November 2006 Newsletter
Issue Number 25
November 29, 2006
__________
Dollar Selling Will Threaten Credit and Equity Markets
Economic Activity Continues to Crumble
Distorted Inflation Plunge Bottoms Out
Gold Prices to Rebound Further
The broad outlook for a deepening inflationary recession continued to intensify last month, at the same time that domestic and global political tensions increased sharply. Main Street U.S.A. dumped the Republican controlled Congress for a variety of reasons, not least of which were rapidly deteriorating pocketbook issues. Reflecting a growing market awareness of these problems, the U.S. dollar has come under some selling pressure. When the current minor selling turns massive, the foreign-capital-dependent domestic markets will face a terrible liquidity squeeze, with resulting interest rate spikes and equity selling. Gold should do well under the circumstances.
Tumbling economic activity was reflected in the continued contraction in retail sales and housing starts, as well as soft industrial production, a declining purchasing managers survey (manufacturing), falling durable goods orders and troubled employment data. In particular, annual change in housing starts -- using a three-month moving average -- has fallen to its deepest decline since the depths of the 1990/1991 recession, as shown in the graph.
This month's Reporting/Market Focus conducts a reality check on the "housing bubble" prices against the SGS alternate consumer inflation measure.
On the inflation front, annual CPI inflation was battered in both September and October by falling energy prices and year-ago comparisons with conditions resulting from a particularly severe hurricane season. The drop in gasoline prices was overdone in the October CPI, and the year-ago comparisons are about to reverse. Accordingly, reported inflation will rise in the months ahead, as will market concerns for same.
In terms of deteriorating global political conditions, look for the Iran nuclear issue to come to the fore again, shortly. As a sampling of some of the significant developments breaking the surface a little, consider Russia's sending air defense systems to Iran. Such highlights how the major global powers are arrayed dangerously against each other. Also Communist China hinted that it was looking to move away from the U.S. dollar in terms of its currency reserve holdings. Of course it is, and it will. The comment helped to trigger some selling of the greenback. Much heavier dollar dumping eventually will follow.
Alternate Realities. In general, if a government economic measure does match common public experience, it has little use outside of academia or the spin-doctoring rooms of the Fed and Wall Street. This section regularly covers the Shadow Government Statistics (SGS) alternate measures of official CPI and GDP reporting. The methodologies for the series are discussed in the August 2006 SGS. Effects of gimmicked methodological changes have been removed from the official series so as to reflect more accurately the common public experience, as embodied by the post-World War II CPI and the pre-Reagan-Era GDP.
The alternate third-quarter GDP growth reflects the "preliminary" estimate with many of the methodological gimmicks of recent decades removed. The alternate third-quarter inflation-adjusted annual (year-to-year) GDP growth rate is a decline of roughly 1.5% versus the official 3.0% gain.
[Note: Historical data on both the official and SGS-Alternate GDP series are available for download on the Alternate Data page of www.shadowstats.com.]
Of some comfort to the low-inflation hypesters -- those continually touting "core" inflation -- the gimmicked annual core inflation rates eased slightly in October, despite high oil prices continuing to permeate broad economic activity. Both the annual "core" and regular inflation reporting should resume their upwards movements with November data.
Eight Levels of Inflation
Annual Inflation for August to October 2006
Measure Aug Sep Oct
I.1 Core PCE Deflator 2.5% 2.4% n.a.
I.2 Core C-CPI 2.7% 2.7% 2.5%
I.3 Core CPI-U 2.8% 2.9% 2.7%
I.4 PCE Deflator 3.2% 2.0% n.a.
I.5 C-CPI 3.4% 2.2% 1.6%
I.6 CPI-U 3.8% 2.1% 1.3%
I.7 Pre-Clinton CPI-U 7.0% 5.2% 4.7%
I.8 SGS Alternate Consumer Inflation 10.1% 9.4% 8.9%
Notes: I.1 to I.3 reflect the core inflation rates, respectively,
of the substitution-based personal consumption expenditure (PCE)
deflator, the Chained-CPI-U and the geometrically-weighted CPI-U.
I.4 to I.6 are the same measures with energy and food inflation
included. The CPI-U (I.6) is the measure popularly followed by
the financial press, when the media are not hyping core inflation.
I.7 is the CPI-U with the effects of geometric weighting (Pre-
Clinton Era as estimated by SGS) reversed. This is the top series
in the CPI graph on the SGS home page www.shadowstats.com.
I.8 reflects the SGS Alternate Consumer Inflation measure, which
reverses the methodological gimmicks of the last 25 years or so,
plus an adjustment for the Clinton-Era geometric weighting that is
not otherwise accounted for in BLS historic bookkeeping.
[Note: Historical data on both the official and SGS-Alternate CPI series are available for download on the Alternate Data page of www.shadowstats.com.]
In general, the broad economic outlook has not changed, but the financial markets are starting to show signs of recognition of some serious economic issues. A deepening recession with uncontained inflation remains the overwhelming threat to financial-market stability. Underlying economic reality should gain broader recognition, quickly, as the accelerating deepening of the 2005 to 2007 (likely 2008) inflationary recession continues to surface in near-term reporting.
