Market Scheming: Stock Market Analysis: Pick your poison: double-dip recession or run-away inflation

Before starting this article, I would like to briefly explain why the focus of this piece is on the United States economy and not the Canadian economy. Despite the obvious reasons, like the fact that the U.S. economy represents approximately 24% of the world’s GDP, 12.5% of the world’s imports/exports, and that the USD serves as the world’s reserve currency, Canada’s economy is very sensitive to the U.S. economy. For instance, Canada’s exports represent 30% of our GDP, of which, 73% head south of the border.

It is safe to assume then that negative economic growth in the U.S. will have a similar effect in Canada. I will not go further on this topic, but I would encourage all readers to follow the developments of the Canada-European Comprehensive Economic and Trade Agreement (CETA) as it has the potential to reduce some reliance on the United States as our main trading partner.

Remember the double-dip hype in the middle of 2010?

There is no globally accepted definition of the term “recession” let alone a “double-dip recession”. A general rule in defining a recession, created by Julius Shiskin in 1975, is “two down quarters of GDP”. A double-dip scenario simply means an initial recession followed by a brief period of growth followed by a potentially deeper recession. A mild case of this “w-shaped” recession occurred in the early ‘80s.

The U.S. economy was forced back into a recession when Paul Volcker in June 1981 raised interest rates to a peak of 20%. This was to fight inflation which hit 13.5% in 1981 and by 1983 was successfully lowered to 3.5%.

By looking at different aspects of the economy, it will be shown that rampant inflation could be just around the corner and that the tools to battle the potential surge in inflation have been effectively rendered useless. Furthermore, I will argue that if the Fed decides to implement a “Volcker Rule 2.0”, U.S. citizens could be in for a very bumpy future.

How unemployment is calculated?

First, we need to examine the mandate of the Federal Reserve which states that it will “… promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”. Unemployment is the first key to this puzzle, and therefore it is important to see how it is calculated.

The United States Bureau of Labor Statistics (BLS) calculates six different unemployment numbers. Prior to 1994, the BLS used U-5 as the official unemployment number, which is defined as “total unemployed, plus discouraged workers, plus all other persons marginally attached to the labor force, as a percent of the civilian labor force plus all persons marginally attached to the labor force”. Currently U-3 is the official unemployment number defined and it is defined as “total unemployed, as a percent of the civilian labor force”.

Expiration of the 99 week extension to unemployment benefits

In my opinion, this change to a tighter definition of unemployment was solely one of political intentions, distorting comparisons to past levels of high unemployment. For example, current U-5 level would approximately be 15%, which would be politically unacceptable if it was considered “official”.

The major difference between U-3 and U-5 is what is referred to as a “discouraged worker”, which is officially defined as “a person not in the labor force who wants and is available for a job, and who has looked for work sometime in the past 12 months, but is not currently looking because of real or perceived poor employment prospects”. The trouble with U-3 as the official unemployment number is that an able worker that has been unable to find work due to the economic situation and gives up will actually result in a decrease of the official unemployment rate. Proof of this phenomenon can be seen with the recent BLS report where unemployment dropped by 0.4% to 9.0%. The reason for the drop was not due to growth in the job market, but by an expiration of unemployment benefits that were extended to 99 weeks to help cushion the landing for workers laid off during the 2008-2009 recession.

This short term “positive” economic indicator is flawed since, if the economy does pick up, discouraged workers will become encouraged again. As they enter the labour force, pressure builds for the official unemployment number to rise.

An additional suspicion of disinformation comes from past “initial jobless claims” revisions. The vast majority of recent “initial jobless claims” have been revised upwards. This understatement is a short-term positive indicator, as fewer jobs have been considered lost until revised upward a week later.

In regard to a double-dip recession, it appears on the surface that the unemployment rate is falling, implying that this scenario is less likely. However, consideration of stagnate job growth is required to draw a deeper conclusion of the current state of the economy.

The stock market recovery

Before exploring the “stable prices” portion of the Fed’s mandate, let’s turn our attention to the stock market. How can there be a double-dip recession if the stock market is reaching new highs since the lows of March 2009?

The simple answer is that we have successfully emerged from the recession. However, the real question is why the stock market is continuing to rally if unemployment is still at significantly high levels. Depending on whom you ask, one should expect to hear a wide variety of answers. My answer is strictly related to quantitative easing (QE), which refers to the Fed’s purchase of financial assets such as mortgage-backed securities and treasury bills.

QE1 commenced at the end of November 2008. The size of the program was tripled by mid-March 2009. This expansion set off the first strong rebound off the March 2009 lows. As the stimulus program came to an end, the market turned sideways. Fear of the double-dip recession laid the ground work for QE2 which was initially signaled on September 21st, 2010. This program is set to end in June 2011. If the economy has not responded to the stimulus as expected, removing this program could result in a severe correction in U.S. stock markets and potentially around the world.

In the past, the traditional method for economic stimulus has been to lower interest rates and, thus, flooding the economy with “cheap” money. This encourages people and corporations to borrow to spend or invest, fueling a recovery. This is precisely what happened after the technology bubble burst. The result of lowering interest rates created a housing bubble which helped drag the U.S. economy out of a recession. During the recent crash of 2008-2009, interest rates were slashed to 0.25% and the Fed lost this tool to combat deflation.

