September 6, 2005
We Could Get a Recession Out of This
Financial volatility is a combination of two conditions: inelasticity and illiquidity.
Inelasticity is essentially the failure of demand or supply to respond to changes in price. We typically think of energy demand as relatively “inelastic,” meaning that even substantial increases in price don't typically reduce demand by much. Economists draw inelastic demand curves as very steep, almost vertical lines. There's some down-slope from left to right, meaning that as prices drop, quantity demanded increases (and vice versa), but not by a significant amount. While many goods have fairly elastic supply (meaning that when prices rise, suppliers respond by substantially increasing output), oil supply is generally viewed as being somewhat inelastic in the short run, being set largely by agreement among suppliers. Still, we usually expect that suppliers have enough capacity to respond to demand shifts in a way that keeps prices contained.
The real problem occurs when you get very close to global capacity constraints, as the oil market is today. At that point, even if demand increases and producers want to supply more oil, they don't actually have the ability to do it. Worse, if you're operating at high levels of demand coupled with capacity constraints, and then encounter a supply disruption, the market can become very disorderly. When inelasticity meets illiquidity, the result is panic, which is exactly what we're seeing in the market for gas here.
Grab a pair of scissors.
OK, now open the scissors slightly. You'll notice that the left arm slopes down to from left to right. That's your demand curve. You'll also see that the right arm slopes up as you go from left to right. That's your supply curve. Notice where they meet. Now close the scissors just slightly. Do you see how quickly the intersection rises between the arms of the scissors? Those are gas prices. With both demand and supply curves very steep and inelastic, it takes very small disruptions to produce profound changes in prices. More importantly, the higher prices are an equilibrium. Once you shift supply and demand curves, the new price is the new price, and changes only if you shift the curves again. In other words, it's a vapid, non-equilibrium argument to say that high gas prices will reduce demand, thereby lowering gas prices. If you follow that sort of logic, you're forced to then conclude that the lower prices will raise demand, resulting in higher prices, which will lower demand… ad infinitum.
While we're certainly likely to see some volatility and even very sharp, periodic declines in oil and gas prices, it won't be because the high prices caused lower demand and lower prices (…). Rather, it will be because very small changes in those inelastic scissors are going to wreak havoc with price volatility.
We could get a recession out of this
On the human effects of Katrina, this is probably more useful than any comments I could make: American Red Cross.
On the economic front, I'll begin by noting that we still don't observe enough evidence to expect a recession, but I do believe that the risks are higher than commonly believed. As I noted the last time I reviewed recession risks (June 6 comment: Recession? Risks Developing, but Not Just Yet), recessions typically don't begin until we observe less than 1% growth in nonfarm payroll employment over a 12 month period, or 0.5% over a 6 month period. We've yet to see how much dislocation Katrina caused in employment, and will need a couple of additional months to gauge persistence. Still, there are other indicators that have historically been more reliable than employment, especially near the start of economic downturns, so employment data is likely to be a confirming, not leading indicator, if the economy slips in the months ahead.
One of the key points I've made over the years is that recessions are not periods of generally slumping demand. If you look at the pattern of industry output during most recessions, the majority of industries are relatively unscathed. Nominal consumer spending has, in fact, never experienced a year-over-year decline in post-war data, and real consumption is generally the most stable class of expenditures.
No, the bulk of the damage in most recessions is confined to particular industries that experience large mismatches between what is demanded and what is supplied. The majority of weakness in GDP during a recession is due to a slump not in consumption but in investment, particularly inventory investment.
In effect, recessions are periods when there is a mismatch between the mix of goods supplied by the economy and the mix of goods demanded. That mismatch causes a buildup of inventories in some industries, and shortages in others. There is no such thing as a “representative consumer” who just consumes less, as Keynes' simplistic modeling of the economy would have people believe. The defining features of a recession are dislocations and mismatches, not “general weakness in aggregate demand.”
What does that mean for us here? It means that if you want to look for recession risk, staring at consumer confidence is the wrong activity. Sure, consumer confidence has a reasonable track record as an economic indicator, but only as a “coincident” or “lagging” indicator – not as a leading one. In fact, you can explain the vast majority of fluctuations in consumer confidence using lagged data on employment, inflation, and capacity utilization.
