January 2005 Edition
Issue Number Three
January 12, 2005
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RECESSION SIGNALS REMAIN BORDERLINE AS STAGFLATION INTENSIFIES
U.S. GOVERNMENT OBLIGATIONS EXPLODE BY 31% IN 2004, TO 409% OF GDP
OUT-OF-DOLLAR OUTPERFORMS DOW JONES INDUSTRIALS
Foreword, Re: Pending Name Change
Within the next two weeks or so, John Williams' Behind the Government's Numbers will become John Williams' Shadow Government Statistics. Please refer to the section at the end of the newsletter for further details.
Annual inflation boomed in November, with CPI hitting a 42-month high and PPI hitting a 14-year high. At the same time, economic indicators such as the purchasing managers' new orders index, help-wanted advertising, building permits and real average weekly earnings, plus revisions to collateral GDP series and industrial production, show or are signaling slowing business activity. In combination, these factors confirm intensifying stagflation, while the better leading indicators continued to hover at the brink of generating a recession signal.
Where signals from the good-quality (and some of the other) leading indicators can be combined to generate early warnings of major upturns and downturns in business activity, the growth levels that trigger a recession signal are close but have not been breached, yet. Based on current trends, the first solid warning signals of a new recession are possible within the next round of monthly reports.
If such a warning were signaled, it would indicate a protracted period of contracting commercial activity beginning in first- or second-quarter 2005. While the downturn would be reflected in vital indicators such as federal tax receipts, corporate profits, payroll employment and industrial production, GDP growth would slow but not turn negative, unless the contraction were particularly severe. The early warning system will be detailed at such time as a signal is generated.
On the pricing front, however, inflation concerns have triggered tentative, cautionary comments from the Federal Reserve. Despite the slowing economy, inflation fundamentals continue to deteriorate, driven by oil prices, fiscal malfeasance and a tumbling U.S. dollar.
The horrendous deterioration in the government's financial condition is detailed in the section on the federal deficit. The ultimate solution to this disaster likely will be a forced monetization of Treasury debt by the Fed, which will be accompanied by a corresponding full-scale debasement of the U.S. dollar. The dollar's implosion already seems to be getting underway in the global markets, and therein lie a variety of problems for dollar-based investors.
Consider the happy news that the Dow Jones Industrial Average gained 3.1% in 2004. Historically, stock prices have been used as a leading indicator to the economy. In the pre-World War II era and the period leading into the Great Depression, the Fed's Index of Industrial Production (this month's "Reporting Focus") and the health of the stock market were the primary indicators available to business analysts and government officials in assessing current economic conditions. Those times, however, also were the days of budget and trade surpluses and a strong U.S. dollar.
The good news on the DJIA is not so good when viewed against the U.S. dollar. Investors holding cash in Swiss francs gained 8.5% in dollar terms in 2004. Likewise holders of euros were up 7.5%, holders of pound sterling were ahead 7.4% and holders of yen gained 4.3%. Investors based in those currencies would have lost money in the DJIA.
The point here, though, is from a dollar investor's standpoint. A person living in a U.S. dollar-denominated world might think he or she would have made 8.5% holding cash in Swiss francs. That is wrong. All the investor would have accomplished was to have held his or her purchasing power constant against the rest of the world. Those enjoying small investment gains in the U.S. are missing the point that their dollar wealth is being eroded away by the U.S. currency's demise. The greenback does matter! Lost global purchasing power will show up in domestic inflation in the month's ahead.
Despite continued mixed reporting, financial market misperceptions of solid economic growth and contained inflation continue, although the inflation-containment confidence has started to soften. As a result, the broad reporting risk to upcoming economic releases continues to weigh in favor of economic growth indicators coming in below, and indicators of inflationary pressures coming in above, market expectations. Where our analysis offers particular insight into likely reporting biases in the next releases of key series, such is noted in the text accompanying the specific series analysis.
This month's "Reporting Focus" examines the Federal Reserve's Index of Industrial Production, which, despite its reporting foibles sometimes is a better indicator of broad economic activity than the GDP. There is no need for Wall Street Pollyanna's to worry, though, since the aged series is being slowly "fixed."
