July 2006 Newsletter
Issue Number 21
July 17, 2006
__________
Second-Quarter Real Retail Sales Contract 1.3%
Employment Indicators Plunge
As Inflation Soars, Fed President Suspects CPI Understatement
Federal Deficit "Improvement" Little More Than Statistical Noise And Accounting Gimmicks
Worst of Times Unfolding for U.S. Equity And Credit Markets
Douglas R. Gillespie, Sr., founder and principal of Gillespie Research Associates, died suddenly but peacefully on June 14th. An obituary is included in the closing portion of this month's newsletter.
We welcome his subscribers who join us this month. Doug's information often offered a happy and unique complement to ours, and Shadow Government Statistics -- in addition to its regular fare -- is expanding to fill part of the void created by Doug's absence. In particular, the Markets Perspective section will address the shifting fundamentals underlying the equity, credit, currency and gold markets. Also, this month's Reporting/Market Focus explores the Federal Reserve's Flow of Funds Accounts and reporting for first-quarter 2006 as it relates to foreign investment in U.S. assets. Details of further and upcoming changes are discussed in this month's closing comments. -- John Williams
Collapsing economic activity and mounting inflation dominated last month's economic reporting. An inflationary recession is in play, and there is little the Administration or the Fed can do about it. This has created a nightmarish scenario for the financial markets.
At the same time, international tensions have escalated to the point where risk of a conventional world war is the highest it has been in 61 years. With U.S. economic and global political conditions unraveling so rapidly, underlying fundamentals do not get much worse for the equity and credit markets, nor much better for gold. Circumstances are fluid and disorderly markets are possible with little or no warning. The U.S. dollar faces severe selling pressure in the near future, although political flight-to-safety effects are providing the greenback with temporary, albeit short-lived, support. The timing of the dollar's demise ultimately will determine the timing of the fate of the other markets.
Economic Indicators Tumble. Confirming a sharp slowdown in business activity, retail sales and help-wanted advertising both plunged and generated recession warning signals in the last month. Housing starts is on the brink of doing so with its next report. All this is in conjunction with downturns in most key business indicators, with industrial production surprising the markets with a monthly contraction. Month-to-month downturns also were reported in durable goods orders, the purchasing managers surveys, the trade deficit and real earnings, while annual growth continued sinking for consumer confidence and real (inflation-adjusted) money supply. Details are discussed in the respective series' sections.
The collapse seen in key employment indicators is particularly striking. While the above graph was included in last month's opening comments, the updated plot includes a further two-point plunge in May help-wanted advertising, which took the index below its recent recession low, to a level not seen in 45 years. The decline, which is a leading indicator to national employment, was mirrored in tumbling June employment indices in the purchasing managers surveys. In particular, the manufacturing index indicated an outright employment contraction, with the index at its lowest reading since the end of the last recession. The jobs downtrend also was confirmed by rising new claims for unemployment insurance.
Monthly payroll employment gains reported in the last two months have been statistically indistinguishable from no growth or outright contraction. But for political massaging, the monthly data would be turning down.
Also a shock to the markets, a June retail sales contraction confirmed the recession with annual, inflation-adjusted growth falling below its warning threshold level of 1.8% (pending a highly likely June CPI result on the plus side of a 0.3% contraction). Assuming the June CPI matches minimal consensus expectations of a 0.2% gain, real retail sales actually contracted at a 1.3% annualized rate in the second quarter.
Where retail sales represent roughly half of the GDP's personal consumption account, and personal consumption represents roughly 70% of GDP, the first quarter's reported GDP boom should have wilted some in the second quarter. Arguing for continued boom is the political manipulation of GDP reporting going into the mid-term election.
On the brighter side of the economy, the Administration happily is touting surging tax revenues and a declining budget deficit, as prepared using the standard cash-based gimmicked accounting, where social security and similar taxes are counted as revenues without offsetting liabilities. The "improvement" is little more than statistical noise and bad accounting.
While tax revenues are higher, almost across the board, the actual deficit is not narrowing. As projected, last year's accounting-gimmicked deficit of $319 billion now is expected to narrow to $296 billion for fiscal 2006. The $23 billion improvement is just 0.7% of the GAAP-based deficit, which is running close to $3.5 trillion.
The federal spending shortfall, however, is getting worse, not better. While the 12-month rolling gimmicked deficit as of June 2006 was $276 billion, down from $336 billion in June 2005, the actual annual increase in gross federal debt was $584 billion in June 2006 versus $562 billion the year before. The difference is in accounting manipulations. As to the factors behind increased tax revenues, eventual detail should show that special factors tied to regulatory or tax changes are at work, not a booming economy. The tax receipt gains should prove to be short-lived.
CPI Understatement Suggested by Fed President. "U.S. inflation may be worse than what is showing up in government data .." opened the June 16th Associated Press dispatch by Kelly Olsen, citing comments by St. Louis Federal Reserve President William Poole:
"... Poole said that more attention should be paid to informal sources of information in addition to official data to determine the true extent of inflationary pressure. "'Statistical studies to detect pass-through from recent energy price increases have failed to show significant effects in U.S. price data,' he said in an address to the [monetary policy] conference. 'But stories about widespread pass-through are becoming increasingly common.' "'We may face more inflation pressure than currently shows up in formal data,' Poole said, emphasizing that his objective was 'to make a general point and not to conduct a full analysis of the current situation.'"
Not surprisingly, Poole's comments were qualified as not necessarily reflecting official positions of the Federal Reserve System.
That said, annual inflation reported for May surged to 4.2% from 3.6% in April for the CPI, while annual PPI inflation jumped to 4.5% from 4.0%. With oil prices continuing at record-high levels, rising inflation is locked-in for the next six-to-nine months. As suggested by Mr. Poole, anecdotal evidence of oil-driven inflation crossing into nonsensical "core" inflation is overwhelming and should begin surfacing with a vengeance in official reporting.
For those who are new to the SGS, "core" inflation is described as nonsensical, here, since it excludes the costs of food and energy, commodities that account for a goodly portion of most consumers' living expenses. The "core" concept originally was introduced as way of viewing monthly inflation changes, net of distortions from unusual monthly volatility in food or energy prices. Now the measure is used by Wall Street and the Fed on an annual basis to proclaim low and contained inflation. Annual "core" inflation, however, has no practical use or meaning other than as tool of political convenience and propaganda.
Global Dangers and Distortions. One area regularly pursued by SGS is the examination of risks, particularly where there is or may be an interconnection of not so obvious issues. Communist China keeps surfacing in such analyses.
As discussed variously in this month's Reporting/Mmarket Focus on the Flow of Funds and the U.S. dollar outlook, foreign holdings of U.S. Treasuries present a liquidity threat to various markets. China is a large holder of these instruments and could throw the U.S. markets into turmoil if it decided to stop pouring its trade-surplus dollars into U.S. Treasuries, or, worst case, to dump its holdings. Nonetheless, there have been rumblings of the Chinese monetary authority starting to do exactly that.
A common Wall Street response to the potential of such actions is that it could not happen, because the Chinese are so dependent on trade with the United States. Therein lies a shortfall in market perceptions. One cannot impute to the Chinese the greed and immediate-gratification needs so rife within the Wall Street psyche. The contrast in cultures is vast. On Wall Street, long-range strategic planning typically is measured in terms of one or two quarters. In Washington, D.C., it is measured in terms of the next opinion poll or, longer range, until the next election, which never is more than two years away. In Beijing, long-range strategic planning begins at the 50-year mark; otherwise it is considered short-term in nature.
