Thursday 3rd August 2006


Emancipation from inflation

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Index of Retail Prices (2003-Present)

Slowing economy sends stocks soaring. Have you ever head of an investing headline that was more counter intuitive than that?

Investing 101, states that when we invest we are in fact purchasing a series of future cash flows. If the actual value of those future cash flows turns out to be more than the current estimate of the present value of those cash flows then we are likely to earn a profit on that investment.

Businesses activity takes place within the framework of the economy within which they operate so if the economy is slowing then that should be a cause for concern for investors as it may make for a more challenging business environment in the future which may then impact on the ability to generate the expected levels of cash flows over time.

Yet the headline that the slowing economy was the reason behind the rising stock market in the US over the last week was splashed across many newswires on Friday last.

This assumption was based on the performance of the markets last week, especially on Friday itself when the Dow gained 119.27 points or 1.07 per cent to close at 11, 219.70.

For the week the Dow ended up posting its best weekly point gain since May 2005. Overall the index ended up 351.32 or 3.23 per cent while the S&P 500 posted weekly gains of 3.08 per cent and the Nasdaq 3.65 per cent.

Comments from the US Federal Reserve Chairman that the economy was moderating put investors in a positive mood at the start of the week as these comments implied that the Fed would probably be nearing the end of the cycle of 17, 25-basis point rate hikes.

Last Friday the US Commerce Department confirmed the slow down releasing data to show that GDP for the second quarter April to June increased by an annualised rate of just 2.5 per cent.

This was a big slow down from the first quarter which posted a 5.6 per cent growth rate—the fastest in two years.

In the final quarter of 2005, GDP growth was 1.8 per cent as a result of the fallout from the Gulf Coast hurricanes. The US economy compensated in Q1 of 2006 as reconstruction work commenced but the Q2 performance was below the three per cent growth rate that analysts were forecasting.

Did someone say recession?

When you put it all together investors should be concerned especially when you also factor in that core consumer prices (excluding energy and food) rose to 2.9 per cent while employment costs also increased a stronger than expected 0.9 per cent.

The latter two indicators suggest that inflation is still a factor in the US economy and neither inflation nor slower economic growth is good for stocks over the long term.

The core inflation reading of 2.9 per cent was up from 2.1 per cent in Q1 and marked the highest inflation rate since Q3 of 1994. Yet despite this the fact that the market still rallied may also offer some level of circumstantial evidence as to the degree of short term trading that currently exists.

The US economy is slowing and inflation is rising. Investors who rallied the market this week are essentially betting that the slowing economy will itself bring inflation in check.

Yet there seems to be more to the equation and there are real risks that something more troubling (even a recession) is beginning to emerge. Data now suggests that there is a slow down in consumer spending as higher gasoline prices begins to take its toll. Less money is being spent on durable goods, homes and automobiles and more money on necessities. At present consumer spending accounts for around 70 per cent of US GDP.

With energy prices doubling over the past couple of years at some time a slow down in consumer spending was expected. Many analysts were hoping that this slow down would have been offset by a rise in business spending.

Right now the evidence does not support this as Q2 has seen businesses reduce spending on equipment and software—the first such decline in three years.

The macro economic picture is causing concern but this is not yet being reflected in the corporate outlook.

With more than half of the companies that comprise the S&P already releasing results, Thomson Financial is reporting that earnings growth for the index is expected to be up 14.8 per cent for the quarter and double digit growth could last to the end of 2006.

US stocks were not the only security to rally last week. The US Treasury market also rallied resulting in a drop in yields. Yields on the ten year note fell below five per cent to close the week on 4.99 per cent. Yields on the two year note also fell and an inverted yield curve remained in effect.

If the Fed were to continue with another rate hike under the same status quo then the yield curve would show a sharper inversion increasing the statistical probability of a recession down the road.

The outlook for the US economy is now balanced on a knife edge and one false move can even see a return to the stagflation phenomenon of the 1970s where growth was stagnant but inflation was rising.

Problems of our own

Speaking of a delicate balance those were the exact words the IMF used a couple of weeks ago to describe the way the local economy should be managed.

