Time to Call an Audible

By: John Mauldin | Sat, Sep 3, 2005
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Nearly all eyes are on the terrible devastation caused by Katrina, and rightly so. I can do little to add to the amount of news you already doubtlessly have, but in today's letter we will look at some of the economic implications from this tragedy, as well as how they fit into the larger picture of what is already unfolding, and specifically Federal Reserve policy. We will look at a lot of individual items up close, and then see if we can then step back and see if we can make some sense of them.

One of my favorite moments in Dallas Cowboy football was when Hall of Fame quarterback Roger (the Dodger) Staubach would come up to the line, see the problems in front of him, and call an audible. (For foreign readers, that means he changed the play at the last second, shouting out a code for a new play.) Let's see if I can make a case where Fed quarterback Greenspan needs to come to the next Fed meeting and call an audible.

First, let's look at the background before Katrina. First and foremost, Katrina struck when oil was already $65 a barrel and gas was within shouting distance of $3 in the US. (To put this in context, most of the developed world thinks $3 a gallon gas is ridiculously cheap.) Natural gas was already above $11. When winter comes, that $11 gas is going to cause as much pain in parts of the country as $3 gas. Gasoline prices will come down as refineries and oil wells come back on line. But natural gas may remain above $10 for the winter. There are no new supplies in sight to materially help the situation. The percentage of incomes that is spent on energy (as noted last week) by those in lower income profiles is already approaching 20%. This is untenable for most families.

While tapping the Strategic Petroleum Reserves (SPR) will keep the price of oil from going to $80 or $90 until supplies can come back online, we have no such reserves of natural gas. Oil is not going to $35 any time soon. Energy costs are going to hit other types of consumer spending hard this fall and winter. We may not be buying as many GI Joes with the Kung Fu grip for Christmas as we did in previous years.

On this note, let me quote from Stratfor.com about gasoline supplies, "The United States currently has commercial stockpiles of 194.4 million barrels of gasoline -- enough to substitute for the loss of Gulf Coast refineries for weeks even in the worst-case scenario. There will be supply disruptions in affected regions that are used to being net gasoline suppliers, not consumers, since adjusting will require a reversal of normal supply routes."

But as Dennis Gartman noted this week, there are 220,000,000 cars in the US. If everyone tops off their tank, and assuming that is an extra 10 gallons on average, that would be 2.2 billion gallons. Coupled with supply problems, this is a big hit. Of course, this sorts itself out in the medium run, but for a week or so it is a problem.

Thus, in the short term prices in various places could rise, but we are not going back as a nation to the 70's. It is a temporary, albeit big, headache.

As an aside, I hope President Bush's critics who roasted him for filling up the SPR will now admit he was right. It is in just such an unanticipated emergency that the need becomes apparent. Can you imagine what they would say now if he had not? I hope this also pushes Congress to act to open up the US oceans and coastlines and Alaska to drilling for oil and especially natural gas. There is enough gas in US waters and land to supply us for 20 years (400 trillion cubic feet of gas!). There will be the votes for it when it costs $500-$700 a month to heat the average home. And while they are at it, can they please make sure we have several pipelines and oil and gas ports on both coasts so one disaster like this does not threaten the bulk of American energy sources? The NIMBY forces (Not In My Back Yard) have got to be put under control for the sake of the country at large.

And while I am on politics, how in Hades could we not get the National Guard into New Orleans and Mississippi within a few days at the very least? With all the post 9/11 planning, is this the best we could do? What if we did, God forbid, have a major terrorist attack? Does it take that long to get troops moved into place? If so, why? Now, back to our regular letter.

1,000,000 Temporarily Lost Jobs

There was a little bit of irony as I was coming in to the office yesterday. I have XM radio in my car, so I have it set to all the news channels. On CNBC I heard that unemployment fell to 4.9%, its lowest rate in four years. I flipped to the next channel, and there the commentator was noting that up to 1,000,000 people will be without jobs due to Katrina. (It will be interesting to see how the BLS deals with this statistic next month.) While this is temporary, it is going to mean a big loss of consumer spending power in the short term. And yes, the reconstruction is going to pour a lot of spending into some industries, but it will not be for several months at the very least. September and October are likely to see reduced consumer spending on a national level.