Commodity bulls sometimes cite the strong Chinese economy as a contributing factor to strong global demand for copper and oil. Alternate analyses suggest some Chinese stockpiling of inventories for war is a contributing factor, too.
Then there is the somewhat unusual behavior of North Korea. In the last month or so, ongoing threats of nuclear war and missile tests have created a high level of discomfort in Japan and predictable huffing and puffing in the United States. It is not credible that North Korea's actions have taken place without the full support -- albeit covert -- of Communist China.
Then there is war in the Middle East. U.S. troops are in Iraq and Afghanistan, on one border with Syria and two borders with Iran. At the same time Israeli forces are engaged in leveling Lebanon, a conflict that easily could expand to a regional war. A war, with Israel backed by the United States and the United Kingdom, against Syria and Iran backed by Russia and China, is fraught with danger of rapid global escalation and unforeseen consequences.
One possible result: With the U.S. forces stretched thin in a multi-front war in the Middle East, Communist China invades and takes Taiwan, and North Korea moves on South Korea. Under such circumstances would China continue to refrain from dumping their dollars and creating havoc in the Western financial markets?
Of course, current market concerns over the possible expansion of Middle East fighting have centered on oil supply disruptions. If the conflict expands, global consequences will stretch well beyond who ends up controlling Middle Eastern oil. The question remains open as to what else is in play here. One can hope for global political tensions to subside.
In general, the broad economic outlook has not changed, but the financial markets now are recognizing early signs of both uncontained inflation and a possible recession. Indeed, the 2005 to 2007 (perhaps 2008) inflationary recession continues to deepen.
A contracting economy, inflation and risks of intensifying dollar selling are upon us and continue to offer the worst of all environments for increasingly less-Pollyannaish financial markets. The exception is the gold market, where the traditional inflation-hedge and flight-to-safety/quality vehicle is earning its keep. The recent sharp deterioration in the global political situation exacerbates the outlook; it does not alter it.
The Shadow Government Statistics' Early Warning System (EWS) was activated in May 2005 and signaled the onset of a formal recession in July 2005. The EWS looks at historical growth patterns of key leading economic indicators in advance of major economic booms and busts and sets growth trigger points that generate warnings of major upturns or downturns when predetermined growth limits are breached. Since the beginning of 2005 a number of key indicators had been holding near or at their fail-safe points. Six indicators now have moved beyond those levels, signaling a recession.
Retail sales and help-wanted advertising generated such signals in the last month. Once beyond their fail-safe points, these indicators never have sent out false alarms, either for an economic boom or bust. The housing starts series appears ready to generate such a signal in the next month.
With a false economic boom massaged into first-quarter GDP reporting, negative GDP growth is not likely to surface in regular government reporting until after the November election, given the rampant political manipulation of most key numbers. The National Bureau of Economic Research (NBER) eventually should time the downturn to mid-2005 and announce same also sometime after the election, so as not to be deemed politically motivated in its timing. Of some interest will be the upcoming (July 28th) annual revisions to the GDP that should show a weaker 2005 economy than previously reported.
Whether or not there is a recession will be a hot topic in the popular financial media, with politics helping to fuel the debate as the election nears. Those Wall Street economists who act as shills for the market will keep up their "strong growth is just around the corner" hype regardless of any and all evidence to the contrary.
From the standpoint of common experience, this downturn will be considered the second leg of a double-dip recession, not an independent contraction as will be claimed officially.
Most economic data have softened, with the trend accelerating sharply. Regular monthly contractions are near, if not already in place for both payroll employment and industrial production, although political manipulation can keep the official payroll and production data afloat for a while longer. Significant deterioration also will be seen in corporate profits and federal tax receipts, despite any near-term volatility to the contrary. Depressed tax receipts will combine with negligible fiscal discipline and ongoing war spending to accelerate deterioration in the federal finances.
This general outlook is predicated on economic activity that already has taken place and does not consider any risks from exogenous factors such as renewed terrorist activity in the United States, world war, major natural disasters or a financial panic.
Market perceptions of the downturn in business activity are increasing sharply. As expectations begin to anticipate weak data, traditional expectations also will be lowered for inflation, despite the obvious oil problem. Even so, worsening stagflation seems to have gained a good foothold in some consensus thinking. Still, consensus forecasts generally will tend to be surprised on the downside for economic reports and on the upside for inflation reports, for some time to come.
The roots of the current difficulties are structural in nature. A consumer starved of income growth and overburdened with debt cannot sustain the real (inflation-adjusted) growth in consumption needed to keep GDP growth in positive territory. The income weakness is a direct result of the loss of a significant manufacturing base to offshore locations and the ensuing explosive, perpetual growth of the U.S. trade deficit.
Exacerbating economic and financial woes will be unusually high inflation during this contraction. Gold prices already signal inflation and other troubles. Fueled by high oil prices, weakness in the U.S. dollar and accelerating Fed monetization of federal debt, inflation will not be brought under control simply by weakness in economic demand. Instead, persistently high prices only will serve to intensify the recession, making it exceptionally long and protracted. Ongoing inflation woes and dollar problems will maintain upside pressure on long-term interest rates, inhibiting the traditional flattening of the yield curve expected with an economic downturn.
The faltering economic activity and mounting inflation have created a nightmarish conundrum for the political operatives at the Federal Reserve. Soft economic numbers and high inflation are being spun as "conflicting data," but an inflationary recession is in play, and there is little the Fed can do about it.
The pabulum fed to the investing public -- that a weak economy means low inflation and interest rates -- cannot work in the current environment. Any conflicts that arise are not in the economic data but in simplistic views on economic activity espoused by Wall Street, or in the statistical manipulation goals of the politicians. Those latter issues explain Fed Chairman Bernanke's recent tap dancing on the inflation outlook. Such is anchored in putting a positive spin on an impossible situation and avoiding a financial-market meltdown before November 7th, but the markets have not been particularly cooperative.
In the present circumstance, inflation driven by robust economic demand would be a happy event, but such is not to be. Rather, the purchasing power of the U.S. dollar is being lost to wasting diseases, eroded by foreign exchange weakness in the trade-deficit plagued greenback, malfeasance in domestic fiscal and monetary policies, and external disruptions such as cartel-orchestrated price surges in oil. All the latter factors are in play.
From the Federal Reserve's perspective, at present, mixed signals are the best that can be offered to the markets. Indications of further faux "tightening" are given to signal Mr. Bernanke's devotion to keeping inflation under control. Alternate suggestions that the Fed at least will pause in hiking interest rates signal Mr. Bernanke's devotion to maintaining solid economic growth. While the tap dancing may keep the markets guessing and gyrating for a while, the Fed is in an untenable position. Raising rates will do little to contain a non-demand driven inflation, while lowering rates will do little to stimulate the structurally-impaired economy.
From the standpoint of the federal government, traditional economic stimuli in the form of tax cuts or increased federal spending have reached their practical limits with the current budget-deficit excesses.
