The Pause Lays An Egg Comstock Partners, Inc. Thursday, August 10, 2006
The Fed is in a bind, and there is little or nothing they can do about it. Whether, at subsequent meetings, they raise or lower rates or keep the status quo, the FOMC will have to force a recession in order to keep the lid on inflation. Currently, a fully justified concern about the collapsing housing bubble has forced the Fed to pause despite the threat of inflation. From this point anything the Fed does can only be a result of bad news. If they hike rates again at an upcoming meeting, it will be a response to accelerating inflation. If, on the other hand, they ease, the cause will be a developing recession. In either case, the stock market will, most likely, decline sharply.
The Fed, along with most strategists and economists, is forecasting what is arguably the least likely outcome—a soft landing accompanied by benign inflation. Realistically, however, the economy is slowing at the same time that inflation is getting worse. The Fed has already raised rates by 425 basis points, and a large number of nations throughout the world are tightening as well. Other indicators of softness ahead are high energy prices, a negative yield curve, declining leading indicators, tepid consumer spending, and, most importantly, a weakening housing picture. Of the last 9 instances that featured a combination of Fed tightening, a negative yield curve and declining leading indicators, 8 were followed by recessions and all 9 by bear markets. The addition of high energy prices and the housing boom are likely to make things even worse this time around.
Housing weakness is reflected in the lowest housing affordability rate in 15 years, the lowest NAHB index in 12 years, soaring inventories of both new and existing homes and the reports of the nation’s largest home builders. Yesterday, Toll Brothers said that signed contracts fell by a whopping 46 % with all regions of the country weakening. The company’s housing backlog dropped 17% and cancellation rates were significantly higher. Since the housing boom has been by far the main growth factor behind the current economic expansion cycle in the absence of normal gains in employment, disposable income and business spending, any bursting of the housing boom has serious implications.
At the same time, it is far from a sure bet that inflation will remain under control. On an annualized 3-month basis core CPI in June was up 3.6%, compared to 2.0% in February. CPI core services climbed 4.5% from 3.0% in February. While inflation is a lagging indicator, inflation in the pipeline looks even worse. Year-over-year core intermediate goods, a leading indicator of future inflation, were up 7.2% against 4.5% in March, with the 2nd quarter up 9.8% on an annual basis. PPI core crude goods have soared 33.7% year-over-year, with the 2nd quarter up an alarming 63.1% annualized.
If the Fed has already done enough to throw the economy into recession, then inflation may turn out not to be a serious problem. If not, additional rate hikes may be necessary. In our view, the Fed is probably finished raising rates, and the economy is headed for recession. Either way, however, the stock market is likely to decline significantly.
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