Volume 58, Number 6 | February 11, 2011
We are wondering whether hoarding is beginning to distort the economic data as inflation fears grow. We get hundreds of e-mails a day from clients, friends, and contacts and at least half of them are focused on rising commodities prices and what it means for inflation down the road. Rumors of planned price increases from a wide range of firms are in the press every day. And given the very modest return to holding cash, pulling ahead expected future purchases seems a reasonable strategy for lifting rates of return. Just in time inventory systems were designed to lift returns when prices were steadily falling (due to China based deflation) and the cost of money – though low by historical standards – was high in real terms. Now prices are rising and real carry costs, at least for purchases of commodities and goods with high commodity content, are falling. Moreover, longer lead times out of China as plants move farther inland add to the need to plan ahead. A hoarding cycle can go on for a long time, as it did in the 1970s, if inflation fears continue to grow — or it can pop real fast. With opinions on overall inflation still widely divergent, we will continue to watch the deviation between manufacturing and the rest of the economy closely for signs of an inventory build.
Last week, we noted that the most obvious sign of weather in the payroll employment report was the drop of -45,000 in the couriers and messengers sub-sector of transportation workers. However, on closer review, we note that this was simply a reversal of the 46,000 rise in this category in December 2010. Now, data is often fluky month to month and such zigzags often occur, though not so large. With our curiosity peaked, we looked closer at the data and discovered that in December 2009, the couriers category rose a hefty 30,000 – only to drop -41,000 in January. In December 2008, it was up 13,000 and dropped -5,000 in January. In December 2007, messenger jobs grew by 7,000 and then fell by -4,000 in January 2008. This growing trend reveals the increasing importance of the internet and the need for overnight delivery of last minute gifts at Christmas – and no need for these workers in January. In time, the seasonal factors will catch and eliminate this zigzag in the data. Many years from now revisions will say this did not happen at all. However, in the short run, our major take away is that removing 46,000 jobs from December and adding back 45,000 in January would produce 75,000 new jobs in December 2010 and 81,000 in January 2011 – after a gain of 93,000 in November 2010. Bottom line, after adjusting for couriers and messengers, there appears to be no weather effect in the January payroll data at all – just a disappointingly soft growth rate in employment that mirrors the disappointingly soft nominal GDP growth in the fourth quarter of 2010.
The Drury Rule of Economic Extremes
One of the reasons we are less optimistic about the outlook for the US economy than our peers is that we cannot find the big winners in this up-cycle. We have long argued that if you are going to talk about an economic boom, and many are suggesting growth north of 4% in the coming year, you need to be able to point to the three cities and three industries that are already booming. Similarly, if you are calling for a recession, you should be able to point to those sectors that are already on the way to depression. All we are saying is that in a complex economy like the US, the headline number is made up of an average of industries and regions, and it is the outliers that are the proof of the pudding. Right now we cannot identify three cities or three industries that are booming. The strongest economy appears to be in Washington DC, and that does not fill us with hope. More importantly, the agricultural Midwest, mining states and oil patch, which should be booming in a commodities-led cycle, are solid, but not runaway. Indeed, we are very troubled to find that Texas has the largest budget deficit as a percent of last year’s revenues (31%) of any state except Nevada. We believe this is a by-product of the offshore drilling moratorium and Texas’ dependence on mineral taxes, but it is nonetheless troubling.
The biggest winner in the US economy appears to be the top 10% (or even less) who are enjoying the equity market’s rebound. There is plenty of evidence around that virtually all of the upside in consumer spending has come from those at the top of the income ladder. Federal Reserve Chairman Ben Bernanke would be proud as one oft repeated goal of quantitative easing was to lift asset values to spur hiring and investment. Well, phase one appears well underway, but we see little evidence that investment or hiring – at least in the United States – is about to spark a broader economic recovery.
Meanwhile, we can still see many laggards. Commercial and residential real estate have not seen any upturn. They continue to drag down major economies like California and Florida, and remain a threat to the banking system. The widely touted auto bounce, which has helped lift manufacturing measures like ISM, still leaves the industry way behind historic levels of activity. Adding autos to agriculture, mining and oil and you still don’t have enough weight to pull the locomotive. Autos are 3.5% of GDP; Farm income is only 0.4% of GDP; and mining & resources employment plus petroleum processing jobs account for less than one million workers. Meanwhile, both the small business sector and the government sector – which each represent roughly one in six American workers, with no overlap — are much bigger laggards than normal at this point in the cycle. Bottom line, we see the drags as still much greater than the boost, and the outlook does not suggest a rapid improvement for the laggards or much more room to grow for the leaders.