But it didn't happen in July. U.S. consumers spent more than they earned in July for just the second time in the last 46 years, the Commerce Department said Thursday. Personal incomes increased 0.3% in July, while spending roared ahead by 1%. As a result, the personal savings rate tumbled to negative 0.6%, the lowest since monthly records began in 1959.

My guess is that this is going to get worse as energy costs force families to adjust and dip into savings in the interim. This is clearly a condition that cannot continue. And yes, I know that the rate does not measure asset growth and other forms of savings, but it is a useful historical indicator of actual spending habits.

Without going into details, as everyone now knows the centrality of the port of New Orleans and the Mississippi, if the Mississippi is not opened up for shipping, and the docks and ports are not cleared for loading and unloading, it is going to be a major hit to US exports and business, especially agriculture.

As an aside, while I have seen little on the topic, if you are a country dependent upon US wheat and soybeans for your food supply, you may be facing a very serious situation. World grain prices may rise due to a lack of supply as US grain prices fall, because bins are full and there is no place to store the excess. They are very few alternatives to the Mississippi for grain and soybean exports, and none that are cheap or timely.

Chemicals, steel and hundreds of other critical supplies we need for manufacturing also come up the Mississippi. Everyone is now talking of a supply shock to the economy from oil. We could experience a supply shock of a hundred much smaller items, but no less critical. While the shipping lanes will get fixed and the docks put back in working order, there is no realistic estimate of how long that will take. Weeks? Months? There is a lot of uncertainty. If it stays closed for too long, it becomes a problem, because the river freezes in the upper reaches and barge traffic cannot pass, essentially shutting down around November in the northern parts of the river system.

Put yourself in the seat of a company that operates a dock in the New Orleans, Gulfport or other local ports. What do you do? When do you get electricity? Who will repair your docks? When will the roads be open? And how do your skilled workers, critical to your business, get to you to do their jobs? If you are going to get your dock open, you are going to have to become a social worker as well.

Right now, they are in refugee camps or with relatives hundreds of miles away. They have no home to come back to. How do you contact them? Can you find them a temporary home? Do you lease a fleet of used recreational vehicles or manufactured housing to house your employees nearby so they can get back to work? If they have to live 60 (or more) miles away to find housing, what about the extra fuel costs for them? That's $600 in fuel costs just for commuting purposes. Will you have to give them emergency gas supplements? What about their families? How can they work, commute and rebuild a home?

It is going to take months to sort through these and a thousand other questions. The good news is that these are mostly small and medium sized businessmen. All their lives they have had to figure out how to solve problems that threaten the survival of their business. That is what makes America so great. American entrepreneurs are some of the most resourceful and resilient anywhere. While this is more than many have faced, my bet is always on the entrepreneurial spirit.

In critical industries, like shipping, the government should step in with quick loans and grants to get things moving and then get out of the way of the business owners. Let them figure out where and how to actually solve their problems. Get them the tools and money and watch how fast things work. But fast is a relative term. It will still take weeks and months.

$100 Billion Here, $100 Billion There

The estimates of how much all this is going to cost are all over the board. A leading catastrophe risk-modeling firm, Risk Management Solutions said today that Katrina and the flooding of New Orleans will probably cost more than $100 billion in total economic losses. In the grand scheme of things, that is less than 1% of US annual GDP. That is one reason why most economists do not think Katrina will push the US into recession. And if we were just dealing with Katrina, and not with other issues, I would tend to agree, again assuming shipping lanes and energy supplies are restored within a month or so.

But as noted above, we were already seeing things begin to slow down because of high energy prices. We can now expect energy to take about 1-1.5% off of GDP this fall. How much will 1,000,000 temporarily unemployed people (read consumers) cut into GDP for the third and fourth quarter? Estimates range as high as 1% for a few months of time. Now, in an economy rolling along above 3.5%, this is a problem but not a recession, but it does take you in the wrong direction.

A little later, I am going to suggest that all this supports the idea that the Fed should hold off raising rates at their September meeting. But let's look at why they might decide to go ahead and raise rates anyway.

