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Soft Landing or Recession - Part 2


The Bureau of Labor Statistics reported the producer price index rose 0.1% in July, lower than the 0.4% increase that economists expected. Core PPI surprised the markets by declining 0.3% in July. Economists had expected core PPI to climb 0.2%. Year over year, headline PPI is running 4.1% higher, while core PPI is up 1.3% -- the lowest it has been since March 2004, according to Bank of America. Stocks and bonds rallied sharply on the news, which played right into the hands of the Federal Reserve, which has been broadcasting that a slowing economy would bring down recently elevated inflation levels. In the wake of the PPI data, traders became more comfortable with the idea the Fed is done with this cycle's rate hikes. The fed funds futures market dropped the odds of another rate hike in September to 15% from 25% Monday. By year-end, the futures market puts 46% odds on another hike, compared with 64% Monday.

PPI was weak due in large part to lower vehicle prices, but vehicle prices are a smaller portion of CPI and are weak predictors of consumer-vehicle prices anyway. "Discounts in vehicle financing depress the PPI components, while having no impact on the corresponding CPI components," writes Peter Kretzmer, senior economist at Bank of America. Bond and stock markets did not bother with the fine print. They rallied impressively nonetheless. The rally on a "grade B inflation gauge" (as Tony Crescenzi puts it) shows quite clearly the high degree of anxiety that exists in the market over the inflation situation. The market entered the trading day on Tuesday fearing rising inflation and was relieved by the benign reading. I have maintained all along that the time to worry was in the fourth quarter of 2004 when the annual rate of change of all inflation measures started to exploded to the upside. Since then, the absolute numbers such as the overall producer price index (left picture above) have been rising but the core producer price Index (right picture above) reached its peak at 2.75% in July 2005, exactly one year ago. Since then, raw materials prices went sideways or down. The pipeline effect may still not have transpired into the CPI readings, but it seems clear, that goods producing companies are now able to manage their input prices better and maintain their profit margins. I believe this is also a reason why stocks exploded to the upside on Tuesday. A tame raw materials sector will allow manufacturers a reasonable margin of profitability, especially in a global setting, where other economies outside the US such as Europe and Asia (even Japan) seem to accelerate while our economy seems to decelerate. Multinational companies will benefit the most from strong international demand while input prices remain stable. The Labor Department reported Wednesday that the consumer price index (CPI) was in line with expectations - a 0.4% headline increase and a 0.2% core increase for the month of July. Both numbers met the consensus forecasts of analysts who had been surveyed by Bloomberg. Year over year, consumer prices were up 4.1%, and the core rate was higher by 2.7%. Investors were on the edges of their seats hoping that the CPI would confirm Tuesday's lower-than-expected producer price index reading. To be fair, the fly in the ointment were Unit labor costs, which were rising at the fastest pace in about six years. Otherwise, this weeks inflation data, combined with weakening growth in industrial production and capacity utilization as well as falling housing starts and a miserable mood among the nations home builders make Fed Chairman Bernanke really look like a hero with a crystal ball. Inflation is indeed falling slightly while economic growth on all fronts is moderating. The Commerce Department said housing starts fell 2.5% to 1.795 million annualized units in July, coming in short of expectations. The Federal Reserve said industrial production increased 0.4% in July, while capacity utilization climbed to 82.4% from 82.3% in June. If the economy can slow down to trend growth of 3% or so and stay there, then a true Goldie Locks scenario might come to pass. How likely is this scenario?

On the whole, Wall Street is viewing the data, combined with Tuesday's producer price index, as weak enough for the Fed to keep interest rates where they are when policymakers meet next month. Bernanke has predicted a slowdown in the rate of inflation. So far he has been right and I expect that the economy will continue to slow. 10-year bond yields trade currently at 4.85% as compared to 5.25% for overnight loans. The fact that long term investments yield less than short term investments is called "an inversion of the yield curve" and takes place when investors believe, that Fed Funds (short term) yields will fall in the not too distant future. Fed Fund yields can fall only, if the Bernanke lowers interest rates. He will lower interest rates in turn only if the economy is in danger to enter a recession. The fixed income market at the moment is putting a 70% chance on a recession within 12 months. I believe this may be debatable since I still hold out hope for a soft landing. Several factors lead me to this conclusion. First, Tony Crescenzi makes a compelling argument that homebuilders will show more discipline and will maintain a tight inventory control, which in turn should limit further home price deterioration. This in turn should benefit the consumer and the concomitant wealth (and ATM) effect. The second argument for a period of slowing but not deteriorating growth seems to be the strength of the global economy. Even while the domestic economy slows, other economies in Asia and Europe are picking up the slack and ease the pain of the consumer somewhat. The composition of this weeks rally seems to support this argument also. Rather than fretting about slowing growth and thus avoiding cyclical stocks, today's big winners for example were especially cyclical stocks rather than consumer staple stocks. The third argument for an economy not totally on the rocks is the performance of the Baltic Dry Index. This Index reflects the pricing power of the international shipping industry. This Index declined from over 6,000 in the 4th quarter 2004 to below 2,000 in the 3rd quarter 2005. Since then it has been recovering to a current index reading of 3,800. This is not the stuff global recessions are made of.

Hermann Vohs

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.