Clowns and Jokers
by Brad Simpson, Barlow Capital Partners
Trying to make some sense of it all,
But I can see that it makes no sense at all,
Is it cool to go to sleep on the floor,
'Cause I don't think that I can take anymore
Clowns to the left of me, Jokers to the right,
Here I am, stuck in the middle with you.
--Stealers Wheel
A staple of financial media is oversimplification. Far too often the explanations for the decisions made by financial people, such as CEOs, business owners or central bankers, are boiled down to being either good or bad. Life isn’t that simple. Many decisions are based menu of lousy alternatives. Take, for instance, the decision last week by Ben Bernanke and the US Federal Reserve to reduce the Fed Funds Rate by .25% to 4.5%.
At the end of the day Mr. Bernanke’s decision was a bad decision, but a decision where there was not a good decision to be made. He was damned if he did and damned if he didn’t. Despite the fact that GDP growth for the 3rd quarter was a very respectable 3.9% the Fed has some very real concerns about the coming months for the US economy. On the other hand the Fed also has some real concerns about inflation.
To understand Mr. Bernanke’s decision we performed a paired comparison analysis of the underlying factors that ultimately led to the decision. For each factor we assigned a score which we tallied up to uncover the best of the worst. This type of analysis demonstrates just how difficult a decision this was because the United States is stuck in the middle of a very difficult spot.
The enclosed chart provides the main factors we considered. We listed factors based on two risk drivers: economic growth and inflation.
Economic Growth
The outlook for the US economy is lousy. Housing prices are weak and getting weaker; for this fact we assigned 4 points. We then considered the subprime mortgage credit market which is a story that “has legs”. Sometimes the headlines come so fast that it is hard to keep perspective, but consider this: in the past two weeks the subrprime market has brought an end to the leadership of two of the most powerful Chief Executive Officers in financial services: Stanley O’Neal of Merrill Lynch and Charles Prince of Citigroup. In Canadian terms, this is akin to the coaches of the Toronto Maple Leafs and Montreal Canadiens getting fired in the same week for losing records.
Thus far the losses for these two prestigious companies alone are at $22.1~$31.5 billion. The fact that Citigroup still has $55 billion of direct exposure to American subprime mortgages through loans and collateralized-debt obligations is a good barometer that there is still an awful lot of these time bombs still ticking. Score 4 more points.
Any survey of the American economy has to give due consideration to the consumer who after years of sometimes awe inspiring determination is finally started to waver. According to Merrill Lynch’s fine North American economist, David A. Rosenberg, consumer confidence today is lower than the following five critical periods:
1. September 11, 2001 terrorist attack
2. The Long Term Capital/Russian crises in 1997
3. The Orange County/Mexican fiasco in 1994
4. The onset of recession in July 1990
5. Black Monday of 1987.
Score 4 more points.
According to the Institute of Supply Management's Index of Activity things aren’t so great with industrial sector either, which just fell to 50.9 from 52. Score 4 points. Lastly, we assigned 4 points for the global economy due to the fact is too much is riding on this one factor.
Inflation
These risks to growth are all sensible arguments for lower rates; however, there is another risk to consider: inflation. In the words of The Fed: The upside risks to inflation roughly balance the downside risks to growth. The Fed’s tool of measurement for inflation, the Consumer Price Index, is an incredibly flawed instrument, but it is a tool they use, so for sake of argument we plugged our nose and assigned 1 point. Secondly, pricing pressures due to cost increases have yet to happen thanks to continued high profit margins. This factor elicits a score of 0 points. Oil is threatening to hit $100 a barrel, gold is well over $800 and most materials continue to go up in price; consequently we assigned 4 points to the inflation side.
We then considered the US dollar, which at present is in a free fall. Add to this rising employment costs, which never bodes well for future profit margins and 4 points are accredited. Finally, we added 4 more points to the inflation side because of growing inflation in many European countries and China.
The Tally
Now let’s add up both sides, remember the high score, is the worse score and in this case the loser is the winner: Growth 22, Inflation 20.
Mr. Bernanks’s decision to lower The Fed Funds Rate was not an easy decision and not a very good one, but the best of a bad bunch.
