December 2004

The Containment Area

Wishing Wells...As you know, according to the Fed, inflationary pressures remain “well contained”.  According to many a Street strategist and many of the favored blue chip economists, domestic inflationary pressures remain “well contained”.  Unfortunately, if you dig behind the headlines of a number of economic stats of the moment, inflationary pressures don’t appear to remain well contained at all.  In fact, one of the rationales China gave for raising rates a few weeks back is that inflationary pressures are rising in the country.  It's clearly evident.  Of course, that’s just their problem, right?

We want to explore some current data regarding inflationary pressures.  Clearly the potential for shifting inflationary expectations over time has direct implications for fixed income investments moving forward.  Implications for the general level of interest rates within the context of a highly levered economy.  Early next year, we plan on devoting at least an entire subscriber discussion to investment themes we believe will be important as we move into 2005.  As you'd expect, this will involve discussion regarding the dollar, the rate of change in profit growth and profit margins, etc.  But what we believe will clearly be one of the important themes as we move into the new year will be the juxtaposition between currently quiescent inflation perceptions or expectations, as fostered and encouraged by such luminaries as the Fed members, and the ultimate reality of the numbers that are to unfold.  In the following set of charts and commentary, we want to explore a bit deeper the actual numbers that are now available in the public domain relating to the current reality of what we consider to be heightened inflationary pressures.  We know folks like Bill Gross are yakking about hedonic adjustments.  In fact, as you probably know, Kurt Richebacher brought the subject of hedonic adjustments in CPI data to light a half decade back.  Is it a real and important issue?  You bet it is.  But it's not new news.  Although the mainstream largely chooses to ignore the issue of hedonic price adjustments and manipulation, it's not an undiscovered phenomenon by any means.  OK, fine.  Rather than ranting about the anti-inflationary illusion borne of hedonic adjustments in the public inflation data, we'll simply use the actually reported data itself in looking for the birthplace and breeding ground of real economy inflationary pressures.  Because as the facts now stand, hedonic adjustments or not, the drumbeats of heightened inflationary pressures are rumbling.  Can you hear them?

The Containment Area...We'll try to move through the graphs and commentary quickly.  We believe that what you see below is quite suggestive of inflationary pressures building as we speak.  Quite simply, we only need to look just below the headlines to find them.  In terms of the financial markets, what is most important to us is the real potential for shifting perceptions and changing expectations regarding inflation as we move into the new year.  For as you know, these are the swing factors that can and do influence financial asset prices in a meaningful manner over time.  Let's get right to the anecdotes of building inflationary pressures as we see them.

     PPI Intermediate Materials Index

As you most likely remember, the unexpected and well above consensus 1.7% PPI headline number recently reported for October, which of course annualizes at 20.4%, was simply dismissed as being totally related to food and energy.  Mere bothers more than anything else, right?  Although we have not brought up the subject for many a moon, we always check in on the PPI intermediate materials subcomponent of the report.  It gives us a good feel for what domestic businesses are experiencing in terms of real input cost pressures.  The types of pressures that China is apparently directly experiencing at the moment.  The year over year rate of change in PPI intermediate materials came in at 9%.  It’s the largest year over year growth rate number since 1981!!!
         

Maybe more importantly, we believe it is quite illuminating to compare the year over year rate of change in PPI intermediate materials prices with the year over year rate of change in finished goods pricing.  In essence, this directly gives us a feeling for margin pressures at the corporate level.  The rise in input costs versus the rise in finished goods pricing ability.  Below is the year over year rate of change differential between intermediate materials and finished goods prices.  As you can see, this ratio currently rests at a quarter century+ high.  As you can also see, these peak experiences directly preceded every recession of the last two and one half decades, with the exception of the 1994/1995 experience (the real acceleration period in the current credit cycle).
        

If this isn't direct inflationary pressure resulting in forward profit margin maintenance questions at the corporate level, then what is it?  Of course one saving grace for domestic corporations currently is that the growth in labor costs remains very low.  That’s a help to offset what you see above.

Crazily enough, even the sacred “core rate” of PPI change rose 7.8% year over year in October – the greatest annual increase since 1995.  The consensus apparently blew off the very inflationary implications of this report due solely to the recent retreat in crude prices.  Unfortunately, from a much longer term standpoint, the recent back off in crude might someday look like a blip on the chart.  Even the CPI report of a few weeks back showed us that the gap has now widened further between the year over year rate of change in headline CPI inflation relative to the year over year rate of change in domestic US wage growth.  In essence, real wage growth just sunk deeper into negative territory, but of course that's only for those workers who actually consume food or use some type of energy resource.  No worries, right?