A contracting economy, inflation and risks of intensifying dollar selling are upon us and continue to offer the worst of all environments for the equity and credit markets. On the bright side, of course, is the gold market, where the traditional inflation-hedge and flight-to-safety/quality vehicle will continue earning its keep -- shy of irregular volatility -- as the dollar weakens, inflation accelerates and the global political situation continues its deterioration.
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, when a number of key indicators had been holding near or at their fail-safe points, seven of those indicators have moved beyond those levels, signaling a recession.
Retail sales, help-wanted advertising and housing starts generated such signals in recent months. Once beyond their fail-safe points, these indicators never have sent out false alarms, either for an economic boom or bust.
The false economic boom massaged into first-quarter GDP reporting was a precursor to the overstatement of, albeit slowing, second- and third-quarter GDP growth. The reported annualized real growth rates of 2.6% and 2.2% for the second and third quarters both should have been contractions. Irrespective of underlying reality, negative GDP did not surface in regular government reporting before the November election. With the election now in the past, negative reporting still could be seen in the next couple of quarters, and there remains the possibility that the recent quarters could turn negative after benchmark revisions. The National Bureau of Economic Research (NBER) eventually should time the downturn to mid- or late-2005. Stories of discussions of a possible Recession Dating Committee meeting already have surfaced.
Whether or not there is a recession increasingly has become a hot topic in the popular financial media. 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. Regular monthly contractions are near for both payroll employment and industrial production, although political gimmicking 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 have increased sharply. As expectations begin to anticipate weak data, traditional expectations also are being lowered for inflation, regardless of the ongoing oil problem. Despite short-lived gyrations in the CPI, stagflation seems to have gained a solid 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 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 have signaled inflation and other difficulties. 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, reversing what still is an inverted yield curve that some view as a recession signal.
Faltering economic activity and mounting inflation have created a nightmarish conundrum for the political operatives at the Federal Reserve. Recent soft economic numbers and high inflation had been spun as "conflicting data," but, again, despite near-term CPI volatility, an inflationary recession is in play, and there is little the Fed can do about it. The recent two-month lull in inflation was due to factors well outside the domain of Federal Reserve activity.
The hype given 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 continued tap dancing on the inflation and economic outlook. Such is anchored in putting a positive spin on an impossible situation and avoiding a financial-market meltdown for as long as possible. The markets have been reasonably cooperative, so far.
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 high prices 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. Despite mounting speculation of a Fed easing to counter the recession, the Fed's allowing for the possibility of renewing the faux "tightening" helps support the dollar and signals Mr. Bernanke's devotion to keeping inflation under control. The Fed's soon-to-be short-lived "pause" in hiking interest rates signals Mr. Bernanke's devotion to maintaining solid economic growth.
While the games playing may keep market sentiment gyrating for a while, the Fed is in an untenable position. Raising rates will do little to contain a non-demand driven inflation, while holding or lowering rates will do little to stimulate the structurally-impaired economy. The current "pause" in the Fed's raising short-term interest rates likely will not survive the end of 2006 or early 2007, due to the soon-to-be-seen pressures of a collapsing U.S. dollar.
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 environment, 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.
Market hype has the Fed moving to an easing stance early next year, in order to help counter a possible recession. The U.S. economy, however, has never gone into a recession so heavily dependent on foreign capital for liquidity. If selling pressure against the U.S. dollar becomes heavy, the Fed will have little option but to raise interest rates to defend the U.S. currency, since the coincident dumping of U.S. dollars will drain liquidity from the U.S. markets and savage both equity and credit market prices. If the Fed should ease, or the markets come to expect that, such will add to dollar selling pressures.
Unlike 1987, when Mr. Greenspan abandoned the dollar by slashing rates in order to prop stocks, the dollar will be the controlling force behind the markets, this time. The outcome will not be a happy one for equities or credit-market instruments, irrespective of whatever machinations the U.S. central bank goes through. While inflation pressures and intensifying dollar weakness soon will start to shift market expectations towards looking for rate hikes, such is not likely before the December 12th FOMC meeting. The several meetings following, however, are an open question.
The economy has crashed, and there is not much the Federal Reserve can or could have done about it. The deepening recession should show up in generally weaker-than-expected corporate profits. Middle Eastern tensions are ready to mount anew, along with renewed upside pressure on the price of oil. If this happens, the recent rebound in gold would tend to accelerate.
The U.S. dollar remains key to financial-market conditions, and recent selling pressures easily can turn into massive dollar dumping. In terms of the broad financial market picture in the weeks and months ahead, the U.S. dollar should sell off sharply on a trade-weighted basis, particularly against the Swiss franc. As a partial result of the mounting dollar and inflation difficulties, the domestic yield curve will turn positive and steepen sharply, due primarily to rising long-term interest rates. This is a trend that will flow through into the New Year.
The combination of softer profits, a weak dollar and higher interest rates likely will not play out happily for equities. Renewed concerns tied to the dollar, inflation and global instabilities, however, suggest an upbeat year-end for the precious metals, despite any near-term volatility.
Equities -- The stock market continues to do well, despite short-term volatility tied to dollar issues. As usual, the market hype is extraordinary, with expectations of a passive-to-accommodative Fed, contained inflation, still a soft economic landing and a relatively tranquil global and domestic political circumstance. Most of these props underlying equity-market irrationality will be short-lived.
