| |
 July 2008 Broken Spiral
Like an infectious disease, it's spread from one part of the market to another, mutating in response to any fiscal or monetary medication. The Fed's easy money policy hasn't stopped it and the President's tax rebate checks haven't really boosted liquidity. No financial institution -- from the largest money center banks to the corner savings and loan -- is immune. Like the hapless scientists in The Thing, no one knows who's infected because appearances -- or in this case, balance sheets -- are deceiving. Initially investors tried to ignore the situation, going on the assumption that the damage would be limited to the financials. But over the past few months, the impact has become much more widespread. Although the economy isn't technically in a "recession", growth in the first quarter slowed to just under 1%. Investors were finally forced to acknowledge the depth of the problem, when Bear Stearns, a financial company believed to be to big to fail, failed. The Fed rushed to the rescue brokering a deal with JP Morgan Chase and rapidly trimming the Fed Funds rate to 2%. Unfortunately, that didn't end the crisis, it only redirected it.
Look Out Below
At this point most investors have written off the money-centers, at least for this year. They've suffered so much damage it's virtually impossible to see how they can return to profitability in 2008. Not only have they been forced to mark down distressed assets, they've also been forced to raise capital through the issuance of more stock. As the additional shares come onto the market, earnings per share drop even further. But here's what nobody anticipated: The crisis has worked its way down the financial food chain to the regional banks. They're the ones holding a lot of local mortgages and business loans. They also took on more risk than they could handle and now their smaller balance sheets afford less access to the credit market. Citigroup, UBS, and Merrill Lynch are being replaced in the headlines by Fifth-Third Bancorp, Wachovia, and Huntington Bancshares. Ironically, it's easier for larger institutions that have lost significantly more money to secure funding and credit than it is for smaller ones. That's why Lehman Brothers can raise billions additional capital every two weeks or so while small Midwestern banks struggle to scrape together $100 million. Once again, it's that difference between being too big to fail and to small to matter. In this environment, things are bound to get worse for the regional banks before they get better. As long as their larger counterparts are still ailing and sucking all the liquidity out of the strained credit market, they'll either have to get by on the crumbs that are left or put themselves on the auction block. This can actually provide an important opportunity for astute investors. While it's still too early to jump back into financials, there will come a time when they'll be at a compelling entry point. You won't be able to gauge that by traditional fundamental measures because after all, most financials are already incredibly cheap by most standards. The problem is they can get even cheaper. Rather than focusing on how the market prices them, the better approach is to monitor how they react in the market. At some point the consolidations will begin. Struggling regional banks will be viewed as takeover targets and a cheap means of expanding existing markets. When banks start taking over other banks, then you'll know it's safe to get back into the financials. When the insiders think it's safe, it's safe for you, too. But beware of false alarms. That's precisely what happened with the Bear Stearns/JP Morgan deal. Investors mistakenly took that to mean it was safe to come back in, and that's at least part of the reason stocks rallied so strongly in its aftermath. Unfortunately, there was more bad news to come and the rally proved to be premature. The time will come, just not yet.
Spillover A country's currency is not unlike any other commodity -- its value is determined by supply and demand. When prevailing domestic interest rates are low, investors seek other alternatives where they can earn a higher return. With dwindling demand, the value of the currency falls. Anyone using the weakened currency will find themselves paying more for the same goods even if the goods' intrinsic value has remained unchanged. In this case, the price increase is a function of the weak currency rather than appreciation in the goods themselves.
Arguably, that's what's been happening with crude oil and other commodities. Crude is priced in dollars and when the dollar declines, the price of oil rises. Although oil has been rising in all currencies, the jump hasn't been nearly as steep as it has been in dollar terms. To be sure, supply also plays a role. Some argue that rising commodity prices have been driven by soaring demand in developing countries, China in particular. But this can't be the whole story. Growth hasn't just started in the developing world, it's been going on for quite some time, but commodities have just taken flight in the past year. In addition, China's growth has actually cooled from the pace set over the past two years, a trend that started roughly when commodities began their ascent. Speculators have played a role, too. Today's markets disseminate information much faster than just a decade ago. Not only that, the growth of derivative products and even commodity-tracking exchange traded funds have made trading easier and potentially more profitable. Speculators who never intend to physically touch a barrel of oil or a bushel of corn can easily control thousands, not to mention affect he price. Conceivably they've played a major role in the commodity runup. Yet it really doesn't matter why prices are rising, only that they are. Central banks and fiscal policy makers around the world need to act sooner rather than later. As we all learned in the 1970s, inflation is extremely difficult to thwart once it runs wild. We also learned what it could do to the stock market, too. If you lived through the 1970s (or at least saw something about it in history books), you've seen that stocks can go nowhere for the better part of a decade. When inflationary expectations are high, stock returns -- from the longest duration investments -- are low. Occasional rallies are followed by declines in a grinding market that basically goes nowhere. Sound familiar? Take a look at the Dow Industrials or the S&P 500 for the past eighteen months. These lessons haven't been lost on the Fed. Monetary policymakers have suddenly changed course and are once again focusing on inflation rather than the slowing economy. For the first time since last September when they began aggressively cutting rates, they're out making speeches citing inflation as the most dire threat. It's not so easy to tell what the fiscal policy makers actually learned. So far, they're still focused on the slowing economy, but that's probably what you'd expect in an election year. You're likely to get more votes with a tax rebate check than by telling the electorate they'll have to tighten their belts and actually save some money. As far as inflation is concerned, don't expect anything that's not counter-productive out of Congress this year. Initially the markets were unfazed by all this. They took tax rebate in stride, but were thrown for a loop when the Fed started talking tough. Yields on government bonds jumped almost a half percent and the futures market priced a 100% likelihood of a half percent increase by yearend. To a certain extent, this is what the Fed desired. Following the two-day FOMC meeting in late June, the tone was a little more evenhanded. Yes, inflation was still public enemy number one, but maybe it wasn't as threatening as it had earlier seemed -- at least that was the message of the post-meeting communiqué.
