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Denis Ouellet, CFA
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Denis Ouellet has been involved in the Financial sector since 1975. Now retired, he is a part-time blogger. Denis has been analyst and head of research for a brokerage company, equity manager for various investment organizations (pension, mutual and hedge funds), head of global equity... More
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    The Philly Fed survey is quite strong. The highlight of this survey is about pricing power and inflation risk.

    The survey’s broadest measure of manufacturing conditions, the diffusion index of current activity, increased from 19.3 in January to 35.9 this month.  This is the highest reading since January 2004.  The demand for manufactured goods is showing continued strength: Although the new orders index was virtually unchanged in February, it has increased over the past six months. The shipments index also improved markedly, increasing 22 points.  Firms also reported a rise in unfilled orders and longer delivery times this month. 


    Firms’ responses continue to indicate improving labor market conditions. The current employment index increased 6 points. More than twice as many firms re‐ ported a longer workweek (23 percent) than reported a shorter one (10 percent).  
    Price increases for inputs as well as firms’ own manufactured goods were more widespread again this month. Sixty‐seven percent of the firms reported higher prices for inputs, compared with 54 percent in the previous month.  The prices paid index, which in‐creased 13 points in February, has now increased 55 points over the past five months.

    On balance, firms also reported a rise in prices for their own manufactured goods. The prices received index increased 4 points and has steadily increased over the past four months. Twenty‐nine percent of firms reported higher prices for their own goods this month, compared to 26 percent in January.


    This part is the most interesting of the survey. For background, Dave Altig
    Senior vice president and research director at the Atlanta Fed, wrote on February 11, responding to criticisms that Fed executives are disconnected from the real world (my emphasis):

    We recognize that the data are, by definition, yesterday’s news, and extrapolating to the future is imperfect (to say the least). For exactly that reason, we do rely—heavily, in fact—on those “consumers and executives” with whom we are purportedly disconnected. In the two weeks prior to every Federal Open Market Committee (FOMC) meeting, we meet face to face with the 44 business leaders (consumers and executives, all) that make up the boards of directors of our main office and the five branches of the Sixth Federal Reserve District. In these meetings we lay out our view of the data, how we are interpreting the information, and what we think it means for the course of the economy going forward. And then we ask them where and how we are getting it wrong.

    Advice-seeking is not confined to those 44 directors, however. Our branch system is the basis of what we call our Regional Economic Information Network, or REIN. Through REIN, between each and every FOMC meeting we reach out to literally hundreds of contacts throughout Alabama, Georgia, Florida, Louisiana, Mississippi, and Tennessee. The goal of these interactions is exactly the same as with our directors: Ask real people, making real decisions, about the real circumstances as they see them. And they we ask them what they see coming, share our views on that question, and try to reconcile the two when they differ.

    Every Federal Reserve Bank has its own procedures for bringing anecdotal and real-time color and nuance to the data. But we are all doing it one way or another. The picture of a Federal Reserve as disconnected from the on-the-ground realities is simply false.

    And what have we been hearing? Yes, certainly highly visible prices and costs have been rising. Yes, some businesses have been able to pass these costs through to customers. Yes, there is some concern about whether price pressures might become more widespread.

    But have they yet? Does it seem, as people contemplate market circumstances and their own pricing plans, that widespread price increases are imminent, or even highly probable? The consistent answer we have been getting is no.

    And here is the result of the special question in Philly Fed survey:

    In this month’s special questions, firms were asked about pricing of their products since the beginning of the year and their expectations for price changes in the near future. Since the beginning of the year, 57 percent of the responding firms indicated some increase in prices for their own goods, with the most frequently cited range of increase between 3 and 4 percent. 


    The weighted average price increase since the beginning of the year is 2.1%. Expected increases over the next 3 months total 2.2% (weighted average). If the 38% of the firms that have not raised prices so far hiked them by 1.5%, the overall price increase would be 2.7%.

    Fifty-six percent of firms have been able to raise prices early in 2011. Fifty-nine percent expect to raise prices over the next 3 months. Obviously, many more companies are seeing enough pricing power to hike prices twice within 6 months. Core inflation has clearly bottomed. Although David Rosenberg wears different lenses:

    That said, the special question in the Philly Fed was all about pricing power and about 60% of respondents claim they have held or will hold their price increases to 2% or lower since the start of the year, and a similar share said they intend to follow the same restraint in the next three months. Only around one-fifth plan to raise prices by 5% or more and two-thirds said they were not experiencing shortages of raw material of any kind. So we expect an inflation hiccup in coming months, but not a cycle.

