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Get Shorty, Part Three


Editors note: This is the third part in a series. Click here to read part one and here for part two.

Smarter folks than I have been dismissive of the Fed for a long, long time; Bill Fleckenstein is one of the most visible and intelligent of those detractors. And whether one agrees with the Fed's policies and decisions, it is important to understand its current path and the potential risks and rewards associated with its policy stance. Not least because the financial markets have embraced the idea of a Greenspan put: that the Fed will do everything in its power to reflate the economy up to and including buying treasury securities and/or printing money. Bond buyers have downside protection (at least in the near-term). Stock buyers have record amounts of stimulus to count on driving demand.

The Fed's objective is relatively simple: to make money more or less expensive in an effort to stimulate investment and consumption. But here's the thing about the last recession: it was related more to supply and not to demand. Actual consumer spending (discretionary and otherwise) never really got to levels that had, in the past, indicated "recession." However capital expenditures, capacity utilization, layoffs, and pricing power -- general measures of corporate economic health -- did sink to recession levels. As importantly, they continue at those levels today.

We know of course, that the cheap capital of the late 1990s and subsequent bubble created massive amounts of overcapacity in almost every industry out there: airlines, semiconductors, apparel, services, restaurants, wine, you-name-it. Heck, I was an intricate part of that limitless spending. As a sell-side analyst during the era's greatest bull market, there was almost no airplane ticket, no hotel room, no expensed meal, no data service, no car rental, and no staff buildups that weren't OK'd if they were in the pursuit of more client business. I was scarcely alone -- this was happening all over the economy.

The single most important characteristic of this economic cycle is that it has not responded in the usual ways to efforts to increase aggregate demand. This is now a clear (if underappreciated) fact. Talk about reflation: 525 basis points of easing and almost certainly another 25 to 50 basis points coming if you believe fed funds futures market; a rapid change from surplus to deficit in the federal budget; a weakening dollar helping exports; the Fed talking openly about printing money and buying treasuries in the open market. Each of these are adding substantial amounts of liquidity to the system -- record amounts. Yet core inflation is at record lows (and getting lower). employment is mediocre at best (and arguably getting worse) and capacity utilization (74.4% and a 20-year low) has never been this low except during a recession. What gives?

Few market participants who are bidding up Internet stocks at these prices realize that there is only one instance in the history of the Fed where stock prices were not higher 12 months after the start of rate-cutting. It was after the crash of 1929. Then, like now, massive overcapacity spawned from the cheap capital created by a bubble in asset prices. And that is why this recovery is so different from previous cycles: The negative effect of inflated asset prices on capital is the elephant in the room that cannot long be ignored. The result of those inflated asset prices is the rather unique profile of the latest recession: it resulted from an oversupply of goods and services rather than a lack of demand for them. Most recessions start because of a lack of aggregate demand. This one did not. And that makes a world of difference.

In Fed governor Ben Bernanke's now famous "printing press" speech last November, he noted (emphasis mine): "The sources of deflation are not a mystery. Deflation is in almost all cases a side effect of a collapse of aggregate demand -- a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers." The only nod to oversupply the Fed is willing to give is in the footnotes to Bernanke's speech, but, remarkably, they note that it would be a good thing associated with a growing economy (again emphasis mine): "Conceivably, deflation could also be caused by a sudden, large expansion in aggregate supply arising, for example, from rapid gains in productivity and broadly declining costs. I don't know of any unambiguous example of a supply-side deflation, although China in recent years is a possible case. Note that a supply-side deflation would be associated with an economic boom rather than a recession."

The reflation the Fed is engineering has an ominous side that few, if any, economists talk about. Insofar as the Fed is making money cheaper, it is doing so for: 1) an already extended consumer who never really stopped spending during the last recession and 2) the weakest and most marginal companies and creating more capacity in industries already suffering from too much of it (PCs, semiconductors, apparel stores). This reflation could be most remarkable for its short-term benefit and its long-term cost.

Corporations to the Rescue

As for the corporate sector, easier money has the effect of keeping marginal companies afloat by allowing them to lower prices and generate some incremental demand. But the process of capital rationalization -- of letting companies die -- is extended, and the cost of that capital stock destruction grows. Here's another way to look at it: if major companies' current capital structure and size are producing nice productivity growth (latest figures 2.5%), and modest earnings gains (13% for the S&P 500), then the only reason to take on more debt or equity is to incrementally lower the cost of capital. Increasing goods production or hiring more workers isn't necessary. Lowering the cost of capital -- reflating -- in an environment of overcapacity simply makes more and cheaper money available to companies weak enough to need it. They aren't the ones that need to be prospering.

