Forecast 2007: Disinflation Then Reinflation, Part 2

The markets generally appear to be under the assumption that the economy is rebounding. Without much fanfare, the economy ended up without a recession in 2006. Recently, jobless claims have dipped, the unemployment rate is low at 4.5%, real wages are rising, durable good orders are up as is the ISM Index: Manufacturing (January falls to 49.3: below 50 = contraction), and corporate earnings are beating expectations. The general perception is that after a brief soft patch things are looking up again. In summary, the economy is slowing down but still growing at a sustainable pace. On the surface this would appear to be good news. However, it is also bad news. A stronger-than-expected economy means the interest rate cuts the markets have been anticipating may be postponed.

The recent rally that began last summer on rate-cut expectations appears to be puttering out. Originally it was thought that rate cuts begin by yearend 2006. As the economy held up and indeed strengthened in Q4, those rate-cut expectations began to be pushed further out. At first it was Q1 2007, then it was Q2, now rate cuts aren't expected until some time in Q4. Some on the Street are predicting that there will be no rate cuts in 2007. Others believe, due to relatively cheap money throughout the global financial system, inflation remains a problem which means there could be the possibility that the Fed could end up raising rates.

With the economic numbers looking stronger, rate cut expectations have been reduced and pushed back until the final quarter of the year. So what we see in the markets now is a clash between profits and monetary expectations. On the profit front, with over 40% of the S&P 500 companies now having reported fourth-quarter results, positive surprises have been accelerating. Of the 197 companies reporting as of last Friday, 68% posted profit results beating expectations, with 17% missing expectations and 15% matching expectations. The results are similar to those reported for the last eight quarters

So With Profits Rising, Why Is the Market Struggling?

The answer is that perceptions are changing once again. The previously expected scenario that the economy would slow down, interest rates would be reduced and another new liquidity cycle would start is fading away. Instead interest rates are rising, inflation remains stubbornly high, and the Fed is still talking tough on inflation. However, is this change in perception of the economy's newfound strength valid? In looking back at the fourth quarter 2006 and the beginning weeks of this new year, there appears to be many one-off events that have contributed to the economy's surprising strength. In fact there are three events that may account for this good fortune.

1. Unusually warm winter weather
2. A drop in long-term interest rates
3. The sharp drop in oil prices

The unusually warm weather that the nation experienced in December and early January may account for some of the strength in the construction industry. Warm weather likely raised the seasonally adjusted number of housing starts by as much as 43,000.[1] The weather also may have influenced construction payrolls during December making them stronger than they would normally appear. The warm weather also influenced energy consumption. Heating bills for December and the first half of January likely will be lower than usual on a seasonal basis. However, this one-time benefit of the warm weather may be behind us as colder temperatures have been moving across the country with places such as Phoenix experiencing a light snow.

Another factor behind the pickup in economic activity has been the drop in interest rates. The graph below illustrates that since reaching a peak in June of last year at 5.24%, interest rates on the 10-year Treasury note (^TNX) fell to a low of 4.42% in early December. This helped to put a floor under real estate as well as cushion the fallout from adjustable rate mortgage resets.

Now long-term rates are on the rise again and the fallout from real estate is beginning to accelerate. [2] The drift upward in interest rates is not only affecting the real estate market, but it may not be long before rising rates have an impact on the financial markets as well as the economy, perhaps by the second quarter of the year.

Finally, the last one-off event impacting markets and the economy has been the sharp drop in oil prices since last August. After reaching a high of nearly a barrel in early August the price of crude fell to as low as , a drop of 35% from its peak. As a result of the drop in crude prices, gasoline prices at the pump declined, putting money back into consumers' pocketbooks. The combination of low energy prices and warm weather meant that consumer budgets were less strained, which helped to fuel a pickup in consumer spending.

The combination of these three events certainly had an impact on economic activity in the fourth quarter, making the economy appear to be stronger than what had been expected. Since then conditions have changed. The weather has cooled, interest rates are on the rise, and crude oil prices are back in the mid-fifties. The drop in oil prices from the August high (while now on the rise again) has also removed a very important source of support for the U.S. Treasury markets. To compensate for the unexpected shortfall in crude oil prices, OPEC has been selling U.S. Treasuries at the fastest clip in more than three years.[3] OPEC has yet to make good on its pledge to reduce production by 1.2 million barrels per day (bpd). But there are other problems to worry about in the oil markets.

