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September 01, 2004

Over A Barrel?

The Recovery Room...Well, we all know by now that 2Q 2004 GDP has registered a 2.8% growth rate. At least that's the latest read. Quite unfortunately, the incredible gap up in the June trade deficit pretty much wiped away any hopes of a higher 2Q number. We do have one more revision to come, so we've still to see just where the GDP chips ultimately fall. We'll admit, 2.8% GDP growth is a bit of a disappointment after four consecutive quarters of above 4% real GDP expansion. But it's pretty obvious something like this should be expected now that the bulk of both fiscal and monetary stimulus has worked its way through the system. As always, nothing ever happens in linear fashion on either Wall Street or in the real economy. The key, of course, looking ahead is whether this slowdown in GDP is temporary or something a bit more than that. According to the Fed governors and assorted Administration spokesfolks, have no worries. We've just hit a little speed bump. A little soft patch. The economy and coincident job creation is set to reaccelerate ahead, right? That's the official line.

As always, we're constantly looking for ways to gauge the forward strength of the US economy. In that spirit, we thought we'd take a quick look at the real GDP growth characteristics of past economic recoveries to try to get a sense for where we are in the current cycle and observe how this cycle compares and contrasts with prior experience. Remember, the current economic expansion has occurred during and as a result of the greatest fiscal and monetary largesse of a lifetime. Let's get right to the numbers. In the following table, we've identified eight economic expansion cycles of the last half century. We detail cycle expansion dates, the length of each expansion in quarters and the average annualized real quarterly GDP growth rate for each cycle.

Clearly not all expansions are created equally. But that is no major revelation in and of itself by any means. As you can see from the data above, economic expansions of the last half century have on average lasted 20.8 quarters. Average annualized real quarterly GDP growth has been 4.29% over the period. As you can also see in the table, we could easily classify the 4Q 80-3Q 81 expansion as an anomaly in that it was really a double dip recessionary environment. If we throw out that period, the average length of economic expansions lengthens to 23.1 quarters and the average annualized real quarterly GDP growth rate is virtually unchanged at 4.28%. Lastly, it is clear that we are currently 11 quarters into the current economic recovery and average annualized real quarterly GDP expansion now stands at 3.21%. A full 100+ basis points below what has been historical experience. And, as you know, this is in spite of some of the most aggressive monetary and fiscal stimulus ever unleashed upon the US domestic economy.

Very quickly, let's have a look at where each of the prior economic expansions stood 11 quarters into each recovery cycle. In other words, exactly at the point in which we currently find ourselves. Of course we have not included periods where the total recovery cycle was under 11 months ('58/'60 and '80/'81). Just how are we fairing at present relative to what has been the front end time-wise experience of each prior recovery cycle?

The results are clear. The current US domestic economic expansion lags prior recovery cycles in terms of real quarterly GDP acceleration. Under the circumstances described above, only the economic recovery of the early 1990's resembles present real GDP growth rate numbers this far into the current recovery cycle. And again, the stimulus fuel injected into the economy over the last few years is considered in many circles to border on utter irresponsibility in terms of its magnitude. And at least so far, this is all it has bought us in terms of real economic growth.

Before leaving this little retrospective on historical post recessionary GDP growth experience, we believe it's very important to see what has happened in prior expansions from the point of view of energy price dynamics (as represented by crude oil prices). In fact, maybe a lot of what is happening in the current environment can be explained within the context of crude prices. Moreover, and we believe quite importantly, we also may be getting a glimpse into our own future when looking back at crude prices in headline economic recoveries of the last 50 years. There's a lot of data in the following table. A few quick explanations are in order. Again, we're looking back at all economic expansion cycles of the last half century just as in the first table above. For each expansion cycle, we're showing you the increases in West Texas Intermediate Crude (WTIC) prices over the entire expansion period. In the second column of data were simply looking at the average quarterly increase in crude prices over the entire cycle. Simply the increase in crude prices divided by the number of quarters of economic expansion. As you can see, for every period with the exception of the "oil shock" experience of the 1970's, the average quarterly increase in crude prices was less than 1%.

Most importantly, in the third and fourth columns of data we're going back and trying to compare our current experience with what happened in the first 11 quarters of each GDP recovery cycle. From our point of view, it's this data that may be the most crucial in helping us try to understand the dynamics of the current economic recovery cycle. Again, what we hope are a few telling observations. First, since the fourth quarter of 2001, crude prices are up 72.7% in absolute dollar terms. And, as you might remember, crude prices as of 2Q 2004 period end were near $38. It was the interim dip prior to the spike to near $50 following the end of the second quarter. As of today, crude prices are still 10+% above the $38 at the end of 2Q. We have not factored this into the table below. As you can see, there is no other economic recovery period of the last half century where crude prices rose this fast at the front end of a recovery cycle. Even during the oil price shock period of the 1970's, crude prices never moved this fast over the initial economic recovery eleven quarter period. Moreover, when breaking crude price acceleration into quarterly periods, it is clear that our current economic recovery experience within the context of simultaneous movement in crude prices has no parallel whatsoever. During the current cycle, crude prices have on average been accelerating at 6.6% per quarter.