Due to the inability of the government or central bank to stabilize this situation, risks of the current situation evolving into a hyperinflationary depression are extraordinarily high. Such a development involving the world's reserve currency would lead to a collapse of the current global currency system. In order to regain public confidence, monetary authorities likely would structure gold into the base of any new international currency system.
The unfolding inflationary recession is the worst of all worlds for the financial markets. Particularly hard hit will be the U.S. dollar, with significant downside moves looming for both equity and bond prices. Despite recent extreme volatility, the price of gold is headed much higher. At such time as the system re-stabilizes, post-crisis, there will be exceptional investment opportunities for those who have been able to preserve their wealth, capital and liquidity.
In his final "Market Thoughts" of May 30th, Doug Gillespie wrote of the key financial markets being in "transition." In general, he was looking for equity prices, bond prices and the U.S. dollar to transition to much lower values. He suggested that intensified weakness in the dollar would "create an objective for bullion of an upside test of the old highs (very general area of $700 to $725) in rather short order."
Doug combined technical and fundamental analysis along with his keen political instincts to provide short-term timing for the markets with a consistency better than anyone else I have known. I am not going to attempt to time the markets, except on rare occasions where a confluence of factors strongly increases the odds of a major move or turning point. Instead, the SGS will focus on the fundamentals underlying the financial markets, both perceived and not recognized. Ultimately, the fundamentals should drive market activity and pricing.
At present, those underlying economic and financial fundamentals strongly support Mr. Gillespie's market thoughts, with little other than flight-to- safety/quality issues providing short-term boosts to the dollar and bond prices. Ahead lie much lower equity, bond and U.S. dollar values and a much higher gold price.
One factor moving the markets in recent more-peaceful times, has been speculation over pending actions by the Federal Reserve. Last month's economic data showed a sharp slowdown in business activity in conjunction with continued acceleration in inflation. Since the Federal Reserve can neither contain current inflation nor stimulate the economy into sustainable economic growth, speculation over defunct or non-existent Fed strategies to handle either problem is a fruitless effort by market participants.
What drives present-day Fed policy is an effort to avoid -- at least to delay as long as possible -- a global financial panic and currency-system collapse. Accordingly, Fed actions are designed to placate the financial markets as much as possible and do not encompass a planning horizon much beyond a week or two. As discussed in this month's Reporting/Market Focus on the flow of funds account, foreign investors have started to pull back from Treasuries. Accordingly, the Fed most likely will focus on the dollar as a policy guide, continuing to raise rates so long as such is deemed necessary to keep the dollar from entering freefall.
Novice Fed Chairman Alan Greenspan pursued such a policy in September 1987, which he abandoned the next month after the stock market crashed. The current circumstance is one of similarly-conflicting policies aimed at maintaining a highly precarious and unstable balance between currency and stock market stability.
Equities -- The stock market is the least rational of financial markets, but it does provide something of a long-term hedge against inflation. As shown in the accompanying graph of year-end closes of the Dow Jones Industrial Average, deflated by the SGS Standard CPI (the way the CPI was calculated in the 1970s as detailed in the October 2005 SGS), the DJIA has held its own against that pernicious eroder of dollar value. While off its 1999 peak, the inflation-adjusted June 2006 DJIA is almost as high as it was at year-end 1965.
Other than inflation, the fundamentals underlying the U.S. equity markets are not good. The economy is in recession and interest rates are rising. Implications are for declining corporate profits and competing investment opportunities in the credit market. With a terrible dollar tumble ahead, investment opportunity competition also will be had from assets denominated in something other than U.S. dollars, as well as from gold, which is a better inflation hedge than the DJIA over the long haul.
In terms of the latest trailing four quarters of DJIA earnings, Friday's closing Dow of 10,739 reflected a price/earnings ratio of roughly 20-to-1. Where the historic norm is about 14-to-1, that suggests a reasonable market value 30% below the present level, at about 7,500. The market, however, tends to overshoot with its movements, so something well below 7,500 eventually is a good bet; the only question is when. Earnings should fall, due to the recession, but such can be muted by inflation that tends to increase revenues, etc.
As stated earlier, the equity market rarely is rational. When the dollar takes its major tumble, and foreign holdings of dollar assets get dumped at a near-panicked rate, the ensuing U.S. liquidity crisis should be enough to take stock prices to relative levels that only could be viewed as nightmarish by the Pollyanna crowd. Such could happen anytime, with no warning; the current circumstance also could linger beyond year-end.
Nonetheless, upside potential on equities would appear to be limited, particularly against the relative safety of increasingly high Treasury yields and the sharp upside potential of currencies such as the Swiss franc.
Two versions of corporate earnings/profits are shown below, and the general topic will be addressed in a future Reporting/Market Focus.
The top chart shows the year-to-year change in quarterly as well as trailing four quarters DJIA earnings. In line with common experience, earnings turned negative in the last recession, bouncing back in late-2003, early-2004, but then turning negative again in 2005, in line with the current recession. The sharp rebound shown in the quarterly data for first-quarter 2006 is a positive sign for the economy, but future quarters likely will tell a different story.
In contrast, the bottom graph shows year-to-year after tax profits on both a quarterly and trailing four quarters basis for nonfinancial corporations, as reported in conjunction with the GDP. Not too surprisingly, the numbers show the impact of the last recession, but suggest booming growth in place since 2002. As to one of the series being closer to reality, the DJIA wins out over Bureau of Economic Analysis estimates, any time.
Credit Markets -- Long-term interest rates are headed sharply higher by the end of the year. This move in rates will be dominated by rising inflation, by a weakening dollar and by foreign investors increasingly moving their assets out of dollar-denominated instruments (see Reporting/Market Focus).
A number of factors drive interest rate movements, including economic activity, inflation, credit demand, political stability and relative dollar strength and accompanying cash inflows and outflows from abroad. Flight-to-safety concerns, as seen at present, will have short-lived dampening impacts on treasury yields, but it is the recession that will offer major downside pressure on rates. Expectations of some slowing growth is why consensus forecasts are for a relatively stable environment.
Nonetheless, the consensus likely is wrong, as usual. The economic consensus on long-term interest rate direction (six months ahead), as published by the Wall Street Journal in its semi-annually survey, historically has been wrong about 80% of the time. SGS econometric models, built on leading indicators of interest rate movement, have a track record of getting the six-month direction of rates right 80% of the time.
The WSJ estimate at mid-year 2006 actually was for a slight increase in the 10-year Treasury note yield, from 5.15% at the end of June to 5.24% at the end of December (range 4.25% to 6.00%). While we predict the same direction, nine basis points of movement is virtually unchanged. More likely will be a year-end yield in excess of 7.00%, possibly 8.00%. The consensus is missing the depth of the dollar and inflation problems, as well as the depth of the economic downturn. Again, the former issues will dominate credit-market action.
As to the Fed, policy and comments will continue to flip-flop like a fish out of water and dying. Near-term pressures from the global markets likely will keep the U.S. central bank tightening at least once or twice more. Any "pause" will be just that, as dollar issues will keep Mr. Bernanke tap dancing for the foreseeable future.
U.S. Dollar -- While the U.S. dollar had begun to stumble into early-June, it averaged out on the plus side for the month. Dollar trading, to a certain extent, fluctuated with gyrating market speculations on Federal Reserve policy. Little the Fed does -- including massive intervention -- will keep the dollar afloat for other than brief interludes.
