WEEKLY ECONOMIC ANALYSIS: August 7th, 2009

Provided by TEAM Financial Services

"A government big enough to give you everything you want, is strong enough to take everything you have."
- Thomas Jefferson

Items for discussion

TEAM has long argued that the Federal Reserve has been painting itself into a major corner from which it will eventually be extremely difficult to emerge. Using our terminology which we have borrowed from the science field, we’ve believed that a critical state has existed for some time. We’ll use a natural science example to explain what we mean.

Avalanches occur once the snow on a mountain reaches a critical state and a catalyst emerges. The critical state is accomplished when the pressure on the mountain reaches a certain point from which a large outcome can emerge. Whether it is a squirrel falling from a limb or a snowboarder yelling to their friend, at some point a catalyst causes the critical state to wreak havoc. Of course, knowing when or what the specific catalyst will be is impossible. However, we believe there is value in identifying a critical state so as to manage the risk of what is typically certitude – eventually a catalyst will emerge.

As things relate to the Federal Reserve, we’d argued that a critical state had been reached in the late 1990’s and that the deflation of the technology bubble could start the avalanche. Indeed, a decent sized avalanche did emerge, but it was only one section of the mountain – technology and large cap growth stocks. To bail out that segment of the economy, the Fed decided to dumb still more snow on the other sections of the mountain to try and compensate. They were “successful” in inflating a credit and housing bubble, which helped offset the prior avalanche. We long argued that the recovery from 2002 through 2007 was being built upon a faulty foundation that would eventually collapse under the mountain’s pressure, and the 2007-2008 global credit collapse and massive declines in credit, stock and commodity markets were certainly significant – an avalanche down the entire mountain.

This time, the Federal Reserve was aided and abetted by the Executive and Legislative branches of the US government. To try and contain this massive avalanche, the Fed cut short term interest rates to effectively zero, while ballooning its balance sheet with toxic assets from bank balance sheets and engaging in quantitative easing – basically printing money from thin air. The Treasury department chipped in with various programs like TARP, while Congress authorized a budget deficit that will likely come in around $2 Trillion dollars for the year. With all of this fire power, they have been “successful” once again in stopping the most recent avalanche.

Unfortunately, we believe the measures they have taken to do so are likely to result in a far more dangerous future avalanche once the current critical state eventually meets its inevitable catalyst. The leading economic indicators we place the greatest confidence in are now forecasting that the economy is likely to recover at a rate significantly higher than what most investors and economists are currently forecasting. One may assume that this would be good news, as faster growth should translate into higher employment and wages for the average household. This is where TEAM sees tremendous danger and the seeds being planted for the next crisis.

If the economy begins to show signs of significant improvement in the coming months, then the Fed will be required to make a very difficult choice. Markets will likely begin to demand higher short term interest rates due to higher commodity prices and increased fears of inflation. Indeed, the Economic Cycle Research Institute’s Future Inflation Gauge is showing early signs of a dramatic pickup in inflation over the next year. Raising short term interest rates would be dangerous for many reasons, but we’ll pinpoint two. First, there is hundreds of billions of dollars of prime mortgages due to reset over the next 12 to 24 months. Higher interest rates could compound a “next wave” in mortgage defaults and further impair a US banking system that appears to be trying to regain some stability. Second, the federal government has been borrowing tremendous amounts of money over short term maturities in recent years. At present, the government is borrowing money for 1 month to 5 years ranging from literally almost nothing to less than 3%. If rates were to double, which would hardly be unusual based on historical inflation and interest rate cycles, the added financing costs to the US government would blow yet another enormous hole into the budget.

Ben Bernanke is widely regarded as a leading scholar in studying the Great Depression as well as Japan of the 1990’s. He has gone on the record many times that the US and Japanese governments made critical errors in tightening monetary policy to soon into the initial economic recoveries that emerged in 1933 and in the early 1990’s in Japan. TEAM believes that it is unlikely that the US Fed would move aggressively to tighten unless forced to do so via a currency crisis. Just to make things interesting though, Mr. Bernanke’s term expires at the end of this year and his re-appointment is far from a certainty.

If the Federal Reserve is slow in addressing market concerns over inflation pressures building, then we suspect that long term interest rates could begin to increase significantly. Also, we believe that currency market volatility could explode, which would likely become a significant problem for global commerce. TEAM believes that commodity prices could increase dramatically, and that the US dollar could decline significantly versus the currencies of commodity linked economies. These trends have already emerged, but we believe could move into parabolic state when/if inflation begins to become self reinforcing.

This is our base case scenario, though is obviously far from being certain. It is certainly possible that the US Fed and US federal government will suddenly come to appreciate tighter monetary policies and fiscal discipline – we simply don’t think that is likely. We believe this is particularly the case due to the nature of what we are calling the “Weekend at Bernie’s” economy. In addition, there are other major global economic players engaged in their own monetary and fiscal experiments. We think China definitely fits this characterization and fear that Chinese policies could also end quite badly.

Ultimately, the big questions we are grappling with are when will investors shift from euphoria over a recovery to concerns over inflation and higher interest rates, and when will currency market volatility explode and create the potential for political unrest? We do not yet see signs that any of this is imminent, but believe there is value in exploring what we see as terrible risks on the horizon – even if they are down the road a bit.

Market/Economic Climate

It is always easy to get caught up in market euphoria, and the current market is showing many of the typical signs. The past two weeks have included explosive trading and moves in penny stocks, which frequently occurs during the most speculative of market periods. For example, AIG enjoyed a move of over 100% during the past week. The total market capitalization for the stock reached $3.65 billion as of Friday, despite our belief that the stock is likely to be worth very little or nothing over the long term. The stocks of Fannie Mae and Freddie Mac rallied by over 80% at one point during the week. Anecdotally, we’ve received some calls from clients expressing concern that they aren’t invested heavily enough. Our experience has been that such calls are the flip side of the coin to the kind of panicked calls we fielded in March (though not necessarily from the same clients!) – just five short months ago!

Along with this speculative activity, most technical measures and sentiment gauges we monitor are at levels that have historically raised the risks of at least a short term trap door for stock prices. Due to the current environment, we’ve taken some modest measures to raise defenses a little. However, we are growing increasingly bullish on commodity related stocks and will likely shift portfolio exposure further in coming weeks to take advantage of an environment in which inflation re-emerges. Energy and agriculture industry segments are two areas we continue to research and monitor for opportunities.

Humor for the Weekend

Weekly Economic Analysis newsletters are provided by TEAM Financial, and are written by TEAM's Chief Investment Officer, James L. Dailey. Visit TEAM's website if you want to receive weekly economic updates right in your inbox - Click here.