"We appear to be entering a period of serious stagflation with sharply rising expected and actual inflation combined with large downside risks to growth and employment."
"I would argue that what we are seeing is an acceleration of expected consumer price inflation in the context of a sharp expansion in global liquidity. It is hardly surprising that the prices of those commodities, such as oil, for which the short-run price elasticities of supply and demand are low move upwards strongly when there is a rise in expected general inflation. The oil market is a very convenient vehicle to speculate on expectations of higher levels of general price inflation. Hence my view is that the 40% jump in oil prices that has occurred over the past few months - roughly the period during which financial conditions have been loosened sharply - is a reflection of the expectation of either an acceleration of global inflation, or a depreciation of the US dollar, or some combination of the two."
- Malcolm D Knight, General Manager, Bank for International Settlements
It was only five years ago that the central bankers of the world, and especially the Fed, was worried about deflation. Ben Bernanke was introduced to the world at large with his famous helicopter speech about how the Fed could deal with a deflationary environment. Who would have thought that what passed as humor to a group of economists would be taken so seriously by the rest of the world?
Today the worry on the mind of investors and central bankers is inflation. It is causing havoc with the markets. In this week's letter, we look at whether we should be worried about inflation, take a mid-year check on the economy, muse on the malaise in the stock market and offer a very contrarian possibility for a positive shock to the world. It should make for a thought-provoking letter.
Inflation, Deflation and Stagflation
The quote at the beginning of this letter is from the managing director of the Bank of International Settlements, or the central banker to the central bankers of the world. (Thanks to Simon Hunt for the quote.)
Stagflation is a strong word to use, but Knight is surveying a world that is increasingly looking like it is in trouble. A Morgan Stanley study suggests that 50 countries around the globe have inflation running at 10% or more, and that this represents over 3 billion people.
Almost all of those countries have negative real interest rates, or interest rates that are below inflation (as here in the US). Central bankers around the world are slowly raising rates and tapping on the brakes, but they are going to be under increasing pressure to do so. Thus, Knight suggests that global growth is due to slow down even as inflation is rising.
A quick sidebar. I am often asked what I think about the inflation numbers produced by John Williams of Shadow Government Statistics. His number, using the methodology to figure inflation that existed in the late 70s and early 80s suggest that inflation in the US is over 11%. That certainly corresponds to what many of us feel like as we see food and energy prices rise. If you are bearish, a high inflation number makes your case easier.
But let me make a few of you mad. I think what Williams' number actually do is show that the government did not know how to calculate inflation back then. If inflation were actually 11.8%, then that would mean that GDP was a negative 6% today, and that the US would have been in a recession for several years. That is obviously not the case. You can simply look at corporate profits and tax receipts to see the economy has been growing the past five years.
The recovery after 2003 was in fact robust, and corporate earnings were solid, and tax collections went through the roof after the Bush tax cuts. That is not something that would happen in a high inflation environment.
That being said, let me make two observations. Inflation for much of America is much more than the headline CPI of 4%. If you make $40-60,000 for a family of four, the cost of food, gas, medicine, insurance, etc. is causing the inflation you personally experience to be much more than 5%. The CPI reflects the inflation of all items, but your personal inflation rate depends on what you actually buy. And it seems like a lot of the necessities are running well north of 4% inflation.
Secondly, there are some of the statistical methods used to measure inflation which I think are quite suspect, like hedonic measurements. Just because the computer I buy today is twice as powerful as the one I bought three years ago does not mean that the price of a computer dropped in half. I seem to still spend about the same amount on my new computers or cars. It is still the same percentage of my budget.
If we used the same methodology as Europe (for instance), US inflation would be somewhat higher. And that is a number I would find useful for comparison's sake. But let's get back to main thought.
Louis Gave recently wrote a very interesting essay on inflation. He makes the point I have made often, that the Fed is not really increasing the money supply. If you look at the growth in adjusted monetary base, which is the only measure that the Fed actually can control, it has not been all that much over the past four years. But M2 and other measures of money supply have skyrocketed. What gives?
