More Signs of Stagflation

By Dr. Duru written for One-Twenty

February 3, 2008

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Friday's poor jobs report was a reminder that even if we avoid recession in the near-term, we should still take seriously the coming economic slowdown. The loss of 17,000 jobs (future revisions notwithstanding) was the first drop in four years. We are pretty much a lock for on-going economic sluggishness - even though December's poor jobs number was upgraded from 18,000 to 82,000 - given that fourth quarter GDP showed a mere 0.6% growth. GDP also grew 2.2% for the 2007, slowest in 5 years. We should all be thankful the stock market was in such a good mood on Friday; otherwise, that jobs number could have sent the market into a deep tailspin on the day. The Fed will also feel vindicated in its rush to slash interest rates last month. Finally, Congress should also try to fight even harder against its stubborn nature to get nothing done and pass some emergency economic stimulus.

I believe this rush to save the economy is different from recent history when forceful action typically occurred after the economic problem became a clear and present danger. But therein lays the next potential problem. Since our troubles started from an over-sized debt bubble, over-extension of credit, undersaving, and overspending by consumers and government, it is hard to imagine that further encouraging all of the above will provide a lasting fix. It is certainly important to unclog the flow of credit and to prevent a catastrophic meltdown of our financial institutions, but we must combine these actions with a return to strict fiscal, monetary, economic (etc!) discipline across all sectors and corners of our economy. Encouraging even more debt will only further drag out the unwinding of the bubble from 1999/2000. I am also wondering what bubble remains for temporarily disguising our economic problems.

So, that is part of the case for persistent economic sluggishness - the STAGnation in stagflation. Looming backstage is the specter of inflation. We know that reducing interest rates and encouraging spending will not reduce inflation. Cheap Chinese goods have helped to-date, but it seems that good fortune could be coming to an end soon. In "China’s Inflation Hits American Price Tags" the New York Times warns us that price pressures are building throughout the Chinese economy. The main wildcard is how successful will producers be in pushing out these price pressures downstream into the supply chain. High gas prices have been a burden to us all, but we continue to guzzle all the gas we can get our hands on. President Bush has even "pleaded" with OPEC with hat-in-hand for them to increase oil production. Well, it seems that we should expect even higher gasoline prices in the near future if we are to believe Valero's (VLO's) proud claims about the healthy outlook for their profit margins. These quotes are from the transcript of VLO's recent earnings report:

"With total gasoline and diesel inventories in the U.S. and Europe less than at this time last year and with the seasonal increase in demand, we expect more favorable gasoline margins this spring and summer as reflected by the forward curve... So, we continue to have growing global petroleum demand with most forecast in the 1.2 million to 1.6 million barrel per day range. We expect an excellent spring, summer gasoline season and a continuation of higher distillate margins."

Higher gasoline prices. Higher import prices. And higher debt to buy it all. Sounds like higher inflation to me. Slow growth plus high prices = stagflation. We do not need a recession to remain bearish on the American economy for the foreseeable future.

I close with a bunch of links for housing-related news. I recently noted the soaring performance of homebuilder stocks this year that has finally broken an extended downtrend in the XHB. I found a healthy number of skeptics regarding this move. I will repeat that the key going forward is how these stocks behave on the next pullback. The most sobering article I found is one from Business Week by Peter Coy: "Housing Meltdown" that states the case for continued housing price declines. The article rehashes many of the bearish arguements, but adds in the devastating influence of the withdrawal of demand from the passing baby boomers. What I like most about the article is that it debunks the myth that a home is an incredible store of wealth: "Shocking though it might seem, a decline of 25% from here would merely reverse the market's spectacular appreciation during the boom. It would put the national price level right back on its long-term growth trend line, a surprisingly modest 0.4% a year after inflation." Sure, a home protects you against inflation, but not much else...and I suspect once you throw in transaction costs, taxes, and maintenance, well, you are better off trying to buy low and sell high and be one of those fortunate market-timers. Here are some more links:

Now is Not the Time to Buy Homebuilders
6 Reasons to Short Housing Stocks
Why Pulte's Stock Boom Will Become a Bust
No Missed Chance with Homebuilders

And it looks like Pulte Homes (PHM) is trying to hold the line on price discounting - working against the industry trend. Should be interesting to watch how that one plays out.

Be careful out there!

© DR. DURU®, 2008