Volume 58, Number 11 | March 18, 2011
Given our world view, the question today is whether the crisis in Japan will act as a safety valve for price pressures in the rest of the world or if the crisis in Libya and Bahrain will exacerbate the situation. In simplest terms, we have been concerned that rapid growth in China and the rest of the emerging markets underpins global price hikes for goods (especially raw materials, but finished goods as well) which forces income constrained developed countries to cut back spending on services – which in turn leads to less hiring in developed country service sectors, reinforcing the income constraint. We had thought this process would reach a crisis point sometime in 2012, just in time for US elections – and with the US still having very high unemployment and a huge budget deficit. That conflict might have produced the crisis needed to bring about meaningful reform on long simmering issues like energy policy, entitlements, military spending, etc.
Now, it seems that Japan’s economy will suffer a substantial shock, with growth sharply negative in the first quarter and maybe second. True, a strong rebound should start later in the year, but that won’t bring real resources use back to pre-earthquake levels for some time. Moreover, we suspect the rebound bounce in Japan will be less pronounced than many assume. Japan has squandered money on make-work government financed projects for years. Now they have an opportunity to redeploy those resources to truly productive uses. This is good for growth both long term and short term, but it still leaves Japan demanding less of the world’s resources than had been previously planned for most of 2011. This respite is reflected primarily in lower interest rates around the world. Lower rates hold out a real opportunity for refinancing in the US housing market, helping to correct more of the income/asset imbalances that put our economy most at risk. Lower rates – and a Fed that stays on hold for longer – also reduce interest rate pressure on the huge deficit. Will this respite lead to some meaningful progress on the key budget issues or will it simply lead to more delay, putting off real reform until the 2012 election. In our view, politicians are rarely moved without crisis, so inaction appears more likely than action.
Meanwhile, the civil war in Libya and the growing proxy war between Iran and Saudi Arabia in Bahrain have kept oil prices over $100 a barrel placing a tax on the rest of the world economy. The ceasefire announced today in Libya may or may not help resolve that situation. Still, it seems clear that Gaddafi and the Benghazi-based rebels are not going to shake hands any time soon. The real question is how quickly will foreign oil workers return and bring back Libyan production. Even in a ceasefire, rebel terrorist action could make that process problematic. The longer Libyan production stays off line the bigger the problem for everyone who relied on that cash flow from Gaddafi and his military to the oil producers and refiners to their banks. The unrest in Bahrain reminds us that most people living in Saudi Arabia’s oil producing regions – and indeed most of its oil executives and professionals – are Shia, not Sunni like the royal family and the majority of the Kingdom’s population. Instability anywhere in the Gulf is likely to keep oil prices high, and Shia/Sunni conflicts are a risk in Iraq, Kuwait, Saudi Arabia – and a setback in Shia advancement may also be a risk to Iran’s government. Japan’s nuclear crisis suggest greater demand for oil – especially from their major provider, the Middle East – adding more risk in this key commodity. Bottom line, we do not view higher oil prices as inflationary, but rather as a tax on US and world growth, so Gulf instability is a negative – and its resolution a plus.
Two Kinds of Supply Chains
In a disaster like Japan’s, there are two types of supply chains that are vulnerable at their weakest link – physical and financial. The consequences of physical supply chain problems are already surfacing from Boeing, to GM and Toyota, to Apple as some suppliers are off line and production, both within and beyond Japan, is threatened by a lack of essential parts. It would seem that the biggest winner from Japanese production problems would be Germany (or Northern European and Italian capital goods producers generally) as they are the major competitors for a wide array of Japanese goods. The biggest loser is likely the US as the major Japanese importer and a less prominent competitor for production. This appears reflected in currency movements, where the dollar is weakening against all major currencies, while the Euro strengthens. China might also suffer from weaker Japanese demand, but they had a red hot economy that could use some cooling. Indeed, they raised their reserve requirement again Friday after their market close to fight still too high inflation. Other Asian suppliers like Australia and Indonesia might suffer as well, but again they had been riding resource price highs.