The Mexican government reported the virtual collapse of Cantarell the world's second-largest oil field in terms of output. The decline is unfolding much faster than previous projections made by Mexico's state-run oil company. Cantarell's output fell from 1.99 million barrels in January 2006 to 1.5 million barrels by December 2006. This brings Mexico's oil output down to below 3 million bpd.[4] Cantarell's problems mirror the larger problems in the global oil market, which is the sharp decline in oil production in the world's oldest and largest oil fields. Nigeria, another major oil producer and exporter to the U.S., is at risk of seeing its production taken offline as rebels accelerate their attacks against the country's oil infrastructure.

Although many of the one-time events of the fourth quarter have begun to reverse themselves, the markets are still far too complacent. Credit spreads have declined, volatility indexes have fallen, interest-rate contracts in the derivatives market continue to mushroom, and credit default swap premiums have narrowed considerably over the last year. The idea of risk seems to have disappeared from the market's consciousness. A recent article in the Financial Times highlighted the explosion in the collateralized debt markets (CDO). Total CDO issuance was probably .8 trillion last year, a threefold increase over 2005. A senior banker with a long career in the credit markets sent a disturbing e-mail to the author of the Financial Times article.

"Hi Gillian," the message went. "I have been working in the leveraged credit and distressed debt sector for 20 years . . . and I have never seen anything quite like what is currently going on. Market participants have lost all memory of what risk is and are behaving as if the so-called wall of liquidity will last indefinitely and that volatility is a thing of the past.

"I don't think there has ever been a time in history when such a large proportion of the riskiest credit assets have been owned by such financially weak institutions… with very limited capacity to withstand adverse credit events and market downturns.

"I am not sure what is worse, talking to market players who generally believe that 'this time it's different', or to more seasoned players who… privately acknowledge that there is a bubble waiting to burst but… hope problems will not arise until after the next bonus round." He then relates the case of a typical hedge fund, two times levered. "That looks modest until you realize it is partly backed by fund of funds' money (which is three times levered) and investing in deeply subordinated tranches of collateralized debt obligations, which are nine times levered.

"Thus every m of CDO bonds [acquired] is effectively supported by less than ,000 of end investors" capital - a 2% price decline in the CDO paper wipes out the capital supporting it."[5]

What the markets seem complacent about is the apparent fact that dollar-based liquidity conditions will remain supportive of financial asset classes. There has been a rebound in liquidity globally. Money supply growth is still expanding with evidence of money growth reacceleration in China. Policymakers in Japan are refocusing their efforts on reinflating the economy which remains favorable toward the yen carry-trade. The Bank of Japan is keeping borrowing costs near zero and letting its currency drop, a sign of its reinflation efforts. It has been this rise in liquidity that has spawned all types of risk taking, notably in the mortgage markets. What could spoil all of the happy talk on Wall Street is another change in perceptions, one where the economy weakens, real estate moves steadily toward a crisis in the U.S., and finally a sudden drop in the equity markets globally.

This brings me back to one of our themes for this year: disinflation then reinflation. For this scenario to play out three things need to happen before the Fed lowers interest rates and the next reinflation cycle in the U.S. begins.

1. Continued deceleration in real estate, moving towards crisis
2. Economic slowdown with breakdown in consumer spending
3. Substantial correction in the equities markets

The combination of all three of these events unfolding likely will provide the Fed with the ammunition it needs to begin its next reinflation cycle. Not until the economy shows substantial evidence of slowing (such as the unemployment rate rising and the strong consumer spending patterns beginning to reverse themselves) will the Fed move towards easing. A financial crisis in the markets would also be a liquidity accelerator.

What Is the Likelihood That This Scenario Will Play Out?

Let's begin with real estate. The warm weather and the drop in long-term rates during the fourth quarter have made the real estate market appear that it has bottomed. Much of this is due to the one-off events mentioned above. Since the fourth quarter, the weather has gotten considerably cooler and interest rates have begun to rise again. In addition to these factors it is my belief that the strong housing sales numbers of the past few months have been a statistical fluke. As mentioned in Part I of this article, the government doesn't count cancellations of home purchase contracts when it measures new home sales. For example, if you signed a contract to purchase a new home at the beginning of the month but cancelled that contract before the month ended, your contract would still get counted as a housing sale even though the contract was later cancelled. Many builders such as D.H. Horton and others have been reporting cancellations of 30-40%. So the new home sales numbers may look much stronger than they actually are.

