March 2006

It's All In The Follow Through

It’s All In The Follow Through…Although we usually abhor the media and assorted Street pundits picking apart every single word of FOMC monetary policy commentary post each and every Fed Funds rate increase, we’re going to violate our own sense of good taste and editorial decency and indulge in a bit of it ourselves in this discussion.  Our sincere apologies in advance.  We’ll try to keep it to a minimum, we promise.  There was a slight change in the FOMC December 2005 minutes wording that was continued in the statement that hit the tape on January 31^st.  Quite concisely, we’ve highlighted the singular sentence change in the box below that is taken verbatim from the 1/31 minutes.  Specifically, the Fed is referring to resource utilization.  Again, this is new in the last few months.

One might think for a moment that they are referring to capacity utilization of some type.  Many folks on the Street believe the comment is directly pointed at supposedly tightening US labor markets.  (We subsequently penned a piece in the subscriber portion of the site disputing the "tight labor market" thesis.)  But, we believe they may be at least in part referring to commodity prices and the potential for higher commodity prices to ultimately flow through into CPI measures of inflation, both the headline and the all-sacred core rate.  As we mentioned at length in our investment themes and considerations discussions in January, we believe the continuation of global liquidity growth arising from both monetary policy decisions and specifically US Fed open market operations (repo and coupon pass activity) has now reached the point where perhaps the unintended consequence is the accelerating flow of that very liquidity into commodity and hard asset prices, both real world and "paper" demand.  As we suggested, Fed sponsored liquidity generation, aided and abetted by the BOJ and PBOC primarily, has already helped support US financial asset prices and US residential real estate values.  But as excess liquidity generation continually seeks out positive and ever higher real rates of return, it has now come to ever increasingly influence hard asset prices higher at the margin.  For a little example of what we’re talking about, just have a look at the table below.

Get the picture?  Of course you do.  Most everything related to the broader commodity complex was up double digits in a single month.  Do you think this is lost on the Fed?  We think not.  So although the Street has lately been tripping over itself trying to anticipate and discount the end of the Fed interest rate tightening cycle, let alone guess as to when the first easing may happen either later this year or early next, it may be the proverbial case of the counting of one’s chickens well before they are hatched.  For ourselves, the change in the Fed comments suggests this band of merry pranksters is mindful of follow through.  That is, the potential for already realized price advances in energy, broader commodities, etc. to eventually show up in headline and core CPI numbers.

Now before going any further, we know that the CPI calculation of the moment leaves more than a lot to be desired.  We've covered this very ground ourselves on many more than a few occasions over the past.  We're not happy about hedonic adjusting.  In many senses, the CPI today is a good bit non-comparable with that of prior decades.  BUT, it's all we've got.  Unfortunately, we nor anyone else has the raw unadjusted data which to analyze.  We have nothing but current and historical CPI data to use as we push forward.  Having said that, let's move on.  

Let’s look at some historical numbers to get a taste for what we’re talking about, OK?  Of course the real world case study is the 1970’s.  What we’re looking at here is the annual year over year increase in crude (West Texas Intermediate) and the CRB alongside the annual CPI and core CPI (less food and energy) readings.  Next to each column we’ve inserted cumulative compound annual growth rates.  What we are trying to do is get a sense for cumulative acceleration in price increases over time and how that parallels core and headline CPI acceleration experience.  And finally, we’ve put in very simple 10 year averages of cumulative growth at the bottom of the table.  Hopefully, in simple terms, we’re trying to get the sense for how the admittedly intermittent acceleration in crude prices and the CRB acted to influence reported headline and core CPI over the ten year period ended 1982.

What seems pretty clear to us is that despite true year over year volatility in crude and CRB price advances throughout the mid-to-late 1970’s and early 1980’s, from 1975 onward, we experienced a pretty steady annual advance in both the headline CPI and core readings.  Are we looking at “follow through”, so to speak, as the volatility in crude and CRB readings ultimately made their way into the headline and core CPI readings?  It sure looks that way.  And it’s clear that over the period shown, on an annual basis both the CPI and the core ultimately achieved an advance greater than the CRB itself.  Of course crude was in an orbit of its own.