The second supply chain is financial, and here the Bank of Japan has already flooded the market with liquidity to forestall the most severe default problems. Still, as the slump in Japanese economic activity curtails income there will be defaults – that is insolvency and not illiquidity. Insurers are already girding for hefty calls on their reserves. Every lender who is exposed to Japanese borrowing is likely to become more cautious, leading to problems for those who are dependent on Japanese lending. Again, the US appears more exposed than Europe. Bottom line, it seems that Europe comes out ahead of the US on a several fronts post the earthquake and energy shocks. Indeed, one must ask whether a windfall for Northern European producers will be large enough to allow them to bail out their weaker siblings in Southern Europe?
Before the Quake
Data released on February prices in the US suggest that a vicious squeeze was underway on corporate profits and consumer incomes. Headline CPI rose 0.5% in February (actually 0.55%) after back to back 0.4% increases in December and January. Even if CPI is unchanged in March (which is highly unlikely) prices would have risen 4.5% in the first quarter compared to the fourth quarter at an annual rate. That is faster than the projected 3.0% growth rate for wage and salary income. Some have noted that credit is starting to flow again to the consumer – and it is a good thing or the higher food and energy prices over the past few months would have swamped income and produced falling real consumer activity. Meanwhile, PPI rose an even toastier 1.6% in February, after 0.7% in January and 0.8% in December. If unchanged in March, this would produce a 11.2% increase for the first quarter compared to the fourth at an annual rate – swamping the growth in CPI. Of course most of this is due to import prices – both for petroleum and other materials – and domestic food prices. While the Fed may ignore these on a trend basis, it is clear that right here, right now, headline inflation is robbing consumers of buying power and producers of profits.
Even in the core, leading indicators of price pressure are as strong today as they were in early 2008 as the recession gained steam. Import prices ex petroleum, as well as core prices for intermediate and crude producer goods are all roughly where they were in early 2008. The February gain in core service CPI was the highest since September 2008 – that is pre-Lehman! We want to be clear that we are not in the camp that believes these price increases will result in accelerating inflation – rather we see them as a tax on US income that erode real buying power and leading to a slower US economy. We still estimate real GDP in the first quarter at less than 3.0%. Moreover, inflation as measured by the GDP deflator may be well less than 1.0%. In the fourth quarter, it was surging import inflation that led the way – leaving little room for domestic inflation, which is what is measured by the GDP deflator. The same scenario is setting up for the first quarter, limiting the pass through of earlier import inflation. Still with both import and domestic prices rising – and wages not – the result over time must be weaker real demand for final goods in the US.
What about the Boom in Manufacturing?
There can be no doubt that there is a boom underway in manufacturing. Indicators like the ISM, Chicago Fed, Philadelphia Fed, and manufacturing industrial production are all running red-hot. The strength in manufacturing is one of the reasons behind the stronger price pressure in the goods sector. Indeed, from a fundamental view-point there is every reason to expect a factory boom: the rebound from depressed levels; strong monetary and fiscal stimulus (particularly directed at equipment purchases); and inventory rebuilding due to low rates, rising prices, and the death of just in time systems. What is disturbing is the lack of follow through into hiring or higher wages, which means less spending growth to stimulate the services sector. Moreover, the general weakness in income growth combined with the negative asset position in housing continues to limit the growth in credit. If this strong a rise in manufacturing cannot spark a self-sustaining expansion, is it possible to get there? Bottom line, our view remains that inflation sparked by the goods side boom in world growth will become a drag on service sector spending power in developed nations before real growth generates widespread hiring. Without income growth at the consumer level to offset inflation, the system falters and sputters into recession.
We will be watching commodities prices – especially oil – very closely to decide whether the twin crisis in Japan and the Middle East are putting pressure on or off the global inflation outlook. A cooling in inflation may buy time for the expansion outside of Japan. We are still uncertain whether that is a good thing longer run or not. We feel it would be better to discuss budget imbalances now before they swell to Greek or Japanese dimensions. A respite from bad news would produce a bounce in equities from depressed levels – but would reverse the recent good news in interest rates. We think it is possible that Europe can use growth picked up from the sidelining of their Japanese competitors to solve the PIGS debt problem. It is less likely that the decline in US long-term rates will lead to a long-term solution to our core housing problem. Bottom line, it is easier to solve a sovereign debt problem via spending cuts and tax hikes than it is to solve an oversupply of housing which requires at least no new construction and maybe outright destruction – even if demand were to pick up.