Is Oil going to come to the Fed's Rescue?

A strange question to ask, perhaps, with oil hovering just above $54 on Nymex; still, an interview in Business Week with a Thompson IFR analyst (Tim Evans) leads me to ask just that. Mr Evans has a contrarian view, the main points of which can be summarised thus:

1. Oil demand growth is lower now than in previous years, when oil prices did not rise as much;
2. Oil production is cyclical, and we are suffering the effects of $12 oil in the 90s, when investment in production came to a halt. Current prices represent the other end of the cycle, not a "steady march to $105";
3. Physical supply growth of the last 18 months of 6% has been hugely outstripped by the growth in open interest in oil futures (72%) over the same period. Thus the current bubble is financial, nothing else.

if you want to read the interview:
http://www.businessweek.com/bwdaily/dnflash/apr2005/nf20050427_5199.htm

Now, if Mr Evans is right, $30 oil may not be so far away; data released today by the CFTC points to a lot of money leaving oil futures:

[hedge funds and specs] decreased further their net long crude oil futures position to 32,651 vs 59,650 week earlier, i.e. 26,999 contracts from a weak earlier. Net longs have fallen from 88,712 as of week ending 5 April when crude oil hit new contract high at $58.28 on 4 April.

Financial markets have been a bit schizophrenic about the oil rally; initially the fear was that it would cause inflation, as costs rose and workers demanded more money to compensate, and bonds were hit as a result. Somewhere along the way this turned into fears for growth, and bonds rallied as oil rallied.

So, what will lower oil prices mean? Initially, a good slide in prices will remove lingering concerns about inflation, which should allow the Fed to remove some of the more hawkish commentary from speeches etc. This should lift bonds.

However, I firmly believe the Fed is committed to raising rates if they can to 4.5% (my target), and the boost to the feel-good factor from lower oil prices should lift the economy sufficiently to allow the Fed to continue hiking. Bonds have not priced this in, being more inclined to believe in the "soft patch" story. I certainly don't believe in runaway growth, but I do wonder if, strangely, the Fed isn't going to be rescued by oil. Stranger things have happened...

Forewarned Is Forearmed

I accidentally put the link to Mish's blog up here while learning a bit more about blogging - I was hoping to bring it up as a URL on the left hand side; still, it really is a very good piece, and although you would need to go through some of Mish's previous blogs to get some of the references, it is worth reading this one on it's own. If there was ever a warning from history, Mish has identified it.

The doomsayers have been firmly relegated to the sidelines for the past few years; economists are scratching their heads and wondering how everything has managed to keep going for so long - why no economic correction has occurred following the mal-investment of the dotcom period; well, folks, it will be visiting a city or town near you this year (that's my prediction).

Mish's Global Economic Trend Analysis

Mish's Global Economic Trend Analysis

If America sneezes, who catches a cold?

Something about financial markets.

There have been some interesting data releases and developments this week, some of which have slipped under the radar. In my view, these have far greater significance than the markets allow, mainly because their impact falls in the medium term (around 12 months out) and traders have clearly focused on "the next big thing", i.e. very short-term indicators (US CPI, Philly Fed) which suggests confusion about the strength of the US economy, the global economy, and hence the likely course of the Fed (and the ECB) in the coming months.

The Fed itself continues to express optimism about the outlook for the US economy, citing good jobs creation (apparently) and strong GDP growth. It expresses moderate concern about price pressures, citing evidence that some businesses in some regions are able to pass on cost increases to the consumer. Maybe because of this optimism, most bloggers express views in contradiction of this. There are pages and pages of analysis and discussion, charts and statistics, which purport to show that the end is nigh. Clearly the Fed is trying to look past the chaff to focus on the wheat, and it is a useful exercise to drown out market "chatter" to identify those items that will have a real (and possibly significant) impact on our economic outlook. But is what the Fed sees valid, or is the Fed trying to talk-up economic sentiment (as the ECB constantly did through 2004, to little avail) to avoid the self-fulfilling descent into economic gloom?

What can be said about the current outlook, without putting a partisan bias on it? It is still a given that the US consumer is dragging the rest of the world along, by consuming more of what everyone produces than any other country (or group of countries); China is still the important supplier, but is only the end of the chain in terms of raw materials (provided by the various commodity producing countries) and indeed components, machine tools and technology (provided largely Europe and Japan). For much of it's exports to the US, China merely assembles and sells, and thus we are all reliant on the continuing strength of the US consumer.

How is the US consumer doing? There has been plenty of analysis of the level of debt held, about the debt/earnings ratio, and the ability to service the debt. Leaving all that on one side (blotting out the market chatter), the truth is that he/she has confounded the bears by managing to maintain consumption levels well beyond what has been thought to be possible. John Mauldin, a commentator of some insight (www.frontlinethoughts.com) has been saying for some time that the US could be described as a muddle-through economy, not strong enough to break out, but not crippled either. Could this be about to change, one way or the other?

I believe two things determine a willingness to spend in order to consume: access to money to spend (sounds obvious, but it is important if that money is not yours, i.e. it is borrowed), and the feeling that spending that money is OK - the reward from spending is greater than the anxiety created by the debt, or indeed, not saving. I am sure there are equations to explain at what point the reward/anxiety ratio turns negative (and curtails spending), but this will depend on personal outlook, which is why sentiment surveys have become so important for traders of stocks and bonds. Personal outlook changes as things pop into view that were not being considered - higher taxes, inflation, redundancies, bigger bonuses (not everything is negative), so peoples' propensity to spend changes even if disposable income remains constant.

So, what are the significant things I mentioned above? Before I cover them, first what is the status quo in the US:

Consumer spending has been achieved through borrowing, by and large; some via re-financing (i.e. equity withdrawal from houses), and some more straightforward credit card borrowing.

