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Today's Commentary: 07.08.05
Half-Baked

I'll admit, the bombings yesterday in London threw me off just as much as it did the rest of the world. The markets, at least in the pre-market, looked as if they would need a little help from the built in mechanisms that are there to keep us from panicking. That would make the risk premium for terror an underlying fundamental, already built into the markets. But the overall fundamentals have been based on the individual investor's belief that we are on firm economic footing.

The day prior to the attack, now being criticized as a "weak effort" to disrupt the G8 summit in Scotland, was coming on the heels of a triple digit loss in the Dow. The fact is the major indices were already significantly down for the year in spite of what the economists are saying about the return to confidence, the steady but slowing pace of profits and growth, and the continued presence of cheap money for every corner of the economy. Those pesky interest rates are now in the "ninth inning" by the way and it is appears that this analogy will take us well into extra innings. The interest rates on the short term over night rate are expected to continue moving still higher before the game is over.

Even there, Fed watchers are seeing a peak by year's end and then an easing in the next year as Alan Greenspan takes his leave. Some long range forecasts even go so far as to suggest that because of Greenspan's skill, the President will ask him to linger until a successor can be found. His presence however might provide more problems than help in any sustainable recovery.

Those fundamentals for sustained growth and corporate profitability have been pushed aside during the first year by the ever present economic threat that China seems to be posing. While some dismiss this notion, one I have suggested repeatedly in this column, the fact remains that the Chinese are an unpredictable and self-serving beast whose economic weight cannot be ignored. The pressure that they will continue to exert on the commodities markets, their ability to grow customers through good will and not military action, and their belief that they can shape markets is not about to go away soon. It seems that this country's presence will dominate the world stage in the future much the way the United States has in the past.

The heat in the housing market continued during the first half of the year keeping the consumer confident that they can keep the economy moving forward simply by consuming - and borrowing. That economic expansion does not appear as steady as it sounds when you begin to factor in the way we arrived at this point of growth. Whether or not there is a bubble here remains to be seen but the effect that this is having on the overall economy is actually quite clear. Housing is affecting not only GDP but inflation as well.

The latest reading offered by the Bureau of Economic Analysis shows the adjusted GDP for the first quarter of the year up 0.3% from the first release leaving the final number at 3.8%. That is almost exactly the difference in the change in inflation, which fell during the same quarter. Hard to believe? The BEA defends its numbers by suggesting that housing prices actually rose at a slower pace than it had in the previous four quarters - and we are talking 2004 numbers here - even if spending on homes was in the double digit range. Spending equates to consumers willingness to buy and you can hardly turn on the television or pick up a newspaper without hearing about the speculative nature of this market. The BEA although reports that the prices of those homes in the January through March period were higher only by a meager 1.1%. Even harder to believe.

The bond market expects that inflation number actually coming down from 2.8% by almost half over the long range which would suggest that they are looking at a slowing in this speculative housing market. The ten-year Treasury yields have been depressed by the continued Asian appetite for these notes but fixed income mavens do not see that remaining steady over the next two years. The speculation - make that belief - that housing prices will rise unabated and unhindered by the lack of or decreased economic growth around it is based on the shaky notion that the increased weight of this market will not be a factor.

the second half of the year will be fraught with the same problems that were shrugged off in the first half.

The volatility in the jobs numbers over the last year have pointed at this inability to find the firm ground needed to sustain any significant growth. Whisper numbers prior to the release of June's Jobs Report showed a lack of confidence with many targeting an increasingly wider range as good.

This consensus range before the number of 146,000 was released this morning showed a safe margin for error at almost 50,000 either way. And when it was released, well below consensus, it was actually viewed as good. The markets will need to accept these numbers, which is peppered with a significant increase (150,000) in service sector jobs and 24,000 job decline in manufacturing.

The numbers for the previous two months were revised upward but it doesn't seem to be something that would cause celebration. The continued lowering of the bar from a previous necessity of a moving average of 300,000 is now around 100,000.

The 2.3% decline in the number of unemployed and the significant increase in service sector jobs does not prove any sort of firm footing for the economy. Question is: can the Federal Reserve Board ignore these weak employment numbers and diminished GDP expectations and still use their Philips Curve model to predict inflation?

Even the augmented or short term version of this economic model (A.W. Phillips developed a long range economic model by using U.K. data from 1861-1957 which implied that policymakers could permanently lower the unemployment rate by generating higher inflation) the Fed uses was developed after the stagflation of the '70's when both unemployment and inflation skyrocketed together. The newer model is based on the short run expectations that these two indicators should move in opposite directions. This means that as the unemployment rate drops, inflation should rise. So far, that has not been the case. And that will have a significant effect on the remainder of the year.

Taking into account China, housing, employment and interest rates, the last half of the year depends on two things. The first is the belief that shareholders can continue to skim more than their share of corporate profits ahead of the average hourly wage. With productivity still high at 3.9%, the wages paid for the effort, the ones that are the supposed fuel of this growth cycle have not caught up. The pay for the average hour worked has remained well below inflation (2.8%) with average increases at a paltry 2.1%. These underpaid workers will be a sizable drag on any future growth in the coming six months even if more of them are working.

This leaves the real measure of growth difficult to measure. Because of the abnormally low interest rate and the overvalued worth of real estate, the economy will move forward at a more slower rate with significantly lower forecasts to beat.

The second problem on the horizon for the next six months is corporate profit growth. If these profits are indeed tied to not only domestic GDP but global numbers as well, the only thing that will significantly impact this growth, oil aside, terror aside, and inflation and wage growth aside, is the increased chance that capital spending will slow to near zero.

BlueMoney Report

The Blue Money Report
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