 EPS * 10 PE = $350 as suggested by a famous Bear Fund manager in recent bloomberg interview.
On Apr 18 12:15 PM Jimbo wrote:
> I am unable to dispute the author's findings and opinions. However,
> as a retiree with a modest investment portfolio that has been crushed,
> I find state and local taxes are not declining and my state legislature
> is now raising any number of "fees" on me and my fellow citizens.
> Gasoline has begun increasing again, our electric utility just received
> permission to raise rates 25%. Packaged grocery items are increasing
> in price or getting lighter or smaller. the cost of services, such
> as haircuts, have been significantly increased in my community. What
> seems to be "deflating" is the living standard of the citizenry.
> In past inflationary periods, people seemed to count on having more
> "money" to pay the increased prices. What do we do now?
I'm skeptical of the spare capacity argument for inflation, however. Inflation can be a monetary phenomenon extricated from capacity issues, just look towards 1920's Germany and Zimbabwe...neither had, or have, capacity issues.
On Apr 17 06:15 PM prudentinvestor wrote:
> My thinking is that the Fed will not only prevent deflation, but
> impose inflation via force-feeding the system with an avalanche of
> created money. They have stated this very clearly, and there is no
> reason to doubt that they can and will do it, and the evidence so
> far is that they are succeeding, as some of this newly minted money
> must surely be behind the stock market climb. The alternative of
> doing the right thing and letting incompetent businesses and irresponsible
> consumers fail, and letting competent and responsible people pick
> up the pieces, is not politically palatable.
>
> I am not saying I agree with the Fed's approach, which I think is
> disastrous in the long-term, but the thinking is always short-term.
> Just kick the can down the road one more block, one more time, and
> let the next guy pick it.
Also, didn't the fed stop issuing the m3 money supply figures a few years ago?
Good article, gives me alot to think about. The statistics you cite show why the fed and treasury are right to still worry about deflation.
On Apr 19 10:50 AM Bevo wrote:
> Stimulus good, debt bad---the Chinese are stimulating their economy,
> and they can afford to. Us? ..not so sure how much more debt our
> system can bear!
I too have an issue with your argument that too much capacity will rule out any inflation threat though. Because capacity is a supply side issue and reduced domestic supply itself plays into inflation scenarios in an environment of an expanding money supply I don't connect with your idea. I certainly agree though that we are in a deflationary death spiral at the moment. Certainly as far as Real Estate is concerned but I see the future more along the same lines as "Prudentinvestor".
I do not for a second underestimate that the Fed will succeed in re-inflating the economy, especially as it has expressly made clear we will have Quantitative Easing for as long as it takes to pull the economy out of it's deflationary trend. Those trillions will find they're way into the economy one way or another. How is not yet clear but my guess it will be under crisis circumstances and it will be big. Now I am not suggesting WW3 to pull us out of our spiral but any major event that spikes energy costs suddenly in an environment of squeezed supply (including under utilized capacity) will reinflate us quicker than you can say "Jack be Nimble". We really need to expect the unexpected and be ready for some serious dollar devaluation to acccompany a return to full employment. In relative terms we will all be poorer for it but we can hopefully stabilize and start getting back to business. I really can't see any of this happening though until we find a bottom in the real estate markets. And the sooner the better for all our sakes.
Cam