Recession risk shows up in more subtle measures that tell you about internal turbulence. Among the most important are credit spreads (the difference between the yield on risky corporate debt and default free Treasuries). After a few months of relative stability, these widened significantly last week. Other indicators include the ISM figures, which showed a substantial drop in production and new orders last month. The Purchasing Managers Index dropped to 53.6 not even including the impact of Katrina. Stock prices are also important, especially when we observe a lack of uniformity. As I've noted in recent weeks, we're seeing increasing evidence of large cap distribution, with growing dispersion in the market action of various industry and capitalization groups. Finally, flat or inverted yield curves are typically signals of economic risk, particularly when the yield curve is rising at the short end.
Historically, when credit spreads have been wider than they were 6 months earlier; when the PMI has declined to 50 or lower; when the S&P 500 has been below its level of 6 months earlier; and the spread between the 10-year Treasury and 3-month Treasury yield has been less than 2.5%, the U.S. economy has either just started a recession, or has been within a few months of a new recession. We aren't quite at that point yet, but the economy has a lot to contend with: the disruptions that we've observed in oil and gas prices, with the likely disruption to shipping and commercial freight in the southern United States, the potential for tepid employment figures, a high probability that automotive demand will be poorly matched with the supply of SUV's and other fuel-inefficient vehicles supplied by auto makers, and the likelihood of at least moderate increases in risk perceptions and the economic caution that will probably accompany that.
In short, the question isn't simply whether oil prices are high enough to cause a slowdown in consumer spending. Slow consumers don't cause recessions. They just don't. Recessions are provoked by a substantial mismatch between what is demanded in the economy and what is supplied. At present, there is a lot of internal turbulence at work, and it is important that we continue to monitor the economy from that perspective.
As of last week, the Market Climate remains characterized by unusually unfavorable valuations and relatively neutral market action. There's continued evidence of distribution and dispersion in market internals, but still nothing decisive that would indicate that investors are quickly abandoning their willingness to bear risk. That's not to say that things can't deteriorate further, but it's not a situation where impatient bears are likely to be quickly relieved. Nor are impatient bulls likely to find durable relief. Unfortunately, relatively dull, range-bound markets can entice investors to look for fast money somewhere. Whether that means IPOs, real estate, or other speculations, the markets have a knack for devastating investors eager for fast money, though they may buoy their dreams for a certain amount of time before dropping the anvil (turning them into just a hat and feet, to borrow a phrase from Fountains of Wayne).
In the Strategic Growth Fund, I am generally maintaining a hedge of 80-90% of the value of the Fund's diversified stock portfolio, depending on day-to-day opportunities. The composition of the hedge between the S&P 500 and Russell 2000 largely matches the composition of our underlying stock portfolio, and since I don't believe there's any merit in exposing the Fund to basis risk in an attempt to game the indices against each other, the positions aren't much different from what you'll see in the Annual Report, and the proportions change slowly, generally in line with gradual changes in the types of stocks the Fund holds from time to time.
In bonds, the Market Climate was characterized last week by unfavorable valuations and moderately favorable market action. In stocks, favorable market action generally merits some amount of exposure to market risk. In bonds, the potential for sustained “bubbles” is very limited, so the level of yields tends to dominate trend and market action considerations. That's another way of saying that we might be willing to take a more substantial exposure to interest rate risk here if the level of yields was higher. At present, however, we've got a relatively unsatisfying situation. Risk of economic weakening, combined with modestly favorable market action, means that there's some potential for lower yields here. The problem is that the yield curve is very flat, and inflation and currency pressures continue to pose risks, so there's also some risk to nominal bonds. Inflation protected securities, though also low-yielding, are in a somewhat better position, and seem to have less risk than nominal bonds given the range of potential economic outcomes. For that reason, the relatively short, 2-year duration of the Strategic Total Return Fund is primarily in inflation protected securities. The Fund continues to hold about 20% of assets in precious metals shares, which account for most of the day-to-day volatility in Fund value.
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