How about a “w” or “W?” or a “bathtub U” - really long and deep? Or, for worst-case-scenario aficionados, the dreaded “L” shaped downturn of many years' duration, as experienced in Japan beginning in 1990 and only now ending after nearly two decades.
In truth we don't know. Moreover, we will not know for years and until then, as always, all economic forecasts, no matter how carefully constructed the mathematical models, ultimately are educated guesses including those appearing in these briefings.
In the meantime, news from the front of the war between inflation and deflation remains grim, as the battle rages between the increasing cost of goods like food and fuel and the decreasing value of assets such as houses and stocks. It would appear that inflation, and, in particular, inflationary expectations seem to have the upper hand at the moment.
Commodity prices are surging, again, and little of these recent movements truly can be blamed on speculators given the monumental size of these markets. Crude oil alone represents a nearly $4 trillion yearly market (at $135/bbl), and natural gas, heating oil and gasoline encompass trillions more, making the $100 billion-or-so of energy index fund holdings seem inconsequential. Grain markets also are of such trading volume size as to preclude a meaningful impact from pure speculation.
Calls for limits to speculative trading, blamed for causing a new commodities “bubble” in the vacuum previously occupied by residential mortgage investments (which arose out of the vacuum left by the collapse of the dot.com stock market in 2000-2002) are unlikely to have an impact given the completely different dynamics of commodities compared with paper assets.
Commodities are not “investments” in the fashion of homes or stocks. They are consumables, drilled, mined, grown and processed once, then used once and gone forever. The law of the economic jungle – supply and demand – is always and everywhere now viciously impacting the values of commodities.
And, at a country level – China in particular - nations must insure adequate supplies of food and fuel, and half the planet looks with longing and envy at the resource-rich lifestyles, by comparison, of America, Canada, Australia and much of Western Europe.
Corn prices are approaching $7.50/bushel, a record level in both real and nominal terms, more than doubling since last year alone as the grim reality of a more meager Midwest harvest filters through grain markets.
A “five-hundred-year” flooding in Iowa, Illinois and parts of other states has hurt an already late-planted corn crop. It is the worst flood since the last five-hundred-year flood in 1993. (Perhaps 1993 was only a hundred-year occurrence, but we digress.)
Regardless, food prices are reacting, and will continue to react to higher input prices, of which petroleum plays a significant role in the form of both fuel for farm equipment and goods transportation and as an input for fertilizers.
Wheat prices also have more than doubled in the last couple of years to record levels, well-above previous highs in 1996.
Fed Chief Ben Bernanke said “inflation remains high” in a recent speech, surprising government statisticians who diligently have labored for years to keep officially reported inflation numbers low.
This would seem to be a remarkable contradictory observation, perhaps not unlike when former Fed chairman Alan Greenspan warned of “irrational exuberance” in the stock market in late 1996. At the time, the Dow Jones Industrial Average traded around 6,500, later rising above 11,700 in March 2000 before succumbing to the reality of the laws of financial gravity.
Dr. Bernanke must have access to different data, as inflation numbers created by the Bureau of Labor Statistics consistently are described as benign, thanks to heroic seasonal adjusting efforts, especially the so-called “core” inflation rate (ex-food/fuel) calculated for the benefit of those of us who neither eat nor drive.
As we have maintained, one of the keys to future price inflation at the consumer level is found in the Crude Foodstuffs and Feedstuffs section of the Producer Price Index (PPI).
In the May 2008 PPI report, 12-month Crude Foodstuffs and Feedstuffs surged at an “unadjusted” annual rate of 41.5 percent. Some, but not all, of those price increases have been passed on to Intermediate Goods processors, who added an annualized 12.6 percent to the cost of goods sold to Finished Goods makers, who, in turn, raised prices by more than 7.2 percent in the last year.
So prices are soaring at the raw materials level, as we are well-aware, but at each stage of processing, so far, businesses are either unable, or unwilling to raise their prices commensurately, instead compressing margins and profits to retain sales.
Inflation is in the pipeline everywhere around the globe, and far worse in other countries including China and other Asian nations which are now exporting their inflation to us. Globally inflation is estimated at more than 7.0%. More likely it is quite higher.
And now to oil. After reaching new highs of nearly $140/bbl in mid-June, crude prices stubbornly remain well-above $130/bbl, despite declining demand (about two percent YOY) in the U.S. and plenty of wishful thinking and finger-pointing at “speculators.”
It's not a “bubble” because there are no available or reasonable substitutes, and unlimited quantities no longer exist to create a supply imbalance, the necessary requirements for the creation, maintenance and ultimate bursting of an asset bubble.
In the 1990s the stock market bubble burst at the point when supply of new stock (initial public offerings of dot.coms) manufactured by Wall Street exceeded demand and reasonable alternatives – cash, bonds, real estate, gold – existed, were easy to exchange into, and appeared inexpensive in comparison.
In mid-2007 the residential housing bubble burst for the same reasons: housing supply created by the nation's builders surged to the point of saturation and less expensive alternatives (renting, downsizing) existed into which households turned.
Oil, at least cheap oil, is a geology-limited commodity with no currently available, inexpensive alternative. Thus the dire, but entirely reasonable, predictions by a Goldman Sachs analyst of $150/bbl by the Fourth of July, or $250/bbl by 2009 from the head of Russia's Gazprom, or $500/bbl petroleum (why not?) in three-to-five years according to a consultant with ties to the coal lobby.
As we have observed before, most such predictions are self-serving – people with vested interests are “talking their books” - and should be regarded solely for the entertainment value which they provide as they make no allowance for changing conditions.
So oil and natural gas likely exist in plentiful, untapped deposits around the world, but these resources will be both difficult, energy-inefficient and very expensive to extract, but extract them we must.
In mid-June, President Bush called upon Congress to ease federal restrictions on offshore drilling first imposed by his father in 1990. Offshore oil drilling could augment domestic production but the 18 billion barrels of recoverable oil estimated available under the outer continental shelves represents about a two-and-a-half year supply at our current consumption rates.
A good start, as would be drilling in the Alaska National Wildlife Reserve (ANWR), but neither certainly are long term solutions. As it is said, the cure for higher prices is higher prices, which will further stimulate the search for suitable, profitable alternatives.
A Fed rate hike anytime soon? Don't count on it. Higher rates seem unlikely despite surging commodity inflation in the absence of noticeable wage inflation, and less likely in an election year. The Fed's most recent meeting statement, while noting concern about inflation, which it expects to moderate later this year and next year, reflected a more upbeat tone about the risks to economic growth.
Oil prices seem to have entered a frothy trading range of $130-$140/bbl, notwithstanding Saudi Arabia's pledge to increase production a bit and China's recent bold step to increase domestic gasoline and diesel prices by 18 percent to curb its demand.
Second quarter corporate earnings reports will begin in earnest at mid-month, and for three weeks or so we will be treated to “the Good (energy, exporters), the Bad (retailers, consumer goods) and the Ugly (autos, airlines, financials).”
Stock markets often have reached a seasonal peak the third week of July, coincident with the bulk of earnings releases, as was the case in 2007, but the wall of worry continually climbed by investors now includes a Royal Bank of Scotland (RBS) analyst prediction for a 20 percent-plus U.S. stock market correction by Autumn.
If we are fortunate, Congress will adjourn soon without legislating fixes for anything which self-correcting markets should repair and, come Labor Day, its members will become so absorbed with re-election they briefly will forget about trying to solve our problems.
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