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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 ECONOMIC AFTERLIFE 0 comments
    Jun 7, 2011 1:00 PM

    “Transitory”. Ben Bernanke and other Fed officials have recently been employing the word to qualify the surge in headline inflation stemming from commodity price increases and reassure investors that such inflation will be brief, fleeting and, as such, needs no special attention from neither central bankers nor investors.

    Obviously, Bernanke and Co. have more than a passing influence on economists. Most of them are now using the same word to qualify the recent deflation in economic news, sympathetically called the “soft patch”, reassuring investors that the slowdown is only transitory, being essentially caused by the supply disruptions from Japan, the spike in commodity prices, principally gasoline, and the volatile weather. Being non-core, all these deteriorating variables are thus not worrisome and need no special attention.

    Last week, an old friend passed away. At his burial, the priest offered the idea that this life is only transitory and that it leads to another, unknown, but presumably better lifePriests are versed in latin; they know that transitory comes from transit, “a passage from one place to another”, not merely a return to where we were before, unchanged and unscathed.

    Bernanke and his economist friends also can’t tell us what we are transiting to, what is this next economic life. The word transitory conveniently conveys faith and hope, something  Fed officials currently desperately need investors to have. Keeping the “next life” unqualified, they make us faithfully believe that the post transition state shall be just about where we were before. For Bernanke, that means just enough inflation to avoid deflation, keep interest rates low for an extended period and conclude QE2 smoothly. For many economists, that means that post transition(s) (Japan, commodities, oil and weather), we shall return to decent enough growth to sustain equity and commodity markets.

    Our economic priests are reassuring: there are no reasons to worry and grieve more than necessary. The afterlife shall be all right. Growth will soon enough resume its course (Larry Summers says that “it will be accelerating before too terribly long”), employment will continue its gradual recovery, commodity prices will be sustained but only transitory, corporate profits will keep rising, and interest rates will stay low almost forever. Close to heaven, isn’t it?

    Bernanke and Co’s afterlife is simply back to the future, when a few but economically important people enjoyed rising equity and commodity prices while most other ordinary people in the world stayed economically miserable. The idea was and still is that the wealth effect on the few will, eventually, save the miserable.

    But the afterlife remains mysterious, even for Saint Ben. How much faith and hope should we have? For her part, last Saturday morning, my friend’s widow was showing little hope that her transition would be painless and toward a better life.

    THE “TRANSITORY” ECONOMIC CONDITIONS

    • Japan’s transition will necessarily be towards reconstruction. Although the exact timing is uncertain, Japan’s transition will be economy positive.
    • However, the reconstruction will sustain demand for many commodities, contributing to high prices for a longer period than Ben’s “transitory” might be assuming.
    • Japan’s reconstruction will itself be transitory but it could last long enough to offset China’s economic slowdown while the Communist Party deals with its own seemingly less transitory inflation problem.
    • Oil prices are another thing. Even Ben Bernanke is having doubts about the transitory nature of the recent oil spike(s). For starters, nobody can confidently predict what will happen in MENA countries where “transitory” is now a buzz word. Secondly, Saudi Arabia, faced with its own domestic challenges, is no longer acting as a swing producer for the West. Quite the opposite, in fact. But not to worry: according to many faithful economists, oil is far from having the impact it used to have.
    • The transitory volatile weather is very likely to remain…volatile and transitory. Hope is very appropriate in this case.

    THE AFTERLIFE WE WISH NOT

    Unfortunately, it seems that Japan does not explain everything as FT’s Gavyn Daviesclearly shows. Notice how the recent “slowdown” is much worse than that of 2010 when we got the double dip scare and QE2..

    Dismissing suggestions that the poor job data reflected transitory Japan and/or weather-related supply chain disruptions, Keith Hall, commissioner of the Bureau of Labor Statistics, told the FT that

    Bad US payrolls data for May appear to reflect a “general weakening in job growth” rather than any temporary distortion.

    As any boxer will tell you, hits received while you’re weak are more damaging than when they occur during healthier bouts. My belief is that the recent economic hits are significant setbacks, not jus a soft patch. Just peruse these charts and compare with the situation in the spring/summer of 2010:

    image

    image

    The US consumer has retreated, along with his real earnings. As a result, inventories have been rising dangerously.

    Housing is clearly double dipping, further eroding homeowners wealth and banks balance sheets. This spiral is just getting worse and worse. Here is how Michael Lewitt (The Credit Strategist) sees that mess:

    Lower prices are being driven by the inordinate number of bank owned
    (i.e. foreclosed) properties for sale. Sales of these properties comprised 34.5 percent of the market according to a survey by Clear Capital, a prominent real estate consulting firm, resulting in a nationwide price drop of 4.9 percent for 1Q11, 5 percent year-over-year in March 2011, and 11.5 percent over the past nine months. This is the sharpest rate of price deterioration since 2008. In 2008, however, the government (as usual) came to the rescue with housing tax credits, a program that had limited success. Another plan is (fortunately) not in the cards, which suggests that prices will fall further until the inventory of foreclosed and other distressed
    properties is absorbed.

    By comparison, in 2010, US manufacturing was recovering, car sales were strengthening, consumer real earnings were growing, the US savings rate was above 6% vs 4.9% currently, house prices were above their lows and China’s economy was growing at double digit rates with inflation in the 3.0-3.5% range.

    image

    China Economy by Numbers - April

    So where are we transiting to? Did I hear QE3?

    But what about the Fed’s transitory inflation bulge? In theory, the transition towards a weaker economy should help cool commodity prices, hence non-core inflation. The real problem may rest with core inflation which, at the present time, is no cause for concerns but, according to SocGen Albert Edwards, will soon become a headache:

    image

    Also, Prieur du Plessis’ chart below reveals that US CPI is not quite yet disconnected from changes in oil prices:

    At least, deflation worries are not in the cards, yet, thank God, or whoever rules the afterlife.

    Next transition: earnings and earnings estimates.

    Be careful at all all crossings.

    Business Insider offers some hope:

    BofA’s David Bianco argues that the economy/market is in a soft patch, and not a sinkhole.

    His key points:

    • Business investment is likely to accelerate (!) due to higher oil costs. Watch for the manufacturing ISM to go back into the mid-50s.
    • A summer market swoon will increase repurchase activity.
    • The weak dollar will boost export activity.
    • S&P earnings estimates will hold up due to the above: exports, commodity prices, FX, and foreign operations.
    • 10-year Treasury rates around 3% are now predicting double dip, but rather record savings.

    Read again carefully: the US will be saved by foreigners. Yet, Europe is struggling while everywhere else there is growth, central banks are tightening to kill inflation. Who will save us in the afterlife?



    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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