    How fast will core inflation be in 2011?

    The answer to that will be critical for equity markets. Rising core inflation would negatively impact PE ratios (see The Rule of 20). Continued subdued core inflation will likely negatively impact corporate profits through a margin squeeze as David Rosenberg likes to emphasize:

    We saw more evidence that companies are facing an intense profit margin 
    squeeze with the recent macro data. The chart below is the spread between Philly Fed prices paid (input costs) and received (prices charged). The last time the spread was at 46.2 was in June 1979 … that was not a good foreboding: the four-quarter EPS trend swung from +21% to -9% a year later. The producer price index data told the same story on margins —  the ratio of PPI at the crude stage to PPI at the final gate just broke above 1.3x … there were only three other episodes where this ratio was above 1.3 … in each case, EPS growth slowed substantially all three times in the next year.



    Full Philly Fed release

    Feb 22 2:59 PM | Link | Comment!

    On December 6, 2010, posted about a diplomatic cable, leaked by Wikileaks, that revealed that Li Keqiang, potentially the next Premier in China,

    described China’s gross domestic product figure as “man-made” and “therefore unreliable”.

    Mr. Li went on to say that China GDP numbers were “for reference only”, revealing that for more accuracy on the economy

    he used three ways of evaluating China’s economic activity,  focusing on electricity consumption, the volume of rail cargo and the amount of bank loans disbursed.

    Absolute Return Partners’ Neils Jensen went to work and, comparing Chinese GDP growth with electricity output over the past 15 years, found an interesting pattern:

    During periods of low economic growth (the Asian crisis in the late 1990s, the US recession in 2001 and the global credit crisis in 2008-09), GDP grows much faster than the electricity output. Conversely, during periods of strong economic growth (2002-07 and 2010), GDP growth is lower than the power output. Clearly the GDP numbers are massaged.

    Digging one level deeper reveals something rather more serious.  Assuming the electricity stats tell the true story, and that the GDP numbers are ‘for reference only’ (remember, not my words!), China’s economy experienced a dramatic slowdown as 2010 progressed. Total power consumption (year on year) grew by a whopping 22.7% in Q1 last year but only by 5.5% in Q4.  The slowdown in Q4 was in fact so dramatic that the power output dropped 6.3% quarter on quarter!


    It thus appears that the Chinese economy is slowing more than official GDP data and commodity prices are showing.


    Recent manufacturing PMI surveys seem to support this notion as reported in theChina Daily on February 1 (my emphasis):

    China’s manufacturing sector purchasing managers index (PMI) fell to a five-month low of 52.9 percent in January, compared with 53.9 percent in December (…)

    Zhang Liqun, a research fellow with China’s top government think-tank — the Development Research Center of the State Council — said the data would likely drop further in months to come.

    The December manufacturing sector PMI figure fell 1.3 percentage points to 53.9 percent from November.

    Sub-indices of the January manufacturing sector PMI data, which tracked the performance of production, new export orders, inventory and employment, all fell by more than 2 percentage points from December, but the purchase prices of raw materials rose. (…)

    China’s National Bureau of Statistics’ leading economic index has declined rather significantly recently and its Quarterly GDP Index is suggesting a slower economy, certainly not an overheating one.

    Another clue comes from retail sales. Nominal sales growth rates have been amazingly stable around 18.5% YoY since March 2010. Yet, the rate of inflation as measured by the CPI has accelerated sharply during the same period, suggesting that real sales have been decelerating as the year progressed. And that assumes that the published CPI reflects the reality. More on that below.



    Car sales have been strong near the end of 2010 as buyers flocked to catch the lastopportunity for tax incentives for small cars and subsidies for trade-ins, as well as to take advantage of Beijing’s quota policy on car purchases. However, this will negatively impact 2011 demand as acknowledged by the Chinese industry (my emphasis):

    “The change in policies makes us lower our anticipation for this year’s automobile market from the previous 10 to 15 percent year-on-year growth to no more than 8 percent,” said Cui Dongshu, vice-secretary-general of the National Passenger Car Information Exchange Association. “And the serious excessive consumption in 2010 even may lead to zero or negative growth this year.”

    The association’s Secretary-General Rao Da said he believes that in 2011 China will probably record the first negative year-on-year auto sales growth for 20 years.

    Another indicator of weakening demand is house prices which have been declining in the wake of Beijing’s determination to cool the housing market off.