     Philly Fed Future Prices Received

As you know, each month we are treated to the Philly Fed Index.  Basically it's a read on business conditions in the greater Philly area as provided to us by our friends at the Philly Fed.  One component of the survey is what businesses believe will be their ability to receive higher prices for their products in future periods.  From our standpoint, it's important because it says something about expectations.  Point blank, the current respondents to this survey expect to receive higher prices ahead.  As of November, the Philly Fed future prices received component of the report rests at a 15 year high not seen since 1989.  Perhaps this is a reflection of blind optimism on the part of business executives.  Or perhaps not.  As we mentioned above, the current spread between the annual rate of change in PPI intermediate materials prices and PPI finished goods prices is as wide as anything seen over the last few decades.  Cutting right to the bottom line, these PPI price relationships suggest profit margins are being squeezed.  From the standpoint of simplistic common sense, a natural response on the part of businesses would be to raise prices of final goods.  Is this why the following chart looks like it does?  Are survey respondents really expecting higher prices for their products out of a current margin squeeze necessity?  Sounds pretty darn logical to us.

As you can see below, this data goes back three and one half decades.  Expectations regarding future prices received trended up from 1968 to 1980, interrupted temporarily only by the mid-1970's recession.  These expectations of higher future prices followed real world inflationary increases like clockwork.  But from 1980 until close to 2000, this price expectations survey dropped in cyclical fashion along the longer term two decade secular trend.  It matches up literally perfectly with the 1970's real cycle of inflation and the 1980 to end of century disinflation period.  Lastly, as is crystal clear, this index has again trended up in meaningful fashion over the last few years.  Are the Philly Fed respondents telegraphing us a message of higher prices (higher nominal prices and inflationary pressures) ahead?  It sure as heck looks that way.  As you know, this is response from the front lines of business experience as opposed to some assumption from either a Fed member or Wall Street "blue chip" economist, both of which do not sit on the front lines the last time we checked.
        

     The Relationship Between Nominal GDP And Interest Rates

As you know, one of the ongoing questions when assessing Fed monetary policy at any point in time is whether these folks are "behind the curve" or "ahead of the curve" in terms of monitoring and forestalling inflationary pressure.  Have interest rates been kept too low in a rising inflationary environment, in essence a circumstance in which the Fed is "behind the inflation curve"?  Or is the Fed too far out in front of inflationary trends by having raised interest rates too much in any cycle, choking off economic expansion perhaps prematurely?  Clearly, these questions can always find absolutely perfect and correct answers in hindsight.  But the financial markets deal in foresight and anticipation.  Hence, we need to look at historical precedent in an attempt to try to anticipate a number of scenarios which might unfold ahead vis-à-vis coincident inflationary pressures and Fed policy at any point in time.

Let's start with the simple relationship between changes in nominal GDP and interest rates.  Historically, there has been a decent directional correlation between annual changes in nominal GDP and interest rates.  In this case, we're using the 10 year Treasury yield as a proxy for interest rates in general.  As you can see, from 1968 through 1980, the annual rate of change in GDP was quite strong, pushing well into double digit territory by the late 1970's.  Was this simply bang up economic growth?  Or was it more of a reflection of significantly rising inflation that was translating directly into rising nominal prices, creating the illusion of real growth?  Again, in hindsight, it's pretty easy to see that it was the latter.  Inflation was influencing inventory values, etc.  So despite fantastic nominal GDP growth, the equity markets pretty much went nowhere point to point during this period because they knew that the nominal growth was illusory in terms of the ultimate translation into real growth.  It was being driven by inflation.  Simultaneously, the Fed was behind the curve, so to speak, in the 1970's.  They were always trying to catch up to almost continually rising prices in terms of setting monetary policy.  It is clear that the year over year change in nominal GDP from 1968 to 1980 outstripped the 10 year Treasury yield by a mile.  The breeding ground for rising inflationary pressures.
          

