Jubak's Journal
5 reasons the Fed will fumble in 2006
Even with a new chief at the helm, the Fed is heading toward a policy blunder that will inflict a lot of pain on investors. Here are five big reasons why.
By Jim Jubak
The odds are now better than 60/40 that the Federal Reserve will overshoot in 2006. It now looks, to me at least, like new Fed chairman Ben Bernanke will finish the inflation battle that Alan Greenspan started by raising interest rates so high that the economy starts to stall sometime next year.
The Fed will then be forced to reverse course and start to cut short-term interest rates at the same measured pace that it used to raise them from the June 2004 low.
Here are the five reasons I believe the Federal Reserve will give investors a painful demonstration of its all-too-human fallibility in 2006.
# The Federal Reserve is fighting the wrong kind of inflation. The classic monetary remedy for inflation is higher interest rates -- that slows the economy, reducing demand. That, in turn, breaks the spiral of higher wages leading to higher prices leading to higher wages, etc. But the current problem isn't classic wage-price inflation. Wages are going nowhere fast; something else is driving inflation. Take a look at the numbers for the quarter completed in September. The economy, as measured by gross domestic product, grew at a 3.8% rate in the quarter. Consumer prices, measured by the Consumer Price Index, climbed at an annual rate of 4.7%, the highest rate of increase since June 1991.
See the news
that affects your stocks.
Check out our
new News center.
Where did that inflation come from? Certainly not from wage increases. According to the Bureau of Labor Statistics, employers' wage costs grew just 2.3% in the last 12 months. That's the slowest growth rate on record, beating out the 2.4% annualized growth rate in wages reported in August. Instead, current inflation is almost all a result of higher energy prices. While inflation including energy is 4.7%; inflation excluding energy is just 1.3%, the lowest quarterly annual rate in two years. (For those readers who think the CPI is so statistically corrupt to be useless -- a valid belief, in my opinion -- the Personal Consumption Expenditures Index, Alan Greenspan's preferred inflation measure, gives much the same result: a general annualized increase of 3.9% in September and a core increase without energy of 1.2%.) This wouldn't matter except . . .
# Higher energy prices -- like higher interest rates -- slow the economy. So, in effect, the Fed by raising interest rates is stepping on the economy's brakes at the same time higher energy prices are working to lower economic growth. You can see the effect in a drop in consumer spending in September. Adjusted for inflation, consumer spending dropped 0.4% in September, following a similar drop in August. And it's not hard to understand why: With energy prices up and wages down, consumers are digging deeper into already empty pockets to keep spending. In the September quarter, that led to a negative rate of personal savings in the U.S. (savings fell at a 1.1% annualized rate). There are certainly big problems with the way that this number counts savings, so it's just about certain that the real savings rate isn't negative. But savings rates are dropping, and we're already in historically low territory: The personal savings rate hasn't been negative since the Bureau of Economic Analysis began keeping quarterly savings numbers in 1947. At a time when consumers can keep spending levels up only by borrowing (whether on credit cards or by refinancing a home or taking out a home-equity loan), higher interest rates from the Fed are Strike 2 against the economy. And the currency markets are set to deliver Strike 3. . .
Related news and commentary on MSN Money
Related resources image
• 5 stocks safe from rising rates
• 5 stocks for the post-Greenspan world
• How the Fed lost the inflation fight
• Insure your portfolio against inflation
• Why gold is gleaming again
# Higher interest rates have produced a rally in the U.S. dollar, which makes U.S. exports less competitive in global markets and puts even more downward pressure on U.S. economic growth. I know it's perverse: The U.S. is running enormous trade deficits that leave us dependent on the savings of strangers; no one in Washington gives a second thought to spending billions we don't have; and companies in core U.S. industries such as autos and airlines are flocking into bankruptcy. But the U.S. dollar has rallied against most global currencies. This week the dollar hit a 25-month high against the Japanese yen, after gaining 14% in 2005 against the yen. The dollar is even up 12% this year against the euro, after falling by almost 50% against the European currency from 2002 to 2004. A higher dollar makes U.S. exports more expensive for foreign consumers. U.S. companies can combat that by outsourcing more production to cheaper, non-dollar international economies, and by firing U.S. workers and hiring workers in those same cheaper non-dollar economies. But those adjustments produce lower incomes in the U.S. and cut into U.S. economic growth. The Fed's policy of hiking U.S. interest rates has contributed to this drag on growth, as well, since higher U.S. rates have propped up the U.S. dollar against other currencies. So why is the Fed pushing up interest rates further when it could be so harmful to the economy?
