Emerging Economies May Not Save Us

As the US economy, as well as the Canadian and much of the European economies, sinks deeper into recession, many are pointing (maybe partly with great hope) that the emerging markets will bail-out the rest of the world by driving overall demand. Unfortunately, that doesn't seem to be the case with emerging markets not only showing signs of weakness, but showing signs of even more drastic declines than what the developed economies are currently experiencing.

This graph is sourced from Charles Schwab's latest webcast and presents a diffusion index of developed (lower chart) and emerging (upper chart) economic forces. Essentially, a downward sloping line is a bad thing and an upward sloping line is a good thing. What I find most interesting about these charts is the leader-follower dynamic that appears to be taking place. While most analysts and market watchers have been pointing to China and India as possible saviors of the global economy with their fabulous growth rates, it now looks as though the declines in demand from the developed economies is beginning to take its tole on their markets. Moreover, it would appears as though the declines that they are now experiencing are more severe than what the developed economies have seen. 

Inflation appears to be the culprit here. While we've seen low single-digit rates, the developing markets (the blue, in the left-hand chart) are showing near-double-digit rates. More importantly, their pace of inflationary growth (the slope of the line) is noticeably more steep. This is primarily due to wage-pressures. While the US and other developed markets have not seen wages rise, this has not been the case in the developing economies. The rest of the world is facing much greater inflationary pressures than we are at home and this spells great trouble for them in the future. 

So what does this all mean for us at home? Well, put simply, we can't rely on any other economy to help bail us out. We are in a global economy, to be sure, but that economy is by no means uniform. The rest of the world, especially the developing parts of that world, are only beginning to enter their own recessions and everything points to their troubles being worse than anything we will see domestically. On the whole, of course, this suggests a very slow and long recovery. While the developed markets may be better prepared to recover sooner, we are no dependent on emerging markets just as they are dependent on developed markets. As they are likely to sink deeper than we are, their economic pains will most certainly ripple through the rest of the world.

Depends on what you mean by 'inflation'

I was drawn to this article by its headline reporting that Warren Buffett, the billionaire investor and world's richest man, does not agree with Ben Bernanke's views on inflation and its medium to long-term impact on the U.S. economy. What I'll comment about, however, is the apparent distinction that the Fed makes between relative-price changes and what we would otherwise call inflation. Did you know that they made a distinction? I didn't!

Relative changes in prices are considered to be the result of the demand and supply forces that underly any market for a good or service. Inflation, more generally, is the resulting affect of a general change in price levels that causes our purchasing power to be reduced (assuming positive inflation, of course). What's interesting about this distinction, beyond the fact that such a distinction is even made, is that the Fed (and by the Fed, I'm really referring to Mr. Bernanke) believes that relative price changes are otherwise transitory and will not necessarily lead to inflation. The argument is one that I've written on before, simply that wages are sticky upward and that will mean subdued inflationary pressure. There is a problem with this argument though...

I do agree that wages are sticky and that will mean that inflationary pressures are somewhat tethered. That said, it would be difficult for anyone to argue that purchasing power has not been affected. Beyond the cost of fuel and the rising cost of food, consumer wealth is falling rapidly and this has a very real affect on consumption. As consumer wealth falls, they have less collateral and a generally lower willingness to spend. This, of course, must necessarily result reduced demand which will then result in slower sales, layoffs, even more bankruptcies, and ultimately even slower economic growth. So, my question, then, why does the Fed make such a distinction between relative-price changes and what we plebes call inflation if they both lead to the same thing?

Competition & Deregulation Fight Stagflation Part 2

Sometimes it seems as though there's a counter-argument for every argument; isn't it great! I just finished writing how competition and deregulation was working to prevent inflationary pressures from spiraling out of control and then I read this article that made me rethink my position, again. I still believe that competition and deregulation are in-fact working to keep those pressures under control, but I neglected to consider the effects of rising fuel prices on the extent to which that competition can take place.

