With the collapse of Intel, turmoil over the euro, and the latest oil price spike, a wave of fear and trembling has swept over the stock market. Add to that the rise of Al Gore putative regulator in chief and you have a recipe for pessimism.
In recent weeks I have been making the rounds to a number of institutional investors on both coasts. A bunch of people are getting worried about recession, and a number are concerned about inflation. Then there’s a group that is worried about all of the above. Nearly all my clients are less optimistic than I am.
The current sour mood is what it is, and no one’s going to change it. Least of all me. For what it’s worth, however, I believe this too will pass.
Here’s a thought. The single biggest prosperity-killer and recession-inducer is inflation. Show me a 5 percent or higher inflation rate that is, a recurring, core, underlying, monetary-induced inflation and I will surely forecast recession within a year.
But if a return to 5 percent inflation is out there, then why isn’t it showing up inflation-sensitive market prices? To wit, spot gold is still hovering in the mid-$270s. Actually, for the first time since last May, the year-to-year change in gold has turned negative. If this mother of all inflation indicators jumps a hundred bucks, then put recession in your gunsights. But not until.
The king dollar exchange rate index is still on a tear, even after the Euro intervention. Never in recorded history, going back 2,500 years at least, has a strong currency coexisted with a rising inflation rate. (Admittedly, the data around 450 BC is a bit sketchy. But all the other evidence holds together.)
Long-term Treasury bond yields are still about 100 basis points below their winter highs, and the spread between 10-year rates and the 10-year inflation-indexed rate is less than 2 percent. So the inflation outlook from this market indicator is benign.
Speaking of bonds, let’s go global. And let’s assume bond rates are like gold. That is, they are good indicators of future inflation.
Despite the recent oil bubble and the euro decline, long-term interest rates in Britain, France, Germany, Japan and the U.S. show no panic. In fact, subtracting real interest rates from market rates, the outlook for expected future inflation is around 2 percent to 3 percent for these countries, with Japan and the United States at the low end and Germany, France and Britain in the upper end. This outlook has seemingly been unaffected by all the oil and euro tumult.
Market rates in these countries have remained low, while real rates essentially haven’t changed. For Britain and the U.S. I used inflation-indexed government notes as the real interest rate. For France, Germany and Japan I used five-year averages for annual real GDP growth. Because of German unification, that country’s real rate and real growth is more difficult to calculate, so I just left it the same as France’s.
Now here’s the key point. If inflation fears were truly being driven higher by the oil shock and the Euro decline, then market bond yields would have jumped significantly. In the event, expected inflation rates (market rates minus real rates) would have spiked up.
But the event didn’t happen. At least not yet. International credit markets are looking through the temporary shocks and predicting continued low inflation. It’s a good thing.
It is particularly interesting that European bond rates haven’t jumped. After all, rising oil prices are scored in dollars. So the falling euro will create a big monthly hit in the euro CPI. But euro bonds don’t seem worried.
The euro-zone core CPI is only 1.3 percent through July, slightly lower than it was two years ago. The low point about a year ago was 0.9 percent. So there’s a small rise, but it’s not a problem. The euro-zone GDP price index including oil is up 1 percent over the past four quarters (through the first quarter). This measure recently peaked at 3.5 percent in early 1996. Its low was -0.5 percent in mid-1997. Not much inflation here.
Over the past three years, the average level of euro gold has been 280. Currently it’s about 320, 14 percent above the trendline. So you could argue there is some excess liquidity in the euro financial system.
For the Group of Seven currency intervention to have any lasting positive effect, it should net out to an unsterilized liquidity withdrawal. At aminimum, it seems likely the intervention has set a floor under the euro and stopped the hemorrhaging.
But the big euroland story is next year’s tax-cuts in Germany and elsewhere. Marginal tax-rate reduction will gear up Jan. 1, and phase in for the next couple of years.
Euro weakness may well continue in the fourth quarter as people hold back their income and investment until lower tax rates kick in. This effect could dampen fourth-quarter euro GDP growth as well. But supply-side tax cuts should gradually strengthen the euro and its underlying economic growth rate over the next few years.
This is the best way to absorb excess liquidity. Lower tax rates and higher after-tax economic returns will generate more output to absorb the existing money supply. It’s a growth solution, not an austerity solution.
As for oil, there is relief in sight. At today’s gold price, an ounce of gold buys only nine barrels of oil. Historically, gold has purchased nearly 20 barrels of oil. So the relationship is way out of line.
If the U.S. dollar remains strong, and gold low, the gold-oil ratio would predict something like $20 a barrel. (See Richard Salsman’s latest Sept. 25 Intermarket Forecaster piece on this and other monetary gems.)
More than likely the SPRO sales in the U.S. set a ceiling on oil. If these sales were accompanied by an anti-trust action condemning OPEC’s international cartel, then the Clintonites could have turned bad politics into good policy. Whatever. Oil prices are going down.
All this is to suggest bond markets are smarter than pessimists. There’s no big inflation in sight. Therefore, there’s no recession in sight.
A bad global CPI for September? Absolutely. But it’s an unsustainable yawn.
A U.S. growth slowdown to 3 percent from 6 percent? That’s my view. With roughly 2 percent inflation, and a 5.5 percent 10-year Treasury yield. The fed funds rate looks to be 100 basis points too high.
The aftereffects of Y2K excesses last year, Fed tightening, the tax-increase effect of the oil shock, a pending inventory correction; all this will lower growth. But King dollar holds down inflation.
Intel, meanwhile, is primarily having an Intel market share problem. Though it probably also signals a slowdown in nominal GDP, or total spending, in the U.S. economy.
But this is no recession. It’s a high-class problem. Used to be that 3 percent was the max, remember?
So, folks, you really should stay the course. This is not the oily 1970s. It’s not even the Persian Gulf early ‘90s. The European high commissioners never get the story right, but the grass-roots tax revolt by ordinary people will lead to very positive things.
I am sure there is a mild recession somewhere out there, but I just don’t yet see it. Meanwhile, Internet economy productivity gains may continue to surprise all of us, as has regularly been the case recently.
So, my advice: Stay the course. Keep the faith. Faith is still the spirit.
Lawrence Kudlow is chief U.S. investment strategist and chief U.S. economist at ING Barings LLC.