RISKY
BUSINESS Lead lining around US
data By Jephraim P Gundzik
As a means to justify the dizzying rally
of US equity markets, economists and investors
have pinned their hopes on an economic rebound in
the second half of 2007. Such a rebound is
exceedingly unlikely. Though mystical core
inflation appears tame, broader price measures
indicate that inflation is accelerating. In
addition to undercutting real gross domestic
product (GDP) growth, accelerating inflation will
sap already weakening private consumption
expenditures, leading the
economy into recession in the
months ahead and prompt a very sharp correction in
overvalued equity markets.
Economists and
investors are ignoring obvious signs that America
has already entered a prolonged period of economic
weakness. First-quarter real gross domestic
product growth was revised sharply lower last week
to a paltry 0.6% growth from the fourth quarter of
2006. Leading this weakness was further sharp
contraction of investment. In particular, the
collapse of residential investment, the product of
ongoing correction in the US housing market,
continued unabated.
The only seemingly
bright spot in the GDP data was the upward
revision of real personal consumption expenditure
growth, which galloped ahead at a stunning rate of
4.4%. Market players quickly assumed that
unusually strong private consumption growth would
continue throughout the remainder of 2007, forming
the foundation of a formidable economic rebound.
This assumption completely disregards the
increasingly strong headwinds America’s insatiable
consumers are facing. Over the last several years,
surging home prices underpinned strong private
consumption growth by rapidly increasing home
equity. Homeowners became equity drunk, regularly
tapping their growing home equity via mortgage
refinancing. This party was so good that America’s
equity drunks refused to leave, though home prices
began to fall in late 2006 - a decline that has
accelerated in 2007.
Rising interest
rates, surging mortgage defaults and much tighter
credit control among lenders strongly suggest that
the US housing market will continue to weaken,
driving home prices and home equity lower in the
months ahead. In addition to contracting home
equity, accelerating inflation is also quickly
thinning the wallets of American consumers.
Like starry-eyed lovers, market players
have embraced core inflation as the definitive
indicator of price trends in America. While core
inflation may have once been useful for shaping
interest rate policy at the Federal Reserve, its
utility has been greatly undermined by the
continual advance of energy prices over the last
several years. More recently, accelerating energy
price inflation has begun to pull food price
inflation higher, further diminishing the
usefulness of core inflation as an overall
indicator of price trends.
The growing
economic irrelevance of core inflation was
demonstrated in last week’s GDP data. Economists
and investors were elated that core personal
consumption expenditure (PCE) inflation only
ticked slightly higher to 2.2%. At the same time,
however, the GDP deflator soared to 4%, its
highest level since 1991. Unlike core inflation,
the broad GDP deflator has a real world
application. It is used to “deflate” nominal GDP
growth into real or inflation-adjusted terms.
Though core inflation in the US, which
strips out energy and food price changes, may
remain relatively stable over the next several
months, broad inflation measures, such as the GDP
deflator, will surpass 5%. This acceleration of
inflation will lead to contracting real GDP
growth, which is another name for economic
recession.
Continued advances of energy
and food prices will pull the GDP deflator higher.
In addition to exceedingly low gasoline stockpiles
in the US and continued very strong energy demand
growth, increasing instability in the Middle East
and Africa are likely to push crude oil prices
higher over the next several months. Crude oil
prices could top $100 per barrel if the North
American hurricane season is as active as
currently forecast.
Rising
petroleum-related energy prices are driving, and
will continue to drive, food prices much higher.
Rising energy prices have created soaring biofuel
demand, which reduces the availability and
increases the price of grains and oilseeds. Higher
grain and oilseed prices are forcing meat and milk
prices upward, a phenomenon that will continue for
many months to come.
Stable core inflation
also belies higher prices suggested by the steady
rise of inflation expectations among Americans. In
the past two months, yields on Treasury Bonds and
Notes have moved sharply higher, with 10-year
yields near 5%. The primary factor behind rising
bond yields is the expectation that inflation will
increase in the future. Indicators of consumer
confidence bear out this increase of inflation
expectations.
The University of Michigan’s
Consumer Sentiment for May showed that Americans
expect inflation to increase to 3.3%. The
Conference Board’s Consumer Confidence Index for
May showed Americans expect inflation to reach
5.5% in 2007, up from 5.1% in the April survey.
Further evidence of rapidly rising inflation can
be seen in recent surveys of manufacturing and
service sector activity in the US by the Institute
for Supply Management, which showed prices paid in
both sectors rising rapidly.
During the
second half of 2007, American consumers will be
greatly challenged by rising inflation and
interest rates and the continued decline of home
equity. These factors will produce significant
retrenchment of personal consumption expenditure,
which will trigger a chain reaction of contracting
investment, weakening output and rising
unemployment.
Few can read the economic
writing on the wall in America and its negative
implications for US equity markets. Rather than
engage in home-grown soul searching, America’s
most prominent financial market commentators,
including former Fed Chairman Alan Greenspan, are
oddly more concerned about China’s so-called
equity market bubble.
China’s equity
markets have had a spectacular run over the past
18 months. However, such a bull market is not
unusual for a developing country where economic
growth is in the neighborhood of 10% annually.
Such rapid economic growth produces equally rapid
profit growth and equity market capitalization
growth, which translates into higher equity
prices.
Alan Greenspan’s fret about
China’s stock market is more applicable to US
equity markets, which continue to advance despite
ever weakening economic fundamentals. Overheated
US equity markets are likely to face a very sharp
reversal in the second half of 2007 as economic
reality bites investors hard.
Jephraim P Gundzik, president,
Condor Advisers Inc.
(Copyright 2007
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