The Fed argues that quantitative easing is not the same as printing money since it is a temporary action that will be reversed when the Fed sells the T-bills on the open market in the future. It is important to note that the Fed has recently become the largest holder of T-bills, surpassing Japan and China. The money the Fed gives to the primary dealers for the T-bills is then spent by the primary dealers as they see fit. This money is generally used to chase high returns by being pumped into the domestic and emerging stock markets. QE is viewed by many developing nations as a mechanism to devalue the USD and export inflation around the world.

Commodity inflation: food, energy, and metals

Cotton prices have surged over 100% in six months. Sugar prices are continuing to reach new five-year highs from lows in 2010 – a gain of over 100%. Wheat prices have climbed substantially in 2010, over 100% from the lows. Similarly, corn has risen over 80% in price since the middle of 2010, oil is back close to $100 per barrel, gold is holding above $1,350, and silver is holding its recent gain of over 50% since September. These spikes in food and commodity prices have contributed to riots around the world and partially played a part in the recent revolution in Egypt.

But where is the inflation in the West? If you look at the core CPI, it presents inflation at a very low figure. However, core CPI, the Fed’s preferred measure of inflation, does not incorporate food or energy prices as they are deemed too volatile. The food component of the regular CPI in the U.S. is the lowest percentage (7.8%) of any other country in the world; a staggering 10% lower than the world average excluding the U.S.

This weighting does make some sense as developed nations spend less on food as a percentage of overall income than emerging nations. However, for the millions of citizens living at the margin in the U.S., increasing food and energy prices are very noticeable and pose additional dangers to a recovering economy. A notable threat is the fact that citizens will have less disposable income to invest, save, and purchase non-essential goods and services. Since 70% of the U.S. GDP is based on personal consumption, this calls into question the status quo.

Retail stores are combating higher raw material prices by reducing sizing of packaging rather than increasing prices. A study conducted in January by the Consumer Report on this topic showed that packaging of specific items tracked decreased by 7.8% to 20%. Comparably, a report by the Associated Press recently warned of a 10% increase in price for clothing starting in the second half of this year as cotton prices continue to rise dramatically.

Housing market and interest rates

Finally, the last part of the Fed’s mandate is to “moderate long-term interest rates”. From the above analysis, it can be seen that due to loose monetary policy, inflationary pressure has started to build around the world. Now, one might say that inflation is under control and if it starts to become an issue, the Fed can start raising interest rates. The flaw in that argument is the assumption that the Fed can raise interest rates without causing great harm to the population.

Housing is the main wealth generator for the middle class in United States and Canada. In the recent housing bust, prices drastically fell across the U.S. leaving many with mortgages that were substantially higher than the underlying value of their home. This led to the considerable increase in foreclosures over the past two years.

By the second half of 2010, new housing starts began to plunge as housing prices continued to slide. The reason for the continued decline in housing prices is oversupply. Banks are holding large quantities of foreclosed homes that are slowly being placed on the market. In addition, a stimulus program called “first-time home buyers tax credit” ended in April 2010 reducing the incentive to purchase homes at current price levels.

As previously mentioned, the housing bubble was fueled by the lowering of interest rates to help grow the U.S. economy out of the technology bust in the early 2000s. Raising interest rates has the opposite effect, making it harder for people to obtain a mortgage as borrowing costs increase. Furthermore, home owners that are currently in a mortgage with a variable rate will face more financial pressure as interest payments become higher which, in turn, will continue to erode disposable income.

The worst case scenario is continued increases in foreclosures, leading to increases in housing supply, leading to larger declines in property values across the board, resulting in nationwide middle class wealth destruction. In addition, rising interest rates would also make it extremely difficult for the U.S. government to service its debt obligations, which currently stand at an unprecedented $14 trillion.

What is the end game?

So is there going to be a double-dip recession? The question no longer matters. It is evident that the U.S. economy is stuck between a rock and hard place. It should be clear as well the economy is heading for a state of stagflation. As inflation starts to creep over the next couple of years, U.S. lawmakers and the Fed will have to make tough decisions.

Scenario 1: pull a Paul Volcker and increase interest rates to kill inflationary pressures, but risk a deep second dip in this recession. This will result in a fundamental re-evaluation of the U.S. housing market and a severe correction in the stock market.

Scenario 2: allow inflation to run its course. Even though this scenario goes directly against the Fed’s price stability mandate, it could be considered the most advantageous option for the U.S. government with its $14 trillion dollar debt. Inflation benefits the debtor, since “new” money is less valuable and can be used to pay down “old” money. The only way this works is if interest rates are not adjusted to offset the loss in value of the “old” money. In this case, asset prices from commodities to housing to stock markets will surge. However, relative buying power of the USD would plummet.

These scenarios assume that the Fed will still be in relative control to determine the best course of action. There are less likely scenarios where either the loss of the USD currency reserve status or bond vigilantes start driving up T-bill yields as the world becomes less certain of the United States’ ability to pay down its growing debt.

If the U.S. government and the Fed can navigate an extremely narrow road to short-term stabilization and moderate growth of the economy, one major unknown remains: an exit strategy.

The Fed’s balance sheet before the 2008-2009 recession was steady at $800 billion dollars. Currently, the balance sheet stands at almost $2.5 trillion, including $1.1 trillion in U.S. treasury holdings. If quantitative easing is a temporary measure, it must be unwound at some point. It is hard to imagine the bond market holding up with a constant flow of treasuries from the Fed. It would be therefore understandable if the dollar index continues its decline from the 2001 highs.