Recession is gaining credence, the dollar is becoming unusually vulnerable and domestic and global politics rarely have been so unstable. Particularly damaging to current market conditions will be the terrible dollar tumble ahead. Liquidity problems resulting from that will tend to push long-term yields higher and equity prices much lower. The dollar's sell-off already may have begun. Major dollar dumping could begin at any time with little warning.
Credit Markets -- Interest rates will head higher. Contrary to all the hoopla over lower oil and gasoline prices, inflation has not peaked. Annual CPI will begin rebounding in November from the hits it took in September and October. While the economy indeed is in recession, the Fed is more likely to be hiking rates to defend the U.S. dollar and ostensibly to fight inflation, than to be lowering rates as a faux economic stimulus. Barring a stock-market crash, the U.S. central bank is not likely to be shifting to a short=lived easing stance to stimulate the stock market or the economy.
Underlying fundamentals continue to indicate that long-term interest rates are headed sharply higher by the end of the year and into 2007. This move in rates will be dominated by rebounding inflation, by a weakening dollar and by foreign investors increasingly moving their assets out of dollar-denominated instruments. Long rates are being driven by the dollar, not inflation, at the moment, but both the dollar and inflation will be key in the rate spike ahead.
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. The recession will offer major downside pressure on rates, but inflation and the dollar will provide the dominant upside pressures on rates.
The yield curve on Treasuries has developed an even more negative slope, with slightly lower yields since the last newsletter. The constant-maturity 10-year yield is at 4.54% (was 4.70%), with the 3-month bill yield at 5.05% (was 5.12%). An added couple of hundred basis points at the long-end still will do a great deal towards flipping the yield curve to a fairly normal positive slope. The inverted yield curve is tied more to the heavy foreign purchases of U.S. Treasuries than it is to recessionary expectations, and recent selling pressure on the dollar has not affected that area, yet. It will, though.
U.S. Dollar -- On average, the U.S. dollar strengthened in October but softened in November and has seen some selling pressure in the last week or so. The U.S. recession and inflation problems are gaining broader recognition outside the United States, and Communist China again is making noises about not wanting to hold so many dollar in its foreign currency reserves. Circumstances have not been helped by the ongoing "pause" in Fed policy, market speculation of Fed easing next year, or the Democratic takeover of Congress.
Mr. Greenspan's talking up the euro as an alternate reserve currency to the U.S. dollar, last month, has gained some play in the markets, but the euro remains something of a mongrel dog. The luster of what once was the German mark as been mixed with currencies such as the French franc and Italian lira. While the euro may take on an increasing role as a reserve currency, it is not likely to supplant the existing role of the British pound in that area. As a flight-to-safety/quality currency versus the U.S. Dollar, the Swiss franc remains the primary candidate.
Very negative and disorderly markets await the greenback. As the downturn in the value of the U.S. currency begins to accelerate, fallout in the U.S. credit and equity markets should not be pleasant.
Underlying fundamentals remain 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 a recession that is gaining recognition; inflation is spiking, despite the near-term September/October gyrations; and interest rates are rising abroad, while the Fed -- at least temporarily -- has stopped raising rates at home. The actual U.S. federal deficit is beyond containment, promising an eventual hyperinflationary environment. Further, the President's low approval rating (and related Republican loss of Congress) is at a level that has crashed the greenback in the past.
Timing is uncertain, but the break in the dollar finally may have started. It should come quickly, with little if any advance warning. Serious shocks loom in U.S. economic and fiscal data (December GAAP statement) and deteriorating domestic politics. New record lows for the dollar still are likely before the end of the year, if not early in 2007, despite any overt or covert supportive intervention by any central bank(s). At some point, certain Asian central banks even could be encouraging the dollar selling.
Generally, the weaker the dollar, the greater will be the ultimate inflation pressure and liquidity squeeze in the U.S. equity and capital markets. As shown in the following graph, the U.S. dollar still is trending lower.
[Note: Historical data on both dollar series are available for download on the Alternate Data page of www.shadowstats.com. See the July 2005 SGS for methodology.]
U.S. Dollar Indices. The Shadow Government Statistics' Financial-Weighted U.S. Dollar Index (FWD) is based on dollar exchange rates weighted for respective global currency trading volumes. For October, the monthly dollar average gained 0.75% after a 0.74% increase in September. November's average, however looks like it will be down about 1.5% from October, with the current level (November 28) at 51.10, against October's average of 52.62.
In the same directions, October's monthly average of the Federal Reserve's Major Currency Trade-Weighted U.S. Dollar Index (TWD) rose by 0.94% after September's 0.52% gain. The November monthly average should be down about 1% against October. November's average year-to-year change should be down by about 5.7%, against October and September's respective annual declines of 3.05% and 2.55%. with the current level (November 28) at 57.94, against October's average of 59.38.
The bigger hit seen recently against the SGS series is due to a much lighter weighting of the Canadian dollar in the FWD versus the TWD. The U.S. dollar has done relatively better against is Canadian counterpart.
Gold -- After averaging around $630 per troy ounce in July and August, the gold price tumbled in September, averaging just below $600 per troy ounce. Where October trading averaged below September's level, the precious metal has rebounded sharply in November, currently trading shy of $640 per troy ounce. The long-term outlook for gold remains highly positive.