# When all you've got is a hammer, all problems look like nails. Raising interest rates may be the worst available tool for fighting inflation caused by higher energy prices. But what other tools are available? The other players in Washington show no inclination to break out their economic policy tools -- and it's even questionable that they know where they are after years of budget-busting neglect. Congress and the president could fight higher energy prices by doing something to damp energy demand (an energy conservation policy that consists of more than a presidential exhortation to drive less would be a start). Or to increase energy supplies (although I'm not sure that throwing money at Archer Daniels Midland (ADM, news, msgs) and the rest of the ethanol lobby is a worthy goal in and of itself.) But not even the members of Congress believe that the recent energy bill will do anything significant to reduce demand or increase supply. So that leaves the Federal Reserve to do the job of reducing demand by whopping the economy over the head with its higher-interest-rates hammer.
# And, finally, circumstances have conspired against the Federal Reserve to increase the likelihood of a policy mistake. Hurricanes Katrina, Rita and Wilma have tied statisticians in knots and made it extremely difficult to figure out the underlying trends in the economy. For example, the Bureau of Economic Analysis reported a healthy 0.76 rise in inflation-adjusted personal income in September. (Personal income, which includes not just wages but rental and investment income, isn't the same as wages.) But, adjusted for the hurricanes, personal income may be higher, lower or the same as in August. For example, in the earlier month property owners in the disaster area took a big hit to rental income, which depressed August's numbers and made it easier for September to show a gain. The Economic Policy Institute calculates that absent the hurricane bounce-back effect, personal income fell 0.43% in August. And the transition from Greenspan to Bernanke encourages the central bank to continue current policy until after the March meeting of the Federal Open Market Committee. Reversing course when Greenspan is barely out the door isn't a reassuring way to begin the Bernanke years.
A slowdown, yes; a recession, no
I think the result of all this is that sometime in 2006 -- around midyear would be my guess given the lag before an economic trend starts to show up in the economic numbers -- the Fed will be facing a big growth surprise. Inflation may or may not be under control, but growth will have dipped toward the low end of the range that makes the Fed comfortable. And it's likely that there will be signs that growth could be headed lower.
Note I'm talking about a drop below the current 3.8% growth to a rate that makes the Fed, Wall Street and Washington politicians (who are facing midterm elections in November 2006) nervous. I'm not talking about a negative quarter and certainly not a recession. A drop below 3% is a certainty if the Fed's interest rate policy overshoots. And somewhere in the range of 1% to 2% growth for a quarter would be a reasonable expectation for a low.
By the time that growth low arrives, the Fed will have stopped cutting rates and is likely to begin sending signals of an ease or two if the growth picture doesn't improve.
To me, this doesn't add up to either economic or investing disaster. More volatility than we've seen even in the last few months? Certainly. Radical shifts of money between sectors as the managers of hot money search for short-term profits? Certainly. Enough worry about rates of interest and growth to cause a flight to safety in assets that range from gold to consumer staples? Certainly.
Jim Jubak's newsletter
Get the latest from Jim Jubak. Sign up to receive his free weekly newsletter.
Your e-mail address:
Learn more about newsletters
Looking out over the next six to 12 months, I think shifting portfolios to include more non-U.S. equities makes sense. In the near term, a stronger dollar will increase the sales of overseas companies. In the longer term, a decline in the dollar as the Federal Reserve stops raising interest rates will give investors in non-dollar-denominated assets a decent exchange-rate profit. I also think looking to U.S. consumer companies that represent safety from inflation and strong guarantees of growth is a solid strategy.
With this column, I'm making buys for Jubak's Picks in iShares MSCI Japan (EWJ, news, msgs), an exchange-traded fund focused on big-company Japanese stocks, and Sysco (SYY, news, msgs), the dominant U.S. food distributor. Both should outperform the market if the Federal Reserve does indeed overshoot in 2006.