Two things. One is the extraordinary growth in credit offered by banks around the world. We saw a true inflation in financial assets of all types.
Secondly, and this is less intuitive, the US consumer has been a large supplier of money to the world by running a massive trade deficit. We have seen trillions of dollars flow into the world markets which has to find a home. Those dollars have been part of the growth in the supply of dollars around the world.
Now, let me offer a hypothetical series of events which could alter the current environment and maybe even bring back the specter of deflation.
The US trade deficit is roughly where it has been for four years, running in the neighborhood of 6% of GDP. Only a few years ago, less than 30% of that was for oil. Now, that has changed. Roughly 60% of our trade deficit is spent on oil, much of it sadly going to countries that are not necessarily our friends.
The US consumer has cut his spending on non-oil items by almost 40% in terms of GDP over the past few years, and the trend is clearly down every quarter.
Financial assets are clearly deflating. Banks are cutting leverage as aggressively as they once expanded their balance sheets. Even though the data shows that bank assets (lending) are increasing, it is because they are being forced to take assets that have been off the balance sheet and put them on the balance sheet. That trend in the data is going to reverse, and with a vengeance.
We are also watching home values decline, not just here but in the United Kingdom and soon to be so in a lot of Europe, which will put European banks under even more pressure. That is serious wealth deflation.
I have been pounding the table for over a year that financial stocks are going to continue to show losses for at least through the end of this year. Dividends will be cut. More shares will be sold and further dilution will be a fact for many banks both in the US and in Europe. Trying to pick the bottom in the financial stocks is like catching a falling anvil.
And their distress is going to translate into distress for businesses and individuals who need to borrow money. All of this is deflationary. It is a strange world indeed in which we are in the middle of two bubbles bursting and for inflation to be the headline topic of every financial medium.
The source of the inflation is clear. One is rising food costs. World demand for grain is growing at 1.2% a year, yet yield increases are growing at 1.1% a year. The developed world, both the US and Europe, uses a lot of food for bio-fuels. The major areas where we could increase production are areas like Africa where the infrastructure and production methods are poor.
Everyone now believes that food costs are going to go up, energy will continue to rise and the dollar will continue to fall. And maybe all these trends continue. But let me offer a very contrarian thought or two.
Farmers around the world are going to respond to high food prices and by this time next year we could see a rise in supply that more meets the rise in demand. Prices might begin to actually fall.
Energy prices have risen so much that demand destruction is beginning to happen. US drivers are using less gas, and as Asia takes away its subsidies demand will fall as well. You could see oil prices drop over the next year.
And if oil prices drop, that means the US is shipping less of our dollars offshore, which slows the growth of available dollars, raises the price of the dollar which further lowers the cost of commodities.
In a world of decreased leverage, debt and housing deflation, coupled with lower food and energy costs and a higher dollar, it is possible that inflation drops below 2% by this time next year. Maybe more.
Far-fetched? Maybe. But it is a possibility that few are considering. In the inflationary commodity boom of the 70's, there was a 30% correction, which most don't remember. Everyone was convinced that commodity prices could only go one way. And we do not have the wage pressures and inflation that we did in the 70s.
The cure for high prices is high prices. High prices stimulate production and reduce demand. I see no reason that this could not happen again. Over time, I am along term commodity bull. I think oil could indeed go to $200 or more in the next decade, and as a developing world increases its need for commodities of all types, I see growing demand and prices. But that is then long term.
Stagflation on a world wide basis is going to have an effect on demand in the short term. I would be cautious about long only commodity funds. While I do not expect anything to change abruptly, I would be more vigilant and recognize that trends which look so good now can change. I am not suggesting that you get out, just pay attention to supply and demand figures coming out of the developing world.
Five years ago everyone was worried about deflation. A lot can happen in a short time. Ben Bernanke may be dusting off his helicopter speech in a few years, as deflation once again becomes the concern.