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, despite any near-term volatility. The currency and inflation issues are chronic and will continue to deteriorate sharply in the next several months, and before an ultimate collapse in the global currency system. Such does not prevent interim wild price gyrations, however, particularly if central banks think they see an opportunity to slam the price of gold.
The updated gold versus oil and Swiss franc graphs show the softer October averages, with estimated November averages showing some firming. As we go to press, gold is trading just below $640, oil is shy of $60 and the Swiss franc is about $0.83.
With the election over, and an economically flailed Main Street U.S.A. throwing control of Congress to the Democrats, some of the political pressures that contributed to distortions of near-term reporting have passed. While upcoming releases of the major series still will be subject to massaging for the perceived needs of the financial markets, generally, the reality of the underlying inflationary recession increasingly should become evident in the popularly followed economic series.
Of particular note, the heavily overstated reduction in annual CPI inflation for September and October, in turn, temporarily has exaggerated growth in certain constant-dollar or "real" measures we report on, such as real wages and inflation-adjusted retail sales and money supply growth. Those distortions will begin to reverse with the reporting of November's CPI.
Employment/Unemployment -- While the October payroll gain of 92,000 was below market expectations, unusual prior-period revisions and a highly-publicized drop in the unemployment rate gave the Bush Administration the positive economic spin it had planned for the final days before the mid-term election. With election pressures gone, any reporting pressures now will be primarily tied to financial-market needs, at least for the near-term.
As reported by the Bureau of Labor Statistics (BLS), the popularly-followed seasonally-adjusted U.3 unemployment rate declined to 4.42% +/- 0.2%, from 4.58% in September, a change that was statistically indistinguishable from an increase in unemployment. On an unadjusted basis, U.3 declined to 4.1% in October from 4.4% in September.
The unemployment rate U.3, however, usually moves with the less-followed but broader U.6 unemployment rate. Unadjusted U.6 held steady at 7.6%, while the seasonally-adjusted U.6 unemployment rate rose to 8.1% in October, from 8.0% in September. Since U.6 is less subject to public attention and, accordingly, to manipulation, it is the more credible number and suggests an actual upturn in the narrower October U.3 unemployment rate. Including the long-term "discouraged workers" defined away during the Clinton administration, total unemployment remains roughly 12%.
The household survey also showed a seasonally-adjusted gain in October employment of 437,000, following September's reported 271,000 increase. That reflects the number of people with jobs, as opposed to the payroll survey, which reflects the number of jobs, where individuals can hold more than one job. The household and payroll survey results officially are irreconcilable.
The seasonally-adjusted October gain in payroll employment was 92,000 +/- 106,000, which was statistically indistinguishable from a contraction. Yet, October was up by an extraordinary 231,000, net of revisions. September's previously reported 51,000 jobs gain nearly tripled in revision to 148,000.
The monthly bias factor (birth/death model), added for good measure into the jobs report for October, was upped to 73,000 from 57,000 in October 2005. That means that the 92,000 gain reported in October was just 19,000 net of the bias gimmick. Last year's bias for November was a positive 21,000, down from October's 57,000, suggesting relatively minimal impact on the forthcoming November labor report.
The revisions, however, were extraordinary, for the second month in a row. They had the effect of boosting total jobs created by the Bush Administration over time, without rattling the credit markets too much with the current month's gain. Much of the revised gain was in education, as the BLS suddenly picked up a large number of teachers who somehow had not shown up in initial September reporting.
Also, as has been the recent pattern, the seasonal factors have been unusual. When properly adjusted, the year-to-year change in the seasonally-adjusted and not-seasonally-adjusted series should be virtually identical. Based on the revisions to the data. The unadjusted level of September payrolls was revised upward by 184,000, but the adjusted levels lost out again, only revising upward by 139,000.
Nonetheless, year-to-year changes in September and October adjusted payrolls were unusually inflated versus the unadjusted numbers. Adjusted versus unadjusted annual growth rates for September and October were 1.483% versus 1.408% and 1.469% versus 1.425%. The difference is that instead of respective monthly gains now of 148,000 and 92,000 for September and October, the gains would have been 126,000 and 60,000. For the two months combined, the current gain of 240,000 would have been 186,000 with consistent seasonals.
The latest report was against a background of an ongoing collapse of growth in help-wanted advertising, renewed weakness in new claims for unemployment insurance and weak purchasing managers employment indices (see the respective sections).
Next Release (December 8): With the mid-term election no longer an issue, the unemployment rate should rebound and jobs growth should slow meaningfully in the months ahead. Look for the November labor report to be weaker than market expectations.
Gross Domestic Product (GDP) -- Helped by the questionable drop reported in the September trade deficit, the "preliminary" estimate revision of annualized real growth for third-quarter 2006 came in at 2.21% +/- 3%, up from the initial reporting of 1.58%, but still down from 2.56% in the second quarter and 5.58% in the first quarter. The third-quarter growth estimate still is indistinguishable from a contraction, as was the reported growth in the second quarter. Such allows, with possible revisions, for eventual formal recession reporting with numbers already in place from the Bureau of Economic Analysis.
In terms of annual growth, the third-quarter's reported pace revised to 3.02% (initially 2.86%), down from 3.51% in the second quarter. Adjusting for methodological distortions built into GDP reporting over time, the SGS Alternate GDP measure suggests economic reality is much weaker, with a year-to-year annual contraction of roughly 1.5% for the third-quarter GDP, deepening from a 1.0% drop in the second quarter (see the graph in the Alternate Reality section of the Opening Comments).