There's no doubt that communications technologies enable for a great deal of competition in the services sectors, but that's going to have a lot less of an impact on the manufacturing side of the economy. Ultimately, manufacturers have too get their goods into a market before they can sell them there and the rising cost of oil has made that far more expensive. The result is that domestically produced goods are just a little more attractive and the demand for those goods, as a consequence, is just a little higher. This higher demand for domestic manufacturing empowers laborers just a little more and makes wage-hikes just that much more likely. As I've written before, rising wages is the key influential factor driving inflation.

So where do the scales balance? Good question; it's anyone's guess really. I will say that the forces of competition and deregulation are not going away, but the oil price bubble may very well disappear. What happens then?

Oil Prices: Speculative Bubble or Not?

Yes, I know, it's not exactly an original headline, but the question does still persist. I'm certainly on the side of the argument that says it is a speculative bubble, but even I have my doubts about the extent to which the latest rise is due to speculation as opposed to real demand and supply factors. No one, for example, could argue that the supply of oil is not ultimately limited and that certainly has an effect on the price of oil. There is no doubt that the price of oil has to rise as the known sources of oil slows.

On the other side of the argument, my side, you balance the falling supply of oil with the rise in alternative fuel sources such as wind power that has received a lot of attention lately. Similarly, there's more talk about hybrids and plug-in hybrids among the automakers than ever before. As the cost of these alternatives fall, consumers will demand more of them and consequently require less oil (traditional fuel), which should drive-down the price of oil. As a result, you could argue that the force of dwindling supply is being countered by the rise in the availability of alternatives. The question then becomes, of course, which force is more powerful?

Actually, would anyone really question the suggestion that alternatives such as solar, wind and nuclear eventually outweigh the demand for oil? The cost of drilling and refining oil is only going to rise as the world's oil companies must search for less available reserves off-shore or in oil sands like those in Canada. By comparison, the improving technologies are only going to help drive-down the cost of the alternatives. The result almost certainly has to be that the demand for oil falls as the demand for the alternatives rises. The real question then becomes, of course, what is the timeline. Unfortunately, I don't have an answer for that, but I will say that I don't believe the current price of oil is sustainable and that a bet against oil will undoubtedly pay off in the long-term. I'm just not sure of my definition of 'long'.

Competition & Deregulation Fight Stagflation

I just finished reading an interesting article that has caused me to rethink my position on the state of the economy and where it may be going. I've written before on how the current slowdown resembles what we saw in the '70s and earl '80s, but after reading this article, I'm reconsidering the affects that global competition may have on the ability of the U.S. economy to ever see the sort of rocketing inflation that we say a few decades ago.

It comes down to wages. If wages don't begin to rise (accelerate, actually), then inflation will remain relatively under control. This is an important fact to remember when you consider that a global economy means that nearly every sector, industry and individual business competes with international vendors willing to cut prices and snatch-away customers. The article uses the airline industry as an example, but the same logic could be extended to almost any market. Whereas airline ticket prices rose by more than one-third in the early '80s, they've seen less than a 2% rise even with the unprecedented rise in the cost of fuel. The reason? Competition and deregulation.

There are more airlines, even with all the trouble in the sector, than ever before. Travelers have more choice than ever before. The result is that airlines are left sitting between a rock and a hard place. With the rising cost of inputs to their operations, the decision is no longer whether or not to raise prices, but rather whether or not to continue operations at all. They are no longer able to raise prices because their competition won't. One of any competitor airlines that had been fortunate enough to hedge the cost of fuel earlier will have a cost advantage and will simply assume all customers should its competitors increase their prices. In economic terms, it suggests an inelastic short-term supply curve. What's interesting about this argument is that nowhere have I mentioned wages, which is traditionally considered to be the primary driver of inflationary pressure.

There's competition for jobs too. Just like there are more airlines fighting over travelers, there are more people fighting over jobs. Workers are less able than ever before to request a wage increase. There are fewer labour unions and those that do still exist are less powerful. Moreover, the ability to outsource leaves employers not with the decision to increase wages or lose employees, but rather whether or not to keep employees or outsource operations oversees where costs could be a fraction of what they are locally. The consequence of all this is that rapidly rising inflation may really be a historical artifact.