THE BIG THREE MARKET MOVERS
(Each of these series is explored in the background article "A Primer On Government Economic Reports," available on the home page.)
Employment/Unemployment -- The popularly followed December 2004 unemployment rate U-3 rose slightly to 5.43% from 5.41% in November, seasonally adjusted, well within the published +/- 0.2% margin of error of the household survey. The broader U-6 measure, also seasonally adjusted, eased minimally, by 0.1%, to 9.3% for December. Including the long-term "discouraged workers" defined away during the Clinton administration, totalunemployment is roughly 12.3%.
The household survey had its historical seasonal factors revised, with negligible impact on the reported historical unemployment rates. The underlying unadjusted data were not altered.
The December payroll survey showed a slightly weaker than expected, seasonally-adjusted gain of 157,000 jobs (191,000 net of revisions). November's previously reported gain of 112,000 jobs was revised to 137,000, with annual growth rising from 1.63% in November to 1.65% in December.
Running contrary to the payroll data, the household survey showed a seasonally-adjusted decline of 137,000 in employment. The Bureau of Labor Statistics has never been able to reconcile household and payroll survey results to within a million jobs.
Next Release (February 4): Look for the unemployment rate to begin creeping higher in the months ahead, while January payrolls should come in far below expectations -- perhaps plunging into negative territory -- before a surprise rebound in the February data (March 4).
Last year, the bias factor (the "Net Birth/Death Adjustment" modeled for imaginary companies) swung from +78,000 in December 2003 to -321,000 in January 2004 and then to +115,000 in February. Although these numbers are not seasonally adjusted, they pretty much flow through to the adjusted data and should be roughly parallel in movement this year.
As a wild card -- enabling almost any reporting the BLS desires -- the next report also will include the annual benchmark revision to the payroll survey. The BLS has pre-announced that it will revise the level of unadjusted March 2004 payrolls upward by about 236,000. There also will be guesstimated proportionate changes going both backward and forward in time. Seasonal factors and bias estimates also will get revamped in this annual re-jiggering of the numbers.
Gross Domestic Product (GDP) -- While the "final" estimate of third-quarter 2004 annualized real GDP growth revised upward to 4.0% from the "preliminary" 3.9% and the "advance" 3.7%, the revisions still were little more than statistical noise in a report that has become a meaningless indicator of current economic activity. Even so, all was not as happy or unrevised as reported by the financial media.
Indeed, revisions in the broader Gross National Product (GNP) and the theoretically GDP-equivalent Gross Domestic Income (GDI) measures for the third quarter were contrary in movement. GNP growth revised from 4.2% to 4.0%, while GDI growth tumbled from the previously reported 3.9% to 2.8%. That latter set of growth rates reflected the impact of statistical discrepancy jumping from $59.6 billion to $90.4 billion (current dollars), in revision.
The GDP is tallied using something akin to double-entry bookkeeping. What gets entered on the consumption side (GDP) is supposed to have an offset on the income side. When the accounts cannot be reconciled, the differences are entered as "statistical discrepancy." As the revisions move to the second or third generation, however, the data should be of increasing quality and smaller discrepancy. The $30.8 billion current dollar increase in reporting error is meaningful and only tends to highlight the poor reporting quality inherent in the national income and product account reporting.
Back to the GDP, where the official third-quarter growth of 4.0% was up from second-quarter growth of 3.3%, it still was lower than the first quarter's 4.5% annualized pace, and real year-to-year growth is in a downtrend, with annual growth easing from 4.8% in the second quarter to 4.0% in the third.
As discussed in the background articles, GDP reporting is overstated by about 3%, which would place actual annualized real growth at roughly 1% plus or minus about 3%, given published 90% confidence intervals.
Next Release (January 28): Expectations for the "Advance" estimate of Fourth-Quarter 2004 GDP likely will be about the same as the GDP growth reported in the third quarter. There is enough actual and unrecognized underlying weakness in the economy, however, to bring in the first estimate well below expectations. Any significant deterioration in November's trade deficit will help to lower those forecasts, but the best bet will remain for a downside surprise in any event.
