Economic diary 9/15/06

This will be an ongoing series of posts (assuming laziness doesn't take over) that will probably be boring to most of you. I want to document my thoughts about what I am observing for future reference. It is quite easy to let thoughts that were somewhat fleeting but correct in the past to become your "opinion at the time". Consider this a way to see how correct I actually am.

Macro:

1. Inflation- I think inflation will be contained in its growth going forward somewhat. A lot of it has already been baked in and the numbers will only slowly reflect it. I do think a lot of the inflation we have seen has been of the demand pull type. If the global economy slows, one would expect inflation to ease downward. Some are even arguing that we are in a deflation trap with easy money and all that (think Japan 1989). That may be the case though it is hard to say. I think any deflationary forces will be muted because of the long term policies I believe will be used (see more below).
   



2. Commodities/Oil- the entire segment has been in a steady downdraft in recent weeks. Oil has dropped but so has everything else. The Gold bug types will say this is a signal that the market doesn't anticipate inflation (see deflation trap). The problem is that if inflation is demand pull, it isn't deflation we are seeing but a global slowdown. The current Oil futures correction has occurred simultaneously with excess supply. I have long thought that Oil was merely responding to increased demand (due to China and India joining everybody else) with some currency effects thrown in.
   


3. Dollar- the dollar has basically treaded water for some time. So what gives? I think it is basically a case of least ugly. Our rates are decent so it is keeping investment flows strong.



4. Housing- Simply put, it is going to get ugly. Though not bubble collapsing ugly.
   

Given all this, what happens? I think we are in a situation where we will have a recession lead by housing (who lead us out of the last one). Inflation will tame somewhat because of reduced demand. Commodities and Oil will stabilize at a lower level. But the choice The Fed has is try to reinflate by dumping even more money and killing the dollar but possibly stopping housing from going downhill too fast OR hang on and hope that deflation doesn't take hold and housing somehow just merely slumps and the economy grows fast enough to prop everything up and give things time to heal (i.e. malaise scenario).

My bet? The Fed tries to straddle the two. They will toss the dollar overboard fairly quickly and without remorse. But they dont want to try to reinflate any asset/credit bubbles - I think they are smart enough to realize they can't play the same game as in 2001. So the best case scenario is a bearable malaise - the softest of soft landings. Maybe a quarter of negative GDP but a long period of no growth. If that sounds familar, it should. It is called 2001-2003. Can we repeat that? I don't think so. What replaces the growth supplied by housing in the previous period? The consumer can not do it. Debt levels are too high for that much heavy lifting. CapEx is floated around a lot as well. It may come to pass but some recent signs are towards less business investment not more.

I think we will have a hard landing. Fed will toss the dollar in an attempt not to crash. Housing will take a 10-20% correction and stay level after (for years) that due to the Fed's action. Similarly, we won't have huge negative GDP but it will be stretched out over the course of years (i.e. instead of a yr of -4% GDP, a decade of -.2% GDP). Again, the Japan scenario looms large. The question is do we experience deflation like they did? I think no. Our debt is too high, our culture too different, banking system much more ruthless. By the numbers, it will seem better but on the personal level, it will be far worse. The Japanese system caused pain but due to its long time frame many suffered long but not so harshly. Our system is far worse. A good fraction will suffer harshly ( see Bankrupcy reform bill).

Stock Market:

The Dow is about 100 points from meeting the last top. If it fails to break through, it looks like a really clean double top. The Nasdaq is about 120 points from a top. The last top was tested several times. Definitely a harder ceiling than the Dow. The SP500 has reached the level of the last top. So what happens from here? I think we get a short term rally. The Sp500 might even break its top. I think that is mainly because the street will read the inflation and commodity numbers and think that inflation is under control, the fed won't boost rates, and we will have a soft landing. I think the first two aren't horrible reads but the last one is totally off. So the market will rally before they realize how bad things are getting and will begin a leg down. I think of the scenarios you put up (bearable malaise, malaise, reinflation of the credit bubble), only a reinflation is positive for the market at all. But the reinflation can't last forever. I just see as best case that the long overdue correction will merely be delayed. Still think there is a good chance of a 15%+ drop before the end of the year- on the low side.