We've Only Seen One-Third of Writedowns?

According to John Paulson, founder of the hedge fund company Paulson & Co., global writedowns stemming from the credit crisis may top $1.3 trillion, surpassing the International Monetary Fund's estimate of $945 billion. Who is Paulson, you ask? He's the guy who placed a bet on the speculative bubble in the sub-prime lending market, which has netted his fund a gain of a whopping 591% in the past year. This is the guy who saw the storm coming so you could say that he's got a fairly good insight into the breadth and depth of the sub-prime market.

$1.3 trillion in writedowns is three-times higher than the writedowns already reported. That's both a staggering total figure and worrying prediction for what the future holds for the global economy and financial markets. The U.S. economy has certainly taken the brunt of the immediate downturn, but as economic speculators are working diligently to maintain a positive attitude in the business press, the reality is that the downturn we've seen thus far is only the tip of the proverbial iceberg.

In a survey of hedge fund managers conducted at a meeting in Monaco last week, more than 80% said that the see the current credit crisis persisting for some time yet so Mr. Paulson is certainly in good company. Moreover, as much as 23% of those surveyed see the current situation worsening further before it gets better. What's interesting, is that it appears that these same hedge fund managers are watching the financial stocks like vultures circling; they waiting for the best time to buy the stocks that have been beaten-down by as much as half. If you're anything like me, then you will be watching the actions of these firms to insights into when, exactly, will be the right time to jump back into the banking waters where the opportunity appears to be astronomical.

If it's not one thing, it's inflation

I wouldn't exactly call it breaking news, but it was good to see consensus among the G8 that inflationary pressures were now the biggest threat to economic growth worldwide. The credit crisis certainly has worked to send many of the largest economies into a tailspin, the US most notably, but the persisting pressure of higher oil and commodity prices threatens to keep these same economies from any sort of near-future recovery.

Oil hit $139.12 per barrel on June 6, 2008; an all-time high. Commodity prices, like wheat, for example, have seen prices double in the past year. On a personal note, I can confirm that I've seen the price of whole wheat flour literally double in a matter of weeks at my local supermarket. While commodity prices represent a relatively small proportion of household spending (food, in general, may only see single digit-increases), the combination of these rising prices with declining home equity and accelerating unemployment figures paints a very black picture for the future.

It's a positive thing to note the G8's consensus, but worrying still is what actions will result from that consensus. To slow inflation, central banks will begin to raise interest rates. While many would tend to agree that this is long-overdue, the current state of the world economy as generally weak and slowing, will likely mean that in doing so, the higher cost of capital will only affirm the recessionary tendencies and result in a very, very slow recovery.

Inflation, excluding the inflation.

No one will be surprised by the fact that I, along with tens of millions of others, believe that inflation is being underreported by the government; I've written on it countless times in this blog alone, and if we've ever talked economics, then I'm sure the subject came-up. It's probably why this article really caught my attention and I'd recommend it to all of you who would like to know more on the subject.

The long and short of it is a comparison of the US economy with that of a couple dozen other countries - including many of America's trading partners. What's surprising is that US inflation rates have been a relatively consistent 3% to 4% lower than that represented by this benchmark group. Of course, economists would argue that this differential can be explained away as a result of greater productivity in the US, but do we actually believe that the US economy is more productive than India or China, for example? 

Many of you know that there are two commonly-quoted inflation rates: the headline rate and the core rate, or what the author of this reference article calls the inflation, excluding inflation. Guess which one is the official rate? What you quickly notice after glancing at a graph such as the one below is that the difference between the official 'core' rate and the more realistic headline rate is growing - the greater the separation between the two, the more unrealistic are the figures being reported by the government, and more importantly for us investors, the less reliable are the valuations used to compute a stock or bond price!

