THE ECONOMY
The economy is doing well, but not that well. The trajectory here starts
with interest rates, and now we all agree that they are headed higher. The
investment community seems to be waiting for the Fed to act, rather than
making the decision now on the probable future. Rate are going up because
inflation is here. Oil is at $40 / bbl. Even the government, who
massages the numbers down, has the CPI and PPI at 7% last month. That means
the real interest rate is negative. The budget deficit is huge and that
leads to printing money to pay for the government expenditures. We bounced off
45 year lows a year ago, and this trend will continue. Once started, the
convexity guys, who have to manage portfolios of bonds and mortgages, have to
reposition in a huge derivative way. They make the trend continue and go
farther than it would from other forces. The trend is now up and they will
insure it continues.
Another weakness is the export of jobs. Not just the low paying
manufacturing jobs, but now the higher paying technology jobs like IT, X ray
reading, and engineering. They are not coming back because the difference in
cost is as much as 10 times. The related figure of Commercial and Industrial
Loans reveal that no one is investing in the US, largely because of the
uncompetitive labor rates.
A big Achilles heal is that we expect foreign investment of $400B per
year to balance our trade deficit. Foreigners, especially central banks, have
shown a surprising willingness to continue to purchase US Treasuries
($10B last week in the Fed's Custody holdings). They have lost billions on
currency exchange losses in the last two years, and will lose much more in
bond prices as interest rates rise. If they stop, US interest rates will rise,
and the dollar will weaken.
The problem with interest rate rising, is that stock P/E multiples
collapse. This is what happened in the 1970s. The economy did relatively well,
and stocks were flat. After inflation the return on stocks was negative. We
are still at very high P/E levels. My prediction is that the economy and
corporate earnings improve, but that stock prices stay nominally flat, and
that inflation makes the real return negative in the decade ahead.
The higher interest rates usually take several months to
negatively affect stocks. This would be bad timing for the election. The
housing bubble may not burst by then, but a decrease in asset prices would be
tough on consumer spending.
This is the traditionally weaker 6 months of the year (through October)
for stocks. Jobs are every important to people, and will be modest in the next
year. The point is that while the Iraq war is a negative for Bush, the economy
is not likely to be particularly supportive either.
Bud
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