Early-July trading has held around average June levels, with the greenback spiking modestly in recent days as a result of flight-to-safety concerns generated by mounting global political tensions. Nonetheless, very negative and disorderly markets await the greenback. The dollar's tumble has just begun.
Underlying fundamentals are so bad, they only could be marginally worse. Driving relative currency values are relative conditions in domestic economic activity, inflation, interest rates, government financial conditions and political stability. Though not fully recognized, all these factors for the United States relative to its major trading partners are negative. The U.S. economy is in recession, inflation is spiking and interest rates are rising abroad, while the Fed is pressured to stop raising rates at home. The actual U.S. federal deficit is beyond containment, and, barring short-term variations with international tensions, the President's popularity rating is the lowest recorded in the 70-year history of such surveying.
Timing is uncertain, but the break in the dollar should come quickly, with little if any further advance warning. Serious shocks loom in U.S. economic and fiscal data and deteriorating domestic politics, and heavy selling pressure against the U.S. currency could intensify at any time. New record lows for the dollar are likely before the end of 2006, despite any overt or covert supportive intervention by any central bank.
Generally, the weaker the dollar, the greater will be the ultimate inflation pressure and liquidity squeeze in the U.S. equity and capital markets.
U.S. Dollar Indices. The Shadow Government Statistics' Financial-Weighted U.S. Dollar Index is based on dollar exchange rates weighted for respective global currency trading volumes. For June, the monthly dollar average gained 1.18% after a 4.25% drop in May. June's year-to-year change turned increasingly negative, down 1.73% after May's 0.54% decline.
In the same directions, June's monthly average of the Federal Reserve's Major Currency Trade-Weighted U.S. Dollar Index rose by 1.10%, following May's 3.89% loss. June's year-to-year contraction was 3.86%, after May's 3.07% drop. The relative strength in the financial- versus trade-weighted dollar, though somewhat muted, still remains at a level that usually precedes a major dollar sell-off.
Gold -- Since topping $720 per troy ounce in mid-May, the price of gold has been on a roller coaster ride, plunging below $570 in mid-June, with the likely encouragement of some central banks, and reclaiming $660 as we go to press in mid-July. The fundamentals that are so negative for the U.S. dollar and the equity and credit markets, are fuel for gold buying.
As a hedge against currency problems and inflation, and as the preferred safe-haven vehicle, the price of gold generally should move higher and set new historical highs in the months ahead. The currency and inflation issues are chronic and will deteriorate sharply before an ultimate collapse in the global currency system. Such does not prevent interim wild gold price gyrations, however, particularly if central banks think they see an opportunity to tarnish gold's image. One of the alluring features of the precious metal, of course, is that is does not tarnish.
Despite the June downswing in the price of gold, the updated graphs on bullion, oil and the Swiss franc suggest that all the political gimmicks, spin doctors and statistical manipulations still are not fooling a number of investors. In the gold versus Swiss franc chart, look for the Swiss franc to move higher to meet the gold line, not the other way around.
This month's opening comments review the sharp turn in many business statistics to the downside. Conflicting pressures on the great manipulators continue -- they need to keep the economy looking healthy enough to satisfy voters, while keeping the financial markets' inflation concerns low enough to make it through the election without major sell-offs in equities and bonds. Hence, there appears to be a continuation of the reporting of soft jobs growth, while conflicting unemployment news remains relatively happy. Direct manipulation of key economic data appears to be well entrenched and should continue at least into the November election.
With the President's ratings continuing to bottom bounce and roll at historic lows, near-term economic reporting will remain gimmicked and managed. As a result, reported economic performance will continue having less than usual relevance to actual underlying activity, and upcoming reporting of the major series will be determined primarily by political need rather than by the economic factors that should drive the results.
Employment/Unemployment - June's 121,000 payroll gain again was well shy of market expectations. Fortunately for the Administration, the unemployment rate held. The continued mixed messages from the Bureau of Labor Statistics (BLS) play both to the Administration's needs to salve the inflation-rattled credit markets (weak payrolls) and to the political needs of the Administration (low unemployment).
The popularly followed seasonally-adjusted unemployment rate U-3 for June eased slightly to 4.60% from May's 4.65%, a decline that was well inside the published +/- 0.2% error margin. The unadjusted U-3 unemployment rose to 4.8% from May's 4.4%, and the broader U-6 unemployment measure rose to 8.7% from 7.9% in May. June's seasonally-adjusted U-6 rose to 8.4% from 8.2%. Including the long-term "discouraged workers" defined away during the Clinton administration, total unemployment remains roughly 12%. The household survey also showed seasonally-adjusted June employment (those people with at least one job) up by 387,000, versus a 288,000 gain in May.
For June, the payroll survey's seasonally-adjusted gain of 121,000 (124,000 net of revisions) was close to the published reporting error of +/- 108,000. This means the reported June gain was statistically indistinguishable from negligible monthly growth. The June increase followed an upwardly revised May gain of 92,000 (was 75,000). Annual growth in unadjusted June employment eased to 1.37% from May's 1.43%.
June's payroll gain of 121,000 included a positive bias of 175,000 jobs in the "net birth/death" adjustment, a fudge factor that was little changed from the 176,000 used for June 2005. The fudge factor swings into negative territory in July (it was a 72,000 contraction in July 2005), which should add some downside reporting pressure to next month's payrolls.
The difference between the household survey's gain of 387,000 and the payroll survey's 121,000 increase has received some press in the last week. After adjusting for definitional differences, the BLS never has been able to reconcile the two survey results to within 1,000,000 jobs at the total employment level. The problem remains that neither report is meaningful at levels of change that normally cause wild gyrations in the financial markets.
June reporting was remarkably free of gimmicked seasonal factors, and the usual distortions from misadjusting June education employment also were absent. Aside from a 175,000 upside fudge factor and any unofficial number doctoring, the report was unusually clean.
The latest report, however, was against a background of collapsing May help-wanted advertising, rising new claims for unemployment insurance and plummeting June manufacturing and non-manufacturing purchasing managers employment indices (see the respective sections).
Next Release (August 4): The political needs of the Administration remain great and will continue to offset the impact of sharply slowing economic activity in the employment data, even more so in the unemployment data.
While underlying reality would suggest further downside surprises to July payroll reporting in the form of an outright monthly contraction, some sort of improvement will be needed before the election. Given a swing in the July birth-death numbers into negative territory, that upside surprise to reduced consensus expectations is more likely for the August payroll report. Nonetheless, it will be interesting to see how July's payrolls will be structured so as to show a seasonally-adjusted gain.
Unemployment appears to be the ongoing vehicle for the politicians' good news, and, with appropriate massaging, should hold the current unemployment rate level, with some further improvement seen before the election, irrespective of diverging reality.
Gross Domestic Product (GDP) -- The "final" revised estimate of annualized inflation-adjusted growth for first-quarter 2006 GDP was a little beyond the realm of statistical noise, aided by inflation and trade-deficit games playing (see the SGS Alert of June 12 on trade manipulation). Growth revised to 5.64% from 5.31% in the "preliminary" estimate and up from 4.82% in the "advance" report. Reported first-quarter growth has rebounded strongly into economic-boom territory from the fourth quarter's tepid 1.65% pace of growth.