Consumer Price Index (CPI) -- After surging 0.6% in October, the seasonally-adjusted November CPI-U eased to 0.2% (0.2% unadjusted). That was enough to push unadjusted year-to-year inflation up from 3.2% to 3.5%, the highest inflation rate reported since June 2001, as shown in the graph on the home page.
Using the CPI's original (pre-Clinton Era) methodological approach of a fixed basket of goods (vs. substitution of hamburgers for steak as estimated by geometric weighting) would leave year-to-year inflation at about 6.2% instead of 3.5%.
Even the "experimental" Chained Consumer Price Index (C-CPI-U), the fully substitution based CPI that presumably is the eventual replacement for current CPI reporting, showed a 3.1% year-to-year gain, up from 2.7% in October. This was the highest annual inflation rate reported in the limited history of the series, which goes back to January 2001.
Next Release (January 19): Inflation pressures will continue to offer upside surprises in many reports, but the December year-to-year inflation rate is a particularly sensitive number, politically, widely used in many reports and forecasts. Accordingly, pressure will be on to keep reported inflation as low as possible. The markets are looking for 0.2% growth for the month, which is enough to hold the annual inflation rate at 3.5% or 3.6%. Any monthly change above or below that 0.2% should subtract or add directly to the currently reported annual growth of 3.5%. A report close to market expectations is the best bet, with some upside risk.
OTHER TROUBLED KEY SERIES
To varying degrees, the following series have significant reporting problems. Each series will be addressed in a monthly "Reporting Focus," with Industrial Production covered this month. In addition to the big three, other series that have been detailed are the background article on The Federal Deficit, Consumer Confidence (November 2004 BGN) and the Trade Balance (December 2004 BGN). A new series commented on in this section is the weekly Initial Claims for Unemployment Insurance report.
Federal Deficit -- As highlighted in the December 16th Alert, the U.S. Treasury released the "2004 Financial Report of the United States Government" about three months early, based on accelerated reporting. Before getting into the generally accepted accounting principles (GAAP) details, here is a quick summary of the most recent monthly numbers.
The official deficit for the fiscal year ended September 30, 2004 was $412.3 billion, up from $374.8 billion the year before. For the twelve months ended November 2004, the rolling deficit was $414.9 billion, versus $376.7 billion in November 2003. Gross federal debt as of the end of September was $7.379 trillion, up $596 billion from a year earlier; at month-end December, gross federal debt was $7.596 trillion, up $595 billion from December 2003.
The GAAP-reporting on U.S. government fiscal operations was almost beyond belief. Where the official cash-accounting deficit for fiscal-year 2004 (year-ended September 30) widened by 10.0% to $412.3 billion, the GAAP-based accounting, excluding the change in the net present value of unfunded Social Security, Medicare and related account liabilities, narrowed by 7.8% to $615.6 billion. Such was largely due to games playing with military and other government-related pensions, which we're still checking out.
The broad GAAP-based deficit (including Social Security, etc.) blew up to $11.1 trillion in 2004, from $3.7 trillion in 2003. Much of the increase was due to a set-up charge from booking the "enhancements" to the Medicare system. Net of the $6.4 trillion one-time expense, the annual broad deficit was about $4.7 trillion, reasonably close to our projection of $4.3 trillion.
----------------------------------------------------------------- U.S. Government - Alternate Fiscal Deficit and Debt (Source: US Treasury; $s Are Either Billions or Trillions, as Indicated) ----------------------------------------------------------------- Formal GAAP GAAP GAAP Tot. Fed- Cash- Ex-SS With SS Federal Gross eral Ob- Fiscal Based Etc. Etc. Negative Federal ligations Year Deficit Deficit Deficit Net Worth Debt (GAAP) ----------------------------------------------------------------- (Bil) (Bil) (Tril) (Tril) (Tril) (Tril) ------ ------ ------ ------ ------ ------ 2004 $412.3 $615.6 $11.1* $45.9 $7.4 $47.3 2003 374.8 667.6 3.7 34.8 6.8 36.2 2002 157.8 364.5 1.5 32.1 6.2 32.7 ----------------------------------------------------------------- *$4.7 trillion, excluding one-time setup costs of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (enacted December 8, 2003). -----------------------------------------------------------------Nonetheless, the total numbers reflect something close to true liability. The new Medicare charges show how quickly politicians can make an already impossible situation significantly worse. By adding features to Medicare without setting up full funding for same, the Administration and Congress increased the total net present value of federal government obligations by 31%, from $36.2 trillion to $47.3 trillion in just one year.