Even more worrisome for the markets is the supply of homes on the market and the acceleration of mortgage foreclosures are beginning to accelerate. According to La Jolla based DataQuick Information Systems, mortgage lenders in California sent out 37,273 default notices to homeowners in the fourth quarter, up 145% from a year ago. In addition to defaults rising, many home builders are still sitting on a significant number of unsold homes. As new home builders lavish incentives on new home buyers, resale sellers are having difficulty competing. The result is that there is a glut of new home inventory in many of the nation's former "hot" real estate markets. Supplies of newly listed condos are up 86% in Las Vegas, up 43% in Washington D.C., and up 110% in Miami.

Source: Housing Glut Gives Buyers Upper Hand, Wall Street Journal, January 25, 2007[6]

December's warm weather turned cold in January in the Northeast. Mortgage rates are back on the rise as long-term bond yields have headed up, and there is more than trillion in mortgage resets due this year. As interest rates rise many of those marginal home buyers likely will end up losing their homes. Mortgage defaults likely will continue to escalate which could create problems for the financial sector. As rates continue to rise, so could defaults which could bring more homes onto the market, further softening prices. The reacceleration of a softening real estate market likely will also add to unemployment, which would spill over into consumption. If this is the case, retail sales should continue to decelerate as we move into the second quarter of this year.

Eventually the softening real estate market could begin spilling over into the general economy. I would be surprised if the GDP numbers don't start to soften again as the first quarter ends. Manufacturing could also resume its downward trend of the last six months. As the weaker real estate market begins to weaken, economic growth likely will decelerate once again.

Two Major Trends

If things progress the way I think they will, two major trends would be in place: the softening of the real estate market and the consequent softening in consumer spending/the economy that could produce a change in attitude at the Fed. However, one more catalyzing event could be necessary before the Fed would be prompted to act and that event would be a serious downward spiral or downturn in the financial markets. What could cause that to happen? Well there are numerous candidates that could shake the markets' complacency. One would be if the broad public perception of the economy as strengthening gave way to perception that it was weakening; the other would be sliding corporate profits. If talks of a recession start to surface again the markets could get worried, but it may not be enough to rattle the markets. To truly rattle the markets, a real scare such as the bankruptcy of a major financial player would need to occur. Further deterioration at Ford (F) could be another confidence-shaker. Last week the markets shrugged off Ford's report of massive losses: the company reported losses of .8 billion in the fourth quarter which pushed up its losses for the year to a record .7 billion, the largest in company history. The company is optimistic that those losses will narrow this year. Ford's confidence may have more to do with the company securing .5 billion in additional financing via secured lines of credit than with the actual strengthening of the company itself.

Then there are always the mortgage and CDO markets which have mushroomed beyond belief. There are plenty of trouble spots lurking in these markets, not to mention many hedge funds' free cash-flow-money-machine: credit default swaps. Up until recently using credit default swaps as a profit strategy has been a no-brainer; a way for hedge funds to make money without using their own capital. All that is needed now for this area to ignite a chain reaction in the credit markets would be a serious financial crisis that widens credit spreads and increases debt defaults. A serious financial crisis that spilled over into the financial markets and caused a 10% correction in the stock market, combined with a slowing economy and a defaulting real estate market would have the Bernanke Fed slashing rates faster than you can say "helicopter drop."

Another scenario that could unfold would be a worsening situation in the Middle East led by provocations from Iran or the U.S. A military strike against Iran almost undoubtedly would send oil prices soaring and asset markets plunging. It is the one event that could accelerate all three of the catalyzing events I have described above.

If… Then Reinflation

If all of this happens as I have described the next stage of my scenario would unfold: reinflation. In this scenario, the Fed would begin to slash interest rates, which would flood the markets and the economy with liquidity, which could set the stage for the next Bull Run in financial and commodity assets. If the Fed slashes rates other central banks likely will follow suit, which could lead to reliquification of the markets. The only problem this time around would be that, unlike 2001, inflation and interest rates will also be rising.