A Nasty Observation on Math
Math can be a very severe taskmaster. As most people in the investing world know, wins and losses are not symmetric. If you lose 20% on an investment, you need a 25% increase just to break even. And the asymmetry is geometric; getting worse the farther you get away from small numbers.
The math of real estate bottoms is equally as nasty. The key is that the ultimate price at the bottom of the market is determined when the strongest of the original buyers finally cave in and sell. For the highest price buyer, each percent of pain is smaller than it is for the guy who got a deal at 25%, or 50% or 75% off. Indeed, the deeper the discount, the more vulnerable the low-bid buyer is to the whims of the guy who bought at the top. For example, assume a property is purchased for $1,000,000, and it falls to $500,000 – a situation which is widespread in soft real estate markets today. A buyer might think they are safe buying at fifty cents on the dollar – indeed, so safe that buying with a 20% down mortgage gives lots of upside potential. Unfortunately, the risk is that in a market still flush with excess supply the remaining buyers at the original price of $1,000,000 finally decide to puke at $400,000. To them it is only another 10% loss – which they might split with Uncle Sam. To the discount, but leveraged buyer, their equity is wiped out, leaving them at greater risk of adding to the price decline if they get in trouble financially. The risk is greater the deeper the discount. At twenty cents on the dollar, only a modest 4% drop in the original price wipes out a 20% down payment. That is why soft markets often stay soft for a long time. We remember five rounds of buyers in the see-through buildings of Houston in the early 1980s. Ultimately, only when the strongest of strong hands buyers – all cash – are the low bidders is it safe to come out and play.
Reflections on Revolution
We have received many inquiries about what we think is going to happen in Egypt, and my easiest response is that I really don’t have a clue. I believe we are still in the fluid period of any revolution – and I think this is a true revolution. Mubarak is out and those that relied on him as their protector and/or source of money and power are now exposed. With a net worth estimated at between $30 billion and $70 billion, the Mubarak family’s tentacles ran deep in Egypt. The easy answer is that the military will retain power. However, as recent events and releases have shown, there is division within the military between the old guard who got rich under Mubarak and the younger officers who are still waiting their turn. The passing of political power to the Vice-President (as we understand it) is ex-constitutional as a resigning President is supposed to pass power to the “elected” Speaker of the Legislature (not to the appointed VP or Prime Minister) and elections should be called in 90 days. Opposition groups, like the Muslim Brotherhood and other non-military groups, may not wait to wrest power through a “democratic” process in the still promised September elections. They must try and force a transition while the blood is still hot.
The risk, as in all revolutions, is that the best laid plans often go astray. In Iran, a very similar example, the Shah tried to hold onto power by appointing an opposition party Prime Minister, Shapour Bakhtiar. However, the Shah was soon driven out – originally by the communist oriented (Tudeh Party) student takeover of the US Embassy. Their power was quickly supplanted by the Ayatollah Khomeni’s first appointed Prime Minister, a moderate pro-business, pro-democracy candidate, Mehdi Barzagan. He was quickly supplanted as the leader of Iran by Khomeni’s appointed president, Abolhassan Bani-Sadr, who represented the left wing of the religious spectrum. Finally, Khomeni consolidated control for the religious right under the Council of Islamic Revolution leading to the cleric run government that stands today.
In the French revolution, the mob ruled during the Reign of Terror under Robespierre, until he himself received the guillotine. The Thermidorian Reaction placed a democratic council, the Directorie, in charge. But, in 1799, Napoleon led the coup which placed his military government in power. In Russia, the Menshiviks forced the Czar from the throne, only to be over thrown in the political process by the better organized Bolsheviks. All we do know is that history shows chaos creates strange bedfellows, with political, military, and religious leaders often taking positions one never would have expected in their attempts to catch the brass ring of power. Bottom line, tread cautiously and keep a very open mind about the ultimate results.