Its all in the core!

Today's batch of economic releases, with higher than expected consumer income and spending, surprisingly strong construction spending and stronger than expected PCE core inflation (a key indicator for the Fed), all for the month of February suggests that the inflation conundrum is far from over. This follows a week in which we saw lower than expected durable goods orders, strong existing home sales but weaker than expected new home sales. Delving into the figures, it is notable that inflation adjusted spending on durable goods was actually negative, reflecting what seems to be the impact of the recent oil price hike on disposable income. The clearly inflationary nature of these latest figures is contributing to a growing dilemma facing the Fed regarding policy action for it leaves them with less room to counter the economic slowdown. The Fed is basically at crossroads at this stage of the cycle and has little else to do than to just keep a close watch on developments.

A potent cocktail in the making...

The growing tensions between the U.K. and Iran is being felt in the markets particularly with regards to crude oil prices that have been rising for the seventh consecutive day. Not surprising considering that a quarter of world oil supplies flow through the straights where the British sailors and marines were seized. Added to the inflating geopolitical risk premium are the Marseilles port strikes and growing worries regarding weather forecasts for the summer season in the U.S., particularly in Florida and the Gulf of Mexico where 30% of U.S. oil is extracted. This potent and highly charged cocktail of disruptive issues could very easily drive prices to the levels we saw last year. Given these developments, it seems that inflation worries, particularly in the U.S. will be with us for a while longer.

Apologetic Japan

Prime minister Abe's surprise apology to parliament earlier today regarding Japan's actions in World War II should help diffuse a row that has been brewing since Koizumi came to power. It is, in our view, mainly indicative of a fundamental shift in economic power in the region. The conciliatory gesture towards mainly China and South Korea reflects the growing dominance of those countries and their rising importance in terms of trading partners. Although it is unlikely to be enough, this is clearly a step in the right direction.
On a side note, today's disappointing home sales figures in the U.S. provides support for the Fed's decision to leave out any mention of "firming" at the last FOMC meeting and raises the probability of cuts later on this year. A neutral bias seems increasingly appropriate considering the housing conundrum and the typical 6 to 12 month lag for core CPI. The Fed will also be watching the employment figures very closely in coming days and weeks as the economic expansion takes an increasingly priority role.

A Bernanke Put?

The Fed's decision to keep out mention of the tightening bias took the markets by surprise, considering that the latest inflation and growth figures paint a mixed picture. One wonders if Bernanke's decision to drop the bias has anything to do with the sub prime debacle by introducing a Federal Reserve put option à la Greenspan. After yesterday's events, the futures market raised the odds of a quarter point cut by mid year. Although we are not out of the woods on the inflation front yet, the tendency is towards a softening, considering weaker commodity prices and the drop in housing, compounded by the general economic slowdown. Put or no put, we have seen how effective they are (take the internet bubble as a prime example). The danger comes from getting carried away by such "cost free" options, the private equity put being another prime example. Nevertheless, in the natural order of things, it does make sense that the tightening bias is no longer mentioned (it was going to happen some day), the slowdown will inevitably take its toll on inflation.

Just another confusing day!

How reassured should we be with today's better than expected housing starts figures? It adds to confusion more than anything else since it's data based on a single month (February in this case), it's highly sensitive to weather changes, and now, indirectly to the growing inventory of existing homes due to the jump in sub prime delinquencies. So as inventory expands (if it actually does is another matter), it will have a direct impact on home builders where pessimism is already rife if we take the National Association of Home Builders/Wells Fargo index of sentiment at face value. There is still some debate going on regarding the actual state of the housing market and how much of a spillover effect we will end up having. This week and early next week should shed some light on this with the release of additional key housing figures and a couple of consumer confidence measures.

The strangle...

With signs that the low end of the housing market is capsizing and the growing risk that this will spill over into the prime market, the economic expansion seems to be increasingly on shaky ground. A scenario in which consumer spending drops dramatically, leading to a collapse in earnings and a subsequent jump in multiples is not that far fetched. In such an event, the Fed would normally be expected to start easing rates but its hands seem to be increasingly tied if recent inflation related figures are to be believed. Indeed, looking at PPI and CPI for February, or even capacity utilization and the surprising strength in industrial production, the message is pretty clear. With the Fed's hands pretty much tied, the most ideal outcome would be for the slowdown to dominate and choke off the rising inflationary pressure. How things will actually unfold is still very unclear at this stage...

