Again With the Conundrums

By Duru

September 6, 2005

When I last wrote, the full scope of the catastrophe in the U.S. Gulf Coast was just beginning to scrape our collective consciousness. I discussed the prospects of seeing a large relief rally versus watching the economy plunge back into recession. Sure enough, the market rallied on Wednesday in classic contrary fashion. In fact, this routine of buyers stepping up when the news seems to get just about as bad as it can get is getting pretty old. If my memory serves me correctly, the buyers usually wait until the market has sold off sharply in response to the negativity. We can only guess how many hedge funds and other institutional players are choosing to skip a few pages in the playbook.

Anyway, last week's relief rally sure was no relief to all the poor folks left stranded to suffer and die in the wake of the Hurricane. In fact, a big difference with this current disaster is that it is very likely to have real economic impact that the market will have to care about. It seems cold to think that the market cares more about the loss of dollars than human life, but such is this capitalist system.

In my last missive, I also made reference to President Bush's incredibly low approval ratings, and I imagine those numbers have sunk even more after this historic debacle in governance. Since you all already know I have a strong bias against the President, and since you all know that I think he has consistently done a poor job over the past five years or so, I will not waste any of your time here diving into my typical anti-Bush rants. Human lives hang in the balance here, and we must do what we can collectively to prevent any further suffering. The time for recriminations, discipline, and correction will come soon enough - assuming of course this time the country's memory will remain fresh and raw, the mind maintains clarity, and the eyes seek the truth wherever it takes us. And if that awakening gets us out of Iraq, all the better.

So, last week, even as oil, gas, and other commodity prices soared, the stock market ran right along with them. Let us say that is conundrum number one. At some point, something has to break this game of chicken. SUVs are now over 50% of the US fleet of cars, and their drivers have so far continued to guzzle right along with the rest of us. In Newsweek (August 29^th/September 5^th, 2005), George F. Will notes that "…since 1980 the share of consumer spending has declined from 9 percent to 6 percent" (emphasis his", and Americans have actually increased the amount of their driving as gas prices have risen (timeframe was not made clear). These revelations tell me that America can still guzzle more and more gas before breaking the bank. I am not sure what other spending will suffer - perhaps discretionary items like clothing or nights on the town - but it sure seems to me that the trajectory for gas prices still points higher. In fact, can we really say we have any idea how much is too much for gas in America? I have noted that retailers that serve lower-income consumers have been in serious decline (see WMT, DLTR, FDO for example), but plenty of up-scale retailers are still reporting stellar results (see JWN, COH, and TIF for example). I am finally noticing that a lot of casual dining and entertainment stocks have fallen on relatively hard times (see DAB, JBX, RRGB, DRI, EAT, and IHP, for example). I do not know how many of these companies are claiming that the consumer has started diverting dollars to gas, but I think the charts tell us plenty of what we need to know at this point.

So if people are driving just as much as ever, then BOTH demand and supply are combining to accelerate the pressure on energy prices. Hurricane Katrina has put a big dent in America's ability to supply gasoline to large sections of the country. In addition, the reconstruction of the Gulf Coast area will add to the demand for energy to keep those motors of healing running. Let us say this is conundrum number two. Just as the economy seems to teeter on the edge of another "soft patch," economic activity may actually apply upward pressure to prices and threaten further inflation. This prospect will particularly trouble the Fed, and eventually, it should trouble the bond market. While the Fed has been trying to kill the housing boom with higher rates, the devastation of Katrina may have actually pushed the economy too close to recession for comfort even for the Fed. The bond market has already pushed longer-term rates down so low that the yield curve has begun inverting. This classic harbinger of recessions may compel the Fed to slow down, if not stop altogether, their rate-hike campaign. But if they do, we could see the housing boom regain full strength on the backs of lower rates. And given that our desire to consume energy has not materially slowed down, we will likely further magnify the upward pressure on energy prices. The bond market will certainly watch these developments nervously as it crosses its collective fingers hoping that we do not get a sustained increase in the longer-term prospects for inflation. I have no idea what I would do in this case. Good luck, Greenie!

My final conundrum is more political than economic. Higher gas prices may benefit domestic refineries, but higher oil prices largely benefit foreign countries. Some of these countries may be allowing (or directing) their windfalls to fall into the coffers of terrorists who in turn become stronger as we become weaker. It is as if we are paying a perverse tax that increases danger all around. This de facto energy tax makes us poorer and less able to fund the defensive (and offensive?) measures we need to secure the homeland against groups who are using those same taxes to strengthen their own capabilities to create man-made destruction. Fareed Zakaria beat me to this conclusion in the August 29^th/September 5^th edition of Newsweek. I hope enough people read and absorb the deep implications of this self-destructive dynamic and heed the advice of conservation (even our dear President has finally given a nod to conservation as a solution). If we do not regain control of our profligate energy habits, we will endanger ourselves in more ways than we can imagine. If Greenspan has to send us spiraling into recession to help us along, then it just might be worth it. But I cringe at the thought.

In the meantime, please, please be careful out there!

© DrDuru, 2005