    Numerous signs thus point to a meaningful slowing in China’s economy during the first half of 2011.

    Yet, the Chinese government is very busy these days finding ways and means to slow it down even further. More housing restraining measures are announced almost weekly while the PBoC keeps raising banks reserve ratio and interest rates.

    imageMy good friend and astute investor Michel Bastien sent me a note pointing out that China’s yield curve has turned negative in December as the PBoC has boosted short-term rates. Michel notes that an inverted  yield curve is often a harbinger of a meaningful slowdown in North American economies, as was the case in 2006-07. He believes that the same could be happening in China. That would be negative for commodities and commodity-related currencies such as the Canadian dollar.

    Michel also points out the recent rise in copper inventories as a possible sign that Chinese demand is slowing. Copper prices have soared 38% in the last 6 months alone, even though copper inventories have been rising everywhere:

    I checked other metal inventories to find that most metals are also showing rising inventories in recent months, obviously not a sign of accelerating consumption, even though US carmakers are currently increasing production, raising doubts about European and/or Asian demand.

    The PBoC hiked interest rates again on February 8, citing rising inflation pressures. The key benchmark rate was raised 25 bps to 6.06%, the highest level since October 2008. It is also expected that the central bank will soon increase banks reserve requirement ratio once more to curb excessive lending.

    But the Financial Times rightly argues that

    For those who believe China is in the midst of a property bubble, gripped by inflationary pressure, and struggling to appease irate savers, Tuesday’s 25 basis-point increase in policy interest rates looks pathetic. The new one-year lending rate of 6.06 per cent will not slow borrowing when gross domestic product growth and inflation are 9 and 5 per cent respectively. The new 3 per interest rate on one-year savings accounts will lure few renminbi out of speculation and into the banks.

    NBF Financial Economy and Strategy Group agrees that Chinese authorities are not aggressively tightening when considering inflation rates excluding food.


    But food inflation is a real problem in China since food consumes a very large share of  income. Few Chinese give any thought to the notion of “core” inflation. The Communist Party is very serious about inflation:

    Wen Jiabao, the Chinese premier, put tackling inflation at the top of the policy agenda on Sunday and suggested that the survival of Communist party rule might depend upon it.

    Many Chinese officials and experts believe double-digit inflation was a leading cause of the public discontent that spilled over into student-led protests in the spring of 1989 and ended in a bloody military crackdown centred on Beijing’s Tiananmen Square.

    “If there is inflation plus unfair income distribution and corruption, it will be strong enough to affect our social stability and even affect the stability of state power,” Mr Wen said in his annual press conference at the close of the national people’s congress, China’s rubber stamp parliament. (Financial Times, March 14, 2010)

    There is no doubt that the recent events in Egypt are reviving the Communist Party’s worst fears.  The China Daily reports that

    In a December survey by the central bank, 74 percent of respondents said they were dissatisfied with rising inflation.

    Could all this mean that China’s economy is slowing down more rapidly than official stats are suggesting and that Chinese authorities, well aware of that, are threading cautiously, trying to control inflation without strangling the economy?

    The task is daunting and time is of the essence as Neils Jansen explains:

    (…) the transition of power from current President Hu Jintao and Premier Wen Jiabao to the next generation of leaders is fast approaching. Although the National People’s Congress, where the new leaders will be officially instated, is not taking place until March 2012, the new power structure will almost certainly become apparent to the outside world at the next party congress, scheduled for October of this year.

    Given the importance of this changeover and the significance the Chinese assign to not losing face, the leadership will do anything in its power to maintain the economic momentum until after the March 2012 congress. (…)

    Jansen places more emphasis on economic growth but I believe that the Party is more focused on inflation for political stability reasons.

    This inflation bout seems more challenging than that of 2007-08. The current drivers of inflation are much more global and structural than domestic and cyclical. Global and domestic supplies are so tight that prices spike immediately after even a small disruption in the normal flow of goods.

    More importantly, Chinese food consumption patterns are shifting as people become wealthier. More meat eating requires more cereals to feed the animals, at a time when both China and world grain supplies are excessively constrained. Food price caps won’t be effective over the medium and longer terms since rising food prices are a pan-Asian issue exacerbated by China’s large and growing absolute demand for most agricultural products.

    Importantly, core inflation is rising. On December 11, 2010, posting on China’s November CPI, I wrote

    It is very important to note that non-food prices were up 0.6% MoM in November after a 0.4% increase in October. This is a 6% annualized rate, well above target and absolutely unacceptable for the Chinese authorities. While non-food prices are only up 1.9% YoY in November (from 1.6% in October), there is nonetheless a clear acceleration in core CPI in China.