The Slow Motion Recession
Last October 5, I wrote a letter called The Slow Motion Recession. The basic premise then and in this space since then has been that we are either in recession or a lengthy period of very slow growth and that this slow growth will continue for some time. The cause of the lackluster growth is the bursting of the two bubbles of the housing market and the credit crisis. These are not problems that can respond quickly to the Fed cutting interest rates, but will need several years to correct. These deflating bubbles will put pressure on consumer spending and thus on corporate profits.
At the end of the day, it is earnings which drive the price of stocks. And if earnings are under pressure, we are going to see the stock market to continue to be under pressure. In a Slow Motion Recession, with growth depressed in the latter half of this year, it is going to be hard for the stock market to gain any real traction. As I have been writing for some time, in a recession the US stock market typically falls 30% or more. We are now down almost 20%. It would not be surprising to see the markets fall another 10%, at least from the perspective of history.
And inflation is not helping. Inflation is often more damaging to stock prices than a slow economy. Inflation, especially in a slow growth economy, eats into profits and can be hard to pass on to customers who are under spending pressure. And while inflation may slowly go away over the next year, it could be a factor for the remainder of the year.
While we should see some rallies in July and August, I think the trend is going to be lower, as the earnings projections are going to come down, and guidance is likely to be soft for many companies.
A Slow Motion Recession, a Muddle Through Economy, and inflationary pressures are not a prescription for a robust bull market. Further giving cause for concern, the recent rise in consumer spending is largely attributable to the stimulus checks being spent. This will be largely over by the middle of the next quarter. As gas and food prices eat into more and more of the average US consumer's ability to spend money on other discretionary items, there will be pressure on almost any company that has exposure to the US consumer.
An Update on Myanmar
My good friend Ed Artis and a team of workers are currently in Myanmar helping the victims of the recent hurricane. His stories are heart- wrenching. My readers have been very generous in helping provide relief. They are one of the few teams that have been able to get in and direct help to exactly where it is needed.
They are working to help re-establish an orphanage, help farmers, supply needed food and medicine to families. The need is overwhelming. He is going to stay a while longer and asked me to ask you, gentle reader, if you could send a donation to help purchase more supplies. The need for food for families is large.
One of the real needs is for more water buffalo. They cost about $500, but allow a farmer to feed his family and more. And it is not as easy buying a buffalo as it looks. Ed tells me that many are in shock. Many of the ones that did not die will not work because they are scared silly. "I never considered that as a possible problem but it is BIG TIME," he writes. "Buffalo with Post Traumatic Stress Disorder just stand there and stare into space."
Donations made thru Pay Pal with a credit card are best as they get quicker access to funds. Go to http://www.kbi.org and scroll down till you find the donate button. Click on it and it takes you to Pay Pal. "We can also accept checks made out to Knightsbridge International, PO Box 4394, West Hills, CA 91308-4394, they just take longer to get funding to us here in the field."
These are the good guys. They are there on their own nickel. Not a penny goes to overhead or salaries. I cannot say too much about them. I can personally vouch for them. They are a small operation, but their efforts are very large. They get in where other groups just can't. Pony up some money for a buffalo.
New York
This next Tuesday Tiffani and I go to New York. I will be on the Larry Kudlow show that afternoon and then we will get to have dinner with Larry and Charles Gave, co-founder of GaveKal. The next morning we head out early to Philadelphia. My friend Thomas Fischer from Jyske Bank in Denmark is coming in and we will be going to see Steve Blumenthal and three of the mangers on the platform that I mentioned above, and another two that evening back in New York. We will be at the Bull and Bear for Happy Hour so drop by.
I am really excited about the line-up that we have with all the partners. They (and I) all do a lot of work looking for managers on behalf of our clients and I think it is paying off. I am proud of the work they do.
As long time readers know, I have an office that is physically in the Ballpark in Arlington. You can watch the Texas Rangers game from balcony in right field. My lease is up on my office this time next year, and if we can get someone to take it before then we will move, as Tiffani and I could each save about 200 hours per year by not having to commute. But I will admit that tonight, with the Rangers playing Philadelphia outside while I write, I will miss it. And tonight, when the two hottest hitting teams in baseball are in the park, it is fun. Even better when we win 8-6. If we only had some pitching.