Alternatively, from 1980 until the late 1990's, the year over year change in nominal GDP almost mirrored the ten year Treasury yield.  Let's face it, in the early part of that period, the Fed was an avowed inflation fighter.  Then Fed head Paul Volcker administered interest rate shock therapy to an economy where rising inflation expectations had become the rule, not the exception.  Bold central banking policy of Volcker ushered in nearly two decades of disinflationary trends in the US economy.  As you can see, despite the disparate percentage increase markers on each side of the graph above, it has really been in the last two to three years that the year over year change in nominal GDP has once again moved out well ahead of 10 year Treasury yields.  It's suggestive of a Fed behind the proverbial inflationary pressure curve.

To try to graphically simplify this a bit, the following chart is literally the difference between the 10 year Treasury yield and the year over year rate of change in nominal GDP.  For us, in simple form this is a gauge of whether the Fed is ahead of the curve, so to speak, or behind it.  Negative territory tells us that the nominal level of interest rates is not keeping pace with nominal changes in GDP.  Nominal changes in GDP, of course, at least in part being influenced by general inflationary pressures.  Over the last few years, we're seeing an occurrence that is not wildly unlike the experience of the early 1970's.
       

Does what you see above absolutely guarantee that inflation is about to make a dramatic and sudden appearance in the current environment?  What the current set of relationships suggest to us is that we've entered the breeding ground for potentially meaningfully rising inflationary pressures over time.  As was the case in the late 1960's and early 1970's.  We believe that the longer this relationship remains in negative territory, the better the chance that rising inflationary pressures will express themselves in the headlines.  As we mentioned, we continue to see characterizations of domestic inflation as "contained".  From the Fed to the Street guru's, this has become the mantra.  But what is really most important looking ahead is whether this is truly consensus thinking.  Looking at the general level of current interest rates, we have to believe it's very close to consensus thought that has been impounded in current prices.  If this perception of contained inflation is questioned ahead for any reason, we can't see how that would be a good thing for interest rate markets and fixed income prices, to say nothing of the spill over influence of higher interest rates on the real economy.

     Measures Of CPI

As we mentioned, let's forget the influence of hedonic adjustments for a moment.  Let's just have a look at actually reported CPI data in the current environment.  Moreover, let's even briefly push aside the headline measure of CPI and have a look at the sacred and almighty "core" CPI reading.  What you see below is the relationship between the year over year change in core CPI and the coincident period Fed Funds rate.  It's clear that there have only been two periods in the last 15 years at least were these two measures have met up in percentage terms, so to speak.  Late 1992 through 1993 and the period from late 2001 until the present.  As you already know, both of these periods can be characterized as being instances of extreme and extraordinary monetary accommodation.  From 1994 through late 2001, the Fed Funds rate was on average 250-300+ basis points higher than the year over year change in the "core" CPI rate.  This is exactly where this spread went post the 1993 bank bailout accommodation period.  Are we about to see the current Fed Funds rate leap 250-300+ basis points ahead of an already rising core CPI rate ahead?  We'd be talking about a 5-6.5% Fed Funds rate if that is to be the case.  We have a very hard time seeing just how that can happen in the current environment without a meaningful financial blow up or two (or more) along the way.  As you know, the total US economy is much more levered to a change in interest rates today than was the case in 1993.

Once again, this is a picture which can give us a sense of whether the Fed is ahead of or behind the curve in terms of addressing forward inflationary pressures in the system.  As with the characterization of the relationship between interest rates and nominal GDP growth above, the picture below shows us the breeding ground for forward inflationary pressures.  Plain and simple.  Unless the world is about to come to an end, it sure looks like the Fed is behind the curve to us.
       

As you can see above, the last time the year over year core rate of CPI change was where it stands today, the Fed Funds rate was over 5%.  As a quick definition, the core CPI measure we used above is simply headline CPI devoid of the influence of food and energy prices.  After all, everybody and their brother knows that any inflationary pressures relating to energy are temporary, right?  After all, part time petro geologist Greenspan has assured us this is to be the case.  But incredibly enough, as we take the reported CPI numbers apart a bit, we actually see that while headline CPI pressures have been building over the last quarter, the rate of change in rising food and energy prices has been subsiding.  Meaning?  Prices exclusive of food and energy have been rising, no question about it.  And despite the hedonic adjusting, it's showing up in the numbers.  Just have a look.
         

The rate of change of the rate of change in headline CPI has been rising over the past three months while the rate of change of the rate of change in food/beverage and energy prices have been falling.  So what's been rising?  We're glad you asked.  Transportation, Education, Medical care, recreation and "other" goods and services pricing, that's what.  Do you think we can adjust the core CPI reading to eliminate these as non-essential or too volatile, as is the case with the elimination of food and energy?