First, inflation is at the upper bounds of what the Fed is comfortable with. Several recent speeches by Fed governors have high-lighted this point. And they are right, it may be creeping up. The future inflation gauge (FIG) for the U.S., developed by the Economic Cycle Research Institute (ECRI) has risen for the third straight month, climbing to 121.1 in August from an upwardly revised 119.7 in July. The smoothed annualized growth rate continued to climb as well, jumping to 4.1% from an upwardly revised 2.3% the month prior. Other FIGs, which lag the U.S. by one month, indicated rising inflationary pressures as well. Most indices increased from the month prior while those that stagnated remain in an upward trend for the year.

I wrote last week that Greenspan and the Fed made it very clear the Fed is targeting asset prices, and specifically the housing bubble. Stephen Roach of Morgan Stanley made the following point today:

"Belatedly, Alan Greenspan has finally paid lip service to the mounting perils of the Asset Economy. In his recent swan song at Jackson Hole, the Fed chairman cautioned that "history has not dealt kindly" with investors (i.e., American consumers) who may have gone too far in "accepting lower compensation for risk" on their asset holdings. Even couched in all the oblique caveats so typical of Fedspeak, this is quite a confession. The Father of the Asset Economy now fears he has created a monster.

"...And if there was any doubt over the bubble-like underpinnings of the Asset Economy, the latest report on nationwide home prices says it all -- a 13.4% year-over-year increase in 2Q05, the sharpest increase since mid-1979. Saving-short American consumers have gone deeper and deeper into debt in order to spend freely out of artificial purchasing power extracted from overvalued homes. All that paints a very compelling picture of an excess-demand-driven US economy."

In spite of the Fed raising rates, housing price increases have not slowed down. If allowed to continue, it could create a real problem when the bubble begins to leak. And Fed members are very aware of that. Hence, Greenspan's clear warning last week.

Further, there are those who make the argument that when the Fed failed to respond in the 70's in the last supply side oil shock, and eased to aggressively in the face of an oil shock recession, it brought about stagflation. And they have a very serious point. If inflation is allowed to come back, even in the face of a recession, we could visit the 70's all over again. But that is a big "if,", as I will note below.

The few Fed speeches and comments we have had since Katrina hit make it seem as if they do not sense this is a big national problem, economy-wise. They seem clearly more focused on the housing bubble. If this view prevails, it means they will definitely continue to raise rates at the September meeting.

Why hasn't relentless Fed rate increases for the last year moved long term rates higher? Why is it such a conundrum in the Chairman's mind? My good friend, Paul McCulley, has a very good answer. I highly suggest you read the whole article at www.pimco.com, but let me give you a sense to what he suggests. Quoting:

Time Inconsistency and the Greenspan Put

"In fact, I submit that Mr. Greenspan's 'technically' upped the ante against himself today [in his Jackson Hole Speech], when he officially declared that policy is becoming "increasingly driven by asset price changes." Let me walk you through the logic of why, using the economic thesis of 'time inconsistency,' which won the Nobel Prize in Economics for Professors Kydland and Prescott.

"Their elegant, but simple thesis was that expectations about future policy reversals can undermine the power of current policy. My favorite real world example is that of a parent who says to a teenager: get a job this summer and save some money, or you will be walking rather than me driving you to school in the fall.

"If the teenager knows that the parent will, in fact, do the driving come fall, regardless of whether junior gets the summer job - because that's what happened last summer and fall - then the parent's policy is time inconsistent: if the teenager knows the summer policy will be reversed come fall, he will rationally ignore the summer policy of getting a job and instead go to the beach. The parent's policy is simply not credible.

"Increasingly, it seems to me, the Fed's policy of threatening never-ending Fed funds hikes, as Mr. Greenspan implicitly did today, so as to induce lower bond prices (higher bond yields) that will 'get at' frothy property markets suffers from time inconsistency. Bluntly put, the Fed has a credibility problem, because the markets know - because Mr. Greenspan has taught us! - that the Fed's asset price bubble policy is asymmetric:

"1. Deny that you can see them when they are inflating, tightening against them only if you can justify tightening on the basis of conventional inflation-pressure models and data.