This balance involves “investing energy windfalls efficiently to advance long-term economic and social objectives, while pacing the use of energy revenues to avoid overheating the economy and pushing up inflation.”

The IMF further went on to state that the economy is showing signs that it is “now operating near capacity. Inflation has accelerated, real estate prices are rising, capacity constraints have become evident in some sectors, and the labour market has tightened.”

To many the situation described by the IMF is not new. I recall writing on the threat of inflation since mid-2004.

Yet the situation is still being allowed to continue unabated and every time there is more data emanating from the Central Bank it becomes clear that rather than getting better it is in fact getting worse.

Last Friday’s repo announcement by the Central Bank stated that “the latest data released by the Central Statistical Office indicate that the domestic economy continues to experience inflationary pressures. On a year-on-year basis to June, headline inflation increased by 8.65 per cent from 7.97 per cent in the previous month. Food prices, which continue to drive headline inflation, rose by 3.7 per cent in June and on a year-on-year basis by 25.7 per cent. Contributing to the sharp rise in food prices were increases in the prices of vegetables (67.9 per cent), fruit (33.5 per cent), fish (31.9 per cent) and meat (10.2 per cent).”

This sounds very much like a broken record as every announcement carries the same news of rising prices.

Over the period October 2004 to October 2005 food prices rose at a rate of 22 per cent year-on-year. The current year on year increase is 25.7 per cent.

In November 2005 I wrote: “Over the period 2000 to 2004 food prices increased by an average of 11.8 per cent, however the above average increases in food prices started in 2003 as from October 2003 to September 2004 food prices increased by 13.3 per cent.

“The 22 per cent year-on-year increase for 2005 represents a doubling of the average increase over the four previous years. The problem of rising food prices have therefore been with us for quite a while especially in the last two years and is having a critical negative impact on the economy.

“Clearly the Ministries of Agriculture and Finance have to redouble their efforts to deal with this problem since what has been done so far has not been adequate. In my view there is a limit as to what the Central Bank can do to deal with this type of inflationary pressure since food is not a luxury item. Further as I indicated last week, the tax break from the recent budget could easily be negated by rising food prices during the coming months.”

Eight months later and we are no closer to dealing with the problem of higher food prices—a problem that has been brewing for a number of years.

The problem of rising food prices is not the making of the Central Bank nor are they in a position to fix it. Increasing interest rates and absorbing liquidity from the economy only serves to slow the rate of economic growth.

The analysis of the US markets at the start of this piece should make that clear. The fact that these measures will only impact the non-energy and the private sectors means that these areas will slow down disproportionately leading to stagflation in the non-energy sector and therefore further dependence on the State for resources.

Further if we analyse the food items that are increasing (vegetables, fruit, fish and meat) there is a heavy local component to these items.

Blaming supermarket owners, calling for the removal of VAT or any other such measure does not address the root cause of the problem and clearly there needs to be some accountability as to how and why we have allowed this situation to deteriorate to the point where it is now.

It may sound controversial but the impact of unused Caroni lands and the lack of agricultural impetus over the past couple of years could certainly be causal factors in the problems we are facing today.

If it is, then it will certainly drive home the point that everyone who lives here is affected by decisions that are made here. Not all of us were associated with Caroni 1975 Ltd but all of us have to eat.

The first part of this article spoke of the perils facing the US economy. If their worst case scenario of a recession were to come true would that not also imply a falling demand for energy resulting in a weakening of oil and gas prices? Would we be able to adequately feed ourselves in the absence of a continuing oil and gas windfall?

Lest I be accused of being political let me conclude by pointing out that information from the United Nations Conference on Trade and Development shows that as far back as 1990, agricultural production was barely one seventh of the norm for a country of our size and level of development—this problem has been with us for a long time.

Just a few days ago we were reminded of what happened in 1990. The high cost of food and other basic necessities was one of the factors which contributed to the actions taken then. In this week of Emancipation can we not do what is needed as a country to emancipate ourselves to the point where we are self sufficient in food production?

Ian Narine, managing director of Republic Securities Ltd can be contacted via e-mail at [email protected]




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