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A Slowing Economy with Higher Costs

The Commerce Department sent mixed messages to the financial markets this morning with a weaker than expected report on durable goods orders and a much better than expected report on new home sales. Expectations for durable goods orders were for a gain of 0.9% to the headline number, but the report showed a gain of only 0.3%. Similarly, the durable orders less transportation were expected to grow by 0.3%, but orders actually fell by 0.2%. The weak numbers helped to put a bid back in the bond market to put a temporary halt in rapidly increasing bond yields/interest rates. Stocks are also getting an oversold bounce with the bond market firming up a bit today. Stocks clearly do not like this rising interest rate environment. New home sales were reported 9.4% higher to 1.226 million annualized units after economists predicted a more modest gain of 3.6% to 1.15 million units.

Thirty-year mortgage rates have now moved above the 6% level which is giving home buyers a reason to move quickly, making their purchase before rates move even higher. The Commerce Department also said the median home price moved higher by 9.6% to $230,700. The payment on a $200,000 mortgage at 6% would be $1,199 per month, at 7% it would be $1,330 and at 8% the payment goes up to $1,467. If this is truly the last chance sale at these historically low mortgage rates, it makes a lot of sense that new home sales are demonstrating a blow-off top as buyers load, lock and fire for that dream home while they can still afford the monthly payments.

A separate report came from the Labor Department showing initial jobless claims rose by 3,000 to 324,000 while economists were expecting claims to actually decrease to 315,000. The unemployment claims along with the weaker than expected durable goods orders tells me we have an economy that is teetering on the edge. I see a number of signs that the economy is due to slow. The two biggest culprits that will put a huge dent in discretionary spending will be higher interest rates and higher energy costs. Higher interest rates are expected to slow business spending later in the year, but higher costs to borrow money and higher costs for gasoline, heating fuels and electricity should cause consumers to get very defensive with their wallets. Three-fourths of our economy is driven by consumer spending, so it should get more interesting as the year progresses.

Overall, I am seeing deflation of financial assets and a continuing inflation of tangible assets. A quick example of deflation of financial assets can be seen in the price movements in the last three weeks for stocks, bonds and the dollar. On 3/7 the Dow had an intra-day high of 10,984 and today closed at 10,442, a loss of 4.9%. Over the same timeframe the Nasdaq has dropped from 2,100 to close at 1,991 today, a loss of 5.2%. On 2/9 the 10-year Treasury Note stood at 112.469 and today closed at 108.469, a loss of 3.6%. On 2/10 the dollar (as expressed by the U.S. Dollar Index) had an intra-day high of 85.42 and today closed at 84.13, a loss of 1.5%. If you take away the dollar rally of the last six trading days, it would have shown a loss of 4.5% to 81.55. All in all, U.S. assets including stocks, bonds and the dollar have all moved lower in price in the last couple months. I call this financial asset deflation.

Inflation has been heating up for commodities and is now beginning to show itself further down the pipeline in consumer goods. Mr. Greenspan says corporations are now getting some pricing power to pass along raw material increases to retail, but at some point they would have to pass along the increases or go belly-up with losses. From a consumer goods standpoint, we could well be seeing the law of diminishing returns at play when it comes to inexpensive labor from overseas. Manufacturing has been moving out of the USA and other countries to lower cost producers in China and other Asian countries for many years now. We have probably already seen the big cost reductions from outsourcing to cheaper labor, and that has worked to offset the raw materials price increases up until now. Now that most of the pricing is already set to the lower labor costs, we still have continuing increases in raw material costs. Maybe this is why Mr. Greenspan says corporations are gaining some pricing power…because they HAVE TO since they can’t figure out any other way to get productivity increases via lower labor costs.

The Shanghai Cooperation Organization

I read a Bloomberg article this morning that really caught my attention. The article is headlined with, “India Oil Chief Says Attack on Iran Would Be Stupid.” Now that’s a pretty simple statement to understand, but let’s look a little deeper. In the text of the article the following countries were mentioned: India, Iran, USA, Afghanistan, Iraq, Pakistan, Russia, Venezuela, and Sudan. Four of the countries listed are members, or soon-to-be members of the Shanghai Cooperation Organization. The core countries of the group include China, Russia, Brazil and India, with Iran and Venezuela as probable new entrants. One thing I found surprising about the Bloomberg column is that the writer NEVER mentioned once about the existence of the international trade group known of as the Shanghai Cooperation Organization. It appears to me that Bloomberg intended to downplay the significance of this very powerful trade alliance. They are working feverishly behind the scenes to secure sources of supply (with each other) for energy and other key commodity items to meet the growing demands.

