Inflation Jumps in August - Implications For Bonds
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. U.S. Falls to #18 in World Economic Freedom Report
2. The Economy: Some Encouraging Signs in Housing
3. Inflation Rises in August – Implications For Bonds?
4. Then There’s the Falling US Dollar
5. Conclusions – Bond Investors at Great Risk
I ran across the following alarming report last week – The Economic Freedom of the World Report – and I summarized it on my blog last Friday. However, this report is so troubling (and eye-opening for most) that I feel compelled to reprint that summary today, for our much larger E-Letter audience of hundreds of thousands of readers.
This is another reason why you should join my blog, especially if you are a regular reader of my weekly Forecasts & Trends E-Letter. There are other postings on my blog that you might not read elsewhere. The story you will read just below was not even mentioned in the mainstream media, as far as I can tell.
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U.S. Falls to #18 in World Economic Freedom Report
The annual Economic Freedom of the World report, including an index of country rankings, has just been released, and it should be a wake-up call. The United States was known as the bastion of economic freedom for more than two centuries, and it was because of its economic freedom that our nation became the pre-eminent economic power. However, in just a few short years, the US has fallen from #3 in 2000 (behind the city-states of Hong Kong and Singapore) to #8 in 2005 and to #18 in 2010, the last year for which complete statistics are available. Worse yet, the US decline continues and in next year’s ranking, it is almost certain to be lower.
The main components of the index include the size of government (taxing and spending), legal systems, property rights, sound money, freedom to trade internationally, and regulation (including credit markets, labor and business regulations). The report says it "uses 42 different variables to measure the degree to which the institutions and policies of 144 countries are consistent with economic freedom." It is published by the Cato Institute in the United States. The authors of the report are economists James Gwartney of Florida State University, Robert A. Lawson of Southern Methodist University and Joshua Hall of Beloit College.
The godfather of the Economic Freedom of the World report was Milton Friedman (1912-2006). Since the report was first published in 1996, it has provided overwhelming evidence that economic freedom is highly correlated with economic progress, liberty and well-being.
A few facts will help illustrate why economic freedom is so important. The freest quartile of countries had an average per capita income of $37,691, while the least free quartile had a per capita income of just $5,188 in 2010. The freest quartile grew at an average annual rate of 3.6% 1990-2010, while the quartile that was least free only grew at an average rate of 1.6% over the same period. Life expectancy in the freest quartile was 79.5 years in 2010, as contrasted with 61.6 years in the least free quartile.
Those people who are more concerned about the poor than economic growth should take note that the poorest 10% in the least-free quartile only had a per capita income of $1,209 in 2010, as contrasted with a per capita income of $11,382 for the poorest 10% in the freest quartile. Greater economic freedom is also associated with more political and civil liberties. In sum, by almost any measure of human well-being, a person is far better off being in a country with a high degree of economic freedom than in one with restricted economic freedoms.
As the accompanying table shows, countries can rise and fall rapidly. The former communist states of Bulgaria and Poland have become far freer economically very quickly. In contrast, Argentina and Venezuela have become two of the least free, and their people are suffering as a result.
Why has the United States fallen so far so fast? For years, the US was near the top in economic freedom for a major country. The US now is behind not only Canada and Australia, but also Finland, Chile and even the small island nation of Mauritius, off the east coast of Africa. The US has declined in the rule of law and property rights because of such things as "the ramifications of the wars on terrorism and drugs, and violation of the rights of bondholders in the bailout of automobile companies." The country also has suffered because of a decline in the freedom to trade internationally, fiscal deficits caused by the growth in government and various forms of regulation.
The report’s authors note that the decline in the US rating is associated with a "reduction in long-term growth [gross domestic product] of between 1.0% and 1.5% annually. This implies that unless policies undermining economic freedom are reversed, the future annual growth of the US economy will be half its historic average of 3%.”
During this election season, the US should be having a national debate about what can be done to restore economic freedom. It is perhaps no surprise that the Obama administration has been silent on the issue, because many of its policies have caused the decline. But Mitt Romney also has had little to say about it. Economic freedom grew under President Reagan, and he made its decline under President Carter an issue in his campaign. It is hoped that this report, detailing the shockingly steep US decline, will wake up the Romney campaign team and the mainstream media (unfortunately, not likely for the latter).
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The Economy: Some Encouraging Signs in Housing
At long last, we have some good news on the housing front. Existing-home sales in August were the strongest since May 2010. They rose 7.8% last month to a seasonally adjusted annual rate of 4.82 million, as reported by the National Association of Realtors last Wednesday. That’s an increase of 9.3% over year-ago levels.
August housing starts, including homes and apartment buildings, rose 2.3% from July to a seasonally-adjusted annual rate of 750,000, the Commerce Department reported on Wednesday. Single-family home starts rose 5.5%, reaching their best annual rate since April 2010. That’s an increase of 29% over year-ago levels.
Housing starts are projected to reach almost 1.1 million next year, up from an estimated 780,000 this year. That remains to be seen but if correct, some analysts suggest that could boost GDP by 0.5% to 0.8% next year.
New home sales for August will be released tomorrow, and the pre-report consensus is for an increase to 390,000 units, up from 372,000 in July. If so, that would be a healthy increase over year-ago levels.
The national median existing-home price was $187,400 in August, up 9.5% from a year ago, the National Association of Realtors said. The increase was the biggest since January 2006. It was the sixth monthly increase in a row.