The GDP inflation rate (deflator) in the third quarter remained understated at a revised 1.77% (initially 1.83%) versus 3.30% in the prior quarter, despite annualized seasonally-adjusted CPI in the third-quarter of 2.94% and of 4.97% in the second quarter.
Alternate measures of GDP growth, in terms of the broader Gross National Product (GNP) and the theoretically-equivalent Gross Domestic Income (GDI), also were released with the revision. Third-quarter annualized real GNP growth slowed to 1.91% from 2.34% in the second quarter. GNP includes trade flows in factor income (interest and dividend payments) and tends to be hurt by the net-debtor status of the United States.
GDI, which is the income-side equivalent of the consumption-driven GDP, grew at an annualized real 3.43% in the third quarter, up from a 0.47% contraction in the second quarter. The statistical discrepancy between the GDI and GDP has been gyrating for the last several quarters.
Next Release (December 21): The "final" estimate revision to third-quarter 2006 GDP should be little more than statistical noise.
Consumer Price Index (CPI) -- The BLS reported the seasonally-adjusted October CPI-U fell by 0.49% (down by 0.54% unadjusted), versus a 0.49% decline (down by 0.49% unadjusted) in September. On a not-seasonally-adjusted basis, October's annual inflation rate (I.6) was 1.31%, down from September's 2.06%. The eight levels of annual inflation, I.1 to I.8, are shown in the table in the Alternate Reality section, as is the plot of the SGS Alternate Consumer Inflation number.
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 (I.5) of 1.56% in October, down from 2.17% in September. What remains extraordinary and exceptional here is that annual C-CPI-U inflation not only has topped the CPI-U for the second month, but the difference is accelerating. There remains a problem in the gimmicked CPI-U weightings.
Adjusted to pre-Clinton methodology (I.7), annual CPI growth was about 4.7% as of October, against 5.2% in September. The SGS Alternate Consumer Inflation measure (I.8), which reverses gimmicked changes to official CPI reporting methodologies of recent decades, shows annual inflation at 8.9% in October.
As discussed in the Opening Comments, September and October inflation rates have taken a double hit from the year-ago effects of Katrina, as well as the recent drop in gasoline prices. As usual, the CPI picked more than the actual drop in energy related prices. With average monthly gasoline prices down 12.5% from a year ago, per retail sales reporting, the 18.3% annual decline in gasoline prices reported in the October CPI seems a little overdone, overstating the CPI decline by 0.24%. Such, however, has been a consistent reporting bias over time. Rising energy prices are slow to be picked up in CPI reporting and rarely are fully accounted for, while falling energy prices tend to be picked up immediately and often go beyond what has happened.
With seasonally-adjusted CPI-U down 0.7% and 0.1% in monthly November and December 2005 CPI reporting, those same months in 2006 will be inclined to show sharp increases in annual CPI inflation.
Next Release (December 15): Inflation has not peaked, but it will take several months to regain its recent high annual rates, starting with the November report. Unless the BLS can come up with a monthly CPI drop in excess of 0.7% in November, the Katrina-distorted plunge in annual CPI and the effects of dropping gasoline prices have run their course. Last year, November CPI dropped by 0.7%. Any monthly change in November 2006 that is more positive than that will push the annual CPI rate higher by a like amount.
Generally, inflation surprises should come in on the upside of weak expectations, tied particularly to core numbers, which will continue to firm. They increasingly are reflecting the slow process of oil prices permeating nearly all levels of business activity.
Federal Deficit -- The officially-gimmicked 2006 federal budget deficit (fiscal year ended September 30th) was $248.2 billion (revised from initial reporting $247.7 billion), down $70.8 billion from 2005's $318.5 billion (revised from $318.8 billion). Despite the misleading reporting, the amount of debt taken on by the federal government showed worsening annual fiscal deterioration. Further, reporting based on generally accepted accounting principles (GAAP) -- due for release on December 15th -- also should show deterioration, with the actual 2006 deficit in excess of $3.5 trillion.
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 2006, the gross federal debt stood at $8.507 trillion, up by $574 billion from 2005, which in turn was up $554 billion from 2004.
For the rolling 12 months through October 2006, the gimmicked deficit was $250.2 billion versus $308.4 in October 2005, a narrowing annual decline of $58.2 billion. As of October 31, 2006, the gross federal debt stood at $8.584 trillion, up by $557 billion from 2005, which in turn was up $597 billion from 2004.
Going forward, the official federal deficit will inflate, as government finances suffer increasingly from tax revenue losses due to the intensifying recession and relative tax receipt declines after the expiration of recent tax incentives. While GDP growth estimates can be gimmicked, incoming tax receipts (based on consistently applied tax policies) 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 moved into slightly less-negative territory (an economic negative) due to deterioration in recent numbers. While new claims over the last month have been virtually unchanged from last year, year-ago comparisons using a 17-week moving average still are distorted by last year's effects of Hurricane Katrina passing through the data. On a smoothed basis for the 17 weeks ended November 18th, annual change narrowed to a 7.7% decline, from an 8.3% drop as of the October 21st week.
Usually, 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 generally is a fair indicator of current economic activity.