Nobody's Playing When resource prices rise, consumers and producers can react in one of two ways. The first fans inflationary flames, the second, although painful, doesn't. At this point, it's not a foregone conclusion that the former will occur; in fact, so far it's been the latter. Higher commodity prices are already pinching margins and profits for producers. This is particularly true in those industries that directly utilize the higher priced resources. Refiners are a classic example. As the cost of crude oil has gone up, they've tried to maintain their margins (the difference between the cost of materials and the revenues from their finished product) by drawing down their existing stockpiles that were purchased when crude was considerably cheaper. But as these supplies dwindle, refiners are forced back into the market and must pay more to replenish them. They're then faced with the choice of attempting to raise the prices gasoline and heating oil, or cutting their margins by holding the line. Contrary to what you might think from the gas pump, most refiners aren't passing along the full increase. If they were, gasoline prices would more closely track the enormous increases in crude oil. They don't, and you can thank the refiners for that. Although their profits have suffered, they realize their markets would grind to a halt if they passed on the full increase. That's not the classic inflationary response to rising input costs.
The classic response typically fuels the "inflationary spiral". When resource costs rise, producers pass the increase along to consumers by raising the price of their finished goods. Consumers must either absorb this extra cost or increase their own resources. To do the latter, they demand (not in the Dagwood-and-Mr.-Dithers way, but in the economic way) higher wages. Their employers, needing to utilize their new, higher cost resources, capitulate and pass the extra expense on through even higher prices. The cycle repeats itself and prices continue to escalate, hence the name, inflationary spiral. This is the first possible response to higher resource costs mentioned above. It's what happened in the 1970s and early 1980s when inflation became so firmly entrenched. It's also a cycle that's extremely hard to break without painful monetary tightening and possibly higher levels of unemployment. But so far around, that's not been happening. If it was, refiners would be passing along all their costs -- possibly plus some. But they haven't. They realize demand is already declining for their products and further increases will only speed the decline. Food prices have been on the increase, too, but they've also been restrained relative to what they could be. So far, the inflationary invitation is out there, but there takers have been few in number.
Gail Dudack, founder of Dudack Research Group put this in perspective in a recent interview with the Wall Street Journal, "With oil prices repeatedly hitting records, one has to ask whether or not this inflation isn't eventually deflationary. It's not like consumers are out there buying everything because the prices are going up -- they are buying less. So I think it's likely to be more recessionary than inflationary." As prices are rising, demand is falling. That's the second response to rising prices, and it's not particularly inflationary. On the other hand, falling demand isn't the best tonic for the economy or stocks. That's a harbinger of recession, not inflation. The economy is teetering near recessionary levels now, and higher prices choking off weak demand may be all that's needed to make it official. That's a painful outcome as well, but arguably the better alternative to a major bout of inflation. As long as the inflationary spiral remains broken at its lowest level, the Fed's hand won't be forced. Ultimately, interest rates will have to rise if for no other reason than because they're currently so incredibly low. The sooner they begin to move back up, the sooner the dollar will regain strength. That's really what's needed and it's the best way to fight inflation. If this can happen in an orderly manner, we can once again skirt the threats of inflation and recession. It could happen. Search this site! Just enter you key word or words:
Get current quotes or follow your own custom portfolio,
courtesy of E-Line Financials:
|
|||||||||||||||||||||||||
T'S BEEN ALMOST A YEAR now and there's still no vacation from the credit crisis. At this point, it's taken on the characteristics of a mosquito in a camper's tent: Try as hard as you can, and you still can't get rid of it. Just when you think it's finally gone, it bites you in a different place. In the process, it's sucking the lifeblood out of the financial markets.