Anyone who's taken a class in finance understands the importance of the inflation rate in the calculation of the price of any asset; it's absolutely critical as a starting-point including the risk-free rate to determine a real rate of return on investment. Without an accurate measure of inflation, we have no real idea of what our real return is - i.e. what the purchasing power is of our investment upon maturity.

The thing that I like most about this article is that the author doesn't present any of this as a conspiracy theory, but rather as an alarming warning to investors - cautioning us all about keeping this discrepancy in the back of our minds when making our valuation calculations and investment decisions. Now go... read it.

Back to the Future: Stagflation

The economy growing had been growing at 5%+ prior to the continuing rise in commodity prices; the country is engaged in a wildly unpopular war, which helps to worsen the growing budget deficit and ever-expanding foreign borrowing; the Middle East is in turmoil; the American dollar is in a free-fall with no bottom in sight due to a lax monetary policy; commodity prices are surging - oil having quintupled in the past half-decade alone. That's right, it's the early 1970s all over again!

The similarities between the current state of the economy and that of three-decades ago are eerie indeed; Dick Cheney is even in the white house - just as he was then under President Ford as his chief of staff and, as then, is often blamed for America's pursuit of so-called stability in the Middle East to help assure the flow of oil. Of course, with no oil actually emerging from Iraq, that's a whole other story. Thirty years ago we were in a very similar situation - it was called stagflation: slowing growth, rising unemployment and inflation. We recovered then at significant cost, which led to slow growth, high interest rates and high inflation for the better part of the following fifteen years. The question now is how will we get out of the current state of economic woes?

Fortunately, there is a growing consensus about what the solution is to get the global economy out of its current doldrums: technological advancement. Although it is an admittedly simplistic analogy, imagine if the cost of the war in Iraq had instead been invested in sustainable technologies - whether in food, energy, water or even climate change. 

Assuring the flow of energy to America need not be as expensive as it has been. The cost of the war in Iraq is estimated at nearly one-half trillion dollars; yes, trillion! The cost of a nuclear power plant is less than $10 billion per reactor - not even counting the fact that the investment wouldn't be flowing across the border and would instead create jobs both during the construction and the following operation and maintenance. Of course this is just one example, but you get the idea.

The sheer numbers involved open the doors to tremendous opportunities for technological advancement. America is currently spending on its war in Iraq the sorts of dollar sums that could quite literally solve problems and answer questions that have caused impediments to scientific progress or, at least, slowed its progress. Science and technology can improve yields per acre - resolving any concern over food shortages. Science and technology can clean not only the drinking water, but also clean-up our lakes and rivers and prevent future pollution. Imagine how much better the world would be, let alone America. Imagine further how admired America would be as a leader in technological advancement.

Of course it's an Oil Price Bubble!

It's almost funny how the discussion over whether oil prices are spurred by speculation or market demand forces; of course it's a speculative bubble. Those arguing against this view are quick to point to China's growing economy and similar demands from India; there's no doubt that that is the case, but it's ridiculous to think that anything changed so drastically in either of those markets within the past year to justify the rising prices we see around the world.

Need some proof, no problem. How about the total notional value of over-the-counter commodities derivatives that have risen from $1.02 trillion in 2004 to a value of approximately $8.4 trillion by the end of 2007. Yes, there no doubt that some fundamental demand must be credited for part of this rise, but numbers are simply so staggering that suggesting a speculative bubble is not the primary culprit is simply irresponsible. So, assuming that it is a speculative bubble, why is that important? Good question!

The prices are now so high that they are actually affecting demand - rather than vice versa. Drivers are driving less; airlines are cutting flights and jobs as well as authorizing new fees for customers to cover the cost of rising fuel prices. Similarly, other commodities are rising (most notably wheat prices, which have doubled in the past few months) under pressure from increased transportation costs. All these rising costs mean one thing: a slowing economy. Given that many, including the likes of Mr. Warren Buffett, have publicly stated that we are already in a recession, this does not paint a rosy picture for our economic near-future.