The first quarter's reported year-to-year growth revised to 3.68% from 3.59%, up from the fourth-quarter's 3.22%, and now slightly above the third quarter's 3.64%. Final sales -- GDP net of inventory changes -- revised to 5.92% from 5.48%, up from the fourth quarter's 0.25% contraction.
The GDP inflation rate (deflator) was cut to 3.13% from 3.30%, in revision, down from the prior quarter's 3.47%. The lowered inflation estimate accounted for half of the upside revision in real GDP growth. Fortunately for the Administration, the GDP appears to be immune to the effects of exploding oil prices.
This "final" estimate, however, is something of a misnomer, as it and all growth estimates back to the beginning of 2003 will be restated in an annual revision on July 28th, published along with the "advance" estimate of second-quarter GDP. Look for earlier growth to be restated to the downside. Redistributing current economic weakness into the past makes it easier for the Bureau of Economic Analysis to show stronger GDP growth in the last two quarters running up to the mid-term election.
Revisions to alternate first-quarter GDP measures, Gross National Product (GNP) and Gross Domestic Income (GDI) highlighted some of the reporting distortions in the system. GNP, which is GDP plus the net trade balance in factor income (interest and dividend payments), showed annualized, inflation-adjusted first-quarter growth of 6.18%, revised upward from 5.18%, contrasted with 0.72% in the fourth quarter. The revision and large quarterly growth swing is an artifact of the revamping of and methodological shifts in the reporting of the services side of the trade deficit. These changes have been designed to narrow the reported trade deficit and to increase reported GDP/GNP growth.
GDI, the theoretical income-side equivalent of the consumption-based GDP, showed revised annualized inflation-adjusted first-quarter growth of 6.82% versus the 5.47% initially reported, and up from 1.89% in the fourth quarter. The greater growth rate is due to a reported narrowing of the statistical discrepancy between the GDP and GDI from $58.0 billion in the fourth quarter, to $33.0 billion in the first estimate of first-quarter GDI, and to $23.0 in the revised estimate. One could hope this reflects improved bookkeeping pending in the annual revisions.
GDP reporting generally is used as political propaganda and usually has little or no relationship to underlying economic reality. Given the long-term upside methodological biases built into the GDP, an annual growth rate slightly into negative territory still would have been closer to reality.
Next Release (July 28): The "advance" estimate for second-quarter 2006 GDP should show a contraction, based on contracting real retail sales and underlying weakness in other key economic variables. Yet something slightly in excess of relatively strong market expectations is the likely politicized result. At least the consensus expects some slowing of growth, but nothing smelling of possible recession will surface before the November election.
GDP estimates back to the beginning of 2003 generally face downward revision in the annual revisions also due on July 28. Again, more than any other series, the GDP numbers likely will continue to be dominated by the political needs of the Administration.
Consumer Price Index (CPI) -- The BLS reported the seasonally-adjusted May CPI-U up by 0.45% (0.50% unadjusted) following April's 0.60% (0.85% unadjusted) increase. Beyond regular seasonal adjustments continuing to depress CPI reporting, a pattern that should reverse in July, the BLS re-jiggered the seasonal factors a little further, and that underreported adjusted CPI by 0.1% from where it would have been otherwise.
Aside from whether the CPI even should be seasonally adjusted (BLS opening comments in the CPI report always formally present the series as not seasonally adjusted), year-to-year change should be the same regardless of the seasonality games. Applying May's unadjusted year-to-year inflation to the adjusted series yields a monthly adjusted CPI increase of 0.55% instead of the 0.45% reported.
May's annual inflation rate rose to 4.17% from April's 3.55%. As mentioned in prior newsletters, reported annual CPI inflation is surging in May and June, due to last year's underreporting. July also should rise sharply as negative seasonal factors start to reverse.
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 annual inflation of 3.44% in May, up from 3.09% in April.
Adjusted to pre-Clinton methodology, annual CPI growth was about 7.3% as of March, while the SGS Standard CPI, net of all the methodology changes of the last 30 years that were designed to suppress inflation reporting, stood at 8.1%.
Annual Core CPI-U inflation rate, which excludes the necessities of food and energy, rose to 2.4% in May from April's 2.3%. In contrast, the SGS Base CPI-U annual inflation rate, which includes only the necessities, rose to 4.6% in May, up from up 3.8% in April. The SGS rate, however, still suffers the standard CPI-U methodological understatement.
Next Release (July 19): The June CPI generally should surprise minimal consensus forecasts on the upside. "Core" inflation increasingly should reflect the effects of staggering oil prices permeating all levels of the economy.
Despite short-term volatility, annual inflation will remain high and should continue to accelerate to the upside as the year progresses, with increasing upside pressures seen not only from oil prices, but also from a weak U.S. dollar. Seasonally-adjusted monthly inflation was reported at a minus 0.1% for June 2005, which means that monthly June 2006 inflation above or below that level will move the reported annual inflation rate in tandem.
Federal Deficit -- As discussed in prior newsletters, the official, accounting-gimmicked 2005 deficit (fiscal year ended September 30th) was $318.5 billion, but it was eleven times higher -- at $3.5 trillion -- on a GAAP basis, per the U.S. Treasury (see the December 2005 SGS Supplement for detail). The official, accounting-gimmicked deficit for 2004 was $412.8 billion.
The Administration is touting a projected decline for the gimmicked 2006 number to $295.8 billion from 2005's $318.5 billion. As discussed in the opening comments, this change is little more than statistical noise in the big picture and is due to accounting games, not booming economic activity.
As of June 2006, the ninth month in fiscal 2006, the twelve-month rolling accounting-gimmicked deficit was $275.5 Billion, up from $273.1 billion in May and $265.7 billion in April, and against $335.5 billion in June 2005.
Separate from the GAAP-based numbers and official deficit reporting, the change in gross federal debt is a fair indicator of actual net cash outlays by the government. As of fiscal year-end 2005, the gross federal debt was $7.933 trillion, up $554 billion from September 2004, which, in turn, was up by $596 billion from September 2003.
The gross federal debt as of June 30, 2006 was $8.420 trillion, up $63 billion from May and up $584 billion from June 2005, which, in turn, was up $562 billion from June 2004.
Going forward, the official federal deficit will inflate, as government finances suffer tax revenue losses from the intensifying recession. While GDP growth estimates can be gimmicked, incoming tax receipts remain an independent estimate of underlying economic reality and eventually will reflect the economy's mounting difficulties.
Initial Claims for Unemployment Insurance -- Annual change in initial claims again rose into less negative territory (an economic negative). On a smoothed basis for the 17 weeks ended July 8th, annual change narrowed to a 4.8% decline from May 27th's 5.5% decline.
The volatility of the seasonally-adjusted weekly numbers is due partially to the seasonal-adjustment process. When the series is viewed in terms of the year-to-year change in the 17-week (four-month) moving average, however, such usually is a fair indicator of current economic activity.
Real Average Weekly Earnings - May's real earnings fell by 0.7% from April, as CPI reporting played a little catch up. April's previous monthly gain of 0.2% was revised upward to 0.3%. May's real earnings also were down 0.2% from the year before, following April's annual gain of 0.4%. Both monthly and annual growth rates should continue deteriorating in June, in tandem with upside moves in reported inflation.
