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I’ve been warning about a rise in volatility for the last month and it arrived in spades last week. Clairvoyant? Hardly. Obviously, I had no idea an earthquake and nuclear disaster was about to strike Japan. If I had, I would have sold the tiny position in Japanese stocks our portfolios hold (less than 1% of our assets). No, it wasn’t clairvoyance or a clear crystal ball that allowed me to predict an increase in volatility. It was just common sense and a healthy respect for history. You see, times of high bullish sentiment and low volatility are always followed by periods characterized by the opposite. The timing is uncertain but a reversal is inevitable. As a conservative investor I try to anticipate these changes and adjust our portfolios before everyone else has the same impulse. It requires that we sell even when the majority are still buying and buy when the majority is still selling. Early is a lot better than late.
My concerns about stocks though were not - are not - just a matter of sentiment. My concerns are more about the fundamentals. The economic statistics have been generally improving, at least on the surface, and it is relatively easy to ignore the things that don’t support the bullish case. Looking beneath the surface is often uncomfortable if the data conflicts with your desires but it has to be done. When I do that now, I find plenty about which to worry.
Inflation is becoming a problem despite Ben Bernanke’s assurances that it can’t happen because of “slack” in the economy. Last week’s numbers show prices at the producer level rising by 5.8% year over year and consumer prices by 2.2%. More ominously, the recent rate of change has been accelerating. For PPI, the annualized rate in November was 9.6%, in December 13.2%, January 9.6% and February 19.2%. The corresponding rates for CPI are 1.2%, 4.8%,4.8% and 6.0%. Bernanke can ignore that if he wants but I can’t. Rising inflation and stagnant wages means individuals are poorer and likely to spend less. Unless the laws of supply and demand have somehow been suspended, Bernanke’s idea to intentionally raise prices in an effort to get people to buy more stuff was always doomed.
Those rising prices at the producer level seem likely to have an effect on profit margins as well. While a lot of companies have announced price hikes to offset rising commodity prices, it is unlikely they’ll raise them quickly enough to maintain near record profit margins. Corporate margins are now over 13% while the long term average is about 8.4%. Mean reversion in margins is most definitely not priced into current stock prices.
The real reason prices are rising is that the US dollar is falling. Throughout all the recent geopolitical turmoil and now the Japan disaster - events that would normally have global investors buying dollars - it has remained under pressure. Bernanke has stated that a lower value for the dollar is a goal of QE II and he is getting his wish. The problems created by a weak dollar policy have global implications beyond the US inflation rate. A falling dollar is driving capital inflows to emerging markets and creating unsustainable booms in those countries. If successful, these countries efforts to reduce capital inflows will have a corresponding effect on their growth rates. Most of these countries are raising interest rates and that will also have an negative effect on growth. With so much of our recent recovery dependent on exports, a slowdown in demand from emerging markets is a serious problem.
The disaster in Japan further complicates the outlook for global growth. As I said above, we have a very small position in Japanese stocks and it is tempting to add to it but last week’s action gives me pause. Investors poured almost $1 billion into Japan focused funds last week despite having no clue as to the economic consequences of the earthquake. It is true that Japanese stocks are quite cheap. Heck they were cheap before the drop last week. But it is impossible right now to predict the effects not only on the Japanese but the global economy. Japan is a key link in the global supply chain and I have no idea whether production can be shifted to other countries or if Japanese suppliers will have sufficient electricity to restore previous production levels. It is possible that production gets shifted to Taiwan or Korea and instead of buying Japan we should be buying those markets. There is just no way to know yet and until I get some clarity on the issue, I won’t be making any rash decisions.
Japan complicates the outlook in another way too. At one point last week, the Yen rose almost 5% against the dollar in a matter of minutes. Japanese investors appear to be selling foreign investments to pay for reconstruction. Friday the G-7 intervened to reduce the value of the Yen and they were successful at least for a day. The history of interventions is mixed but generally they are successful when they reinforce the current trend. Unfortunately, the Yen has been rising and changing that trend will require selling a lot of Yen. If the Bank of Japan is willing to print enough Yen to reduce its value, it is essentially another round of quantitative easing for the global economy. The so called Yen carry trade may be about to make a big comeback with implications for commodities and other assets worldwide. The volatility I warned about is not over.
The economic data last week points to a peak in the rate of improvement. That doesn’t mean we are about to fall off a cliff and back into recession but considering the unemployment rate it surely isn’t good news. The most disturbing data was on the inflation front which I wrote about above. The CPI and PPI weren’t the only data pointing to rising inflation. Import and export prices continued to surge up 6.9% and 8.6% respectively. Those numbers won’t improve if Japan is unable to return to its previous production levels.
The Goldman and Redbook retail reports indicate a weakening in consumer spending. The Goldman report showed a rise in sales but also a shift to drug stores and deep discount retailers. Spending more on staples leaves less for other stuff. The Redbook report was weaker showing a month to month drop of 0.5%.
Manufacturing may also be peaking. The Empire State manufacturing survey printed a good headline but the details were less robust. Most of the individual components showed slower month to month growth. The Philly Fed survey was likewise a bit disappointing. Shipments were strong but near unchanged, unfilled orders were unchanged and delivery times showed a slight easing in delays. In addition, price pressures continue and inventories rose.
Other bad news came from housing starts which fell back to near all time lows at 479k. That’s a full 20.8% lower than last year. Of course, this is what is required to clear the excess inventory but in the short term, less construction means less GDP. Mortgage applications were also down 0.7%.
Jobless claims did provide a glimmer of good news, falling 16,000 to 385k. As I’ve said many times, that is still too high for a healthy economy. In a normal expansion claims would be under 350k at least but a level closer to 300k will be required to reduce unemployment quickly and significantly. With inflation now rising, I think the prospects for more rapid job creation have been reduced. As noted above, higher inflation at the producer level likely means lower profit margins. Companies don’t seem likely to hire more if margins do come under pressure.
The economy appears to be hitting a growth peak with unemployment still stuck near 9%. If this is as good as we can do, that number won’t be coming down anytime soon. With little prospect for deficit reduction or tax reform, that is not good news. We need major economic policy changes and we need them soon. Will we get them? I have my doubts.
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