Yes, inflation is also a big deal. With all these rising pressures the concerns over inflation have been rising as well. The only thing that has kept those inflation rates from jumping along with commodity prices has been the Fed's ability to retain the trust of its citizenry who appear to continue to believe it has things under control; this belief has led to stable wage prices. Basically, people don't believe that it's in their interest to demand higher wages because of the rising unemployment rates. That said, this won't last. As prices continue to rise, people will eventually have to demand more money in order to pay for that expensive gasoline and bread and, when they do, the Fed will lose control. Fed Chairman Ben Bernanke has received a lot of kudos for his efforts thus far, but if inflation isn't brought under control many believe that he will be faced with an economy similar to that faced by his predecessor Volker.

When inflation grew to double-digit-levels in the late 70s and early 80s, Fed Chairman Volker was forced to move interest rates even higher; this, of course, led to one of the deepest recessions since the great depression. Many now believe that we may be heading into a similar situation if the Fed doesn't begin to raise rates sooner rather than later. The Fed is enjoying low inflation expectations, but those expectations are beginning to show signs of upward movement and the Fed really does need to take this seriously. 

Trusting the markets to manage themselves is wise, in theory, but the market won't keep itself out of a recession. The business cycle is a natural phenomenon and the only way to flatten that cycle is via fiscal and monetary policy. If the Fed doesn't do its job, the speculative bubble will lead to one of the worst economic slowdowns ever. Ask anyone who was invested in the markets during the bubble-burst of 2000 and you're likely to hear about their lessons learned. Well, this is another bubble; it's time to apply those lessons-learned and react proactively rather than reactively.

Is the CPI a scam?

The latest consumer price index figures were released yesterday and they showed a less-than-expected rise in the prices the average consumer pays for goods ranging from food to medical expenses. Of course, with the news dominated by the high cost of fuel and food prices continuing to rise, it's difficult to believe that inflation is not still higher than what is being reported. Consequently, I'm not surprised when asked how the CPI could possibly be an accurate reflection of the changes in the prices we really pay.

The reality is that it's probably not too far off from the truth. Sure, there are likely to be some estimation errors that come from the fact that not every single product can be monitored, but - on the whole - the Department of Labour is most likely reporting the figures it actually does record from in the marketplace. So, then, what is the discrepancy? Why is it that it seems as though our prices are rising faster than what our government is telling us?

The answer, unfortunately, is unlikely to satisfy many who are pondering the question. For one, the media isn't helping matters. The fact that we hear so much about commodity prices and the cost of oil on the rise and hitting record levels tends to overwhelm the public consciousness as it relates to prices. 

Furthermore, it's important to remember what the CPI actually represents: the average price paid for a specified bundle of goods by the average consumer in America. Now, ask yourself: are you average? To answer the question, consider the goods that you buy; are they representative of what the average person buys on a regular basis?

Although unsatisfying, the reality is that the CPI does probably represent a relatively accurate estimate of how prices change for the average consumer. Maybe what we should all be complaining about is the fact that there is no price index for the middle class, middle-upper class and so-on. All our concerns over gasoline prices are warranted, but does the average consumer drive an SUV or take the bus? While the 100% rise in the price of rice is undoubtedly troubling for developing nations, the extra $5 a month for the American household is, in all likelihood, going to go unnoticed as a change in the bank account balance.

The Real Price of Oil - Forbes.com Interactive Chart

There is, no doubt, a lot of talk about oil prices these days. Maybe more surprisingly, however, is the sometimes devil's advocate-like position that some take when discussing today's real price of oil relative to that of a decade or more ago. Similarly, in comparing the oil prices faced by American today with those faced by citizens of most European countries, some critics argue that we shouldn't by arguing at all. Well, for those of you still reading, you should check-out this link to a chart prepared by Forbes.com

The fight over the difference between nominal and real prices will continue to undercut some arguments when it comes to the CPI, but given the chart prepared by Forbes, it's difficult to see anything but a staggering rise in the real (i.e true) cost we face at the pump. In the last ten years alone we have seen almost a 10-fold increase in the price of oil and a similar rise in the prices of gasoline. That's a ten-times increase; put differently, 1,000 percent. 'nough said.