So how will an investor know whether the scenario I have outlined may unfold as I have described? There should be several signposts and markers that the alert investor should watch out for. They are listed below:

I. Economic Signposts (Stock Charts)

• Subprime lenders
• Brokerage shares
• Homebuilders
• Ford/GM
• Fannie Mae/Freddie Mac
• KAS Index
• Yield curve
• Rate of credit expansion

II. Financial Market Signposts

• Emerging Markets/Nasdaq (high beta stocks)
• Dow/S&P 500 (market/low beta)
• Transports

III. Catalysts

• Iran
• Housing: foreclosures, financial crisis
• Widening credit spreads, credit default swaps

If what I have described indeed unfolds, the downturning charts of individual stocks and of the major indexes, including a breakdown of the emerging market stocks, should give investors a clue as to whether or not my scenario may indeed play out. A breakdown in high beta markets should alert investors that something is amiss in the markets and that risk trades may be unwinding. If that happens the major indexes such as the S&P 500 and the Dow should soon follow. The breakdown in brokerage stocks, the main beneficiaries of the rise in liquidity, should confirm the trend breakdown in the indexes. A fall in subprime lenders, home builders, Fannie Mae and Freddie Mac, and the rise in the yield curve likely would precede the accelerated downturn in real estate I have described. Finally, a continued drop in the KAS and the Dow Transports along with a rise in oil should confirm a weakening economy. Also watch Ford and GM for further softening and trouble in the manufacturing sector.

Forecasting is an uncertain business. To rely on analysts' predictions completely in charting one's financial future is risky. Events can change suddenly, reversing what was once commonly held to be true. For these reasons I have learned over time to keep my own forecasts broad and simple. I've avoided some of the fallacies of trying to predict the exact number of the Dow will reach by year-end or what interest rate will prevail as the year closes out. Instead I've laid out a broader picture as to how I expect events to unfold. Last year I predicted the Dow would reach a new record high, which it did. I didn't know how high, but I felt a new a new record was possible. I felt there was too much bearishness last year; doom was everywhere, especially for the real estate markets. Yet all I saw was oceans of liquidity, which told me markets were headed higher despite all the talk of doom.

This year complacency reigns everywhere. You can see it in the rise in margin debt, the takeover of mortgage sub prime lenders by investment banks, and the narrowing of premiums on credit default swaps and the VIX. The effects of the one-off events that seemed to give strength to the economy last year I believe will soon fade. The assumption that oil prices will continue to fall at a time when geo-political tensions with oil-producing countries are rising and major oil fields are peaking indicates that these negative factors are being completely ignored by markets all around the globe. Rising complacency, low volatility and obliviousness to all forms of risk are usually the status quo right at the time when some catalyzing event appears out of nowhere to take the markets by surprise. This is what I expect this year. Expect the unexpected. As for ourselves, we are raising cash on expectations of better buying opportunities ahead. I expect markets to reach new record highs this year; in the case of the Dow it already has. Last year at this time our theme for 2006 was "first the gain, then the pain." I believe the time of pain will soon be upon us. I end on a brighter note.

“If a man look sharply and attentively, he shall see Fortune; for though she is blind, she is not invisible.” - Sir Francis Bacon (1561-1626), English philosopher, statesman and essayist.

References:

[1] BusinessWeek, February 5, 2007, "Seasonal Trends", p. 26

[2] The New York Times, December 20, 2006, "Study Predicts Foreclosure for 1 in 5 Subprime Loans," Ron Nixon; The New York Times, January 7, 2007, "Mortgages; Storm Clouds over Risky Loans," Bob Tedeschi.

[3] Bloomberg.com, January 22, 2007, "OPEC Dumps .1 Billion of Treasuries as Oil Tumbles (Update 2)," Bo Nielsen and Daniel Kruger.

[4] The Wall Street Journal, January 27, 2007 "Mexico's Oil Output Cools," David Luhnow.

[5] Financial Times, January 14, 2007, "Elaborate Debt Deals Spread Risk but Distort the Data," Gillian Tett; Financial Times, January 18, 2007, "Unease Bubbling in Today's Brave New Financial World," Gillian Tett.

[6] The Wall Street Journal, January 25, 2007, "Housing Glut Gives Buyers Upper Hand," James R. Hagerty and Ruth Simon.