Diverging From Expectations

U.S. Inflation: Diverging From Expectations

June 02, 2008

U.S. core consumer inflation, as measured by the PCE price index, remains near 2%. In contrast, consumer inflation expectations continue to soar, courtesy of gasoline and food prices.

U.S. inflation worries have intensified, as the surge in highly visible gasoline and food prices continues. Government data are not trusted because they show that core consumer price inflation has failed to rise. The build up of pipeline price pressures from rising input costs is a long-term concern, but higher core consumer inflation will only become a threat after the economy gains significant momentum, i.e. not a danger for 2008. Sub-par economic growth ensures that there will be minimal leakage from producer prices into retail/consumer prices. Moreover, housing accounts for about one third of the PCE index, and the decline in this sector is not over.

Bottom line: It is still premature to worry about higher inflation, and bond yields should soon calm if oil prices stop rising.


Is A Commodity Correction Approaching?

May 28, 2008

Our global Leading Economic Indicator (LEI) is signaling that some contagion from the U.S. slowdown is spreading beyond the G7 countries, which could finally trigger a shakeout in commodity prices.

Since the end of 2006 there has been an unprecedented divergence between the G7 and non-G7 LEI. However, the steady decline of the non-G7 indicator warns that some contagion may soon develop. Though the worst of the U.S. economic slide may be past, a long period of sluggishness seems probable, and there remain downside risks given the ongoing housing slump and relentless rise in energy prices.

Bottom line: A slowing in non-G7 economic growth at a time when the U.S. is still weak could be the catalyst for the long overdue correction in commodity prices. We would hold back from putting fresh funds to work until overbought conditions and sentiment ease.

U.S. Home Builders: No Light At The End Of The Tunnel

May 20, 2008

Sentiment among U.S. home builders remains at rock bottom levels— builders expect no improvement in sales over the next six months.

The fundamentals for housing remain weak, especially since the employment outlook has deteriorated this year and mortgage rates have not fallen in line with policy rates. The budding rebound in mortgage refinancing activity faltered the minute Treasury yields blipped up, underscoring that borrowing rates are too high to support the housing market. The spring selling season so far has been disappointing, implying that inventories will remain excessive.

Bottom line: The housing market will stay depressed for the foreseeable future, acting as a limit on the upside in Treasury yields.

Natural Gas: Stay Bullish

May 13, 2008

Long-dated natural gas (NG) prices have adjusted upwards in recent months, but have lagged crude oil. We remain bullish and believe that it is too soon to scale back long/overweight positions.

Canadian natural gas production and rig count remain weak because of cost inflation and the strong Canadian dollar. U.S. natural gas production has rebounded but depletion rates are high and the rig count may be topping out. In addition, significant exploitation of non-conventional gas shale deposits will be expensive and take years before bearing fruit. Moreover, the plunge in liquefied natural gas (LNG) imports during the second half of last year underscored that they will not be a panacea with Asia and Europe competing vigorously for LNG.

For example, Guangdong Dapeng, operator of China's first LNG receiving terminal, is looking to double its spot cargoes in 2008. North American liquefaction facilities are unlikely to come onstream before 2011, at the earliest. As for NG substitutes, the prices of residual fuel and coal continue to hit new highs. Finally, speculators remain net short NG in contrast with net long crude oil exposure.

Bottom line: Continue to hold long-dated natural gas futures in absolute terms and relative to crude oil.

Fundamentals Remain Negative For Small Cap Stocks

May 08, 2008

The bounce in small cap versus large cap stocks is over.

The recent bout of small cap outperformance has been primarily driven by the relative weakness in large cap bank shares, due to their outsized sub-prime-related write-downs. However, this drag should diminish going forward since the bulk of the losses have been disclosed. Moreover, bank lending standards could stay restrictive for some time to come as banks work to stem the rise in non-performing loans.

Tightening lending standards have historically weighed on small cap relative performance vs. large caps, given the riskier credit profiles of small firms and the ability of large firms to secure financing from global sources. Meanwhile, sluggish domestic demand growth, persistent house price deflation and a weakening dollar continue to point to a relatively bleak operating environment for small companies.

Bottom line: Stay underweight small versus large caps.

U.S. Leading Economic Indicator: Economic Mush, At Best

April 21, 2008

The Conference Board's Leading Economic Indicator (LEI) showed a small uptick in March.

It was slightly positive news that the LEI did not continue to erode, but the index is still well below its boom/bust line (based on a deviation from trend), which implies a weak economy for another six months. Further interest rate cuts, and possibly more non-conventional tactics, are probable, especially because credit sector problems have not been resolved. Interbank spreads have failed to narrow and mortgage rates remain stubbornly high.

Bottom line: A sustained breakout in risk assets (i.e. a rising stock/government bond ratio and decisive narrowing in corporate bond spreads) awaits a solid rebound in the LEI.


The Sources Of U.S. Consumer Misery

April 16, 2008

Consumer confidence in the U.S. may not improve significantly until house prices stabilize.

In the 1970s and 1980s, consumer confidence closely tracked the so-called Misery Index, the sum of the unemployment and inflation rates. However, this relationship has broken down, with sentiment at the lowest level since 1982, despite a historically low unemployment rate and relatively modest inflation. The relationship is re-established if the Misery Index is adjusted by adding in the change in house prices. The implication is that, even if the U.S. labor market holds up, some stabilization in house prices will be needed before there is a rebound in confidence. Unfortunately, that is not imminent. While tax rebates will provide some temporary relief to consumers over the summer, the underlying trend in consumer spending will be sluggish for some time.

Fed Looks For Second Half Revival

April 04, 2008

In Congressional testimony, Fed Chairman Bernanke spent most of his speech explaining what has happened in credit markets and why the Fed bailed out Bear Stearns. However, he also suggested that the worst for the economy is almost over.

Specifically, the Fed Chairman commented that "much necessary economic and financial adjustment has already taken place, and monetary and fiscal policies are in train that should support a return to growth in the second half of this year and next". While we agree that much adjustment has taken place, it seems complacent to bank on a growth revival in the second half with housing prices melting down, leading economic indicators still falling, elevated food and oil prices weighing on consumer sentiment, and unemployment claims on the rise. One problem is that credit markets have thwarted much of the Fed stimulus; private sector borrowing rates have either risen or declined only modestly and lending standards have tightened dramatically.

Bottom line: The Fed can never sound alarmist on the economy, but internally may be overly complacent on growth.

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  M O R E. . .

Normxxx    
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