Subir Raha, the government-appointed head of India’s largest oil company, Oil & Natural Gas, said it would be stupid to attack Iran as it would risk imposing record oil prices on the global economy. Raha partially blamed the current high oil prices on the U.S. invasion of Afghanistan and Iraq, and said, “You launch one more attack and you can’t even guess where the speculation will go.”

The U.S. Administration must be quite concerned over the developments since they sent David Mulford, the U.S. Ambassador to India, to speak with India’s Oil Minister on March 10^th to express concern about India’s plan to import gas from Iran through a pipeline. Less than a week later on March 16^th, Secretary of State Condoleeza Rice was in New Delhi and said that the U.S. has “concerns” about India’s plan to buy gas from Iran. (Remember that Iran has also struck a deal with China to supply liquefied natural gas.) China is in the process of building a special fleet of ships designed for the sole purpose of shipping LNG from Iran to China. If another big chunk of Iran’s LNG production goes to India, how much will be left to ship into the USA?

The Indian response seems to be realistic in my mind. “I see no reason why India's priorities should be subservient to U.S. priorities,” said Raha, who has worked for state-run oil companies for the past 35 years. “The U.S. is chasing oil and gas as badly as China or India or anybody else.” The article went on to say that Oil & Natural Gas (India’s national oil company since 1959) will buy 20% of Iran’s Yadavaran oil field and may take a stake in the Juffair field. Oil & Natural gas also has contracts with Venezuela, Sudan and Russia for drilling new fields and India is also in talks to acquire assets of Yukos Oil Company from Russia. To play it fair, India is also in talks with Exxon Mobil to discuss deep-water drilling off India’s coast.

The big picture has India and China doing deals with Russia, Iran and Venezuela…not to mention Europe buying roughly 80% of their oil from Russia. These are clearly energy deals centered on the member countries of the Shanghai Cooperation Organization. You won’t hear much about the SHO in the mainstream media, but when the countries mentioned get into the headlines, remember the close trade alliances they have with each other that do not involve the USA. It’s no wonder Iran and other countries are working to establish an oil trading exchange that will be denominated in euros rather than U.S. dollars…we’ll see if they can pull it off or if the U.S. will insist that all oil be traded in dollars…it’s becoming quite the battle royal!!

Silver could still see another twenty cents or so to the downside, but in my judgment the potential upside reward greatly outweighs the downside risks from here. Long-term trend line support is at $6.60 with the 200-day moving average at $6.85. From the chart you can see we have dipped the 200-dma on several occasions, but the zone in the area of the 200-dma (+/- 5%) has worked as long-term support throughout all the early stages of this bull market for silver. Now let’s look at the recent silver decline from the perspective of Fibonacci retracements. The prior move up began on 2/8 with a low of $6.49 and ended with a high on 3/9 at $7.68, a gain of $1.19. With today’s close at $6.94 we have retraced $0.74 of the $1.19 move higher (62%) which fits perfectly with a common Fibonacci retracement of 61.8%. We’ll find out next week if it’s that easy to pick the bottom for silver, or if silver investors are going to get beaten-up a bit before moving higher again. As always…time will tell!

Overall, this week was another poor performance for U.S. stocks and bonds, but the dollar rallied with higher interest rates. Higher rates will not save the U.S. dollar unless they get very serious about moving the rates MUCH higher as Paul Volker did back in the early Eighties, but they can’t do it because we live in a debt-driven financial world. The dollar will find a floor when our leaders get around to addressing Federal Government budget deficits and our enormous trade deficit. Until then, the Fed can jawbone the market with the threat of much higher interest rates, but I don’t believe it will happen. For now stocks and bonds are still under pressure, but I enjoy trading commodities on the long-side as I believe we are in this commodities bull market for quite a few years to come based on the insatiable global demand for raw materials. Everybody around the world wants a taste of the good life! If you really want a taste of the Good Life, just remember the REAL REASON for the Easter Season. It’s not about egg hunts and candy baskets…it’s all about what He did for all of us to set us free from ourselves!!

May you and your families have a Happy and Blessed Easter Holiday!

Mike Hartman

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