Have a great week.
Your ready for the Big Apple analyst,
John Mauldin
____________________ Don’t Try to Predict the Future / Be In Harmony with the Market / Don’t fight the Market ~Charlie Wright
Note From Publisher
The oil price continues to surge. Inflation rates are rising rapidly. Central banks are forced to be ready to further raise interest rates or stop cutting rates. At the same time, economic growth is under pressure from high commodity prices and a slowing US economy. These are the issues investors are worrying about at the moment.
On the domestic front, the political soap opera continues, complete with conspiracy, murder, sex, and power struggle. As in any exciting soap opera, the victorious party in Malaysia’s current political drama will only be known at the end and after many thrillers, twists and turns, and surprises. Investors are likely to get more worried and confused. i Capital will stay vigilant, objective, and focused during this difficult times and it will be reflected in our analysis.
____________________ Don’t Try to Predict the Future / Be In Harmony with the Market / Don’t fight the Market ~Charlie Wright
Strength from weakness ? Subscribers must have been shocked when we wrote that in last week’s i Capital. Since then, it looks like not only is Malaysia getting strength from weakness, but the weak is getting stronger. Don’t ask us how it can be done but our Malaysian magician politicians are of world-class standards, at least as world-class monkeys instead of world-class administrators. As the price of oil refused to budge, our politicians have also refused to budge.
With the latest sodomy charge emerging, our political monkeys, both in the ruling coalition and the opposition, have managed to turn the whole country in just a few months into a zoo, a zoo full of asses (pardon the pun). With one leader having to defend his back (again pardon the pun) and another leader having to face statutory declarations, the weak is actually getting stronger. For now, Malaysians are not bothered with this twist of event. Malaysians are more interested in wanting to know (or rather to gossip) who did it and why. The two most obvious persons that coffee-shop talk is focusing on are the 4th prime minister and the current prime minister. Both have a lot to gain.
The list of “who done it” does not stop there. There are so many possible politicians, all with plenty of political mileage to gain, who would gain from this sodomy addiction. There are so many theories as to who did it and all of them seemed plausible. Since you guys, aka political monkeys, are having so much fun at our expense, let us Malaysians have some fun too by gossiping. While your fun destroys the whole country and make all us poorer, at least our fun is harmless and helps to establish the truth behind this political hedonism. Business at coffee shops should be roaring. Can we do a coffee shop IPO ? At least its NAV would not drop. So, please do not sue us or make us sign statutory declarations of all kinds. Some theories are so interesting that we would not dare to publish it. Some even say that it is a powerful woman who did it. He…he…. As everyone is gossiping and no one is managing the country and the economy, we better stop here, as we need to pay attention to the economy and the stock market. One thing is for sure though. Looking at how dirty and unscrupulous our politicians can be, the May 1969 riot was certainly orchestrated by our unscrupulous politicians.
As Malaysia gets deeper into an oily patch, the price of crude oil gets deeper into stratosphere. The Malaysian government has promised no more price hikes after the recent jump. Can we afford it ? Can Malaysia with years of budget deficit afford to live beyond its means ?
When the government raised the price of petrol and diesel, many protested. Why should we have to pay higher oil price when Malaysia is an oil producer and net oil exporter ? The argument of the protestors is that we should not compare our oil price with Thailand’s or Singapore’s as they are net oil importers. Malaysia should compare its price with those of the oil producers which are absurdly low. Is this argument complete ?
Due to the unproductive and wasteful spending under the 4th prime minister, Malaysia has been “enjoying” many years of budget deficit. Although Badawi has been controlling it and reducing it gradually, by 2007, it was still 3.2% of GDP. When we were asked to compare our petrol price with those of the oil producers, how many of us know that these oil producers are running massive budget surplus in contrast to Malaysia’s budget deficit ? Table 1 below shows some comparisons.