    But if GDP data are “man-made”, so are inflation statistics as Neils Jensen found out:

    (…) I received an email from China specialist Simon Hunt, who notified me of the fact that the National  Bureau of Statistics  of China has just announced that the weight of food in the consumer price index has been reduced as of 1st January 2011. In an emerging economy such as China, where 35-40% of disposable income is spent on food items, sharply rising food prices are actually likely to lead to food accounting for a higher percentage of overall disposable income, so the Chinese reaction defies all logic. There can only be one motive: to cook the books.

    Andy Xie asserts that China’s inflation problem is endemic and needs tougher measures.

    Massive monetary growth in the past decade has led to the accumulation of a huge amount of latent inflation in the system. It showed up first in land inflation. As the speculative frenzy concentrated money in the property market, the monetary growth did not at first lead to rampant inflation. But the dynamic changed: labour shortages and rising energy prices triggered broad-based inflation, and the stock of money suddenly became its fuel. (…)

    Inflation is always a monetary phenomenon. When money supply grows faster than the underlying economy can grow through output, it results in inflation. Inflation tends to appear in supply bottlenecks first. Labour, energy and agriculture, for example, are leading inflation now, as their supplies are relatively inelastic. Cost-push inflation is spreading to goods and services in general. (…)

    The government’s measures to cool inflation are far from sufficient. It must recognise that inflation will remain high for the next five years, and bank deposit rates must rise above the expected inflation rate. The current deposit rates are likely to be three percentage points too low. Stability can be achieved only if people don’t lose money by keeping it in banks.Tiny tightening steps cannot reverse the accelerating trend in inflation; the monetary policy just becomes further behind the curve.

    How much behind the curve? Neils Jansen:

    (…)  SocGen attempted to estimate how much behind the curve the Chinese actually are, using the Taylor rule as a guideline. According to SocGen’s calculations, the People’s Bank of China should tighten by approximately 200 basis points in order to close the gap. That will almost certainly not happen ahead of the congress next year.

    China has been the engine of the world between 2000 and 2007. Its own QE program in 2009 helped set a floor on collapsing world economies; its swift economic rebound has propelled world commodities through the roof. Meanwhile, its domestic resources, commodities and labor, have been stretched to the point where inflation is now everywhere.

    If the Communist Party fights inflation, it seems unlikely that it can be done without a meaningful economic slowdown. All recent PBoC statements have been citing inflation as the main policy target. The Chinese central bank has let the yuan appreciate at a faster rate recently, an effective way to restrain inflation from imported goods. The other side of the coin, so to speak, is that Chinese export prices are rising.

    For most economies and financial markets, inflation is becoming the no. 1 enemy. Food inflation coupled with higher oil prices are eating into consumer disposable income and reducing income available for non-discretionary goods and services. Rising commodity prices are pressuring profit margins, pushing companies to try to raise their own prices. If they succeed, core inflation will accelerate and compress PE multiples; if they don’t, profits will suffer.

    Feb 16 8:26 AM | Link | Comment!
     Ever since the end of WWII, the American eagle has been gliding the skies, growing stronger and prouder, its reach and power seemingly endless. Seriously bruised by the banking crisis, he was able to lift again thanks to Uncle Sam’s and Uncle Ben’s fiscal and monetary impetus. For a while, many saw signs of his previous poise. Yes, he would do it again. Someone, almost impersonating him,  even shouted: “Yes, we can!”.

    Alas, our bird has been more than bruised. His wings have been weakened. He is feeble, physically and morally. Uncle Sam and Uncle Ben are now effectively windless. The American eagle, already flying low and almost idle, is dangerously losing altitude. The whole world is anxiously watching the dive. Can he regain some composure, can he find the necessary strength, like always before? At worst, will he, miraculously for many, be able to land softly, softly enough to recover, fly again and resume its dominance of the skies?

    Last Friday, the US employment report confirmed that this economic recovery was incapable of shifting from low to high gear. Total employment in September 2010 was only 0.4% higher than the previous year, lower than last May, and 4.8% below the November 2007 peak. The recession officially ended in June 2009, yet employment remains 0.5% lower.



    Private employment has recently shown a very feeble improvement although private employment remains 6.6% below its December 2007 peak, in spite of the substantial recovery in corporate profits.