We believe the above table is "telling us" a number of very important facts. First, as you can see, there were three periods of front end economic real GDP expansion (first 11 quarters of recovery) where crude prices actually fell - '58/'60, '82/'90, and '91/'00. Referring back to the first table in the discussion, these were the very periods characterized by the most lengthy total cycle economic expansions. Each cycle witnessed GDP growing for more than 30 quarters before eventually turning down. Contrasting this to the very significant rise in crude prices in the current cycle suggests that there is no way that the current cycle will be long lived. Adding credibility to this notion is that fact that in cycles where crude was rising, longevity of cycle expansion was much shorter lived than not. In the '54/'57 and '70/'74 cycles, total economic expansion was 14 quarters each. Remember, we're already 11 quarters into the present cycle. If we repeat the experience of the '54 or '70 cycles, we could theoretically be in a recession by 2Q of next year. The other cycle where crude was advancing noticeably was the 1975 cycle - 20 quarters in duration. But as we mentioned, the current cycle has witnessed crude price acceleration more than twice as fast as the 1975 cycle in the initial 11 quarters.

Secondly, the only total economic recovery periods to witness crude prices rise in excess of what has already transpired in the current environment were the GDP growth cycles of the 1970's. You don't need us to tell you that this total period was characterized by rapidly rising interest rates, soaring inflation, and a general sense of macro economic stagflation. At least for now, history tells us that it is very possible we face these exact same financial and economic demons ahead, or possibly something worse given the unprecedented nature of short term crude price acceleration since 2001. For now, our current experience with crude goes a long way towards explaining just why real GDP growth has been well below post recessionary historical norms of the last half century. We believe it also helps explain just why the incredible monetary and fiscal stimulus of the current cycle has been so ineffective in facilitating employment expansion, real GDP growth, reconciliation in household balance sheet characteristics, etc. In essence, recent stimulus has simply been offsetting the negative economic influence of rising crude prices. When looked at from the perspective of the data in the table above, the interplay between the real current domestic US economy and accelerating crude prices of the moment is without precedent in US history at the front end of an economic recovery cycle. What a way to kick things off, right? By the way, if we update crude prices in the current cycle to where crude stands today, we're now up close to 91% since the beginning of 4Q 2001.

Is The Fed Finally Over A Barrel?...You know that we have been preaching about and harping on energy as an investment theme for well over a year now. To be honest, it's a tough call as to where crude prices go short term. Have we witnessed a short term blow off spike in crude at the moment? Is crude simply, albeit rather violently, adjusting to longer term global supply and demand dynamics? How much "speculation" is in current prices? Is crude just climbing a wall of worry? We wish we had the definitive answers to these questions, but as usual, a few observations are going to have to suffice. Although this may sound like a stretch, it's becoming very apparent to us that at least in part, the Fed is part of the problem when it comes to crude. And under the always universal law of unintended consequences, potential further dramatic acceleration in crude may force the Fed into rather dramatic action of its own. Potential dramatic action we're not so sure the financial markets have factored in at all.

Certainly the incredible monetary stimulus of the past few years has sparked economic growth stateside and has gone a long way in helping to foster global economic acceleration. Along with this growth has naturally come increased demand for energy resources. In absolute terms, this demand has helped pressure energy prices to the upside. But it is clear that the Fed in no way has a monopoly on liquidity creation. As you know from our discussions regarding trade deficit and global capital flow data, the Central banks in Asia are also major players in the stimulus/liquidity creation game within the context of the global marketplace. Both strength in US import markets and accelerating foreign direct investment in Asia have caused economic growth to register incredible gains over the past few years in Asian economies. Coincident demand for energy in the Asian economies, along with US economic recovery driven demand, is certainly a large part of the reason why energy commodity prices have moved higher over the past few years.

Away from the "real world", so to speak, Fed sponsored liquidity creation in the US has also been responsible for various forms of asset inflation over the recent years simply as an outlet for this excess liquidity. Whether in stocks, bonds, or housing, accelerating prices to the extent we have experienced would simply not have been possible without incredible monetary stimulus. It's no secret at all that the Fed's unspoken modus operandi in terms of kick starting the recent domestic economic recovery was in good part grounded in asset inflation and subsequent monetization, primarily as it related to residential real estate. And as we have seen over the recent past, when price acceleration in one asset class cools down, the growing pool of speculative investment related liquidity simply migrates to another asset. The very nature of excess liquidity has provided the fuel for virtually unprecedented financial speculation. And real commodities have not been exempt from this tidal wave of liquidity in the least. Certainly at least some part of the recent rise in crude is due to the act of financial speculation in real commodity markets, although we firmly believe that longer term energy prices are squarely driven by supply and demand dynamics. Thank you Fed for the cheap cost of capital and plentitude of financial ammunition with which to speculate.