Yes, crude prices have been volatile year to year, just as was true in the 1970’s.  It has not been a straight up game.  Same characterization can be applied to the CRB.  And yes, at least since 2003, the headline and core CPI readings have been accelerating.  But, as we look ahead, the key question is one of follow through.  How much more upward pressure on the CPI and core reading is still yet to come?  As we suggested, we also need to realize that, at least according to our book, CPI calculations across the decades leave a lot to be desired.  If we can be so bold, there is certainly a meaningful degree of non-comparability as the CPI calculations began to be heavily influenced by hedonic adjustments in the 1990’s.  But be that as it may, we’re a bit stunned by the fact that both crude and the CRB prices have grown so significantly over the last six years while the reaction/follow through in the headline and core CPI readings up to this point appear almost benign.  Is the Fed telling us in their recent change to FOMC meeting note commentary that they believe there may be follow on pressure to come in the CPI and core ahead due to what has already happened “yesterday” with crude and broader commodity prices?  Although we never want CI to sound like conspiratorial corner, we believe that’s a very reasonable interpretation.  Clearly, six years ago the Fed acted to cool the bubble in equities they themselves helped create as they raised the Funds rate meaningfully into 2000.  We believe the monetary tightening cycle of the last year and one half was their way of in part cooling the housing bubble they sparked post the equity market break.  Now are they setting their sights on a perceptual bubble in energy and commodity prices that excess Fed sponsored liquidity generation helped inspire short term? 

A few last explanatory items that bear on what we’ve said above.  First, we’ve heard it said a million times now that the US is less energy and commodity dependent as a total economy than was the case in the 1970’s and early 1980’s.  No argument from us at all.  As we have outsourced the US manufacturing economy, we’ve also outsourced to an extent the economic factors of manufacturing input costs and energy usage.  We can just thank our lucky stars at the moment that China has so graciously agreed to support massive overcapacity and lack of profitability in the interests of helping to keep US CPI growth to an absolute minimum (and most importantly to grow their own long term global market share, to which many in the US seem blind, or at worst totally complacent).  But you’ll remember our absolute fixation on the US consumer looking into 2006, not just for what consumer trends will mean to the US economy, but really to the global economy.  Let’s have a look at a few relationships of just how “meaningless” higher energy and commodity prices are to US consumers, shall we?

In the chart directly below, we’re looking at US personal consumption expenditures for gasoline as a percentage of disposable personal income.  It’s clear that as US personal income grew in the 1980’s and 1990’s, and as energy prices basically stagnated (or worse), gasoline costs ate less and less into growing consumer income.  But what is also clear is that this relationship has changed relatively dramatically over the last three years.  Does the word “spike” characterize the current experience?  So although pundits far and wide can rant and rave over how meaningless energy prices are to the current US service economy, we happen to know a number of households measured in the millions who’d probably have a different take on life.  What has clearly helped dull the pain in recent years has been incredible amounts of mortgage equity withdrawal.  If that ends, what you see below will become much more meaningful to US households.
        

Same deal really goes for personal consumption of electricity as you can see below.  To be honest, the relationship below in many senses parallels the price of natural gas.  What is clear is that although being well below early 1980’s peaks, we’re nonetheless resting near decade highs right here.  Rising energy costs are increasingly crowding out otherwise disposable income that could be headed for discretionary spending.  The facts are clear.
     

So when you hear various pundits simply blow off energy and commodity prices as being not too meaningful to our service driven economy, you may not want to accept that at face value.  Moreover, if you believe that energy prices in aggregate, and specifically at the household level, move higher in the years ahead, what you see above will become an increasing force to be reckoned with.  Again, is this what the Fed is thinking about?