The major rating agencies should be looking closely at these numbers in considering the sustainability of the AAA rating given to U.S. sovereign debt. Never has an investment-grade sovereign rating, let alone a AAA country, been supported by such negative extremes in underlying fiscal condition. Based on the latest numbers, the broad GAAP deficit for 2004 represents 96% of GDP, up from 33% in 2003, with total obligations now at 409% of GDP, up from 334% in 2003.
Further, the General Accounting Office, which audited the report, would not certify it, finding material problems in the government's bookkeeping. The full document is available at www.fms.treas.gov/fr/04frusg/04frusg.pdf. See the background article on the home page for further detail on the basic issues raised here.
Producer Price Index (PPI) -- The seasonally adjusted November Finished Goods PPI rose by 0.5% (fell by 0.1% unadjusted), once again surprising the markets on the upside. Year-to-year PPI inflation rose to 5.0% in November from 4.4% in October. November's annual inflation reading was the highest since December 1990.
Next Release (January 14): The monthly variations in this series have a large component of random volatility. Nonetheless, PPI inflation reporting over the next three-to-six months still should average above consensus forecasts. The markets are looking for a monthly gain of about 0.2% in the December PPI.
Initial Claims for Unemployment Insurance -- As a weekly series, the initial claims number often is a market mover. The problem with the series is that it is seasonally adjusted by the Department of Labor, which never has demonstrated an ability to seasonally adjust weekly data. As a result, weekly reports that encompass a legal holiday, such as July 4th, Christmas, New Year's Day or the upcoming Martin Luther King Birthday, often show unexpected and market-moving swings that have nothing to do with underlying economic activity. When the weekly numbers are smoothed over three months and compared year-to-year, however, they often show a meaningful leading relationship to the economy. This will be explored in February's "Reporting Focus."
Real Average Weekly Earnings -- November's seasonally-adjusted real average weekly earnings fell by 0.4% from October and were down 1.6% against November 2003. Allowing for the biases built into the CPI series used to deflate the weekly earnings, annual change in this series is on the brink of generating a recession warning signal.
Retail Sales -- Seasonally-adjusted November retail sales rose 0.1% +/- 0.8% (0.7% net of revisions) from October, up a robust 9.0% from November 2003. The report was not as weak as viewed by the markets and signaled a stronger open to holiday-season sales than is supported by anecdotal evidence. Where inflation-adjusted growth in retail sales below 1.8% (using the standard CPI for deflation) signals recession, annual growth still is holding comfortably above that level.
Next Release (January 13): The December report should come in on the weak side of expectations, with possible downside revisions to November's report.
Industrial Production -- November industrial production rose by 0.3% (0.0%) net of revisions, after a 0.6% (previously 0.7%) gain October. With year-to-year change slowing to 4.2%, but that was revised to a declining 3.8% (October was 4.6%) in the ensuing benchmark revision discussed in the "Reporting Focus." As a coincident indicator to the economy, industrial production suggests slowing growth in the manufacturing sector, reasonably consistent with the still positive readings out of the overall purchasing managers survey.
New Orders for Durable Goods -- November seasonally adjusted orders rose by 1.6% (1.3% net of revisions) from October, which was down 0.9%(previously 0.4%) from September. Year-to-year growth in rebounded to 10.8% after October's downwardly revised 2.3%. The widely followed Nondefense Capital Goods Orders gained 8.1% after a 4.1% decline in October. Monthly volatility is high for this series, which used to be one of the better leading indicators of broad economic activity, when smoothed using a three-month moving average. After the semi-conductor industry stopped reporting new orders, and the series' quality fell apart.
Purchasing Managers Survey (Non-Manufacturing) -- Published by the Institute for Supply Management (ISM), there is nothing unusually wrong with this survey of the service industry, except it does not have much meaning. Unlike its older counterpart, the manufacturing survey, if service companies such as law firms, hospitals or fast-food restaurants have "increased orders," that does not necessarily mean the economy is picking up.