Real Average Weekly Earnings -- Spiked again by the distorted collapse in CPI reporting, October's seasonally-adjusted real earnings soared 1.3% for the month, following September's 1.0% gain. October's real earnings also jumped by 3.2% from the year before, following September's 2.3% gain. If these numbers were real, the Republicans might have held on to Congress. The "improvement," however, all was tied to year-ago CPI comparisons that were distorted by the effects of Hurricane Katrina and BLS gimmicked reporting of energy prices. Those effects and distortions will start to reverse in November's reporting.
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 still signals ongoing severe financial strain on U.S. households and continuing recession.
Retail Sales -- October's seasonally-adjusted retail sales fell by 0.2% +/- 0.7% (down 0.7% net of revisions) for the month, well below market expectations, again. Retail sales in September were down a revised 0.8% (down 0.3% after the negative September CPI inflation), a change initially reported as a 0.4% contraction. Net of gimmicked CPI inflation, the October change was up a tepid 0.2%.
When inflation-adjusted year-to-year growth in retail sales falls below 1.8% (using the official CPI-U for deflation), such signals recession. The signal was generated in June. Before inflation adjustment, October's annual growth was 4.5%, down from September's 5.2%. Net of Katrina-dampened annual inflation, October's annual growth was 3.2% against 3.1% in September. That number will sink with next month's rebound in annual CPI inflation.
Next Release (December 13): November retail sales also should come in below expectations, generally reflecting declining economic activity and a less-than-robust start to the holiday shopping season. Inflation-adjusted growth should be negative on a monthly basis, with annual real growth also slowing sharply.
Industrial Production -- Seasonally-adjusted October production gained 0.2%, following September's 0.6% plunge. As often happens, the gain was aided by a weather distorted surge in utilities. Despite an upward revision to the index level, year-to-year growth slowed in October to 4.8% from September's upwardly revised 5.8% (was 5.6%.)
Next Release (December 14): Look for industrial production to contract in November, increasingly mirroring the recession. Such would surprise market expectations on the downside. Tentatively due on December 11th, the annual revision to the series likely will show a weaker economy since 2004 than previously has been reported.
New Orders for Durable Goods -- The highly volatile durable goods orders plunged in October by a seasonally-adjusted 8.3% (7.4% net of revisions), after jumping a revised 8.7% (previously up 7.8%) in September. While much of the decline was a reversal of the aircraft order surge seen in the prior month, orders still fell by 1.7% ex-transportation. October's orders were up just 2.6% from the year before, a near-recessionary level if the pattern held for several months.
The widely followed nondefense capital goods orders fell by 15.6% in October, following September's revised 24.7% (previously 21.9%) gain. Where the monthly volatility here also was exacerbated by changes in aircraft orders, October orders still were down 5.1% ex-aircraft. October's annual growth rate for all nondefense capital goods orders was 9.4%.
At one time, durable goods orders was a solid leading indicator 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 -- Surprising the markets, the September trade deficit showed an unusually sharp narrowing and helped boost the "preliminary"-estimate revision to third-quarter GDP.
The seasonally-adjusted trade deficit narrowed to $64.3 billion from $69.0 billion in August. While the "improvement" could be explained by the reported decline in oil imports -- half tied to price, half tied to volume -- this is one of those numbers that has a terrible odor to it. There were unusual carry-over revisions (related to paperwork flow through the Customs Service), as well as possible seasonal-factor distortions from last-year's Katrina effects on the Port of New Orleans. Regardless, the deficit will rebound sharply in the months ahead, setting new records. Of some note, as with the CPI, the trade numbers suddenly seem to be anticipating price cuts that have not taken place yet.
Next Release (December 12): The October trade deficit should rebound some from September's understatement, surging beyond consensus forecasts. The months ahead will see a pattern of the deficit regularly setting new records.
Consumer Confidence -- November confidence measures eased after a mixed October showing. The Conference Board's November consumer confidence fell by 2.1%, following a 0.8% decline in October and a 6.7% increase in September. The Conference Board number is subject to suspect seasonal adjustment. The unadjusted University of Michigan's consumer sentiment fell by 1.6% in November, following gains of 9.6% in October and 4.1% in September.
On a year-to-year basis, the damage done to confidence in 2005 by the severe hurricane season largely is responsible for the near-term gains seen in current annual growth patterns. On a three-month moving-average basis for November, annual growth in the Conference Board's measure increased to 15.8%, up from 11.9% in October, while the University of Michigan number gained 16.5%, following October's 8.7% increase. These lagging, not leading, indicators still are suggesting that the economy is in recession.
Short-Term Credit Measures -- Annual growth in short-term commercial credit measures remained strong, holding double-digit percentage annual growth, while annual growth in consumer credit remained below average and softened again.
Growth in seasonally-adjusted consumer credit remained sub-par in September, with annual growth easing to 3.7%, from a revised 3.9% (was 3.4%) in August. Without inflation-adjusted growth in income, growth in real personal consumption can be supported over the short-term only by debt expansion or savings liquidation. Consumer debt expansion -- though moving -- remains soft enough to constrain economic growth significantly.
Annual growth in commercial paper outstanding remained strong in October at 17.6%, although that was down from September's annual pace of 19.6%. Annual growth in commercial and industrial loans notched higher to 14.9% in October, from a revised 14.8% in September (previously 14.9%). Rising sales can fuel short-term credit needs, but so too can slowing sales, slowing collections and rising inventories.
