FYI | Sep 22 2006
By Greg Peel
For a while now I’ve been running the “damned if you do, damned if you don’t” theme in these occasional overnight reports. As the US enters a period of what can only really be described as stagflation – although this is a word that should not be uttered in polite company – a battle rages in the minds of investors as to what is good news and what is bad.
The oil price has basically wiped out its geopolitical/weather premium, and everyone is feeling more comfortable with US$60/bbl. The fact that $60 is a rather high price for oil is now inconsequential, simply because it’s a lot better than $77.
Although the Fed warned last week, while leaving rates untouched, that inflation is still a problem to be closely monitored, inflation fears have really all but evaporated. To some observers, a lower oil price and continuing low bond prices means we can all go back to profligate consumption (even though that, in itself, is inflationary but let’s not get too complicated).
More important in the Fed’s non-move was that it responded to the fact that previous rate rises need time to actually have an impact, and that inflation is to some extent self-correcting (cutting back on oil consumption is an example of such).
And then there’s the US housing crisis. Yes – it’s no longer a slowdown but more of a crisis and has taken a lot of people by surprise. A fall in housing values puts a big brake on consumption, even though housing value is somewhat irrelevant if you only own one house. Given the Americans’ (and Australians’) propensity to borrow against uncrystallised equity in what is every individual’s most important asset, any shying away from such a cavalier practice means money is no longer entering the system in abundance.
The housing slump resonates through every market, from retail stores to base metals. Falling commodity prices are a positive in terms of curbing inflation and the cost of goods, which thus should be an impetus to equities in general (lower bond yields), outside of the resources sector, until you start thinking about wider ramifications.
To wit: a slowing economy is not good for equities. It’s hard to win, isn’t it?
That was Wall Street’s mood last night when the Philadelphia Fed indicator of manufacturing activity was announced as having fallen 0.4% in September. So take off the “low inflation is good” hat and put on the “slowing economy is bad” hat. All in the space of a couple of days. The Dow rallied 72 points on the unchanged interest rate on Wednesday night, and fell 80 points on the Philly indicator last night.
What is a poor investor to do?
Economists are arguing over the possibility of a nasty recession in the US, or the possibility that a commodity price correction takes the heat off and sets equity markets up for a more sensible rise from here. Most stock brokers are now advocating a strategy of “the economists don’t know, and we’re not too sure, so let’s just go defensive for now”.
The sidelines, for now, seem like a cosy place to be. The commodity price correction has not yet really been significant. This does not mean the super-cycle is over. It just means there is potentially more downside. In the bigger picture, China and India are not going back to subsistence farming.
In many commodities, the supply side finally appears it can catch up some of the ground to runaway demand. It has just taken a lot longer than most expected (not withstanding maintenance shutdowns and strikes), and hence prices have been, temporarily, off the graph.
Base metals are abundant. Iron ore and coal are abundant. It’s just a matter of getting them out of the ground and into a boat. Oil is either abundant or scarce depending on who’s propaganda you believe, but either way fossil-fuel substitution is moving forward at a rapid pace and individuals and companies are adjusting to lower fuel consumption targets. Uranium is abundant, but a long, long way behind growing demand. Gold is becoming rapidly more scarce, and no one really knows just how much is left above the ground (despite claiming to know). In the ground, production is not increasing.
When the correction began in May the most definitive prediction was for that of ongoing volatility. Never was a truer word spoken. Until the dust settles, it is unclear which way to confidently turn in the short term.