Never mind a cut to 2%, how about a hike to 2.50%

On Wednesday this week, the Federal Reserve, headed by Ben Bernanke, will meet to decide the fate of interest rates for the next six weeks. The rate currently sits at 2.25% - 3% lower than it was just nine-months ago. Mr. Bernanke and the Fed have been very aggressive with their cuts to help keep the economy out of a recession. Today, however, with most people agreeing that the economy is already in a recession, what should the Fed do next? More importantly, with inflation concerns higher than ever, a further attempt by the Fed to keep this recession as mild as possible could come at an incredible cost a year from now.

The rising cost of fuel and, more recently, commodity prices have made living expenses rise for the average consumer. The Fed hasn't helped either. The lower interest rates have caused the American dollar to sink against the Euro and other currencies - as much as 7%! This too has caused import prices more expensive and driven-up costs for consumers. All these rising prices mean one thing: inflationary pressures.

Today's economy is being compared to that of the late 70s and early 80s more than ever. A lot of people are beginning to foresee high inflation. The only thing that has helped the Fed, and the economy, is the general believe by the American people that the Fed is doing (and will continue to do) all that it can to keep inflation under control. This belief may quickly vanish, however, if the Fed doesn't begin to deliver on those expectations. Why care?

If inflation does start to creep-up like a lot of people believe that it will, then it will need to eventually be brought under control by the Federal Reserve. In the 80s, Paul Volcker, then Fed Chairman, pushed interest rates up to the high-teens in order to bring inflation back from its double-digit levels. This, of course, sent the economy into a VERY deep recession. If Mr. Bernanke isn't careful, his successor will need to do the same thing because he'll certainly be out of a job.

As speculation mounts over whether the Fed's meeting will result in a quarter percentage point cut to 2% or stay-the-course at 2.25%, maybe the Fed should rather be considering a quarter-point hike!

Inflation and the Interest Rate, what's the deal?

So some of you have asked about the connection between interest rates and the rate of inflation. Why do the two always appear in the same sentence? Why do we care; what does it mean?

First, you have to understand that there are many definitions of the interest rate. What most people really mean whey the talk about the interest rate is the nominal rate. The nominal rate is actually the combination, itself, of a few things. Without getting too complicated, it's comprised of:

1. The real interest rate, and
2. The inflation rate

Ignoring other stuff, the nominal rate = the real rate + the inflation rate. Beginning to see the picture? No? That because you need to understand why you really care about the real interest rate, not the nominal rate.

The real interest rate is the return on your investment (or savings) that you expect to receive as compensation for letting others (banks, and borrowers from banks) use that money. Unfortunately, no one pays you real interest - they pay you nominal interest. The reason is that no one actually know the rate of inflation at a give point in time - only in hindsight and even then not all that accurately.

Let's say that the bank pays you 5% on your savings or investment(s) for one-year. Ignoring compounding for the time being, you expect to get $105 back a year later for an investment of $100. What if you find out a year later, however, that inflation over that period was 4% (like it is today!). An inflation rate of 4% means that it roughly costs you 4% more to buy the things you normally buy (your mortgage or rent, food, gasoline, etc.). So a year later you're only better off by 1%, right? ...actually, wrong!

We forgot about taxes. Yup, taxes.

It would be great if we got taxed on only the 1% that we're really getting a year later, but the government taxes us on the whole 5% (the nominal rate). To keep things simple, let's say that we get taxed at a marginal rate of 50%. Well, that would mean that our 5% has been reduced to 2.5%. So, now if we subtract the inflation rate (the rise in the cost of living), then we're really left with -1.5%. Yes, that's a negative sign ...sorry, it's not a typo.

So, now that we're clearer on what all the fuss is about, I hope that those boring discussions about interest rates and inflation will mean more to you... it should. Really.