Volatility in this series comes primarily from variations in reported CPI growth. Allowing for the biases built into the CPI-W series used in deflating the average weekly earnings, annual change in this series signals ongoing severe financial strain on U.S. households and continuing recession.
Retail Sales - As discussed in the opening comments, real (inflation-adjusted) June retail sales not only triggered a formal recession signal, but also dragged the second-quarter 2006 real sales into contraction.
June's seasonally-adjusted 0.1% (+/- 0.7%) decline, before inflation adjustment, was the third month in the last five where sales contracted after the effects of inflation had been removed. May's unrevised 0.1% increase turned into a 0.3% decline after May's CPI rose by 0.4%. Core inflation has no relevance here, where food and energy account for more than 30% of retail sales. As first reported, April's gain of 0.5% fell by 0.1%, adjusted for the 0.6% jump in April CPI. April retail sales, however, have revised to a gain of 0.8%, which is a gain of 0.2% net of inflation. Nonetheless, average real retail sales in the second quarter declined at an annualized pace of 1.3% from the first quarter's average
When inflation-adjusted year-to-year growth in retail sales falls below 1.8% (using the official CPI-U for deflation), such signals recession. Almost certainly, this happened in June. June's year-to-year retail sales were up 5.9%, following May's 7.6% annual growth. As long as this Wednesday's seasonally-adjusted June CPI puts in a stronger showing than a 0.3% contraction, inflation-adjusted June growth will be below 1.8%.
Next Release (August 11): July retail sales should come in well below expectations, once more, reflecting declining economic activity. Real (inflation-adjusted) growth should remain negative on a monthly basis, with annual growth continuing to soften.
Industrial Production -- Seasonally-adjusted May production surprised consensus expectations with a 0.1% monthly contraction. Such was consistent with an unfolding recession. Recent upside distortions from utility usage still were present, but were less severe. April's overall 0.8% production surge remained intact, even though recently reported production levels were reduced in semi-annual revisions. May 2006 production was up 4.3% versus the year before, down from April's 4.7% annual gain.
Next Release (July 17): Look for industrial production to mirror the recession, with increasingly regular monthly contractions and a pattern of slowing annual growth. Such will surprise market expectations on the downside. Accordingly, look to today's June release for continued downside shock.
New Orders for Durable Goods - Durable goods orders fell for a second month, with May's seasonally adjusted new orders down 0.8% (down 0.7% net of revisions) following April's revised 4.7% decline (previously 4.8%). May's annual growth rate slowed to 5.1% from 6.7% in April.
The widely followed nondefense capital goods orders also fell in May, by 1.9%, following April's 6.3% drop (previously reported as a 6.0% decline).
At one time, durable goods orders was one of the better leading indicators of broad economic activity, when smoothed using a six-month moving average. After the semi-conductor industry stopped reporting new orders, however, the series' predictive ability suffered a serious setback.
Trade Balance - As discussed in the SGS Alert of June 12th, the reporting of the March trade deficit was manipulated to show an artificially low trade shortfall, based on a pending one-time change to trade levels that were published along with the April trade data. The phony trade improvement was used to help support a faltering U.S. currency and as a basis for generating booming growth and upward revisions to reported inflation-adjusted first-quarter GDP.
The gimmicked and guesstimated trade in services suddenly is showing a surplus surge, and that has helped contain the April and May deficits. This series appears to have fallen victim to intensifying political manipulation of the market-sensitive series.
May's seasonally-adjusted trade deficit rose to $63.8 billion from April's revised trade shortfall of $63.3 (was $63.4) billion, and both months were up from the rigged March deficit of $61.9 billion. The revised, benchmark seasonally-adjusted record monthly trade deficit is $66.6 billion as of October 2005. Despite the manipulations, there is little question that the trade deficit remains in a phase of meaningful deterioration.
Next Release (August 10): Contrary to consensus expectations for a minor monthly change, the June trade deficit should widen sharply. While the level of reported deficits as been reduced through benchmark revisions and methodological revisions to service-sector reporting, upcoming deficit reports will surge beyond consensus forecasts and regularly set new record monthly deficits in the months ahead.
Consumer Confidence - June consumer confidence measures showed some monthly bounce but sank on an annual basis. The Conference Board's June consumer confidence index rose by 1.0%, after falling by 4.6% in May (previously down 6.0%), while the University of Michigan's May consumer sentiment rebounded to 7.3%, after falling 9.5% in May.
On a three-month moving-average basis for June, annual growth in the Conference Board's measure slowed to 4.4% from 6.1% in the prior month, while the University of Michigan number was down 7.1% after the May's 4.4% decline. These lagging, not leading, indicators still are signaling that the economy remains in recession.
Short-Term Credit Measures -- Annual growth in short-term credit measures for businesses remains strong, holding double-digit annual percentage growth, while annual growth in consumer credit remains unusually soft at 2.5%.
Seasonally-adjusted consumer credit remained in serious slowdown. Preventing meaningful monthly growth, annual growth has remained soft, at 2.8% in May, following 2.4% year-to-year growth in April and 2.5% in March. Without growth in income, growth in personal consumption can be supported over the short-term only by debt expansion or savings liquidation, and consumer debt expansion has ground to a halt.
Annual growth in commercial paper outstanding in June came in at 16.8%, only slightly below May's powerful 17.5% annual rate of increase. Annual growth in commercial and industrial loans inched higher to 13.7% in May, up from 13.0% in April. Rising sales can fuel short-term credit needs, but so too can slowing sales, slowing collections and rising inventories.
Producer Price Index (PPI) -- The seasonally-adjusted May finished goods PPI rose by 0.2% (0.4% unadjusted), following April's 0.9% (1.0% unadjusted) gain. May's annual PPI inflation rose to 4.5% from April's 4.0%.
Next Release (July 18): Despite a large component of random volatility in monthly price variations, PPI inflation reporting over the next six-to-nine months should continue topping market expectations, which are in the 0.3% range for June. "Core" inflation, in particular, should offer upside surprises to consensus forecasts.
Purchasing Managers Survey (Non-Manufacturing) -- The overall index fell again in June, down by 5.2% to 57.0, after May's 4.6% decline. The index is a diffusion index, where a reading above 50.0 indicates a growing service economy, in theory. Both the employment and prices paid components have some meaning.
The June employment component tumbled by 10.3% to 52.0 from 58.0 in May, suggesting a sharp deterioration in the service sector employment environment.
The prices paid component diffusion index is a general indicator of inflationary pressures. The June index eased back to 73.9 from May's 77.5, still generating an intense inflation signal. On a three-month moving average basis, June's annual growth soared to 18.0% from May's 8.4%.
There is nothing unusually wrong with this survey of the service industry, except it does not have much meaning related to broad economic activity. 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 that economic activity is increasing.
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 -- The June new orders index rose 7.8% to 57.9, after May's 6.8% decline to 53.7. This measure breached its fail-safe point a year ago, generating an SGS early warning indicator of pending recession.
The Commerce Department provides suspect seasonal factors for the series, and the resulting adjusted monthly numbers can be misleading in the reporting of month-to-month change. This problem is overcome by using year-to-year change on a three-month moving average basis. On that basis, the June index increased by 3.3%, versus May's 3.6%. The index gradually has notched lower from its peak annual growth of 42.6% in April of 2004.