Producer Price Index (PPI) -- Continuing to suffer annual distortions due to Katrina effects, as well as being subject to the overly-aggressive logging of energy-related price declines by the BLS, the seasonally-adjusted October finished goods PPI fell by 1.6% (down 1.2% unadjusted), following September's 1.3% drop (down by 1.1% unadjusted). October's annual PPI inflation dropped to a decline of 1.6% from September's 0.9% gain. Seasonally-adjusted September intermediate goods fell by 1.1% for the month, while crude goods were down by 10.5%.
The decline in PPI inflation was exaggerated by highly unusual seasonal adjustments and by highly-publicized hedonic adjustments to new model light trucks. Current PPI reporting has passed into the realm of the nonsensical.
Next Release (December 19): Despite the large component of random volatility in monthly price variations, PPI inflation reporting over the next six-to-nine months should top artificially depressed expectations. November reporting, in particular, should reverse the decline in annual PPI inflation. "Core" inflation should continue offering upside surprises to consensus forecasts, despite reporting games played by the BLS.
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 October new orders component fell 3.9% to 52.1 from September's unchanged level of 54.2. As an SGS early warning indicator of a pending major economic shift, this measure breached its fail-safe point in mid-2005, generating a signal 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 October new orders index fell by 9.0%, following September's 6.8% contraction. 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 October ISM manufacturing index dropped to 51.2 from September's 52.9. An index level of 50.0 divides a growing versus contracting manufacturing sector. The October employment component moved to 50.8, up from September's contraction-territory of 49.4.
The service-sector ISM index 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. That said, the overall services index rose to 57.1 from 52.9 in September.
Both the services employment and prices paid components, however, have some meaning. The October employment component dropped to 51.0 from 53.6 in September. The prices paid component is covered in the Inflation Indicators.
Help-Wanted Advertising Index (HWA) -- The series has not been updated since the last SGS. Showing rapidly deteriorating employment conditions, the September help-wanted advertising index held at 30, the same as the revised August reading.
The September and August readings were the lowest seen since early 1961. The index was last lower than this during the Eisenhower Administration, in October 1958. While the series never recovered from the 2000 recession, its recent plunge -- annual change is down 18.6% on a three-month moving average basis -- is signaling a renewed and rapid contraction in economic activity.
Housing Starts -- Annual change continues to deteriorate. Seasonally-adjusted October housing starts fell by 14.6% +/- 7.6% for the month, following a revised 4.9% (was 5.9%) gain in September. With October's year-to-year change down by 27.4%, following September's 19.4% contraction, the annual change on a three-month moving-average basis now stands at a year-to-year drop of 22.2%, the worst reading since the depths of the 1990/1991 recession. Such is generating an intensifying recession signal.
Further, in related data, with respective rates of annual contraction for October new- and existing-home sales at 25.4% and 11.5%, respectively, activity remains consistent with a sharp economic downturn.
Money Supply -- Despite underreporting of annual CPI inflation, real annual growth rates for October M1 and M2 remain consistent with the ongoing recession, while the nominal (not-inflation-adjusted) annual growth in M3 -- as estimated by the SGS Continuing M3 Series -- not only remains strong enough to fuel inflation concerns, but also is accelerating.
Annual growth in October for monthly M1 fell by 0.4%%, versus a 1.1% contraction in September, while annual M2 growth rose to 4.8% from 4.4%. The SGS Continuing M3 Series for October gained 9.6% from the year before, rising from September's 9.2% gain. The October annual growth was the highest seen in more than four years, since March 2002.
[Note: Historical annual growth data for the money supply series, including the ongoing SGS estimates of M3, are available for download on the Alternate Data page of www.shadowstats.com. See the August 2006 SGS for methodology.]
Before inflation adjustment, monthly seasonally-adjusted October M1 and M2 rose by 0.8% and 0.9%, respectively, following a 0.9% decline and 0.2% increase in September. Month-to-month M3 change was approximately 1.2% for October, up from 0.9% in September.
Adjusted for the distorted CPI inflation, October's M1 and M2 year-to-year rates of change were down 1.8% and up 3.4%, respectively. On a three-month moving-average basis, the October inflation-adjusted annual rates of change were down 3.4% and up 2.1%, levels that still remain well underwater using the old-style CPI.
Inflation Indicators
Purchasing Managers Surveys: Prices Paid Indices -- Declining oil prices continued hitting the purchasing managers surveys. On the manufacturing side, the October prices paid diffusion index plunged to 47.0 from September's 61.0, a reading showing declining inflationary pressure. On a three-month moving average basis, October's annual change was down by 19.4% against September's 12.4% gain.
On the non-manufacturing side, the October prices paid diffusion index declined to 51.9 from 56.6 in September, still on the rising side of inflation. On a three-month moving average basis, October's annual change was down by 17.6% against September's annual 5.2% decline.
Published by the Institute for Supply Management (ISM), the prices paid components of the purchasing managers surveys are reliable leading indicators of inflation activity. The measures are diffusion indices, where a reading above 50.0 indicates rising inflation.
