Ramblings of a Portfolio Manager

Extra! Extra! Commodity Prices to Derail the Economy!

So say the popular financial news media, each and every day since oil broke $100 per barrel back in February on Mid East and African tensions. Scores of “analysts” have appeared on TV to tell us that $100, $110, $120, $125/bbl…well, you get it, is the “tipping point” (annoying resurrected economist slang for the straw that broke the camel’s back), which will send the US economy spiraling back into economic recession. A host of others have also appeared to tell us that copper, steel, corn, cotton and grain will pose a similar threat. We even had Saudi Arabia posit a $350-$300/bbl number should they face Libya’s fate (read, we want US forces and ordnance). Combined with the idiot politicians, who cannot come to terms on budget “cuts” (actually less of an increase but still an increase) that amount to 0.30% of this year’s annual budget and continued troubles in Japan, the “double dip” camp has reemerged as a potent voice on the airwaves. This time, however, they don’t have their stories well coordinated. The Commodity chickens fear commodity-induced inflation will crimp corporate margins, slowing hiring and killing the consumer, thus reducing earnings and throwing us back into recession. The Budget and Japan watchers (in league with the Euro-contagion conspiracists) argue that Japan’s weakness, European austerity and a Government shutdown will simply shave GDP growth estimates back to a point where job loss, rather that creation, will ensue. The outcome of either camp’s dire prediction is that our economy will slow, falling back into recession. Just recently Goldman Sachs trimmed their 2011 GDP forecast by a full percentage point, to 2.5%, a level inconsistent with job growth, based on all of the above fears—no sense in angering any one of the camps, all of whom cold be a potential client for Goldman’s next custom crafted special purpose vehicle. Are all these really bright folks correct? Has anyone ever done a real follow-up on Goldman’s stock-specific or economic calls? We have, they stink. So much for the “smartest guys in the room.”

Let’s throw out a few basic statistics. First of all, US inflation is 70% based on wages. 20% is commodity pricing. The rest is miscellaneous paper transfers and non-commodity spending. As many have lamented over the years, we don’t make anything anymore over here but lawyers and bankers. And right now those paper-pushers aren’t doing as well as the popular press would have you believe. There is still actually deflation in financial services with the continued surfeit of workers. Add in nation-wide U7, which is still above 15% and there is an overhang of people ready to enter the workforce but whom haven’t gotten “the call.” True, that overhang could hit like a Tsunami at any time, should US industry find productivity gains are no longer low hanging fruit, but for that to occur, GDP growth would have to be several percentage points higher than it is now—and that would signal a very, very strong economy, flying in the faces of the doomsayer scenarios we described above. We just aren’t there yet and capacity utilization (save for the Airlines who are desperately cutting back flights in the face of rising energy prices) is still just below a level that would signal additional hiring and capital investment.

Secondly, as we have often heard, consumer spending comprises a nice round number, also about, 70% of our GDP. For true economic weakness and a double dip to occur, we have to damage that consumer. Quick to respond, the Commodity guys point out that higher oil prices mean higher gasoline prices, which will slow consumer traffic. As a double whammy, when “she” gets to the mall, the consumer will find higher goods prices as the result of climbing cotton and other raw material inputs into the products purchased. In fact, there is already some evidence of “demand destruction,” the reduction of energy usage as a direct result of higher energy costs. Miles driven are down 3% year-over-year, according to AAA, and that can almost be directly related to higher energy prices. FedEx and UPS are raising shipping rates, hurting online sales as well (or at least the margins of the online retailers). But the argument that finished goods prices are rising is specious at best. Retailers are cutting, not raising prices for a host of goods from apparel to automobiles and amid those price reductions they are reporting record margins—why? Because the greatest input into manufacturing those products is labor, not commodities and labor in this country is highly flexible (still high usage of temps) and gaining no traction in pricing and manufacturers have learned flexible manufacturing techniques over the years, able to quickly move production to the lowest cost producing countries world-wide. The tech companies, hit with supply disruptions resulting from the Japan quake, are a prime example of this move to flexible manufacturing. Small wonder the Korean stock market has done so well of late—which stable, cheap labor country do you think benefits most?

Do we think the US will experience inflation over the next 2-3 years? Yes, of course. But not the hyper-inflation for which so many experts have been clamoring. QE2 will end and we just don’t see enough political resolve for a QE3. Prices will have to stand on their own after June and then we shall see. With no more downward pressure on the dollar, we would expect prices for commodities to fall. The offset is that US manufacturers will become less competitive world wide with the stronger currency but, as we have pointed out, the rest of the world (27% of S&P 500 earnings) is doing better than we are. So, perhaps, exporting our inflation (and higher margins) abroad will save corporate margins here. Next week we will start to see US corporations reporting Q1 earnings. We expect little or no impact on Q1 from either oil, Europe or the earthquake, which occurred late in the Quarter. Guidance and forward looking statements will be key to where the market heads over the next 6 months. However, as of last week, Corporate manager optimism was still at a recent high. Given all that has occurred over the world in the last two months, for that level of optimism to stand, we would expect guidance to be much better than expected and the market to move higher