    Government employment, as usual,  has not declined as much but notice the downward trend during 2009 and the severe drop post the 2010 census. Unlike the 2000 experience, government employment is in a clear downward path.



    Not so much at the federal level (yet), but clearly at the state and local levels.





    During 2010, total US employment increased 613,000. Private employment rose 863,000 but total government employment decreased 250,000 of which 269,000 were lost in state and local governments. State and local government finances are so bad that more layoffs are inevitable in coming months and years (read THIRD WORLD AMERICA: FROM THE JETSONS TO THE FLINTSTONES).

    Can private employment soon rise strongly enough to keep the eagle flying? Consider that

    • small and medium size businesses are the main job creators in the US. NSBA surveys continue to show that small business owners have little inclination to increase employment levels. Surveys reveal continued high uncertainty with regard to the economy, access to capital, taxation and regulations as well as the impact of heath care reform. New private sector jobs totaled 274,000 during Q3 2010, down from 353,000 in Q2.
    • Construction, retail and finance account for 28% of private employment and none are showing clear recovery signals. Together, these sectors created 10,800 new jobs in Q3, up from –41,600 in Q2.
    • Manufacturing has gained 136,000 jobs in 2010 but accounts for only 10% of total employment and remains in a secular decline. New manufacturing jobs totaled –2,000 in Q3, down from + 81,000 in Q2.
    • Information-related industries employment peaked in 2001 and has yet to show any sustained signs of stabilization. No new jobs were created in Q3, but a small improvement from –17,000 in Q2.
    • In total, 40% of private employment is in weak sectors. Only education, health, leisure, hospitality and professional and business services (46% of total) are displaying positive momentum, having added 670,000 jobs so far in 2010, 78% of total private new jobs. In September alone, these sectors contributed 108% of all new private sector jobs. Interestingly, these sectors face relatively little foreign competition. As such, the US uncompetitive taxation is not a major threat for these service sectors, unlike most other industries which are undoubtedly losing share to global competitors in more business friendly environments (who thought we would ever say that of the US!). But even these sectors seem to be losing momentum: they created 185,000 new jobs in Q3, down from 263,000 in Q2.

    American consumers are very much aware of the exceptional economic difficulties facing their country. Their wealth has been severely reduced by the crisis and although equities have recovered some of the losses, housing remains extremely weak. Consumers seem to have changed their old habits as a result: the so called “new normal” calls for the restoration of  family balance sheets through increased savings and a severe curtailment of the use of credit.

    US consumer credit has been falling, yes falling!, continuously since early 2009. The year 2009 marked the first annual decline in US household debt since the Fed began tracking this series in 1946 and it is continuing in 2010. Even the extraordinary recovery in equity prices has had no impact on the confidence of Americans and their desire to adjust their standard of living by deleveraging (chart from




    We are currently in the most important period for the US economy: back-to-school sales were soft, normally a signal that Thanksgiving and Christmas holidays will be challenging for US merchants. Weak sales during this crucial period of the year will hurt profits and force corporations to curtail activity during the first half of 2011. This would negatively impact employment and government finances, aggravating an already very weak economy. Consumer, business and investor confidence would decline further, potentially resulting in a hard economic double dipping.

    Even a cheap market with even lower interest rates and lots of liquidity would be hard pressed not to succumb to the despair that would ensue. With no political leadership in the US, little if any ammo at the Fed, a weakening greenback raising havoc in currency markets, more serious deflation threats, possibly never before in peacetime has it been more important that God Bless America!

    What about QE2? After “Helicopter Ben”, could “Ben’s Boat” be the solution? ISI’s excellent economist Ed Hyman rightly says that

    The fact that QE2, which is a radical measure, is being discussed means the economy appears to be in deep trouble. (…) an open-ended (unlimited) QE2 program seems likely to be announced Nov 3  –  desperate measures for desperate times.

    Can we reasonably expect that more liquidity will boost the economy after QE1 and Obama’s fiscal stimulus together failed to show any meaningful lasting impact? Can even lower mortgage rates attract FICO-bruised buyers to invest in an asset whose value remains fragile? Can even lower interest rates lead business people to invest when their confidence in the economy and their government is so low and tax rates so high? Pushing on a string is likely to be the buzz word in coming months.

    The only hope seems to be that the QE2-induced liquidity explosion will find its way into the stock market and help create enough wealth effect. What else can turn the tide?

    Disclosure: NO POSITION
    Oct 12 9:14 AM | Link | Comment!
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