One last chart we believe is helpful in the current environment.  A quick explanation for what is otherwise a "noisy" chart.  What you see below is the difference between the annual rate of change in headline CPI and CPI less energy.  In other words, we are isolating the impact of rising energy prices on the headline CPI.  Simple enough?  Overlaid on top is the Fed Funds rate.
       

If you'll indulge us for a minute, a few observations.  Historically, the Fed has responded to rising energy prices that can and do influence the general level of inflationary pressures over time.  As you can see above, the most significant instances of this phenomenon were seen in the mid-1970's and early 1980's.  Clearly crude prices were advancing handsomely in both of these periods.  Even during 1999 and into early 2000, the Fed was raising the Funds rate as the absolute dollar price of crude nearly doubled.  We've shaded this periods in blue in the chart above for clear visibility.  We believe that based on the historical data above, in the past the Fed has acknowledged and responded to meaningful increases in the price of energy commodities over short periods of time.  This is exactly the message of history.  Why then is the current energy pricing environment only "temporary", according to Greenspan?  Why the lack of meaningful current monetary response relative to what has happened over the last half century when the influence of rising energy prices on the CPI is as meaningful now as that which we have experienced in prior cycles?  Although the Fed currently offers no public answer for this obvious change in current attitude toward rising energy prices, we believe the answer is simple.  The Fed simply does not have the flexibility at present to put forth a monetary response to meaningfully higher energy prices as it has in the past.  The extremely levered nature of the US economy precludes such a response as would be consistent with historical precedent.  Is there any other answer you can think of?  We believe the Fed has two clear choices.  Accelerate monetary tightening to head off burgeoning inflationary pressures and risk a debt related negative total economy response to rising rates, or keep short term interest rates in negative territory and jawbone about "contained" inflationary pressures.  Oh yes, the second choice also involves a certain amount of praying.  

Placing Your Wagers...One of the most powerful drivers of the general level of inflation over time has been wage inflation.  We saw this in a big way during the 1970's when mid-to-high single digit annual wage increases were more the norm than not.  As you may remember, the year over year change in service sector wages right now is running at 2.6%.  (The bulk of the jobs created over the past 15 months have been service sector jobs.)  In other words, at the moment, the year over year change in service sector wages is negative (below the year over year change in the CPI).  But, as you can see below, periods of negative annual wage gains were more than present in the 1970's.  In fact, they virtually characterized the period.  Yes, wage growth is a big driver of inflationary pressures.  But we suggest that sustained negative wage growth is a sign that inflationary pressures are building and may be much greater than is anticipated by the public.  Especially wage paying members of the public who actually have employees.  Is the current experience a tip off that inflationary pressures are building perhaps even more than the public realizes?  Admittedly, it's a bit of a tough call at present given the labor outsourcing opportunities available to corporate America.  Nonetheless, it's yet another anecdote from the treasure box of historical experience.
       

As we move into 2005 and beyond, we believe the idea that current inflationary pressures are "well contained" will be challenged in the financial markets.  We believe this is to be an investment theme of importance looking forward, with implications for investments in fixed income vehicles, the metals, commodities, TIPs, etc.  Despite what may be consensus thinking or Fedspeak of the moment regarding supposedly contained headline inflationary pressures, now is the time to start thinking about and implementing portfolio hedges against a shift in inflationary perceptions and expectations ahead.  One last comment.  As you know, we have not even touched on inflationary pressures already building in the greater global economy.  China has already acknowledged these pressures.  Moreover, academically a declining domestic currency is the devils playground in terms of building inflationary pressure.  Dependent on the direction of the dollar ahead, it just may not be too long until commentary regarding the importing of increasing inflationary pressure starts to heat up in meaningful fashion.     

Are we about to experience a replay of the 1970's experience with inflation?  At this point, who the heck knows.  But what seems apparent to us is that the structural breeding ground for rising inflationary pressure is in place.  For now, the incubation and realization process remains to be seen in terms of ultimate magnitude of inflationary pressure.  What we suggest is important, though, is the potential for shifting perceptions and changing expectations ahead.  These are the swing factors that can and do influence financial asset prices in a meaningful manner.  As they used to say in the old Cisco commercials, "are you ready?"