Friday, June 13, 2008

Kicking and screaming

Another day, another bloodbath. Following on from yesterday's limp close in the S&P 500, Macro Man's screens are a sea of red this morning (USD/JPY excepted, naturally), with yet another bout of capitulative selling in European front ends. Intriguingly, a couple of sell side shops are now expecting the Fed to at least partially validate the tightening that's priced into the Fed funds/OIS markets; given the Fed's predilection for "not disappointing the market", this pricing could well turn into a self-fulfilling prophecy.

And so it seems that the Fed, like many other central banks, may be dragged kicking and screaming into running a tighter monetary policy than the growth data would ordinarily warrant. Well, perhaps not kicking and screaming; some Fed heads, such as Charles Plosser, seem to positively relish the idea of ratcheting up rates. But following on from other CBs such as the ECB, the RBA, and the Bank of Canada, it seems clear that the world's central banks are hiking (or at the very least not easing) not because they want to (i.e., tightening into a cyclical upswing), but because they have to (tightening because of inflation regardless of the cycle.)

And so we come to a rather important datapoint this afternoon, namely US CPI. While yesterday's retail sales figures buoyed confidence, if only temporarily, Macro Man couldn't help but notice that the actual y/y dollar figure only rose 2.5%; this is highly suggestive that sales in volume terms are probably falling. The reason, of course, is rising prices. Now, there's a school of thought that suggests that while food and energy prices may indeed continue to rise in the west, there will actually be disinflation/deflation for many consumer goods, given the lack of labour market pricing power.

This is fairly compelling, given that Western workers' wages are being hit by both a slackening of domestic labour markets and by ongoing competition from lower-cost foreign producers. And this explanation works, as long as one believes that labour is the hegemonic determinant of consumer prices. However, thanks to the higher cost of feeding foreign workers and shipping foreign-made goods to the US, the price of foreign-made manufactured goods is rising sharply; indeed, the inflation rate on imported manufactured goods in May was higher than US headline CPI in April.
So if the price of foreign-made goods is rising, why wouldn't US manufacturers also follow suit? In that vein, Macro Man was interested to hear recently that Ethan Allen, a maker of premium home furnishings, is set to raise prices by 6-8% across the board in July. Given that luxury furniture is the ultimate consumer discretionary and also linked closely with the housing market, Macro Man feels comfortable in concluding that these price hikes are not demand-driven; they simply reflect the marginal cost of making the stuff, which is going up, up, and away.

It would, of course, be reasonably to expect Ethan Allen's sales to be hurt by raising prices in a soggy demand environment (yesterday's retail data notwithstanding.) And that, ultimately, is the crux of the bear argument for financial assets. Like central banks, firms are getting dragged kicking and screaming into doing things that they'd rather not, because they'll either hurt margins or top-line sales.

Macro Man's pet indicator of financial asset returns, the rolling two year typical pension fund local asset portfolio, is still comfortably positive in the US and Europe, and even bounced in May. Compare that to the readings of the last recession/financial crisis, when the two month rolling returns went comfortably negative.

One reason for the uptick last month was the fact that May of 2006 slipped out of the rolling calculation. Not coincidentally, that was the last time that the Fed dropped the hawkish hammer because of inflationary concerns.

Add in a dose of the expected- currency volatility because of an Irish "no" vote on the Lisbon Treaty referendum, or even a sudden bout of relevance from this weekend's G8 meeting- and paper assets continue to look like a dicey proposition.


CV said...

Nice one MM ...

I have one question. In those domestic portfolios. How is the equity position in Europe constructed? Simply Eurostoxx 50 (etc) or something more complex you would be reluctant to divulge?


Macro Man said...

Claus, to be honest, I wrote this spreadsheet so long ago that I don't remember....but I suspect it would have been something like MSCI Europe.

JJ said...


I miss your portfolio

will you be posting it again at some future date ?

best regards

D said...

The May retail statistic would mean something if it was adjusted for inflation and we hadn't started mailing-out $165 billion in stimulus checks. Retail sales are on a $385 billion monthly pace and a one-half percent increase amounts to $1.925 billion. What a great return on US tax-dollars!

The mute reaction to the Irish Lisbon vote is puzzling, I was hoping to get some more color from my friends here over in the city.

Risk correlations should reestablish shortly.

sargon TM said...

In the words of MM,
"This is fairly compelling, given that Western workers' wages are being hit by both a slackening of domestic labour markets and by ongoing competition from lower-cost foreign producers. And this explanation works, as long as one believes that labour is the hegemonic determinant of consumer prices."

And indeed, to emphasize the point, even for domestic workers, the more that productivity gains are not reflected in wages, the less important are wage increases in fuelling inflation.

The positive feedback in pricing that central bankers rightly worry about is present in all pricing mechanisms. For example, the price of the raw material content of machines and processes used to extract more raw materials exhibits similar positive feedback. To avoid fighting the last war it's necessary to identify which channel dominates this time, and it's probably not domestic labour.

sargon TM