"2. Ease vigorously and purposefully when bubbles confirm their existence by blowing up.

"...It's a time inconsistency problem! Why should we in the bond market bearishly discount an ever-rising Fed funds rate, if an ever-rising Fed funds rate will surely burst property prices, begetting a reversal to vigorous easing?

To the Moon, Alan?

"...So, what's the Fed to do, facing a dilemma similar to the parent trying to figure out how to get the teenager off the beach into a job? Conceptually, and consistent with the consensus of bearish pundits, the Fed could simply hike short rates until the housing market cries uncle, accepting that such a course is likely to invert the yield curve. To wit, the Fed could resignedly accept that the longer end of the curve is not going to 'do its work' and do the 'heavy lifting' itself with more nasty short rate hikes. This is, indeed, a plausible scenario."

Paul then goes into a very interesting exchange between Senator Shelby and Alan Greenspan where the Chairman asserts that the yield curve no longer has its predictive power. I might point out this is a useful concept for someone who is getting ready to invert the yield curve, which has historically always forecast a recession. If inverted yield curves now don't mean a recession is coming, then there is no reason not to go ahead and risk an inversion! Then he gets to the main point. This is an important concept, class, so pay attention. There will be a test, at least of your bond portfolios!

"Mr. Greenspan is surely right - and for the right economic reasons! - that an inverted yield might not imply a recession, as it universally has in the past. Yes, this time might be different! But it might not be, either. Thus, for the Fed to defy the risk management lesson of history - don't invert the curve unless you want to underwrite the odds-on risk of recession - would be a hugely bold decision. Is the Fed willing to make it?

"I don't think so. In fact, I think there is more than a sporting chance that this whole issue becomes moot, as 'speculative fervor' in property markets exhausts itself from its own exuberance. But I wish I could say that with greater confidence. What I do feel highly confident about is that if the Fed does attempt to bearishly invert the curve a little, the market will subsequently respond by bullishly inverting it a lot.

"Put more technically, the value of the Greenspan Put will rise exponentially if the curve inverts, while the cost of 'buying' that Put will actually become negative: in an inverted curve, a duration-equal barbell of cash and long bonds yields more than a bulleted portfolio. Such is the weirdness of an inverted curve: the less volatile, convex barbell structure actually yields more than the more volatile, less convex bullet. Rather than paying for insurance, you get paid for taking it!"

Put in layman's terms, if you believe the Fed is going to lower rates, you are better off actually taking the lower long term interest rates, because they are going to go even lower and you can make a profit as rates go down as well as get more for your cash today!

So, let's cut to the chase. The Fed will meet in 17 days. While we will know a lot more by then, there is a lot we will not know. We will certainly not be able to assess the short-term impact of Katrina by then. While gas prices should come down by October as pipelines and refineries come back online, there is no certainty. Those most affected by the storm will still be trying to figure out how to get their lies, homes and businesses back together.

Even though inflation seems to be pushing upwards, Katrina may reverse that trend. We just don't know. Housing inventories, both new and used, have begun to rise in recent months, something that needs to happen before housing prices level off or decline.

Further away from home, in what seems eerily reminiscent of the Thai baht having serious problems in 1998 which augured the Asian debt crisis, we are watching the Indonesian rupiah show serious signs of deterioration. China is clearly on a path to slowing down, which would take some (though certainly not all!) pressure off the commodity markets. While the argument, mentioned above, that the Fed allowed stagflation by making money too easy in the 1970's is correct, that was when then overall tendency of world prices was inflationary. Today, we have the opposite case. Deflation, except for raw commodities, is still the prime backdrop for world goods.

I think Paul put his finger on the prime issue. If Greenspan continues to raise rates slowly, the market knows that it will eventually hurt the housing market as well as bring on an inverted yield curve and a recession, which is what the Fed has always done. They always go too far. The market will anticipate this and invert the yield curve for him, perhaps aggressively, making long rates lower and doing the opposite of what Greenspan is trying to do. Mortgage rates will drop and housing prices will rise. Things get weird.

