The latest results out of FedEx, and its downbeat forecast, sent the market lower at the open. While the world’s second-largest package delivery provider posted results that beat expectations and the 55% drop in operating profit (based on the year-ago level) was an improvement from the previous quarter’s yoy decline of 75%, the company stated current economic conditions continue to “throttle” the results.
If not for aggressive cost-cutting the firm’s results probably wouldn’t have beat expectations. Businesses can’t build on bottom line results via cost-cutting for an extended period without some business-cycle expansion. Now, a few quarters out, this reduction in costs means that profits can be high-powered when activity does bounce. For the meantime, however, the market was disappointed this major economic bellwether did not offer somewhat optimistic guidance.
Financial shares were the biggest losers yesterday after Standard & Poor’s reduced its rating on 18 U.S. banks, citing tighter regulations and the implementation of changes to reflect this new environment.
Market Activity for June 17, 2009
New RegimeThe big news of the day was the proposed changes to the way the government oversees financial markets -- the new regulatory regime. I’m not going to waste a bunch of space on the specifics – besides it would be kind of tough to do so since I chose not the read the 80 page manifesto (opted for the summary instead), but will only touch on the overall issue and comment on the way the current administration views these things.
One can’t measure the cost, or more accurately the unintended consequences, these regulations will have on the economy – especially after Congress has its say. But I can take issue with President Obama’s belief that strong regulation is why people invest in the U.S. (Team Obama wants to guard against market participants taking “exorbitant” risks. But this topic of discussion is incomplete without acknowledging that the Fed’s reckless monetary policy, specifically in the years 2002-2005, drove real Fed funds negative and therefore played a key role in engendering a move farther out on the risk curve – a massive mispricing of risk as investors’ hunt for yield was on. There is also no mention of Washington’s two-decade drive to socially engineer the housing market. When that social engineering combined with negative real interest rates... well, that was a nasty brew.)
Actually, the reason capital is deployed in the U.S. is because of strong property rights law, low taxes on capital (and thus higher after-tax return expectations) and sound money policy. In the end, it’s a high risk-adjusted after-tax rate of return on capital that is the reason the world invests in America.
Problem is the administration sees no problem in forcing the abrogation of contract law (the Chrysler workout) and desires to raise tax rates on capital, while the Fed has not implemented sound monetary policy for several years. These issues are likely to create problems for us.
Let’s be clear, simply implementing massive levels of regulations – even if some aspects may prove beneficial (such as the receivership authority with regard to the largest financial institutions, which makes much more sense than ad hoc “bailouts”), you know many more will do harm – is not what attracts capital, capital that is very mobile and free to go almost anywhere it desires. If this were the case, hedge funds would find it impossible to raise capital.
Another disturbing aspect of the regulatory plan is that it seems to substantially change the structure of the Federal Reserve system by seeking to shift the process of regional bank presidents from the current appointment process (currently appointed by local boards) to a structure that is based on Senate approval. Uh, this is a major issue. The Fed is currently in very dangerous territory as most people already believe that they have lost their independence.
This proposed change, if implemented, would really increase doubt over the Fed’s ability to remain unlinked from the political process. It is a necessary condition for the Fed to be independent from politics -- when they are not, decisions that are essential to price stability are replaced by short-term politically expedient policy. This could be a major problem and if the market by and large believes the independent status has broken down, this will have adverse consequences with regard to inflation expectations. But Messrs. Obama, Geithner and Summers clearly believe they are smart enough to pull all of this off – maybe too smart for everyone else’s own good. We shall see, maybe I’m completely off base.
Mortgage Applications
The Mortgage Bankers Association reported that their mortgage apps index fell again, down 15.8% for the week ended June 12 – this marks the fourth week of decline as refinancing activity stopped when the 30-year fixed rate began to rise back toward 5.00%.
Purchases, which had risen (albeit slight) for three-straight weeks, fell 3.5% last week.
As we touched on yesterday, home sales just can’t keep going with the unemployment rate near 10% and likely to move above that level. The Fed can boost sales at the margin by taking action that pushes interest rates lower, but even this has a short window; if the market becomes concerned about future rates of inflation and massive debt issuance it will easily overwhelm anything the Fed has the capability of doing – unless they are going to take things to an entirely new level, which will assure runaway inflation down the road.
Consumer Price Index (CPI)
The Labor Department reported that the consumer price index registered another benign reading, rising just 0.1% in May. The core rate, which excludes food and energy, also rose 0.1% for the month.
The decline within the housing and food components, which make up 60% of the index, were the main reasons CPI remained so tame. I’m going to predict food prices will not remain held down for long, particularly with the heavy rain in the U.S. this spring. Farmers have been unable to get corn planted and wheat fields are flooded, just to name a couple of the big crops, and this should have an effect on the food component within the inflation gauges. Further, the producer price data shows some building in foods price within the early stages of production.
The gasoline component within CPI rose 3.6%, but this was partially offset by a large decline in utility costs – the third large monthly decline, down 1.3% in May, 1.7% in April and 1.4% in March. The rise in gasoline prices was held back due to the seasonal adjustment and with oil above $70 and wholesale gasoline up 10% in June, one should expect the energy component to boost the next print on CPI.
On a year-over-year basis, CPI fell 1.3% in May, the largest decline since 1949. This will change. Currently, the year-over-year readings are matched against the figures that reflected the commodity-price spike of last spring/summer. By the end of the year, this will change in a meaningful manner.
The core rate rose 1.8% year-over-year, a slight deceleration from the 1.9% in April.
People will become, and have been, lulled into thinking inflation will not arise for a very long time, if at all. But these things take a little time to build; the ingredients are all there, they just need to be mixed together and that occurs when the economy bounces and credit begins to pick up again. Recall, the last time the Fed monetized the debt – coming out of the 1940s to ease the burden of financing WWII – CPI jumped from -2.9% on a year-over-year basis in July of 1949 to 9.5% by March of 1951.
This is just an example to make a point; it is not to say things will turn out the exact way this time. Inflation will begin a large issue at some point, and the problem for the economy is that this means the Fed will need to aggressively tighten -- unwind what they are currently doing and beyond.
The FOMC won’t do anything for a while as they will view a high unemployment rate and low capacity utilization as impediments to higher prices, which increases the chances of inflation rolling – we’ve known for three decades now that these Keynesian models are flawed. The tightening that will be necessary will be a major issue for the economy and will very likely make the eventual recovery short-lived – there’s just no way to get around what we are doing, and have done with regard to monetary policy for quite some years now. I’m looking down the road a ways, 18 (maybe 24) months, but short-sighted thinking can be dangerous in this environment.
Have a great day!
Brent Vondera
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