Okay, now for one last philosophical and rhetorical point.  IF we’re even close to being right in terms of thinking that the Fed IS indeed worried about follow through of energy and commodity prices into headline and core CPI readings (clearly based on historical precedent set in the 1970’s and 1980’s), the big question then becomes just how the Fed can act to influence what truly are prices set in the global economy, not just here in the US?  If indeed the Fed is looking to cool down energy and commodity price acceleration in hopes of heading these influences off at the pass, prior to obvious filtration into CPI, can they exert enough domestic pressure to influence global price setting?  In one sense it seems too big a job for the Fed to even attempt.  But on second thought, IF we are even near correct in our thought that excess global liquidity is now having the unintended consequence of jacking up energy and commodity prices relative to alternative asset classes, the Fed can act to influence change through backing off excessive liquidity expansion while perhaps nudging rates a bit higher yet than now expected.  As you know, not even the first hint of this has happened yet as the Fed has done eleven coupon passes in the first two months of this year!  Unprecedented!  Although it may sound like sheer lunacy on our part for even suggesting this, the Fed needs to cool down excess US consumer spending.  It is clear that personal consumption has outstripped personal income growth for a good while now.  What if the Fed simply targets bringing these two growth rates into line with each other?  Not blatantly or overtly forcing a recession, mind you, but keeping the pressure on excess US consumption.  Yes, we probably sound like lunatics to suggest this given Fed real world actions of the past and their blatant accelerated coupon pass activity at present.  But one thing is for sure; this thought process is not mainline consensus thinking by a long shot.  We’re simply trying to anticipate alternative outcomes.  Moreover, given that it is absolutely clear that the Fed is now knowingly and proactively inverting the US Treasury curve, are our thoughts here regarding Fed intent really that wacky?

In our minds, if the Fed simply stops raising rates somewhere over the next three to four months, yet continues the excess liquidity pump, we believe very little to nothing is gained in terms of trying to stall accelerating energy and commodity prices ahead.  And IF indeed this acceleration is not halted to some extent and these forces do show up in headline and core CPI as part of natural economic follow through in the quarters ahead, the Fed is going to have one big problem on its hands.  They just might have to restart the rate increase cycle later in the year (assuming they pause in the interim) if CPI rates move north at the exact time that the markets have been acting to discount the demise of the rate increase cycle.  If you ask us, we believe the Fed faces some very tough choices over the near term.  These are the issues which Greenspan has laid on Bernanke’s desk as a welcome aboard gift.

On an absolute worst-case basis, even if you think we’re nuts, we believe this deserves some thinking and consideration.  Of course, if indeed this is what the Fed may be thinking about, then it has very important implications for energy and commodity stocks, emerging market equities, etc.  Although this may sound like a suicide plan for the Fed, isn’t it really what they should have been doing all along now?  As you’d guess, we’ll be watching and discussing the multiplicity of these asset classes on an ongoing basis ahead.  You can count on it.

One More For My Baby And One More For The Road?…We'll see.  So, at the moment, the Fed Funds futures market is clearly discounting another rate rise in late March and is pretty much 75% sure of a 5% Fed Funds rate before June.  Don't know if you saw this, but just last week a name brand Street firm upped it's monetary Fed Funds conclusion point estimate to 5.5%.  As you know, where the monetary tightening action stops in terms of exact basis point rate is probably not really the important issue when it comes to how this decision affects the financial markets as the final hike will ultimately be anticlimactic.  The importance, we believe, is already playing out in terms of the market’s anticipation and discounting of the end of the rate tightening cycle.  As you’ll remember, when the FOMC meeting notes for December were released, market participants homed right in on the specific comment made that “the number of additional firming steps required probably would not be large”.  And you’ll remember the result in the equity markets particularly.  The response of investors was vertical and immediate price acceleration.  This is not the first time this has occurred and it won't be the last.  We’ve seen minor repeats of this type of action with various public commentaries of individual Fed members over time.  And let's face it, just what do you think the markets were doing when the iitial 4Q 2005 GDP report was released a while ago?  Do you think they were focusing on the implications of a slowing economy for corporate earnings?  Of course not.  They were rejoicing in the fact that the report was yet another nail in the coffin of forward interest rate increase momentum, plain and simple, as equity prices ramped higher.  In addition to attempting to discount the end of the Fed Funds tightening cycle on many occasions now, the markets have also naturally learned to anticipate and discount in stock prices yet more excess liquidity from the Fed on any weak economic report.  From our standpoint, the markets are conveying the message with these types of real world responses that once the Fed is done with monetary tightening, the equity and bond markets only have upside.  After all, the whole “don’t fight the Fed” theory of life can essentially be thrown out the window for yet another monetary cycle, no?

