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PRUDENTIAL SECURITIES INC.
One New York Plaza, New York, New York
(September 22, 1997) FINANCIAL INSTRUMENTS: LOW INFLATION SAVES THE DAY–The Treasury market surged sharply higher during the past week in response to good inflation data. The price action confirms that the market is focused solely on inflation and remains unconcerned about growth. So far, with the “new paradigm” theory working, the optimistic view seems to be paying off. Given the flatness of the yield curve and the tight spread in yields at the short end of the curve over funds, it appears that the market is prepared for more of the same.
In keeping with the theory that the economy can grow at a rapid rate without generating inflation, the economic data were largely ignored in favor of the price data last week. Industrial production rose a sharp 0.7% during August despite a drop in utility output. Manufacturing output alone was up 1%. On an annualized basis, it looks like Q3 industrial production is running at over a 4% rate, consistent with the pace of the first half of the year. Inventories don't seem to be a problem as the inventory/sales ratio declined to near record lows during July. Capacity utilization hit 83.9%–territory that used to generate concern at the Fed.
Some comfort was derived from the housing starts which showed an unexpected decline of 4.7% in August. This is really perplexing since every other indicator in the housing sector is strong. In fact, the day before the starts figures were released the National Association of Home Builders indicated that their index rose to 59, near the year's high. Moreover, demand for housing remains strong by all measures. Mortgage applications continue to hold at high levels. Floor traffic is strong and existing home sales and prices are rising. With housing inventories very low by historical standards and ample financing available, why would home builders suddenly slow down? Typically, these are the guys who over build at the peak of the business cycle. The explanation is probably mundane. The seasonal adjustment program for housing starts seems to be off for the months of July and August, as they have indicated declines in those months over the past few years which have been inconsistent with the trend the rest of the year.
INFLATION DEBATE CONTINUES–The big market mover last week was the CPI report which came in a full one tenth of one percent lower than anticipated. This was enough to send the bond market skyrocketing as shorts ran for cover and the bulls aimed at new highs. Details in the report were perhaps somewhat less comforting than the overall figures. Food and energy prices did rise as anticipated but were offset by declines in apparel prices and airfares. According to the Bureau of Labor Statistics, the 1% decline in apparel prices was the result of a seasonal adjustment problems Retailers have delayed the introduction of fall fashions until September while the seasonal adjustment program assumes they start in August. Airfares are also questionable since a 5% fare hike was just announced. If these factors adjust next month, then the CPI data will not look quite as friendly. Then there is the ever-popular “renters' equivalent housing” index which has barely moved this year despite the fact that housing surveys indicate year over year increases close to 5%.
More to the point, the issue of inflation rests on whether you embrace the “new paradigms” or not. If you do, then global competition and technology-based improvements in productivity are holding down inflation in a robust economic environment, it seems to be intuitively true, but has yet to be proved. The productivity numbers don't show much improvement but they could be understating the trend. After all, how else to explain the rise in corporate profits? As for global competition, it seems to abound and appears to be holding down inflation. After all, look at all those imported consumer goods from China.
Yet, these arguments can be turned upside down as well. The unexplained rise in corporate profits could all be the result of the squeeze on labor costs. If that is true, the longer the labor markets remain tight, the more risk there is that costs will rise as wages move up and that either corporate profits get squeezed or cost increases are passed along to finished goods prices. In fact, wages are beginning to rise as unemployment declines. Similarly, there are theoretical problems with assuming that global competition is holding down costs. If that were true for the U.S., then one would expect to see imports rising as a percentage of the economy as companies and consumers substituted imported goods for domestic ones. Yet, as the Federal Reserve Board of St. Louis has pointed out in a recent study, imports are holding steady where they have been for most of the 1990s. Moreover, the foreign exchange market does act as an equalizer, adjusting for inflation rates across borders, It could very well be that the rise in the dollar over the past two and one- half years has been a major contributing factor to holding down inflation. Import prices continue to fall, largely as a function of the strong dollar. Now that the dollar has stabilized, it will be interesting to see whether the trend in import prices shifts.
At the end of the day, inflation is supposed to be “always and everywhere” a monetary phenomenon. Or, in the terminology of Economics 101, “too much money chasing too few goods.” If that is the case, then there has certainly been a lot of money pumped into the economy. Money supply growth has exploded in the past year with both M2 and M3 growing well above the upper end of the Fed's target ranges. On a year over year basis, M2 was up 10.3% in August and M3 was up 8.4%. Broad money growth is now accelerating at the fastest rate in a decade. So while it is currently fashionable to worry about deflation, perhaps the market should be focusing on inflation. At some point, creation of money in excess of the economy's ability to generate capacity, will result in inflation. It is simply a matter of how long the lag will be.
What is most amusing is that the Fed doesn't seem to know what to think either. Greenspan has flirted with the “new paradigm” theory but has not embraced it wholeheartedly in public. Other Fed officials, based on their comments, seem just plain confused. Chicago Fed President Moskow said that it may be “years” before we know if we've entered a new era. Fed Governor Phillips said she “doesn't know” how long favorable inflation will last. Fed Governor Meyer sounds unsure of whether to forecast the economy or the markets. In a rather rambling statement he indicated that the market usually gets the economy and the Fed's intentions right and is therefore rewarded. But sometimes they don't price in expectations properly and then it is the role of the Fed to provide an “anchor” for the market. All of this begs the question of whether it's what you don't know that will hurt you or whether it's what you think you know that will hurt you.
Right now the market thinks it knows that inflation is dead and the Fed won't tighten. The yield curve is very flat, and short-term rates are sitting right on top of the Fed funds rate. With two and five-year note auctions approaching, there doesn't seem to be much worry about who will buy the issues at these levels. Perhaps with diminishing supply, dealers will be willing to pay up for two-year notes, but it doesn't seem likely that retail investors will have the same appetites.
Next week's data calendar is very light. The only reports due out arc durable goods orders and existing home sales. So the market is likely to remain well supported. A lot of investors missed the move up in the bond market and now that the outlook appears favorable, there is likely to be good buying on setbacks. With the Fed out of the picture at the September 30 meeting, it is only the economic news which could stand in the way of new highs. So despite our reservations about the fundamental basis for the market's strength, we are inclined to step aside and not fight the market.
Over the intermediate term however, it is still difficult to see how yields can fall to 6% with a robust economy, rapid money and credit expansion and a Fed biased towards tightening. It would be a lot easier to forecast, bond yields with a 5% handle if the economy were slowing, excess capacity existed and money growth was contracting. But as Fed Governor Meyer said, sometimes the market gets it right and sometimes they don't.
Kathy Jones
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