Finally, it's pretty darn clear that a declining dollar over the last few years has likewise pressured all commodity prices higher, given that most commodities are denominated in US dollars in terms of global payment or trade. Is the Fed's incredible monetary largesse at least in part responsible for relative dollar value slippage over the last few years? Of course it is. Dollar slippage that the global producers of commodities can only offset with higher absolute dollar prices. Again, whether crude prices have been influenced by real global economic growth, excessive financial speculation, or as an offset to the declining dollar, the Fed's monetary machinations have in good part supported all of these factors that have in part pressured crude prices higher.

If The Thunder Don't Get Ya Then The Lightening Will...Although this may sound like far too simplistic a question, is the Fed really down to the choice of higher US domestic interest rates or higher crude (and perhaps broader global commodity prices) prices ahead? Either way, the Fed appears over a barrel. Neither choice is pleasant and neither offers an acceptable outcome as far as the US economy is concerned. Much higher crude prices ahead risks perhaps at best a stagflationary outcome for the US. As we described in the tables above, already the current interplay between crude prices and the economy is beginning to look a whole lot like the 1970's. Significantly higher interest rates ahead would risk a credit contraction in the US economy. A contraction in the very same financial structural underpinning that has supported US economic growth during the current recovery period. For hopefully some perspective, the following chart tracks both the history of the Fed Funds rate and crude over the past three-plus decades. As is clear, directional relative acceleration in both crude prices and Fed Funds have gone hand in hand over the period shown. Based on historical precedent, unless the recent spike in crude is quickly followed by a near term and very sharp sell off in price, it would seem a darn good bet that much higher short term rates lie ahead. The Fed is being pushed into a very tight corner. With each tick higher in crude prices, the Fed is increasingly being forced to choose between perhaps very unacceptable outcomes.

But maybe more than anything else, what has truly amazed us over the recent past is what appears to be the casual manner in which the financial markets have viewed higher crude prices. If you had told us one year ago that we would virtually kiss $50 per barrel on crude pricing, we would have expected an efficient market to perhaps react much more violently to the downside than has been the case so far. And it's not just the broader financial markets that appear to be dismissing crude pricing strength of the moment as completely unsustainable. The energy stocks themselves have sold down from recent highs prior to oil retreating from near $50. Many analysts are still using a low $30's crude number in their earnings models. Moreover, many companies are using crude estimates in the $20's when developing capital budgets. If the energy stocks don't believe crude pricing strength is sustainable, then why should the broader market, right? And, as we have mentioned many a time, capital spending in the industry likewise is telegraphing the current message that macro crude pricing strength is transitory. Again, we really have no way of knowing where exact near term crude pricing will go over the short term, but it sure appears to us that there is a mile of room for financial market price reconciliation if indeed crude stays above $40 or anywhere even near the half century mark for any extended period of time as we move forward.

In addition to potential financial asset reconciliation, perceptual reconciliation is also a very important risk to the broader economy at the current time, again dependent on near term crude pricing ahead. It's no mystery that consumer confidence readings have been improving as of late, at least until this week's report anyway. But quite importantly history teaches us that accelerating crude prices and accelerating consumer confidence readings simply do not go hand in hand. This is especially true when crude prices spike. Our very humble question of the moment is, based on historical precedent, just which of these will reverse direction first, crude prices or consumer confidence? As of this week's data, so far it's both.

To suggest that a meaningful break in consumer confidence ahead based on perceptions of accelerating energy prices would complicate the Fed's dilemma of the moment is an understatement. Despite higher consumer confidence readings as of late, real world anecdotes of consumer spending activity have suggested consumers are growing weary. Perhaps very weary. And, as we have mentioned many a time, corporate capital spending is definitely not stepping in to fill the void in terms of supporting broader domestic GDP growth at the moment.

Enough for now. The bottom line is that what is very different about the current economic recovery cycle relative to prior historical experience is the acceleration in crude prices at the front end of this recovery. As we have shown you, there is no precedent for what has happened over the last 11 quarters. As there is likewise no precedent for the monetary and fiscal stimulus unleashed by the Fed and Administration over this same period. Although we sure wish we could see clearly what lies ahead for commodity and financial markets, we're just going to have to settle for trying to understand the dynamics of the situation and hope that this understanding, along with a good dose of historical perspective, leads us in the proper direction in terms of investment actions. Unless crude backs off significantly from current levels, we see an increasingly dark set of potential outcomes for the broad US economy and financial markets. To say nothing of an increasingly limited set of choices for the Fed. Could this be what all of those 50 day moving averages crossing down through 200 day moving averages in both individual stocks and macro equity indices are telling us as of late?

Market Observations
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