The Prices Paid component diffusion index, however, is a general indicator of inflationary pressures, and the December measure was up 18.4% year-to-year. On a three-month-moving-average basis, the Prices index was up 22.1% from December 2003, versus a 20.6% annual gain in November.
Trade Balance -- The October trade deficit in goods and services widened sharply to $55.5 billion from a revised $50.9 billion in September (was $51.6 billion), suggesting a significant trade deterioration that will soften up fourth-quarter 2004 GDP reporting.
Next Release (January 12): Due to this month's late release of December employment data, the newsletter is late in its possible publication cycle, but has been written before the release of today's scheduled November trade report. Further sharp deterioration is likely in the trade deficit in the month's ahead. If the November trade shortfall is close to, or worse than, the October number, fourth-quarter GDP growth expectations will be lowered by consensus forecasters.
(NOTE: Gillespie Research Associates clients should check the GRA website late today or early tomorrow for details of today's trade report Gillespie Research Associates.)
Consumer Confidence -- While both the December Consumer Confidence and Consumer Sentiment surveys showed strong monthly gains (10.5% and 4.6% respectively), the three-month moving average for both series continued to slow. Year-to-year, smoothed confidence was up 8.2% in December versus 12.3% in November and a near-term high of 27.8% in September, while sentiment was up 2.5% in December versus 4.2% in November and a near-term high of 8.9% in September. As lagging, not leading, indicators, these numbers confirm the economy had been slowing into fourth quarter of 2004.
BETTER-QUALITY NUMBERS
The following numbers are generally good-quality leading indicators of economic activity and inflation that offer an alternative to the politically hyped numbers when the economy really is not so perfect. In some instances, using a three-month moving average improves the quality of the economic signal and is so noted in the text.
Economic Indicators
Purchasing Managers Survey (Manufacturing) - New Orders -- While the December index rose to 67.4 from 61.5, the numbers, again, were seasonally adjusted with government estimates. Seasonal factors often can be misleading in the reporting of month-to-month change, an issue overcome by using year-to-year change on a three-month-moving-average basis. The December number was down 7.8% from the reading a year before, compared with November's 13.9% drop. Using a three-month moving average, December was down 10.4% versus November's 9.6%.
Published by the Institute for Supply Management (ISM), the New Orders component of the Purchasing Managers Survey is a particularly valuable indicator of economic activity. The index is a diffusion index, where a reading above 50 indicates rising new orders. The current year-to-year downturn in the three-month moving average is closing in on generating a recession warning signal.
Help Wanted Advertising Index (HWA) -- November's help wanted advertising dropped once more to 36, hitting a 43-year low, down a point from October's reading of 37. The year-to-year change in the three-month moving average was down 1.8%, the third decline in four months. The weakness in this newspaper-based index is matched in parallel weakness indicated for Internet-based help-wanted sites. Published by the Conference Board, the HWA is a reliable leading indicator of employment activity. The series continues to be borderline in signaling a pending recession.
Building Permits -- Seasonally adjusted November building permits fell 1.5% from October (up 0.2% net of revisions), with year-to-year change rebounding from 0.2% to 3.5%. On a three-month moving average basis, annual growth increased to 2.1% from October's 1.1%, but it still is the lowest in more than two years, outside of October's reading.
As a leading indicator of economic activity, the series has shown a meaningful slowdown and remains borderline for generating a recession warning.
Inflation Indicators
Purchasing Managers Survey (Manufacturing) - Prices Paid -- The December Prices Paid diffusion index softened further to 72.0 from November's 74.0. The index has been signaling a strong rise in inflation since late in 2003. On a three-month moving average basis, the year-to-year change in the Prices Paid Index rose by 19.1% in December, somewhat slower than November's 28.0% growth.
Published by the Institute for Supply Management (ISM), the Prices Paid component of the Purchasing Managers Survey is a reliable leading indicator of inflation activity. The prices paid index is a diffusion index, where a reading above 50 indicates rising inflation. While reduced in magnitude, the December inflation signal remains strong.