Oil Prices -- The monthly-average West Texas Intermediate Spot (St. Louis Fed) dropped to $58.88 per barrel in October, down 7.8% from September's $63.87. Nonetheless, oil prices persist at extraordinarily inflationary levels, despite October's average being down 5.6% from the year before, after September having been down by 2.6% on the same basis.
Annual price comparisons for September and October are against the oil-price spike seen last year from hurricane impact. Current trading is holding just shy of $60 per barrel, which is above last November's average level of $58.30.
Spot prices will continue to gyrate and can be expected to be on the rise again shortly, now that the November election has passed. With OPEC cutting production, with Middle Eastern tensions about to explode anew, and with intensifying dollar weakness likely to put upside pressure on dollar-denominated oil prices, current market pricing likely will prove to be close to a near-term bottom for a while.
Despite recent extreme near-term price volatility, high oil prices will remain a major contributing factor to the inflation side of the current inflationary recession. Oil prices remain extremely high, and still are working their way through the system. 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. Reporting of same should pick up despite any near-term easing of oil prices.
Oil price volatility affects CPI and PPI reporting. Downside oil price movements are picked up more quickly and fully by the BLS in its inflation measures than are upside movements. This pattern has started to show in monthly trade deficit reporting, too. These distortions were particularly evident in the September and October CPI and PPI. Even as currently understated, though, CPI and PPI inflation will rebound sharply now, in the post-election months, tending to be stronger than commonly predicted for the next several quarters, partially as a result of the persistency of the high oil prices.
The coverage and available prior material are detailed below for various series. Data reported with a less-than-monthly frequency also are updated here or in the Reporting/Market Focus.
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 is in the September 2006 SGS; next analysis is due September 2007).
Quarterly:
* Flow of Funds Accounts of the United States (the most recent analysis was in the October 2006 SGS; the next analysis is due in the January 2007 SGS).
Reporting/Market Foci -- The various economic and financial-market series are being addressed in a monthly "Reporting/Market Focus," with this month's analysis running a reality check on housing-bubble home prices. Employment, GDP, CPI and the Federal Deficit separately 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 [updated October 2006], October 2005 SGS, alternate numbers introduced August 2006 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, alternate numbers introduced August 2006).
* Help Wanted Advertising (January 2006 SGS).
* Housing Starts and related housing statistics (June 2006 SGS, November 2006).
* Income Variance/Dispersion (September 2005 SGS, September 2006 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, M3 continuing series introduced August 2006).
* Producer Price Index (April 2006 SGS).
* Productivity (October 2006 SGS).
* Purchasing Managers Survey (February 2006 SGS).
* Retail Sales (March 2005 SGS).
* SGS Early Warning System (May 2005 SGS, June 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).
At subscriber request, SGS is addressing the issue as to how much of the bubble in housing prices really might be accounted for by inflation. Issues on quirks in trade data, previously mentioned as this month's Reporting/Market Focus, will be addressed in a later publication.
Real Estate Remains An Inflation Hedge. A subscriber mentioned a recent article by a fine economist, where it was argued that home prices, adjusted for inflation, had risen in a manner not seen since before 1900. Further, that left room for a large decline in home prices, which in turn would be a primary recession trigger. With the National Association of Realtors (NAR) just reporting the October median existing home sales price down by 3.5% from a year ago, one could argue that process was underway.
Where the analysis looked at the median prices for existing homes, as published by the NAR, and the CPI as published by the BLS, our subscriber rightly argued that the home prices picture might not be so bad if the series were deflated by the SGS Alternate Consumer Inflation Measure.
Having looked at the numbers, here are some thoughts on the issues raised. The economy is in recession and was in recession before the housing decline started. The weakness in the housing industry certainly will exacerbate the decline in the national economy. Some of the bigger economic problems tied to the housing bubble were the adjustable-rate and low-quality mortgages issued during the housing and refinancing boom. Defaults already are rising sharply, and consumer liquidity is getting pummeled as a result.
Housing prices certainly have risen sharply in recent years, and areas that had the most speculative buying likely will be subject to the most severe price adjustments.
Assuming for a moment that the median sales price of an existing home is the appropriate housing price measure to deflate, the official CPI is not the instrument with which to deflate it.
In theory, the CPI measures housing costs, but it has not done so adequately since the early 1980s, when housing cost measurements were switched to owner's equivalent rent (what the government estimates you would pay yourself to rent your own home) from home sales prices. The SGS Alternate CPI is corrected for that change.
Looking at the average annual median existing home prices from 2001 to 2005, home prices rose by 43.4% for the four intervening years. For the same period, the SGS Alternate CPI rose by 40.6%. What that indicates is that on average, over time, real estate is a solid hedge against inflation. Real estate does not have the liquidity or portability of gold, but it can be used as an effective inflation hedge.
Still, there are heavily overvalued properties out there that will take a price hit or sit on the market for an extended period. Nonetheless, in a hyperinflationary environment, which looms eventually, even today's overvalued real estate will act as a significant store of wealth.
The December Reporting/Market Focus will cover the annual GAAP accounting on the U.S. Government's financial condition. Due for release on December 15th, the financial report's results will be summarized as a separate Alert.
December's "Shadow Government Statistics" is targeted for release in the week between Christmas and New Year's, with a specific date to be advised closer to publication. The posting of the next SGS newsletter on the Web site, as well as all interim Flash Updates and Alerts, will be advised immediately by e-mail.