Further, the collective wisdom of the market is telling Greenspan that he should wait. Fed fund futures are pricing in only 25 basis points of rate hikes this year, as opposed to 75 basis points it priced last week. The market is screaming for the Fed to slow down.

And let me mention the unthinkable. The National Weather Service suggests we may see 4-5 more hurricanes this season. Who knows where and how strong? It might just be prudent not to tempt fate.

Greenspan: Time to Call an Audible

Quarterback Greenspan should come to the Fed meeting September 20 and call an audible. He now has the perfect excuse. They should not raise rates, announcing that they would like more time to assess the affect of Katrina on the economy. With the properly worded Fed release, no one would think he (or the Fed) had lost his rate hike nerve. It is just the Chairman acting with wisdom and restraint.

They could make it clear that if as it now appears that the economy will weather this storm just fine, that they will again start the measured pace of rate hikes. This is assuming the rise in "asset prices," (read your home) keep up their relentless rise.

The next meeting is November 1, just 40 days after Sept 20. If they are still nervous about "asset prices" then they can start to raise rates again. 40 days of rates staying where they are is not going to bring back inflation. There is no need to rush when there is a lot of uncertainty. By November 1, we will know the effect of Katrina. We will know if rising energy prices are going to slow the economy on their own. We will know if consumer spending stays resilient. We will know if the recent trend in increased inventories of homes for sale is indeed a real trend, or a few month aberration.

Between now and the next meeting, the Fed can begin to lay the framework for a specific pause in the rate hike process. Transparency is important.

My bet is that the US economy will weather Katrina and that my gulf region neighbors will get it going again. But it is not certain. Greenspan's own rule is that central banks must first make sure they do no harm and avoid the most negative of outcomes. Housing prices rising another 1% in the 40 days between meetings is not a huge negative or risk. Getting us to an inverted yield curve when there is a reasonable (though not probable) risk of an energy shock is a very negative outcome.

Mr. Chairman, make like Roger. Call an audible.

Palo Alto, San Diego, Toronto, Houston and Europe

Sadly, there will be no New Orleans Investment conference in New Orleans this fall. This is the Grand-Daddy of investment conferences, going continuously since the late 70's. The late (and honored) Jim Blanchard started the conference, and I went to my first one in 1982, at the beginning of what would turn into a career in investing. I have been going to New Orleans for business and pleasure since 1976. It is one of my favorite cities in the world. I actually won a trip to New Orleans as a Dallas Morning News paperboy in 1963 at the ripe old age of 13. I saw my first "adult" movie on Canal Street. Some racy thing called "Cleopatra" with a young Elizabeth Taylor and some guy called Richard Burton. Come to think of it, it may have been my first movie house movie. I was kind of sheltered. Southern Baptist and all, you know. Certainly made an impression on me. And Bourbon Street was a lot different back then.

I was happy to hear that the Commander's Palace has apparently weathered the hurricane, and will be back in operation when the town comes back to life. I have had some of my most memorable, not to mention finest, dining experiences in that old house.

My understanding now is that the plan is for the conference to be held in April, but I will, of course, keep you posted. My heart felt prayers go out for Bryan Lundin and his team at the Jefferson Companies as they try to sort through how to get their business back on track. If anyone can, they will.

My daughter just called and the church she goes to is rounding up volunteers. Seems more than a few busloads of people routed from Houston will be showing up in a few hours, around midnight, and they need help. The Dallas area will be taking tens of thousand of refugees in the next few days.

I will be going to a conference dealing with the accelerating pace of change in Palo Alto September 16-18 and then to San Diego then next day. You can find more on the conference at www.accelerating.org. Then I will be in Toronto Sept 27-29 spekaing locally and at a ahedge fund conference (details in a later letter) and working with my local partners at Pro-Hedge. The morning of September 30 I speak at a conference in Houston and then the next day leave for London, Malta, London, Denmark, Bulgaria, Brussels, London and then home on the 14 of October. I am sure it will be good to be home at that point.

This weekend is family and friends, as it should be. And I hope you enjoy yours.

Your praying for those in the gulf region analyst,


John Mauldin

Author: John Mauldin

John Mauldin

John Mauldin

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