Home builders are getting more confident. Last Tuesday, the National Association of Home Builders reported that builders’ confidence is the highest since 2006. The NAHB’s list of 99 improving local markets now includes some hard-hit areas such as Jacksonville and Tucson.
Housing prices have fallen so sharply in recent years that the ratio of home prices to incomes is now near the average from 1985 to 2000, said Stan Humphries, chief economist at real-estate website Zillow.com. Factor in interest rates, and house payments are 16% easier for today’s average buyer than they were for a decade and a half before the bubble, he said.
Last Wednesday’s data show that the supply of homes added to the market is rising, even as foreclosure sales slow, meaning that regular buyers and sellers are gaining confidence. Demand is growing even faster than new supply, at least over the last couple of months. The stabilization of home prices is bringing out buyers who hesitated while values were falling.
In other economic news, retail sales grew a solid 0.9% in August following a 0.6% gain in July. The University of Michigan Consumer Sentiment Index climbed to 79.2 in the first half of September, up from 74.3 in August. The Consumer Confidence Index out this morning jumped more than expected this month to 70.3, a seven-month high, up from 61.3 in August. This is very encouraging.
That about rounds out the good economic news of late. The manufacturing sector continues to show some contraction. The ISM manufacturing index fell to 49.6 in August from 49.8 in July. Any ISM reading below 50 indicates that manufacturing is contracting. Industrial production fell 1.2% in August.
Inflation Rises in August – Implications For Bonds?
The Consumer Price Index rose more than expected in August, up 0.6%. That was the largest monthly increase since June 2009, over three years ago. More importantly, the Producer Price Index (wholesale prices) jumped 1.7% in August. Both of these indexes were influenced by rising energy prices; nonetheless, they bear watching closely.
Since early August, I have been alerting my clients and readers that intermediate and long-term interest rates have turned higher, which is always bad news for most bonds and bond funds. The question is whether the recent uptick in long-term interest rates is just a “correction” or if this represents a major trend change.
As discussed last week, the Fed just announced QE3, an open-ended policy of buying more mortgage-backed securities (not Treasuries) in an effort to boost the housing market. This announcement has bond investors resting easy that there is nothing to fear. But the thing to keep in mind is that the Fed’s interest rate manipulation only works until it doesn’t.
We may be at or near that point. Remember that the Fed announced it will purchase $40 billion a month in mortgage-backed securities indefinitely. While some analysts concluded that this new Fed buying, coupled with what they are already doing, will keep a lid on long-term interest rates. Some even expect long-term rates to fall further.
Even Fed Chairman Bernanke has admitted that additional rounds of QE will have “diminishing returns.” Since the Fed will be buying mortgage-backed securities this time around, QE3 may NOT keep a lid on long-term interest rates.
Take a look at the 30-year Treasury bond in the chart below. As you can see, the yield on 30-year bonds bottomed in late July just below 2.5%. Since then, the rate climbed sharply to above 3%. Maybe this is just a “correction” – that’s what we are told to believe – and the rate has since fallen back below 3%. Not to worry?
I think we should be worried. It is my feeling that the Fed’s latest announcement of an open-ended QE3 raises the threat of higher inflation. I’m not talking about big inflation, but then it doesn’t take much of an increase in the price indexes to get the attention of the bond markets and foreigners who own almost half of our outstanding debt.
As noted above, both the CPI and the PPI surprised on the upside in August. Will these inflation numbers continue to surprise on the upside? Probably not in September because oil prices have taken a big hit over the last couple of weeks. Longer-term, however, it’s anyone’s guess.
I do think we will be hearing more about rising inflation in the US in the coming weeks and months. Rather than putting a lid on long-term interest rates, I believe that QE3 may well serve as a FLOOR for long-term rates. We shall see, but remember that you read it here first.
Then There’s the Falling US Dollar
Even if US inflation remains tame, there is still the issue of the falling US dollar. The dollar peaked in 2001 at around 120 in the US Dollar Index futures. It was in freefall until 2008 when the credit crisis hit and the world looked to US Treasuries for a safe haven. But as you can see in the chart below, each rally since 2008/2009 has peaked lower. This chart is rolling over to the downside.
The US dollar bottomed in 2008 at around 72. One wonders whether the dollar will test its 2008 lows in the weeks or months ahead, or even make new lows. I don’t claim to be a currency expert, but it seems clear to me that if this country continues to run trillion-dollar budget deficits, the US dollar is doomed to trade lower over time. That, too, is not good for bonds.
Now there are certainly those who argue that the European sovereign debt crisis will keep US dollar demand relatively strong. Some also argue that Japan is on the verge of a financial crisis, and that it will be the next major country to go into a depression – which they also argue will keep the demand for dollars firm. Maybe so.
Then there is QE3. Bernanke made it abundantly clear at his post-FOMC press conference that the Fed is fully committed to printing at least $40 billion a month in new money as long as it takes to see some real improvement in the labor market. That could be a long time! That is not good news for the dollar.
Conclusions – Bond Investors at Great Risk
If I am correct, then most bond holders are facing much more risk than they think they are. Especially US Treasury bond holders. In our recent client and reader survey, over 50% of respondents said they were invested in long-only bonds, bond mutual funds and ETFs. Just about everyone is in love with bonds. This is scary!
Let me encourage you to read my new SPECIAL REPORT and think about it seriously, especially if you are overweight in bonds. There are some good alternatives to long-only bonds and bond funds. There is even the potential to make money when interest rates rise.
Hoping you lock in some profits,
Gary D. Halbert
Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.