Turbulance ahead?

News that sub prime lending delinquencies reached a four year high is worrisome to say the least. The sustained abnormally low interest rate environment seems to be taking its toll on the economy with the rise in defaults. As mentioned earlier, a long period of low interest rates is conducive to lenders becoming more lax with regards to their lending requirements. This is a behavioural phenomenon in that the more the good times last, the less we remember the bad times. Its in fact what leads to those famous market bubbles that we just can't seem to rid ourselves of. What's unsettling in all this is that a collapse in the housing market (for we haven't seen the end of it yet) will have a psychological impact in the form of a drop in consumer spending, a key component of growth. Now that could punch a hole in the fundamentals that have so far remained unscathed by recent events.

Almost there...

Japan's revised stronger than expected fourth quarter GDP rate confirms yet again that the economy is pulling itself out of the doldrums. The continued strength in exports has prompted firms to upgrade existing plants and build new ones. An increasing share of demand is coming from its neighbors, particularly China with its insatiable appetite for not only construction equipment but also high tech instruments as a distinct middle class starts to form. As mentioned before, the emergence of China and India as new economic powers should help reduce volatility related to the historical dependence on it's largest export client, the U.S. With record low unemployment and improved consumer and business confidence, the disinflationary cycle seems to be in its last throes, although its unlikely that we will be seeing a sudden jump in prices especially considering the recent drop in oil prices which can only add downward pressure on prices in a country that imports almost all of its energy needs.

Out of the storm?

Markets around the world rebounded after a turbulent week triggered by a combination of woes in China and negative news regarding economic expansion in the U.S. and elsewhere. Recent economic figures confirm our outlook of a slowdown in the U.S. with a risk that inflation surges. The latest unit labor cost and productivity figures suggest that inflation is far from being tamed considering that labor costs represent more than two thirds of manufacturing costs and that productivity figures are ebbing towards their lowest level in a decade. A surge in unit labor cost is not surprising considering the the advanced stage of the business cycle and the resulting relative tightness of the labor market combined with peak in capacity utilization. Until recently, firms had the margin of maintaining prices steady as productivity gains diluted the effect of rising labor costs, but with the latest development, firms could very well pass on the additional costs to consumers. We think that the programmed slowdown will suffice to counter the inflationary threat in coming weeks and months. This should be confirmed in upcoming employment figures.

An embedded put option?

Markets are taking a thrashing as unease at the rising volatility is prompting an increasing number of investors to unload their riskier positions. We see this "flight to quality" move as the yen shoots higher and treasury yields drop lower. Fundamentals remain intact in the U.S., however, with earnings growth trends and multiples at reasonable levels and a slower rate of growth already built into expectations for 2007 and beyond. For emerging markets, it's a different story altogether, the democratization of markets such as those of China have led to a large number of relatively inexperienced individuals making investments left, right and center, a bit like the day trading activities of the dot com era. So yes, there is a bit of a bubble out there, but nothing dramatic enough to pull the heavy weights into a full blown recession. The U.S. put option in the form of approximately 2 trillion dollars in private equity is, after all, waiting on the sidelines for the right occasion to enter.

What goes up must come down!

The sell off triggered by China's Tuesday drop continued amid deepening pessimism regarding the outlook for global growth. A flight to quality ensued as volatility surged and the appetite for risk dwindled somewhat, boosting the yen as carry trades started to unwind and pushing treasuries higher, especially in the short end, as the likelihood that the Fed would start cutting rates earlier than anticipated increased. The big uncertainty in this environment became the extent to which this unwinding activity would continue. There was at least some good news to cheer about with the release of stronger than expected personal spending and personal income figures to help counter the growing slump in housing and manufacturing. Also, a stronger than expected PCE Core indicator, one of the Fed's favorite gauges for inflation, confirmed the view that inflation warranted close scrutiny. We don't believe that the current correction will lead to a recession, considering that fundamentals are stable. We think the sell off is due to the unwinding of riskier positions that have been accumulating over the last couple of months.