Updates
Buy Sysco
Sysco looks like it has turned the corner toward lower inflation a year or more ahead of the rest of the economy. Food inflation, which ran at 6% to 8% a year ago, has dropped to just 1% to 2%. Although the company can pass along higher food costs to customers, the lag between when costs go up and when customers pay higher prices made the last 12 months tough for Sysco, as its stock fell 6% in that period. But with food inflation down -- and with the company able to much more readily pass along rising fuel costs in the form of surcharges -- the next 12 months look much brighter. The company's efforts to cut costs, a necessity when food inflation was so high, have resulted in permanent savings in transportation and inventory costs. The rollout of regional distribution centers, for example, where slower-moving items can be held for distribution to local operating units, has cut freight costs and lowered inventory. The company has also geared up its growth plans with a goal of adding 3% to annual revenue through acquisitions in fiscal 2006 and 5% to 6% in organic sales growth from a larger and more-aggressive sales force. It won't hurt the stock, either, that growth in the next 12 months will be compared to the weak results of the last 12 months. Wall Street now projects that earnings growth will climb to 14% in the fiscal year that ends in July 2007 from 5.2% in fiscal 2006. The shares trade at 19.7 times projected fiscal 2006 earnings per share. I've owned this stock in Jubak's Picks before, selling it in October 2003 for a 10% gain and at approximately the same price as today's buy. I'm setting a target price of $37 a share by May 2006. (Full disclosure: I will buy shares for my personal account three days after this column is posted.)
Buy iShares MSCI Japan
I'm using this ETF to add broad exposure to Japan's big company stocks -- Toyota Motor (TM, news, msgs) is, at 5.2%, the largest of the fund's holdings. I think the Japanese economy is finally showing sustained growth -- and even a bit of inflation. The Bank of Japan has raised its projections for economic growth to 2.2% for the fiscal year that ends in March 2006. Inflation, the bank now estimates, will climb 0.1% in fiscal 2006 -- not much but a huge step forward for an economy that has experienced years of falling prices. With the dollar up 14% this year (and trading at a 25-month high) against the yen, I think the big companies in the Morgan Stanley Capital International Japan index, which this fund mirrors, will show strong export growth into 2006. And I'm looking for a kick from the dollar-yen exchange rate as the dollar goes lower to correct against the yen in 2006, when the Federal Reserve stops raising interest rates. I'm adding these shares to Jubak's Picks with a target price of $15 a share by June 2006. (Full disclosure: I will buy shares for my personal account three days after this column is posted.)
New developments on past columns
How the Fed lost the inflation fight
I added ENSCO International (ESV, news, msgs) to Jubak's Picks on Sept. 23 as a hurricane play, pure and simple. "Drilling rigs were in short-supply before the big storms hit the Gulf of Mexico; they're in even shorter supply now," I wrote then. "And short supply means higher day-rates for drilling companies that have rigs to hire. ENSCO International is a buy on the timing of the contracts for its fleet of 43 jack-up rigs. Only 39% of its fleet is under contract through 2006." So far, that logic seems to be working just fine. On Oct. 25 ENSCO International reported third-quarter earnings of 53 cents a share, six cents above Wall Street estimates, on revenues of $277 million. (The company managed to escape serious hurricane damage, taking only a charge of 3 cents a share for damage to its ENSCO 29 platform, which will be declared a total loss.) But the best news was a 37% increase in the average day rate -- to $75,400 on average from $54,900 in the third quarter of 2004 for the company's fleet of jackup rigs. The company also saw a 15% increase in day rates from the second quarter of 2005. That bodes well for increases in day rates for other rigs due to come off contract in the next few quarters. Analysts have now begun to push up their earnings projections for 2006 as it becomes clearer that, with rigs in such short supply, the peak of this cycle could be as far out as 2008. As of Nov., 4 I'm raising my target price to $58 by September 2006. (Full disclosure: I own shares of ENSCO International.)
Editor's Note: A new Jubak’s Journal is posted every Tuesday, Wednesday and Friday. Please note that Jubak's Picks recommendations are for a 12-to-18 month time horizon. See Jubak's CNBC Picks for shorter six month recommendations. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: ENSCO International. He does not own short positions in any stock mentioned in this column.
|