Saudi Arabia
12.6
UAE
11.3
Kuwait
39.9
Libya
36.1
Venezuela
3.0
Malaysia
-3.2
Table 1: Fiscal Balance in 2007 (% GDP)
Instead of protesting the rise in petrol and diesel price, Malaysians, be they from the opposition or ruling coalition, should be asking where are all our spending going to ? Why are oil-producing countries like Saudi Arabia, Venezuela, Kuwait, Libya, etc all enjoying massive budget surpluses when Malaysia, an oil producer and a net oil exporter, is suffering from its 11th year of budget deficit ? Where are we spending our taxpayers money ? Why is our spending more than our revenue ? Get our budget into surplus, then, we can talk about our “high” petrol and diesel prices.
In Malaysia, the price of flour is still controlled. In Indonesia, the price of flour is not. In 2007, the price of flour in Jakarta jumped more than 100%. Incidentally, the Jakarta stock market is holding up very well despite the global turbulence and inflation and interest rates rising in Indonesia. Pakistan, with a budget deficit expected to rise to 6.5% of GDP, is getting her people ready to totally phase out fuel subsidies by Dec 2008. When is Malaysia getting ready to do the same ?
When will our political monkeys remember that they have a duty and responsibility to all Malaysians to ensure that the economy is managed successfully and responsibly ? Are there not effective and better ways of having a democracy AND a better economy ? Do not turn this beautiful country into a zoo.
The KLSE
First, the KLSE was sodomised by worries of a global meltdown. Then, it was sodomised by the 2008 election results. Now, the KLSE looks like getting it again. Maybe after getting sodomised so many times and with investors getting sore, the KLSE may already be numbed. i Capital revises its immediate-term outlook of the KLSE to a range of 1,150 to 1,300. For the short-term, i Capital retains its outlook to a range of 1,150 to 1,400. For the medium and long-term outlook of the KLSE, i Capital still expects the KLSE CI to hit 2,000 points. With the 2008 election results now history but with the political comedy still being acted out, i Capital will review its medium- and long-term outlook at a relevant time.
____________________ Don’t Try to Predict the Future / Be In Harmony with the Market / Don’t fight the Market ~Charlie Wright
[Updated on 05/07/2008]
Marketing research is a popular tool used by marketeers to determine what consumers want. Although used frequently, marketing research often lead to the wrong marketing decisions. Marketing researchers have found out that what consumers say and what they actually do very often diverged, leading to situations where the results of the marketing research lead to the wrong products being launched. The same can be said for consumer confidence surveys, which of late has been capturing the media headlines.
In response to surging oil price, consumer confidence in every country has plunged. From this, economists and investors are concluding that consumers are not spending. For the US, if this happens, it will be especially worrying as consumer spending makes up 70% of the US economy. Besides having to deal with the surging oil price, consumers have to contend with falling house prices. If the consumers are not confident, if the high oil price is not dropping, and house prices do not show signs of bottoming, why would the consumers want to spend ?
Just like the experience of marketing research, what the consumers say they will do is very different from what they actually do. Figure 1 below shows plummeting US consumer confidence versus continued growth in personal consumption. Since mid-2007, US consumer confidence has plunged. Yet, growth in US personal spending has not followed suit. In fact, one can safely say that personal spending has moved in the opposite direction of consumer confidence. This opposing trend has been in place since the subprime problem broke out in Jul 2007 and is not just a recent phenomenon. The confidence of consumers, i Capital suspects, has been badly battered by the mass media’s incessant coverage of the negative news, ranging from the subprime problem to surging oil price to the worst financial crisis to rising inflation. On the other hand, growth in US personal spending has been supported by the sustained rise in income, which in turn is the result of sustained economic growth. What the diverging trends show is that the US consumers, despite all the prevailing negativism, are still in the mood to spend. The consumer resilience brings hope that the doom and gloom scenario relating to the US economy is misplaced.
Figure 1 : US Consumer Confidence vs Personal Consumption
i Capital retains its short-term outlook of the NYSE at a range of 1,250 to 1,500. This is the part where the NYSE tries to establish its bottom and trading can be volatile. i Capital retains its long-held bullish longer-term target of the NYSE at 1,900 - 2,000.