The real world financial market anecdotes of the last few months tell us that market consensus is centered on the very idea of price upside post the end of the Fed tightening cycle.  Rephrasing that a bit, at worst the consensus believes that there is much less price risk in the markets when the Fed finally calls an official halt to the game.  Sounds kind of crazy in that financial asset risk premiums are already rock bottom relative to historical context.  Given this, we thought it a very appropriate time to check in on what historical experience might have to say about this line of reasoning.  Follow through, if you will, in historical equity market response to the end of the monetary tightening event itself.  

In the following table we detail the end of each Fed monetary tightening cycle of the last five decades.  We’ve put an asterisk by each cycle conclusion that was followed in relatively short order by an official recession.  As you can see, it’s the majority of occurrences.  In each case we are documenting the S&P 500 price only performance in the 3,6,9 and 12 months after the official end to each cycle.  And quite clearly the historical experience is varied.  As a very generic comment, it’s our belief that history is telling us something a bit different than what the consensus may be anticipating or trying to discount at the moment.  Although we present the average experience for each period at the bottom of the table, these numbers may falsely lead one to believe that the post Fed rate tightening cycle is simply flattish or benign.  But you can see the real world volatility when you look at the numbers for each cycle specifically.  By and large, when a Fed cycle has concluded and the economy has not entered recession, (’68 and ’95), upside has been pretty strong.  Lastly, if we were to exclude the experiences in the bull mania period in and around the 1990’s (’89 and ’95), the average post Fed cycle equity price performance experience would look a whole lot different than the averages you see in the table.  After all, nothing was going to stop the equity market freight train that was the 1990’s.

                   * = Recession Follows

We believe the markets are discounting something more than merely a coast is clear environment for the post Fed tightening cycle period that will ultimately be upon us in the not too distant future.  We believe the markets are trying to anticipate a degree of upside that deserves, if not mandates from an institutional perspective, involvement to a level beyond a modicum of participation.  In other words, something not to be missed by the greater majority of investors.  But history is suggesting to us that a high degree of optimism for the immediate post tightening cycle period surely ahead may indeed be very misplaced.  And at worst, history is suggesting that the current consensus deserves questioning.  The numbers in the table above argue that point.  Moreover, if we were to strip out the equity market experience in the post 1989 and 1995 tightening cycle conclusions, here’s how the adjusted average quarterly performance would look.  A touch darker.

We’ll end this with a few quick charts.  As part of the exercise of creating the data in the tables above, we dug back through daily market activity over the last half-century.  We’re just putting that historical daily market data into graphical form below.  First is a look at the average daily S&P price only performance in the twelve months following the conclusion of each monetary tightening cycle described in the first data table above.  All cycles from 1953 to the present are averaged below.
      

Finally, we again look at the same data with the post 1989 and 1995 cycle experiences excluded.  This chart makes some sense if one wants to believe the 1990’s as a whole was some type of mega bull market experience seldom seen.
        

As with many historical charts we have shown you over the years, what we believe is important is to get a sense for the potential direction of experience to come.  The actual exact percentage change averages are much less important.  How it all plays out for this cycle will be told ahead.  But our main point is that to come to the immediate conclusion that the minute the Fed is done raising interest rates we automatically find ourselves facing some type of important equity market buying opportunity is premature at best.  As you know, our job as supposed contrarians is to identify a widespread consensus belief that deserves thought and philosophical challenge.  Looking ahead, we can only hope that the current consensus is indeed disappointed in some manner from which will come opportunity for those who questioned the consensus premise in the first place.  Lastly, if indeed history is anywhere even close to being a rough roadmap for what’s to come after the current monetary cycle breathes its last, it again reinforces in our minds the very important need to get sector selection and asset allocation right this year.  That’s where this game is going to be won or lost in 2006 and beyond.