This report was prepared by my firm LPL Financial.
Last week’s key economic data came in better than expected, including the closely watched ISM report gauge of manufacturing activity, auto sales, and employment. This string of better than expected numbers is consistent with the rapid pace of healing in the credit markets—the key driver of the recession. Last week marked the 12th week of improvement in the LPL Financial Current Conditions Index. Important gauges of stress in the credit markets are back to pre-crisis levels; the TED spread, a key measure of interbank liquidity, is back down to a relatively normal 0.50%. On Friday, the employment report reflected a net job loss of 345,000 for the United States in the month of May, far less than forecasted and only half the loss reported four months earlier for January. May’s job loss was the smallest since the crisis began with the failure of Lehman Brothers and the seizure in the credit markets in mid-September of last year. The data increasingly paint a picture of a still weak, but rapidly improving U.S. economy.
This is not the way the markets are viewing it. On Friday, the best employment report in eight months failed to inspire a rally. In fact, stocks, bonds, and commodities fell. The S&P 500 Index slipped 0.3% to 940. The yield on the 10-year U.S. Treasury note jumped to 3.83%—rebounding to levels that preceded the crisis. Commodity prices, measured by the Commodity Research Bureau Index, fell 0.7%. Market participants’ concerns are shifting from a potential lengthening and deepening of the recession to the inflation that might be stoked by a rapid recovery.
Presented with evidence of more rapid improvement than expected in the economy and key drivers of growth, market participants’ worries have quickly shifted to what policy actions may follow. Governments around the world are still in stimulus mode. Central banks around the word continue to cut interest rates and provide capital to banks to promote lending. Government spending programs continue to be announced around the world, and here in the United States, the vast majority of the $787 billion stimulus package passed earlier this year has yet to be spent and remains in the pipeline. However, now that the economy is beginning to gain traction, the issue is becoming how quickly and effectively policy makers will rein in stimulus to avoid inflation. In the past, high and rising inflation has proven to be a far harder problem to solve than a weakening economy in recession. In fact, it often requires a recession to curb accelerating prices. With Fed rates currently set near zero, federal funds futures contracts show market participants expect the Fed will hike rates to 0.50% by November. The expected rate nearly doubled on Friday after the release of the data on the labor market. The uncertainty of the timing and effectiveness of the Fed’s response—and concerns that action to rein in stimulus too soon could tip the global economy back in to a second downturn—are weighing on investors’ confidence.
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What about Inflation?
We believe there will be substantial inflation in raw material prices, but only a modest rebound in prices for finished goods measured by the Consumer Price Index. Indeed, we are already seeing raw material prices soar. Over the past few months, the prices of many commodities have soared 25-50%, including the four C’s: crude oil, copper, cotton, and coffee. However, raw material prices alone are unlikely to push up prices for finished goods for several reasons. Raw material prices are a relatively small portion of the cost of most goods or services while labor makes up the vast bulk of the cost. The world has abundant excess labor and factory capacity. Inflation is not usually a problem until excess capacity is absorbed and wages begin to rise. Presently, wages are not reflecting upward pressure and are unlikely to do so for some time.
The power of excess labor capacity and low wage growth to limit prices can be most easily seen by looking back just a few years. Following the bursting of the tech bubble, the Fed lowered interest rates to a record low, credit was being created through the rapidly increasing leverage in the financial system, raw material prices were soaring (led by oil prices), and the dollar was falling. Yet outside of food and energy commodities, the United States did not experience much inflation. Fed chairman Ben Bernanke was nominated by Bush and began his four year term in 2006. President Obama is likely to replace him with a Democrat when his term is up in early 2010. This likelihood adds to the uncertainty surrounding the Fed’s response to the improvement in conditions and threat of inflation. We believe the Fed will not move aggressively and risk undermining the improvement in banks, credit markets, and the economy. It is too early to determine whether inflation is a likely to be a big problem for investors in late 2010 or 2011 as excess capacity may begin to be absorbed. However, investors can take steps now to both seek a profit and protect from rising prices.
- The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
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