Falling Inflation is Good for Balance Sheets
01/15/09
Producer prices fell 1.9% in December. It looks likely that prices will fall more and faster than this in the immediate future. Recent behavior of commodity prices and the large amount of anecdotal evidence indicating that businesses are cutting prices is one indicator. Another indicator for future price declines are the large price drops in crude materials which eventually will lead to price declines in semi-finished goods and then finished goods and ultimately to falling consumer prices. The transmission lag time between these various stages varies and can amount to several months. Specifically, the prices of goods at earlier stages of the production process have plunged. Prices of crude materials, which represent goods at the earliest stage of production, fell 5.3% in December following a 12.5% drop in November and 18.6% in October. At the middle stage of the production process, intermediate goods prices fell 4.2% in December, following a decrease of 4.3% in November and 3.9% in October. All of these data point to sharp decreases in producer prices in the months to come. Eventually, the Core Producer Price Index (second chart) will also decline towards zero or below.
The first chart shows you the three different stages of the processing chain. Crude materials have declined by 24.84% annualized. Intermediate goods show an annualized decline of 1.975% and finished goods of 1.225%. These are the signs of price deflation at work. The last time when crude materials prices lost this much ground in such a short period of time was in 2002. Not surprisingly, Ben Bernanke gave his famous speech "Deflation: Making Sure "It" Doesn't Happen Here" in November of 2002, exactly 10 months after the crude materials index showed an annualized decline of 39%. These numbers are without precedent, except (of course) when one goes back to the Great Depression of the 1930s. These comparisons have to be made almost every single day, because the events that are unfolding have never been so extreme since. So, while the headlines are uniformly bad - historical unemployment numbers, historical drops in manufacturing output, trillion dollars of wealth lost in home price and stock market declines - these comparisons also give me some hope. I refer to Marc Chandler's article again. He states: "The economic expansions that preceded both the 1929 crash and the more recent one were both driven by consumption, especially of durable consumer goods, rather than investment. And in both cases, the increase in effective demand was fueled not by higher real wages and salaries but by increased consumer credit." He continues: "The historical record is clear: the recovery from 1933-1937 was fueled by the rising demand for consumer goods. Rising consumer demand was a result of a shift in income shares from profits toward wages. This was paid for by government spending, and reinforced by a reinvigorated labor movement." The consequences of this statement are thus: No economic recovery without a recovery in the average household. No recovery in the average household without a recovery in the labor market. No hiring in the labor market without increased private consumption of durable goods. No increased consumption of durable goods unless the consumer's balance sheet has been repaired to a savings rate of at least 5%. This latter statement is my own and a ball park assumption. The economy rises and falls with the average consumer. Let us look at the updated chart from two months ago:
The first chart shows us that the personal savings rate as a percentage of GDP has improved further. We have already passed the 2% mark. Two more quarters may improve the balance sheet of consumers sufficiently to ignite a virtuous cycle of consumption and production. The second chart shows the Real (inflation adjusted) average earnings of those fortunate enough to have a job. Real average earnings are calculated by adjusting earnings in current dollars for changes in the Consumer Price Index for Urban Wage earners and Clerical Workers. The jump in the last two months was not due to an absolute jump in earnings (they actually dropped from $613.39/week to $611.39/week) but to the collapsing rate of inflation, which raises the average buying power of the consumer dramatically. If we can stabilize the unemployment rate somewhat in the coming months, we may have a shot at stabilizing private consumption. I may be grasping at straws, but Ford came out this week announcing that the company still has a pulse. All indications are that industry wide sales have picked up in January, although to a still-low level. It could be that car sales have already bottomed, helped by the recent cash injections and because the Federal Reserve will soon support the asset backed securities market, which should enable prospective car buyers to obtain financing again. These are early days still and almost no other area of the "real economy" is improving. However, the healing has to start somewhere. The credit markets are already recovering and due to leave the intensive care unit soon. LIBOR has fallen dramatically, commercial paper issuance has increased substantially, mortgage backed securities have rallied somewhat and most importantly, corporate and municipal bond yields have fallen sharply of late. Bill Gross seems to think, according to Reuters, that the worst for bank balance sheets may be over, even though the worst is yet to come for the real economy. Nevertheless, I see the light at the end of the tunnel and it may not be an oncoming train - it may be the end of the tunnel. I maintain my bullsih stance.
Hermann Vohs
"To predict the behavior of ordinary people in advance, you only have to assume that they will always try to escape a disagreeable situation with the smallest possible expenditure of intelligence."
Friedrich Nietzsche
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