____________________ Don’t Try to Predict the Future / Be In Harmony with the Market / Don’t fight the Market ~Charlie Wright
[Updated on 05/07/2008]
The bearish onslaught on the Shanghai market shows no signs of abating. It was only in 2007 that warnings after warnings were issued about the bubble developing in Shanghai. Now, there should be advice about selling irrationally. At the rate the Shanghai Composite Index is dropping, the largest stock market in China should be reaching a bottom sometime in the next few months and the Composite Index would probably be below 2,000 points by then. Many were expecting the Shanghai market not to fall before the Aug 2008 Olympics. The unexpected has happened. Now, few expect Shanghai to bottom out anytime soon and even fewer expect a new rally to emerge post the Aug Olympics. The unexpected will happen again.
For the Hong Kong market, a stabilised Shanghai stock market will make a major segment of its market look more attractive again. With the China stocks nowadays overshadowing the local stocks, the fall in Shanghai is unfairly capturing all the attention. During the fall, investors may have forgotten the long-term potential of China and thus, her stock market. In the first instance, the Hong Kong economy is in pretty good shape. Unemployment rate for Mar-May stayed unchanged at 3.3%. Even though the consumer price index jumped to a rate of 5.7%, up from Apr’s 5.4%, and the banks in Hong Kong are now beginning to raise mortgage rates, economic growth for the rest of 2008 and for 2009 are expected to remain healthy. Global economic growth is not falling off the cliff, despite the many naysayers saying it is. While property prices have risen substantially, signs of a bubble have not appeared. Overall, there are not any major macro-economic imbalances facing the Hong Kong economy.
At the same time, the 11th anniversary in the handing back of Hong Kong to China serves as a useful reminder of the peaceful and non-disruptive way China handles her affairs. One can expect the same peaceful and gradual approach in the next 11 years. 11 years from now, Hong Kong will be even more integrated with China. Hong Kong is bound to prosper further. One needs to be able to see beyond the current global financial turbulence. Notwithstanding the inevitable short-term disruptions, the longer-term outlook for the Hong Kong market remains uniquely attractive. i Capital is still expecting the Hang Seng index to scale greater heights with a medium-term target of 45,000-50,000. Meanwhile, the Hong Kong stock market is still trying to stabilise and form a bottom. i Capital retains its short-term outlook to a range of 22,500-27,000 for the Hang Seng index.
____________________ Don’t Try to Predict the Future / Be In Harmony with the Market / Don’t fight the Market ~Charlie Wright
Strength from weakness ? Subscribers must have been shocked when we wrote that in last week’s i Capital. Since then, it looks like not only is Malaysia getting strength from weakness, but the weak is getting stronger.
What are they talking about?
Strength from weakness? But weak is getting stronger?
What language?
Me think I can understand Master Yoda more.
Don’t ask us how it can be done but our Malaysian magician politicians are of world-class standards, at least as world-class monkeys instead of world-class administrators. As the price of oil refused to budge, our politicians have also refused to budge.
Fuuuuyoooh! World Class Monkeys?
So they taruh here and there... which I do see and agree their point of arguement.. but then.... their conclusion is really like a screw-ball man!
First, the KLSE was sodomised by worries of a global meltdown. Then, it was sodomised by the 2008 election results. Now, the KLSE looks like getting it again. Maybe after getting sodomised so many times and with investors getting sore, the KLSE may already be numbed. i Capital revises its immediate-term outlook of the KLSE to a range of 1,150 to 1,300. For the short-term, i Capital retains its outlook to a range of 1,150 to 1,400. For the medium and long-term outlook of the KLSE, i Capital still expects the KLSE CI to hit 2,000 points. With the 2008 election results now history but with the political comedy still being acted out, i Capital will review its medium- and long-term outlook at a relevant time.
Immediate term outlook revised to a range of 1150 to 1300? LOL! Huge revision hor.. previously it was 1200-1300.
Hmm.. so... in conclusion... icap outlook for KLSE is from 1150 to 2000.
Wah... so brave hor... icap has not cover its rear from below 1150?