Job creation appears to be quite strong; however, there is some mystery surrounding the probity of this data - the official non-farm release contains a modelled figure for new jobs created by small business start-ups. This figure is fictional, and is revised on a six-monthly basis to try and put some hard fact into it, although it is up for debate whether this is achieved or not.

What is certain is that manufacturing is losing jobs, and the service sector is where they appear to be being created. And it seems that many of these jobs are at the low end of the pay scale.

Which is where we get to the two nuggets extracted from the week's releases:

1. Average weekly earnings in the US fell by 0.3% in March, and for the 12 months through Feb 2005 fell by 0.5%; this means that 80% of the workforce has earnings that are shrinking, and by more than the headline if inflation is added to the mix.
2. The Comptroller of the Currency (where do they get these titles?) is pressing credit card companies to up minimum repayments from 2% of the balance to 4%; this is to ensure that an element of the principal is repaid, rather than just the fees, which allowed the principal to be rolled over month to month.

There are lots of other items which impact on the consumer (look into the new bankruptcy laws which the Senate passed recently), but I often think that the big changes are at the margin, because that is where the impact was least expected. Everyone is waiting for the consumer to say "enough is enough" as rates rise, and stop spending, when in fact it may be that the higher charges are ignored while they can be met, but the day the weekly pay packet does not feed and clothe the kids as well as meet the new 4% payment on the credit cards, that's when the consumer wakes up.

If America sneezes, who catches a cold?

The older readers may recall the saying: If IBM sneezes, America catches a cold. I think this has morphed into my headline above. The debate is now on whether America has sneezed or not; by my reckoning, it has, but the data is yet to show this, so it is merely an opinion. Still, manufacturing is obviously up the swanee, and with GM responsible (directly or indirectly) for huge numbers of people (and only the most visible company of a long list), the decline and fall of the US consumer is imminent. Other sectors are not taking up the slack. This is just becoming visible elsewhere, but most clearly in Europe.

With the rally in the euro last year, export industries in Europe were squeezed; with the natural time-lag, this is just becoming apparent now, with growth forecasts being trimmed by governments, central banks and think-tanks. With domestic demand not growing, and in some cases falling (UK & France showed steep declines this week), the impact has begun to be felt, and it may be about to accelerate.

China, and Asia as a whole, is harder to judge. China in particular does not use a Western model of economic management. Despite the shift from central control to a capitalist approach, large Chinese companies appear to be used to mop up large numbers of surplus workers (as does the public sector in the UK and Europe), and are not run to make a profit. Attempts to turn the average Chinese into a consumer are having mixed results - of the $22bn in car loans made to individuals since 2000, 50% are in default. China needs to absorb the workforce, or face considerable political instability. The US is absorbing large amounts of Chinese output, and thus helping that stability. If it stops, no one can predict the outcome.

In conclusion, there are several signs that the US consumer is squeezed; there are factors in the pipeline that will make this situation worse. The US consumer can retrench, and US industry will have to restructure, and the process will be painful. However, for those countries relying on the US, and without domestic demand to cushion the blow, the pain could well be a lot worse.

If things are so good why does it feel bad?

The Economics Editor of the Sunday Times recently posited the question: why, after 54 quarters of growth (according to the govt), does it not feel like the good times? In reply, I sent him a short email highlighting just one area of that generates a lot of anxiety - pensions. Despite paying a generous amount into my pension every month, I find my fund growth negligible, and the projected income when I retire (many years hence, it seems). This is partly due to changed rules governing pension firms, which means they no longer seek growth, but attempt purely to iron out risk; it is also due to the Chancellor changing the tax treatment of dividend payments to the tune of £5bn a year.

Somewhat to my surprise, the week following a think-tank released a report indicating that British disposable incomes are declining, for the first time in many years. With an election coming up, you would think that there would be exploration of this, with the opposition attempting to make a hay out of it, but it appears to have sunk without a trace.

So why are our incomes falling (and I stress that we might be earning more, but our disposable income is lower)? There are a number of reasons:

1. The cost of housing is way higher than it should be - the Washington Post recently invited readers to submit to it's annual "New Words" list; the aim is to take an existing word, add or subtract one letter, and come up with a brand new word. My favourite was "Cashtration" - having taken on a mortgage so large one has no free cash for several years...

2. The Labour government is committed to income re-distribution. It is doing this under the guise of "eliminating poverty" - which is a bit spurious as the calculation used to define poverty does not actuall highlight real need. What they are managing to do is take from those who have worked for it, and give it to those who haven't; in the meantime, the real markers of "poverty" - an inability to identify opportunity, a lack of education to take advantage of opportunity, a willingness to let the state look after you - are not being addressed at all.

3. Despite the increasing tax burden, the infrastrucure is clearly crumbling - roads, schools, hospitals, to name the obvious visible elements, but also water mains (Thames Water is proposing to cut water pressure so that it's leaks don't lose as much water, but flats above the 4th floor will not have water...), sewers, rail lines - in fact, you name it, it needs revamping or replacing. This is not a purely British phenomenon, it is prevalent across the developed world - the US has identified trillions of $s of infrastructure spending requirements. So not only do we have an increasingly crummy environment, to alter it is going to require a huge hike in taxes.

4. The residue of the 20th century philosophy of "rights" for everyone, and society being to blame for casuing people to go bad, has yet to be fully corrected. Half-hearted attempts to improve the lot of those at the bottom of the heap have reslted in considerable spending with very little result.

And finally, among all this, we discover that we are responsible for the pensions of numerous MPs and civil servants, the architects of the current mess, who are all able to retire at an age when retirement will still be enjoyable, on pensions that will enable them to enjoy it. Now do you understand why 54 quarters of growth don't make you feel good?