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 50.0 indicates rising new orders. The overall June ISM index continued a softening trend, down to 53.8 in June from 54.4 in May. An index level of 50.0 divides a growing versus contracting manufacturing sector. The June employment index fell into contraction territory, at 48.7, down from 52.9 in May.
Help Wanted Advertising Index (HWA) - As discussed in the opening comments, the May help-wanted advertising index plunged by two points (5.7%) to 33, the lowest level since July 1961. Such was the second two-point plunge in as many months. The latest index reading breaks below the lowest level seen in the last recession. Although this series ever recovered from the last recession -- just bottom bouncing and rolling -- with the annual contraction in the three-month moving average sinking to 8.7% from 6.7% in April, it is sending out a fresh signal for economic contraction.
Housing Starts -- Seasonally-adjusted May housing starts rose 5.0% after declining by 5.5% in April. Beyond the regular monthly reporting volatility, however, annual change on a three-month moving-average basis remained negative, down 3.0% in May versus a 2.9% decline April. As discussed in the June SGS, reporting for June should push the series into generating a recession signal. The May three-month moving-average annual growth rates for both existing and new home sales continue to indicate a contracting economy.
Money Supply -- Annual growth for monthly M1 turned to a 0.1% contraction after a 1.7% gain in May, while annual M2 growth notched higher to 4.8% from 4.7%. Both measures are in deepening-recession territory. Therein remains the beauty of the Greenspan/Bernanke version of three-card monte. The broader, but no longer visible, annual M3 growth continues to spike, somewhere over 9.0%, a level that should be raising the hackles of the inflation-jittery financial markets.
While the Fed may be pushing interest rates higher, it still is not tightening. The U.S. central bank continues to flood the system with liquidity Such should be visible in next month's Reporting/Market Focus with the introduction of an new alternate measure of M3.
Before inflation adjustment, monthly M1 and M2 declined by 1.8% and rose by 0.4%, respectively, in June, versus May's 0.2% and 0.3% gains. Adjusted for CPI inflation, June's M1 and M2 annual year-to-year rates of change were down 4.3% and up 0.3%, respectively, versus down 2.2% and up 0.7% in May. On a three-month moving-average basis, the June inflation-adjusted annual rates of change were down 2.7% and up 0.7%, levels that remain well underwater using the old-style CPI.
Inflation Indicators (Please note that the U.S. Dollar section has been moved to the Market Perspectives/Currencies section.)
Purchasing Managers Survey (Manufacturing) - Prices Paid -- The June prices paid diffusion held reasonably flat at 76.5 versus 77.0 in May, a reading still indicative of intense inflationary pressures. On a three-month moving average basis, June's annual growth exploded to 25.3%, up from May's 6.4%.
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 measure is a diffusion index, where a reading above 50.0 indicates rising inflation.
Oil Prices -- West Texas Intermediate Spot (St. Louis Fed) notched minimally higher to a new record average in June of $70.96 per barrel, up from May's $70.94 average. Oil prices persist at extraordinarily inflationary levels, with June's average price up 26.1% from the year before, after May's annual gain of 42.4%. Oil prices in early-July trading again were on the rise, with Middle Eastern tensions pushing prices towards $80 per barrel as we go to press.
Spot prices will continue to gyrate. Despite ongoing near-term price volatility, high oil prices will remain a major contributing factor to the inflation side of the current inflationary recession. 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. Cost pressures already have passed significantly into the so-called "core" inflation sectors. With confirmation of same surfacing in official reporting, Wall Street's and the Fed's core-inflation scam has started to fall apart.
Oil price volatility affects CPI reporting. Downside oil price movements tend to be picked up more quickly and fully by the BLS in its inflation measures than are upside movements. Even as currently understated, CPI and PPI inflation should be much stronger than commonly predicted for the next six-to-nine months, partially as a result of the persistently high oil prices.
Quarterly/Annual Reporting -- Most series analyzed are published on a monthly or weekly basis. Followed economic/market series that are published with less-than-monthly frequency include:
Annual:
* Financial Statements of the United States Government (most recent analysis was a Supplement to December 2005 SGS; next analysis is due as a Supplement to the December 2006 SGS).
* Income Variance/Dispersion (most recent analysis was September 2005 SGS; next analysis is due September 2006).
Quarterly:
* Flow of Funds Accounts of the United States (most recent analysis: current SGS; next analysis is due October 2006 SGS).
Reporting/Market Foci -- All series eventually will be addressed in a monthly "Reporting/Market Focus," with this month's analysis examining the Federal Reserve's Flow of Funds Accounts. Employment, GDP, CPI and the Federal Deficit are explored in the background article "A Primer On Government Economic Reports", available on the Home page of www.shadowstats.com.
The series detailed so far in the Reporting Foci or background articles are listed below. The referenced SGS publications are available on the Archives page of www.shadowstats.com.
* Consumer Confidence (November 2004 SGS).
* Consumer Price Index (an original background article and October 2005 SGS).
* Credit Measures, Short-Term (August 2005 SGS).
* Durable Goods, New Orders for (May 2006 SGS).
* Employment/Unemployment (an original background article, alternate measures (April 2005 SGS).
* Federal Deficit (an original background article, update in the Alert of July 7, 2005, update in Supplement to December 2005 SGS).
* Gross Domestic Product (an original background article).
* Help Wanted Advertising (January 2006 SGS).
* Housing Starts and related housing statistics (June 2006 SGS).
* Income Variance/Dispersion (September 2005 SGS).
* Industrial Production (January 2005 SGS).
* Money Supply (Part I / SGS Early Warning System - May 2005 SGS, Part II - June 2005 SGS, M3 update November 2005 Supplement, M2 update March 2006 SGS).
* Producer Price Index (April 2006 SGS).
* Purchasing Managers Survey (February 2006 SGS).
* Retail Sales (March 2005 SGS).
* Trade Balance (December 2004 SGS).
* Unemployment Insurance, Initial Claims for (February 2005 SGS).
* U.S. Dollar Indices, Financial- and Trade-Weighted (July 2005 SGS).
While still funding the bulk of net U.S. Treasury and corporate debt issuance, foreign investors appear to have started a meaningful pullback in the buying of U.S. Treasuries. Such is the conclusion of an examination of the first-quarter 2006 flow of funds analysis released in June 2006 by the Federal Reserve.
The quarterly flow of funds accounts published by the Board of Governors of the Federal Reserve System (Z.1), reports on all the major sources and uses of cash and debt flows within the U.S. economy and against the rest of the world. The numbers actually tie into the U.S. National Income and Product Accounts (NIPA), such as the GNP/GDP. Of particular interest, the flows show major factors that affect the liquidity of the credit markets, including flows to and from investors outside the United States.
While the system is subject to some of the same foibles as GNP/GDP reporting, many of the problems with the broadest measure of U.S. economic activity are related to the deflation process, where the nominal or current-dollar numbers are deflated to the real or constant-dollar numbers. The flow of funds numbers use only the unadjusted data.
Where both the NIPA and flow of funds data are based on something akin to double-entry bookkeeping (consumption versus offsetting income numbers for NIPA, sources versus uses for the flow of funds), the two sides of the ledger rarely equal each other, and balance is achieved using a statistical discrepancy account.
That said, here is how some of the more interesting flows were reported on a not-seasonally-adjusted basis as of first-quarter 2006.