Oil Prices -- West Texas Intermediate Spot (St. Louis Fed) continued to decline in December, falling 10.6% versus November's average. Even so, year-to-year, the spot price is still up by a highly inflationary 34.8%. While oil prices have tumbled from recent highs, broad inflation still will rise more than consensus expectations.
Oil price changes permeate costs throughout the economy, ranging from transportation and energy costs, to material costs in the plastics, pharmaceutical, fertilizer, chemical industries, etc. Where the effects of recent oil price volatility will be picked up quickly in the CPI, on the downside, broader inflation -- even as currently understated -- will be stronger than commonly predicted for the next six-to-nine months, as a result of the net run-up in oil prices, to date.
U.S. Dollar -- December's dollar average (the Federal Reserve's Major Currencies U.S. Dollar Index) was down 1.1% from November and down 7.0% from December 2003. New record lows for the dollar remain likely in the months ahead, despite any near-term official or unofficial supportive intervention by any central bank(s).
Generally, the weaker the dollar, the greater will be the ultimate inflation pressure and the eventual liquidity squeeze in the U.S. capital markets.
JANUARY'S "REPORTING FOCUS" -- THE FED'S INDEX OF INDUSTRIAL PRODUCTION
As the oldest, regularly published government economic series, the Federal Reserve's Index of Industrial Production at one time was viewed as the equivalent of today's GDP. The index was started after World War I (data are available back to 1919), and provided the only systematic measure of manufacturing activity that once was the predominant driver of overall U.S. economic activity.
The index provides a monthly measure of real (inflation-adjusted) output of manufacturing, mining (including oil and gas) and gas and electric utilities. Although some analysts may view production as an artifact of an earlier age, production does tend to generate physical wealth, unlike the services sector so heavily favored in today's politically-adjusted economic reporting.
As published, the index does tend to move with the broad economy, regardless of what is published by the Bureau of Economic Analysis on the GDP. Industrial production is used, along with factors such as payroll employment, in calling turning points in the economic cycle, as determined by the National Bureau of Economic Research. Industrial production still shows a 2000/2001 recession, while the GDP does not.
That said, there are problems with the series. As of the December 22nd benchmark revision, 46% of industrial production was estimated by electricity consumed or by the number of manufacturing employees in a given industry, 50% was based on actual physical production records and 4% was guesstimated. Prior to the revisions, fully 50% was estimated by electricity usage and worker counts and 46% was from direct physical measures of production.
The trend away from estimates based on electricity and workers could be a plus, or not, since the replacement data are coming from the same people who give us the GDP. The problem is that production based on electricity usage can be skewed by unusual weather factors. Also, manufacturing payrolls can be skewed by reporting problems at the Bureau of Labor Statistics, but the bias factors added into the data are minimal in the manufacturing area.
In that the series tends to work as a coincident indicator, it probably is best left alone, and corrected, when possible, in annual revisions. In the latest revision, overall industrial production growth was revised downward by 0.6% through November 2004, downward by 0.3% for all of 2003, upward by 0.1% in 2002, upward by 0.2% in 2001 and downward by 0.4% in 2000. In broad summary, the 2000/2001 recession was deeper than previously reported, and the recovery from same has been weaker.
Published along with industrial production is a measure of capacity utilization, which tends to be a less reliable indicator than production, due to the poor quality of data available on capacity.
Upcoming "Reporting Focus" for February -- Initial Claims for Unemployment Insurance, a series widely mis-followed by the markets, can be used as a meaningful economic indicator.
February's Shadow Government Statistics is scheduled for release on Wednesday, February 9, 2005. Its posting on the website will be advised immediately by e-mail, as will any interim alerts that might be published beforehand.
Re: The Newsletter's Pending Name Change
As mentioned at the outset, John Williams' Behind the Government's Numbers will soon become John Williams' Shadow Government Statistics. The website changeover should take place within the next two weeks, so don't think you've come to the wrong place the next time you log in. Only the name is changing; the newsletter content continues as is!
The change is being made to prevent any potential confusion between the name of our publication and website and the great service provided by David W. Tice & Asscoiates, offered as, "Behind the Numbers" -- a name in use for a long time. That service and what we do are very different indeed, but the folks at Tice are close and highly valued friends of long duration. Therefore, we decided to take this step to avoid possible confusion.