Stay the Course
By Lawrence Kudlow
With the collapse of Intel, turmoil over the Euro, and the latest oil price spike, a wave
of fear and trembling has swept over the stock market. Add to that the rise of Al Gore --
putative Regulator-In-Chief -- and you have a recipe for pessimism.
In recent weeks I’ve been making the rounds to a number of institutional investors on
both coasts. A bunch of people are getting worried about recession, and a number
are concerned about inflation. Then there’s a group that is worried about all of the
above. Nearly all my clients are less optimistic than I am.
The current sour mood is what it is, and no one’s going to change it. Least of all me.
For what it’s worth, however, I believe this too will pass.
Here’s a thought. The single biggest prosperity-killer and recession-inducer is inflation. Show me a 5% or
higher inflation rate -- that is, a recurring, core, underlying, monetary-induced inflation -- and I will surely
forecast recession within a year.
But if a return to 5% inflation is out there, then why isn’t it showing up inflation-sensitive market prices? To
wit, spot gold is still hovering in the mid-$270s. Actually, for the first time since last May, the year-to-year
change in gold has turned negative. If this mother of all inflation indicators jumps a hundred bucks, then put
recession in your gun sights. But not until.
The King dollar exchange rate index is still on a tear, even after the Euro intervention. Never in recorded
history, going back 2500 years at least, has a strong currency coexisted with a rising inflation rate.
(Admittedly, the data around 450 BC is a bit sketchy. But all the other evidence holds together.)
Long-term Treasury bond yields are still about 100 basis points below their winter highs, and the spread
between 10-year rates and the 10-year inflation-indexed rate is less than 2%. So the inflation outlook from
this market indicator is benign.
Speaking of bonds, let’s go global. And let’s assume that bond rates are like gold. That is, they are good
indicators of future inflation.
Despite the recent oil bubble and the Euro decline, long-term interest rates in Britain, France, Germany,
Japan and the U.S. show no panic. In fact, subtracting real interest rates from market rates, the outlook for
expected future inflation is around 2% or less for these countries. This outlook has seemingly been
unaffected by all the oil and Euro tumult.
INTERNATIONAL BONDS
10-yr. Note - Real Rate = Inflation Expected
Germany 5.25 2.3 1.95
France 5.40 2.3 2.1
Britain 5.33 2.3 2.0
U.S. 5.84 4.0 1.84
Japan 1.90 1.3 0.6
Ave 1.7%
Market rates in these countries have remained low, while real rates essentially haven’t changed. For Britain
and the U.S. I used inflation-indexed government notes as the real interest rate. For France, Germany and
Japan I used 5-year averages for annual real GDP growth. Because of German unification, that country’s
real rate and real growth is more difficult to calculate, so I just left it the same as France’s.
Now here’s the key point. If inflation fears were truly being driven higher by the oil shock and the Euro
decline, then market bond yields would have jumped significantly. In the event, expected inflation rates
(market rates minus real rates) would have spiked up.
But the event didn’t happen. At least not yet. International credit markets are looking through the temporary
shocks and predicting continued low inflation. It’s a good thing.
It’s particularly interesting that European bond rates haven’t jumped. After all, rising oil prices are scored in
dollars. So the falling Euro will create a big monthly hit in the Euro CPI. But Euro bonds don’t seem worried.
The Euro-zone core CPI is
only 1.3% through July,
slightly lower than it was two
years ago. The low point
about a year ago was 0.9%.
So there’s a small rise, but it’s
not a problem. The
Euro-zone GDP price index --
including oil -- is up 1% over
the past four quarters
(through Q1). This measure
recently peaked at 3.5% in
early 1996. Its low was –0.5%
in mid-1997. Not much
inflation here.
Over the past three years the
average level of Euro gold
has been 280. Currently it’s
about 320, 14% above the
trendline. So you could
argue that there is some
excess liquidity in the Euro
financial system.
For the G7 currency intervention to have any lasting positive effect, it should net out to an unsterilized
liquidity withdrawal. At a minimum, it seems likely that the intervention has set a floor under the Euro and
stopped the hemorrhaging.
But the big Euroland story is next year’s tax-cuts in Germany and elsewhere. Marginal tax-rate reduction will
gear up January 1, and phase in for the next couple of years.
Euro weakness may well continue in the fourth quarter as people hold back their income and investment
until lower tax-rates kick in. This effect could dampen fourth quarter Euro GDP growth as well. But
supply-side tax-cuts should gradually strengthen the Euro and its underlying economic growth rate over the
next few years.
This is the best way to absorb excess liquidity. Lower tax-rates and higher after-tax economic returns will
generate more output to absorb the existing money supply. It’s a growth solution, not an austerity solution.
As for oil, there’s relief in sight. At today’s gold price, an ounce of gold buys only nine barrels of oil.
Historically, gold has purchased nearly twenty barrels of oil. So the relationship is way out of line.
If the U.S. dollar remains strong, and gold low, the gold-oil ratio would predict something like $20 a barrel.
(See Richard Salsman’s latest September 25, 2000 Intermarket Forecaster piece on this and other
monetary gems.)
More than likely the SPRO sales in the U.S. set a ceiling on oil. If these sales were accompanied by an
anti-trust action condemning OPEC’s international cartel, then the Clintonites could have turned bad
politics into good policy. Whatever. Oil prices are going down.
All of this is to suggest that bond markets are smarter than pessimists. There’s no big inflation in sight.
Therefore, there’s no recession in sight.
A bad global CPI for September? Absolutely. But it’s an unsustainable yawn.
A U.S. growth slowdown to 3% from 6%? That’s my view. With roughly 2% inflation, and a 5*% 10-year
Treasury yield. The fed funds rate looks to be 100 basis points too high.
The after effects of Y2K excesses last year, Fed tightening, the tax-hike effect of the oil shock, a pending
inventory correction; all this will lower growth. But King dollar holds down inflation.
Intel, meanwhile, is primarily having an Intel market share problem. Though it probably also signals a
slowdown in nominal GDP, or total spending, in the U.S. economy.
But this is no recession. It’s a high-class problem. Used to be that 3% was the max, remember?
So, folks, you really should stay the course. This is not the oily 1970s. It’s not even the Persian Gulf early
‘90s. The Euro high commissioners never get the story right, but the grass roots tax revolt by ordinary people
will lead to very positive things.
I’m sure there’s a mild recession somewhere out there, but I just don’t yet see it. Meanwhile, Internet
economy productivity gains may continue to surprise all of us, as has regularly been the case recently.
So, my advice: stay the course. Keep the faith. Faith is still the spirit. |
