The "S" Word? 2/21/2008
Weekly Changes
DOW 12284.30 -92.68 -0.75%
S&P500 1342.53 -6.33 -0.47%
NASDAQ 2299.78 -32.76 -1.40%
Talk about between a rock and a hard place. Dr. Bernanke and his cadre of policy makers find themselves in quite a predicament. As this week’s FOMC minutes revealed (not to mention last week’s testimony before Congress), the state of the economy is in all likelihood worsening for the foreseeable future. The recession debate has shifted, by-in-large, from “if there is going to be one”, to “how bad and how long is it going to be.”
The FOMC’s minutes held a trove of dreary information, although the prima facie analysis was, of course, a positive spin. Pundits agree that the bias of the minutes portends future rate cuts. As it stands now, a 50bp is all but baked into the March 18 meeting. This would lower the federal funds rate to 2.5%, the lowest since Q1 2005; a transient level as the Fed tightened rates from 1% up to 5.25%.
The minutes were an account of the scheduled January 29-30 meeting, the emergency meeting on January 21 when the Fed slashed rates by ¾ of a point and, oh yeah, that other emergency meeting that they had on January 9 that they didn’t tell anyone about. Isn’t selective transparency grand? According to the text of the minutes “several participants noted that the risks of a downturn in the economy were significant” and that “further significant easing in policy was warranted at this meeting to address the considerable worsening of the economic outlook.” This is some of the strongest verbiage mild-mannered FOMC members have used in quite some time.
As we have discussed numerous times in this space, the Federal Reserve has two established mandates: to foster growth and contain inflation. Growth is obviously at risk. The Philadelphia Fed survey, released this morning, came in at -24.0, the lowest level since the 2001 recession. This, in conjunction with the equally dismal Empire State Manufacturing Survey, all but assure that the next ISM index, the broadest and most followed indicator of manufacturing, will be brutal.
But the biggest albatross around the economy’s neck comes not from the ISM, but rather the non-manufacturing ISM. This is the broadest gage of the service sector of the U.S. economy. On February 5, the business activity component of the ISM non-manufacturing contracted for the first time in 58 months. This is troublesome as services account for almost 80% of the U.S. economy. We await the next ISM Non-manufacturing due out March 5. If it follows suit, confirmation of a recession is only a matter of time as both the services and manufacturing elements of the domestic economy would be under significant pressure.
But what about inflation? Yesterday’s CPI sent shivers down the spines of classical economists. As any Phillips Curve junkie would attest to, the worst case scenario for an economy is contracting job growth in combination with increasing inflation; a situation known as stagflation. Theoretically, a worsening economy should result in the lowering of prices. As we discussed in this month’s Proving Grounds, recessions are the catalyst for increased joblessness. The unemployment, in theory should cause prices to fall – supply and demand 101.
Exogenous pressures, however, can cause both growth to fall and prices to rise. In the seventies the OPEC oil embargo exacerbated stagflation. Today not only do we have price pressure from energy, but our number one trade partner (China) has rampant inflation, the dollar continues to weaken and our manufacturing base is ill-equipped to provide a counterbalance to these forces.
Next week’s PPI should clarify the inflation situation. If PPI is elevated, a reassessment of exposure to equities is in order. PPI traditionally leads CPI. The FOMC believes that economic weakness ought to ease inflationary pressures, but they very well could be wrong.
Many economists are currently contending that growth is contracting due to the credit crunch, not fundamental weakness. There is a bucket-load of stimulus in the system that has yet to be realized. The rate-cuts in concert with the stimulus package may head stagflation off at the pass; on the other hand it just may make matters worse. After all, the only way to combat runaway inflation has proved to be to aggressively raise interest rates; just ask Paul Volker. Prudent investing with significant downside protection is in order for the immediate future.
Please Trade Carefully.
Jeffrey A. Hirsch, Editor
J. Taylor Brown, Director of Research
Stock Trader's Almanac® Almanac Investor
Copyright © 2008 Wiley Periodicals, Inc., A Wiley Company.
111 River Street, Hoboken, NJ 07030
Tel: 800-762-2974
