It's been a random walk through the data fields this week. The headlines say that inflation rose a mere 0.1% in August. The markets liked that. But digging deeper, the data is not as sanguine. We had the depressing Philly Fed manufacturing index last week, but today we find that Chicago is doing more than fine. The Dow flirted with a new all-time high, but then took the train home early for the weekend, leaving those who care about such things feeling like a teenage boy at a Baptist youth camp, flush with excitement during the day but frustrated as you go back to your dorm. But there's always tomorrow. Or maybe not.
Copper is the metal with a Ph.D in Economics. But has the metal been too smart for its own good? Looking at some recent trends in copper usage, we can learn something about an economic concept called substitution and the cure for high prices. I comment on my "debate" on Kudlow and Company this week, and muse on growing older and the passage of time. Let's jump right in.
Trimming Inflation
Measuring inflation is not easy. The Department of Labor creates the Consumer Price Index (CPI). The Department of Commerce creates the Personal Consumption Index (CPE). The market seems to pay more attention to CPI, but the Fed (read Greenspan and now Bernanke) prefers to look at CPE. And they really like core CPE, which takes out food and energy, because otherwise the number can be too volatile for sensitive central banker stomachs.
But however you measure it, getting it right is important. If you allow inflation to become pervasive and persistent, it does nasty things to economies and markets. No US central banker ever wants to revisit the 70s. While it is popular in certain circles to depict Bernanke as Bomber Ben, a reference to his remark in a speech about dropping cash from helicopters, you can be sure that he understands that inflation at too high a level is just as pernicious as deflation. There is a fine grey line they walk, but the general consensus seems to be that when inflation is over 2% it is too high.
(The dropping cash reference was an economist's attempt at humor. There is a reason why we never become stand-up comedians.)
Inflation is well over 2%. It may even still be rising, as some data we will look at suggests. So why did the Fed stop raising rates? Are they not worried about inflation?
The answer is that they think (hope?) that a slowing economy will ease the pressure on inflation without having to resort to further rate increases. If the economy is indeed slowing, the thinking seems to be that to pile on with more interest rate increases would simply add to the problem and maybe even cause a recession. That has been the pattern in the past. If the economy remains strong or gets stronger, they can always increase rates later.
I think this is the correct approach. But that makes the Fed very data dependent. Each bit of new data becomes ever more important. The futures market is pricing in a 30% chance of a rate cut at the January meeting, and the odds in the futures market of a rate cut increase with each meeting. That means the futures market thinks the economy will be visibly slower in the not too distant future, otherwise why forecast a rate cut? (We will visit this point later when we look at the recent stock market action and my conversation with Larry Kudlow this week.)
The Inflation Trend is Not Your Friend
As noted above, the headlines said that inflation as measured by PCE only rose 0.1% of August. In July PCE rose 0.8%. That means inflation is falling, right? Well, maybe.
June was "only" 0.3%, yet May was 0.7%. As you can see, the monthly numbers can be quite volatile. As I wrote last month, Dallas Fed president Richard Fisher argues that a six month trending average is actually the best measure.
Without going into the detail we did last month, the Dallas Fed has developed a new methodology for measuring inflation, called the Trimmed Mean PCE. It was developed by Dallas Fed economist Jim Dolmas.
Dolmas notes (quite correctly, I think) that to exclude food and energy, just because they are volatile, ignores the other quite volatile measures of inflation that are still left in. Further, energy and food inflation do have meaning in the real world.
What Dolmas does is use a statistical device called "trimming." From the field of statistics, trim analysis borrows the idea of ignoring a few "outliers." A trimmed mean, for example, is calculated by discarding a certain number of lowest and highest values and then computing the mean of those that remain.
How accurate is his new measure? Dolmas suggests it is a lot more accurate: "That is to say, compared to the usual ... measure, on average the monthly trimmed mean measure would be expected to come closer to true monthly core inflation by roughly .75 of a percentage point, when the inflation rates are expressed in annual terms." That is huge, at least in my book, especially when we look at how much the difference is with the Fed's favorite methodology.