Here's a case in point that uniquely illustrates how the Fed is pushing on a string with its increasingly aggressive reflation efforts: The automobile business. Consumers, responding to record incentives from auto manufacturers over the last two years, have pretty much bought up as many cars as they now need. As a result, auto companies are sitting on much more inventory than usual for this time of the year. Ford is at something like 95 days (SUVs) and 70 days (cars); GM at roughly 80 on both classes of vehicles. Industry norms are in the 60 days area. Meanwhile, incentives have already reached a point of decreasing returns and SAAR levels (Statistically Adjusted Annual Rate or industry-wide annual sales) are looking like they are coming down from the industry's early 2003 projection of 17 million to 18 million. Lowering the cost of capital for Ford or GM so that they can make more cars for consumers who neither want nor need them is not good for the economy. It reinforces the negative cycle of deflation and overcapacity. In the end, it is not smart monetary policy.

And lest you think the auto business is an anomalous example, according to the latest NABE survey of economists, "corporate investment in new plant and equipment is expected to rise by just 1.4% in 2003. This latter forecast is only a third of what the NABE panel projected during its February survey, and suggests a 'disconnect' in 2003 between profit growth and the willingness of CEOs to invest for future growth." The automobile business isn't the only one with demand and capacity issues.

Europe will not be a source of growth

Selling our goods to the rest of the consumers in the world might help demand but the data "over there" is even worse than ours. Germany is double- dipping (it's the world's third largest economy); Italy is in negative GDP territory. France is close. And at the European Central Bank meeting tomorrow, there is a good chance that lower rates will be on the table. Because the strong Euro is hurting their exports and driving Euro economies in aggregate closer to a double-dip, this is a distinct possibility. Whereas only two months ago, ECB officials were saying the next move in rates would be up, they have been very active on the newswires saying that there is "room" for lowering rates. This is a major verbal 180-degree turn.

Why care? Because the mantra that the weak dollar means more exports for U.S. companies -- and thus higher revenues -- conveniently ignores the necessity that there be a demand for them. Where will there be demand? Europe? Asia? Japan? With these economies already weak and getting weaker, that hardly seems to be the panacea. Indeed, I could make a strong argument that a strong dollar could be the "shock" that pushes some big economies into recession; after all, we are effectively exporting our deflation to them via a weak dollar.

Of course, the weak-dollar-is-good crowd takes no reserve against the idea that few of these other economies want their currencies to appreciate more than they already have (for the above "shock" reason). And if they can't control the foreign exchange markets indirectly (through headlines) or directly (through interventions), the political desire to act in some other manner to bolster their domestic economies will increase materially. The nightmare scenario: think an outbreak of protectionism (isn't the WTO meeting soon?).

What's the Fix?

The elixir to this oversupply problem is part deflation, part unemployment, part bankruptcy, part time, and part asset writedown. None of these seem to be politically expedient, especially with an election year coming up. But all are necessary. The Fed, however, is doing everything it possibly can to forestall them. Thus, in the end, the risks from the Fed's reflation policy is threefold: create even more excess capacity, delay the rebalancing of supply and demand and plant the seeds of a possibly extraordinary inflation.

Pessimists could argue that what the Fed is doing is worse than doing nothing at all. By setting the stage for a credit bubble in the consumer sector, the Fed is extending consumers' debt at precisely the time that consumers should be making their balance sheets more healthy. And the unintended consequences of low rates, including a possibly unsustainable increase in housing prices, have their own long-term costs. Of course, lowering the cost of capital for corporations that should be rationalizing their businesses, too, has long-term consequences.

What now from the Fed?

Even a modest perusal of the latest speeches from Fed voters suggest they are losing patience with this slowing economy. Add to that this Fed's history of easing soon once they have moved to an easing bias. So it would seem further Fed stimulus is a function of when and how, and not if. What happens when the Fed lowers rates again? What does that say about overall demand? About employment? With fully 80% of the latest stimulus "in" the economy without a notable pickup in demand, what can be expected of more cuts?

These are more than just rhetorical questions; sadly I don't have a definitive answer. But here are a few observations: The yield curve's flattening over the last several weeks, though roundly proclaimed as a bubble top in prices, seems entirely sensible in light of a Fed that may soon be buying 5s and 10s or "produce as many U.S. dollars as it wishes" in an attempt to fight deflation. The Greenspan put for the bond market remains alive and well. But beyond the mechanics of this Greenspan put lies a weaker economy, so bond buyers may have more salad days ahead than even Bill Gross believes. And in case you want to know where consensus is: Street economists believe that the 10-year Treasury will be at 4.9% inside 12 months. This same group of folks predicted that the 10-year would be yielding 5.8% now (that's a 230-basis-point error). Maybe the bond market is telling us something.

Check back tomorrow for the final installment of this series, a look at deflation and clues on how to play it from here.
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