The U.S. Economic Metronome Keeps Dangerous Rhythms

 |  Includes: DBC, DIA, GCC, QQQ, SPY, UCI
by: James Picerno

The economy has a familiar rhythm these days. Unfortunately, it's a dangerous rhythm.

Several economic reports hit the street today, and they ring familiar. It's been clear for some time that inflation is bubbling while the housing sector, among others, is still weakening. Today's economic updates reconfirms the trends.

New housing starts fell again last month, dropping to the lowest level since the early 1990s, the Census Bureau reports. Meanwhile, the forward-looking metric of new building permits issued slipped in May compared with the previous month, which means it continues to trawl depths last seen more than a decade ago.

There's also a fresh update on wholesale inflation, and the news is as unsurprising as it is humbling. Producer prices are now rising by 7.2% a year through May, the Bureau of Labor Statistics reports. Once again, the main culprits are higher food and energy costs. Stripping those items away reduces PPI to an annual pace of 3.0%, although that's the highest since the early 1990s too. The problem is that stripping out energy and food costs, whatever the merits for the dismal science, isn't possible for Joe Sixpack, who must pay the higher costs.

What are we to make of all this? For starters, there's momentum in the trends. That doesn't mean it can't all end tomorrow, of course, but that's unlikely. For what it's worth, this observer thinks that inflation will continue to creep higher and housing and other sectors of the economy will continue to weaken. Nothing dramatic, perhaps, but sudden salvation looks remote.

Perhaps a bit more stability in such metrics will come later this year, or perhaps early in 2009. But the emphasis will be on stability, not growth. That's the best-case scenario, by this editor's reckoning. Why? One reason is that the inflationary bubbling of late has only just started to work itself into the nooks and crannies of the broader economy.

Energy costs have been rising for some time now, and that's finally starting to look obvious in transportation costs. "Everything you purchase in the supermarket, the clothing we put on our backs, the wood that goes into a home – it's all transported there somehow," Kevin Smith, general manager of Dart Transit Co., an Eagan, Minn. trucking company, tells The Dallas Morning News. "So as the price of fuel goes up, everything is going to go up."

Consumers are feeling the financial pinch and will act accordingly, which is to say, reduce spending to compensate. That will continue to be a headwind for the general economy for some time. In fact, the spending downturn is already obvious in a number of statistics. The only questions: how long, how deep?

Adding to the woes is the view that the banking system is still hurting, and will continue to hurt for some time. Deleveraging balance sheets and raising cash is still very much a high priority for financial institutions around the world. As a result, loans are harder to come by, even with low interest rates in the U.S. In fact, those low rates are helping stoke inflationary momentum. And while it's not imminent, at some point the Fed will raise rates, which will introduce yet another complication into the recovery efforts.

It's anyone's guess when this cycle will be broken, or what mix of catalysts will align to trigger a break. The only point of confidence we have is that the recovery will take time and bring only modest improvement, at least initially. But even that thin reed is a ways off. The correction, in short, still reigns.

Meantime, one could argue that commodities are overextended and that bonds and equities don't look deeply discounted. All of which leaves us suspicious that it's time to lean heavily in any one or two strategies or asset classes. Rather, we prefer to take a relatively neutral approach across all the broad asset classes, with a touch higher cash levels than normal. In short, more of the same.

Strategic-minded investors must learn to pace themselves. The era of quick fixes is over.