The Dallas Fed uses the same data as the Department of Commerce does to create the PCE. I have to compliment them that they have updated their web site from data released today. The charts below compare PCE, core PCE (ex food and energy) and the Trimmed PCE. The numbers show what the rate would be on an annualized basis for one, six and twelve month's worth of data. (www.dallasfed.org/data/pce/index.html)
The trend is not your friend. Inflation on a 6 month and a 12 month basis has been trending up for the last six months in all three series. The 1 month numbers, while more volatile, are well above the 2% comfort threshold. Let's look at the tables:
If you are so inclined, you can make an argument using just the 1 month numbers that inflation may be starting to slow down, but the truth is that one month's worth of inflation data is pretty much useless as a predictor.
What we can see is that inflation, at least through August, has not gone away. If inflation is still this high at the end of the year, then the Fed is going to be forced to think about raising rates, not lowering them. Can you have a slowing economy and rising inflation? The answer is yes. Remember that 70's show? Bottom line? The Fed will fight inflation, even risking as recession, as to not do so risks an even worse recession in the future.
Now, the probability is that a slowing economy will indeed bring inflation down. But it is not the only possibility. That is why the Fed is on hold, waiting for more data. There will only be one more month's worth of data between now and the November meeting. That will not be enough to justify a move either way. But at the January meeting, they will have seen three more month's worth of data. A trend will be established: either up, down or flat. The futures market is betting down.
Which is odd, because that means the economy is going to slow. And a slowing economy is not usually the stuff of higher stock markets.
Consumer Spending Slows
Consumer spending rose just 0.1% in August, which was the slowest increase since November. When you adjust for inflation, consumer spending actually fell 0.1%, the first decline since September 2005, a month when consumers were dealing with the fallout from Hurricane Katrina.
Personal income rose at the lowest rate since last November, at an anemic 0.3%, which depending on how you measure inflation, could actually be down in real terms. But not to worry. We dipped into our savings. Savings were negative for the 17th straight month at -0.5%.
On the positive side of the ledger, the Chicago Business Barometer, also known as the Chicago PMI, rose to 62.1 in September, up from 57.1 in August and far higher than economists had expected. This was in stark contrast to the gloomy Philly number of last week.
How did we do as a nation? We will find out Monday when the national numbers come out. The Chicago numbers come out on the last day of every month and the national numbers from the Institute of Supply Management come out the first day of the (ISM) month. Chicago is a big portion of the manufacturing number. But the correlation between Chicago and the US is not all that tight. Stay tuned.
The Dow failed to close at a new high. (I wish it would go ahead and do it so that they could talk about something else on CNBC in the morning while I am getting dressed.) If Monday's ISM number comes out in line with Chicago, then expect that new high. If it comes out in line with the Philadelphia number, then we have seen the high for this cycle.
My "Debate" on Kudlow
I was on Larry Kudlow's show this last Tuesday. The topic was "Will there be continued growth or a recession in our future?" It will surprise no one that I argued for an economic slowdown or a mild recession. Professor Nouriel Roubini was on with us, and he was even more bearish. But John Rutledge and Kudlow more than balanced our views.
My summary points?
- You can't ignore the negative yield curve. It is the most reliable forward indicator of future recessions or slowdowns. And it is telling us that a slowdown, at the very least, is on the way. To ignore it must mean you are willing to say "This time it's different." Those are the four most dangerous words you can utter in a trading room. Since the stock market drops an average of over 40% before and during a recession, if the yield curve is right, we are going to get to buy this market at lower prices.
- There are other indicators suggesting a slowdown/recession, such as the Leading Economic Indicators and the ratio of the Coincident to Lagging Indicators. The data on consumer spending shows it tightly correlated with housing prices, and housing activity has become highly correlated with the S&P on a lagging six month basis, which does not bode well for the stock market, as housing activity is in free fall.