The two graphs above show the net foreign holdings of U.S. financial assets, as of year-end for the years through 2005, and as of quarter-end for first-quarter 2006. The top graph is expressed in trillions of dollars, the bottom as a percent of U.S. GDP, just to give the numbers a little scope. Net foreign holdings of U.S. financial assets rose to $6.3 trillion (or roughly 48% of GDP!) as of the end of first-quarter 2006. While the pace of growth appears to have slowed in the graphs, that is only because of the use of the first-quarter's number against 2005 and earlier annual numbers. At an annualized pace, the first-quarter number is growing at a somewhat higher pace than the 30% growth rate seen for all of 2005.
In the above graph, however, please note the foreign holdings of U.S. Treasuries as a percent of publicly held U.S. Treasury debt declined to 46.4% in the first-quarter from 47.0% at year-end 2005, and that is not a quarter-versus-annual distortion.
Based on the trailing four quarters' net acquisition of U.S. Treasuries, foreign investors funded the equivalent of 62% of net Treasury debt issuance in 2003. That funding jumped to 101% in 2004, and eased back to 97% in 2005. Based on the four quarters through March 31, 2006, that number has fallen to 85%.
In other areas of investment holdings, as of both December 31, 2005 and March 31, 2006, foreign holdings of U.S. corporate bonds accounted for a record 29% of bonds outstanding, funding 51% of the net issuance of such securities in each of the trailing four quarters.
As to U.S. equities, foreign ownership accounted for 15.9% of the market at March 31, 2006, up from 15.2% at December 31, 2005.
Foreign investors have provided significant liquidity to the U.S. financial markets, particularly to the market for U.S. Treasuries, helping to keep U.S. interest rates in check. While net foreign holdings of U.S. assets have continued to increase at a robust pace, there appears to have been a recent slight shift away from the holdings of U.S. Treasuries.
We expect not only for that trend to intensify, but also for a major shift away from U.S. dollar assets to unfold. As those assets are sold and unwanted dollars are dumped, the greenback will come under major selling pressure, as will U.S. stocks and bonds, as liquidity is drained from the U.S. financial markets.
This month's Reporting/Market Focus originally was scheduled to examine corporate profits. Events of the last month and timely introduction and coverage of first-quarter flow of funds data have bumped the profits focus to a later SGS. That said, corporate profits will be covered regularly and two contrasting measures are shown in this month's Market Perspectives/Equities.
If all goes as planned, SGS will introduce a reasonably close approximation to the late M3 in next month's newsletter. This is in response to popular demand. If the Fed is uncomfortable with our measure, they certainly are free to resume publishing their old series. We find the M3 series to be neither worthless nor cost prohibitive to produce and have had numerous client requests to publish something in this area.
Douglas R. Gillespie, Sr. (1945-2006)
Douglas R. Gillespie Sr. of Ho-Ho-Kus, New Jersey, died peacefully at home on Tuesday, June 13, 2006. Doug is survived by his loving wife Patricia of Ho-Ho-Kus, and children, daughter Blythe and son Douglas Jr., both of Jersey City and formerly of Ho-Ho-Kus. Doug also is survived by his sister Bonnie of Rochester, New York, and many nieces and nephews.
Born in Paterson, New Jersey, January 19, 1945, Doug was a 1967 graduate of Gettysburg College, where he received his BA in Economics with a minor in Political Science.
Doug spent most of his career on Wall Street. Most recently, he managed his own economic and financial-market research and consulting firm, Gillespie Research Associates (1987 to 2006). A publisher of independent financial and economic research, he co-founded the Straight Shooter newsletter (1990 to 1996) and was executive editor of the four publications comprising the newsletter's "Bullet Edition."
Prior to founding GRA, he was a partner and officer, respectively, of two independent, SEC-registered investment-counseling firms: Gillespie Fixed Income Management, Inc. (1984 to 1987) and Forstmann-Leff Degnan (1980 to 1984).
At the United States Trust Company of New York (1967 to 1980), he was co-head of USTC's taxable fixed-income department, managing employee benefit and endowment relationships of substantial size (1973 to 1980), and responsible for managing large equity portfolios for individuals of significant wealth (1967 to 1973). He also was an officer and director of a subsidiary firm, UST Advisory Company, Inc., and a member of various policy and management committees.
In his leisure time, Doug was an avid fisherman and sports fan.
Click here to read Doug Gillespie, Jr.'s letter on the Gillespie Research Associates Web site.
Expanded Shadow Government Statistics
With the loss of Doug Gillespie, his great wit and his extraordinary insights and instincts on the financial markets and political environment are gone. Much of what he wrote about, however, we can and will cover in an enhanced Shadow Government Statistics (SGS).
Doug and I met in 1989, at the onset of a rather severe recession that consensus forecasters were very slow to recognize. Finding that we were coming up with nearly identical contrarian views on the economy and markets -- from different approaches (a circumstance that generally persisted until Doug's passing) -- we co-founded the Straight Shooter newsletter and wrote same for a number of years. Two years ago Doug asked me to pen a series of articles on the quality of economic statistics. Extraordinary response to that material led to my writing and publishing Shadow Government Statistics (SGS) on the Gillespie Research Associates (GRA) Web site. What I have provided to date largely complemented Doug's offerings. I avoided as much as possible material that duplicated his efforts and vice versa. Where concepts needed to provide standalone newsletter products overlapped, we often would cite each other's work.
The SGS's original content and concept continues, but readers will note changes this month and in the months ahead with expanded coverage, particularly on the financial markets. As with the economic data, however, the new material will focus on underlying reality, stripping away as much as possible the hype put forth by Wall Street hucksters and Administration and Federal Reserve spin meisters.
In addition to a nascent Markets Perspective section, this month's SGS begins a regular analysis of the Federal Reserve's quarterly flow of funds data (see Reporting Focus). Doug properly viewed the flow of funds material as an invaluable resource widely ignored by the markets. Information on the sources and use of credit highlight much of the current imbalance in the global financial situation, and answer questions such as why long-term interest rates have been so slow to rise in the current environment. Fed officials, including former Chairman Greenspan, sometimes have feigned ignorance as to the politically uncomfortable answers.
Where Doug provided frequent updates on market or economic developments, Interim Updates and Alerts from SGS will become more frequent.
You also will note changes to the Web site (now www.shadowstats.com). Archives have preserved Doug's various missives. The GRA Data and Charts section will become an active SGS section. It will be updated regularly, starting in the next month (an e-mail will advise of its activation). The section will be expanded to include historical detail of unique SGS series such as the alternate CPI and GDP measures.
Importantly, the needs and desires of you, the subscriber, will help shape the scope and content of SGS going forward. Please let us know (e-mail: shadowstats@hotmail.com) what you would like to see included regularly in the newsletter. We will accommodate your wishes as best we can.
Many thanks for your understanding and support during this transitional period.
Best wishes to all,
John Williams
August's "Shadow Government Statistics" is scheduled for release on Wednesday, August 18, 2006. Beginning with the September newsletter, regularly scheduled posting of the newsletter will shift to the second Wednesday of the month (September 13). This often will coincide will the prior posting schedule of the Wednesday following the Friday release of the employment statistics. The posting of the next SGS on the Web site, as well as any Interim Updates or Alerts, will be advised immediately by e-mail.