- Even if we have a "mere" slowdown, that is going to mean disappointing earnings in our future, which will lead to a stock market decline. Yes, earnings are strong now, but we are at a peak in earnings as a percentage of GDP. Earnings growth is mean reverting. That means we will see earnings growth drop back to GDP plus inflation or around 6%, at the very minimum. A recession will mean it drops below that. And that means we get to buy this market at a lower price.
- The market doesn't look forward, or at least not very well. You can simply go back to August of 2000 and watch the market almost make new highs (other than the NASDAQ and tech stocks). Two and a half quarters later we were in a recession. Oops. The market simply takes the most recent trends, anchors on them and then projects them into the future.
- Yes, the housing market is only a small part of the overall economy, but it is an important part. It contributed about 1/3 of the new jobs during the recovery. It is highly correlated with consumer spending, which is slowing. Recessions happen at the margin. The world does not end. It merely slows down. If housing slows down by 25-30%, coupled with lower consumer spending, that could easily put us in a mild recession.
When asked about what the rising stock market was telling us, Roubini said he thought it was a sucker rally. I agree. In my view, to be unreservedly bullish on stocks at this point is to ignore what seem to be clear warning signs.
Let me be clear on one thing. I expect the stock market to be higher in 5-7 years than it is today. Maybe in less than 5. I simply think I can buy this market at a lower price at some time in the future. I expect to become more or less bullish during this next recession, or at the very least selectively bullish. But for now, I think it will pay to be patient.
(Usually, when I get asked to be on CNBC, it is with only a day notice. Maybe they will one day let me know a few days in advance and I can alert my readers.)
Copper: The Metal with the PH.D
Copper prices have been increasing rapidly in the last five years. From a low at $.63, today copper is $3.43. It was close to $4 last spring. This has not been a steady rise. The chart below shows that prices have risen rapidly in the last 2 years. (Chart courtesy of my friends at www.kitco.com)
What is the reason? China, strong growth in US housing and solid world GDP growth. Copper is said to have a Ph.D in economics. When copper prices are rising, it means that the economy is booming. But copper may be too smart by half. It may be pricing itself out of the market.
A new report by Simon Hunt, one of the true experts on copper, suggests that copper demand could actually drop over the next three years as companies figure out ways to substitute cheaper metals for copper. With copper trading almost 6 times it low just a few years ago, there is ample reason.
In economic terms, it is called substitution. If beef gets too high, we switch to pork or chicken. While it is a lot harder to switch the metals you use in a product, it is the same principle.
But " ... substitution is not just the use of an alternative material to copper. It is also the 'need to make more with less' through micro-miniaturization, improved design techniques, optimization of materials usage, improved fabrication methods, greater attention to end-product weight and the use of lower copper containing alloys."
As an example, air conditioning manufacturers use about 900kt (kilotons) of copper a year, or about 5.4% of global usage. Two-thirds of that is in copper tubing. They are now working to use thinner and smaller pipes, which will reduce the amount of copper per tune by 25%. In China, they are using aluminum for external tubing.
New designs have air conditioning systems which use all aluminum. Smaller and newer manufacturers which do not have large investments to write off are beginning to produce these new models. They may be able to price them very competitively, forcing larger manufacturers to follow suit.
Even without the new models, global demand for copper from air conditioning manufacturers could drop as much as 300kt in the next three years.
Refrigerators, copper boilermakers, gutters and roofing, telephone wires, cable, and a host of other products are being designed to use less copper. All told, we could see world wide demand drop by almost 15%, and as much as 20% longer term.
Even in a world where GDP is growing, we could see demand for copper soften. Of course, this means that other metals, especially aluminum, will see there demand increase. The old line that the cure for high prices is high prices is true.
And that Ph.D in Economics? It may be as useful as a real one when it comes to making predictions.
John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. Contact John at John@FrontlineThoughts.com.
Disclaimer
John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.
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