Now, Chavez’s aggressive economic policies are again being called into question, this time as the country slides into what could be a protracted period of stagflation, which is defined by the exasperating mixture of torpid economic growth and high inflation.

Before that, however, the period from 2004-2007 was marked by rapid economic growth – punctuated by a miraculous 19.42% burst in 2004. Since that time, unfortunately, Venezuelans have watched as their standard of living was slowly eroded by restrictive price controls, rapid inflation, unsustainable public spending, and widespread nationalizations that have put a stranglehold on industry.

Even as these problems festered, an unprecedented surge in oil prices allowed Chavez to maintain his questionable – and ultimately unsustainable – economic policies. When the bull market in commodities abruptly stalled last year, Venezuela’s economy lumbered to a stop.

Venezuela’s economy grew by 3.2% in the fourth quarter of 2008 and just 0.3% in the first quarter of 2009. Then – for the first time in more than five years – that country’s economy contracted, shrinking 2.4% in the second quarter.

Unfortunately for Venezuela, the decline in gross domestic product (GDP) did little to quell surging inflation.  The annual rate of inflation climbed to 26.2% in July, according to the Central Bank of Venezuela. Many foreign sources have it higher.

President Chavez insists his country is not in the midst of a financial crisis, but analysts believe this is just the beginning of a bad-news saga that will trip up a country whose heavy-handed economic policies have made it few friends.

“To sum up, we could say that such scenario of stagflation has two basic components,” Orlando Ochoa, an economist and professor with Andrés Bello Catholic University (UCAB), told El Universal. “On the one hand, price control, exchange control, nationalizations and restricted distribution of foreign currency damage supply. On the other hand, lower oil prices curtail revenues and have an impact on demand.”

Going forward, Venezuela’s currency controls are perhaps the biggest hurdle for the economy to overcome. Chavez and his cabinet have said they are preparing to announce measures to stimulate the economy, but that may not be enough.

The problems that come with over-reliance on oil and a vast net of unwieldy social programs and the cost burden of nationalized industry aren’t going anywhere. And the nation’s other obstacle – the gap between its official and parallel exchange rates – won’t be addressed until at least the end of September.

An Unparalleled Problem

Indeed, the problems facing Venezuela are many. But President Chavez and his cabinet believe they have the solution.

“There is a remedy,” Venezuelan Finance Minister Ali Rodriguez said in an interview broadcast on state television. “The differential between the official dollar and the [so-called] ‘parallel dollar’ can be reduced.”

Rodriguez was referring to the difference between the country’s “official” exchange rate – which remains at 2.15 bolivars per U.S. dollar – and the so-called “parallel market,” which suggests a rate of about 6.5 bolivars per U.S. dollar.

The official exchange rate of 2.15 bolivars per U.S. dollar was arrived at in 2003, when Chavez imposed currency controls that force Venezuelans who want to import goods to apply for a government permit. Importers that are unable to get permits to buy currency at the official exchange rate have been forced to turn to the parallel market, where they pay three times the official price.

The problem now is that a large drop in oil revenue has sharply reduced the amount of dollars the government has available to exchange. That has driven more importers to the pricier parallel market. Some have stopped importing entirely.

With limited access to imports, Venezuela’s manufacturing sector contracted by 8.5% in the second quarter.

“The manufacturing sector is going to have a negative performance, mostly because of the restriction in imports and dollars, which has caused a drop in the supply of primary materials,” Miguel Carpio, an economist at Banco Federal CA in Caracas, told Bloomberg News. “Add to that the drop in consumption, and this is going to be a very difficult year.”

Now, with the threat of stagflation looming large, Chavez has no choice but to take action. But economists are unsure of what the government will do.

Few analysts expect the government to order an outright devaluation, because it would push inflation beyond the 28% annual rate. (Venezuela last devalued the official rate in 2005, weakening the currency by 11%.)

Instead, the government could try to lower the parallel rate by issuing dollar-denominated debt, by creating a second, separate exchange rate for “necessary” industries, or by doing both those things.

Traditionally, the government chooses to subsidize certain favorite industries – mainly heavy machinery, foodstuffs and medicines – by allowing them to trade bolivars at the official rate and driving other non-essential goods producers to the parallel market.

This could be taken a step further by imposing a tax on lower priority industries seeking dollars at the official exchange rate, Russ Dallen, head trader at Caracas Capital Markets, said in a research note. Or the government could simply create multiple “official” rates for different industries. Venezuela may create four different exchange rates to help the government deal with a drop in oil revenue.

“This complicated system, if implemented, would satisfy the requirements of the government of pretending not to have a formal devaluation of the exchange rate,” Dallen said.

Credit Suisse Group AG (NYSE ADR: CS) said in an Aug. 28 report that it expects the government to avoid devaluating its currency by selling dollar-denominated debt to the parallel market. In 2008, after an aggressive sale of dollar-denominated bonds, the administration was able to bring down the parallel rate to around 3 bolivars.

Ultimately, it’s Chavez – who opened the door to speculation in August by saying he would “restore balance” to the parallel rate – who will decide what to do about his country’s quandary. But he won’t be making a decision until later this month.

“Is there going to be an adjustment? I can’t respond to that right now,” Chavez said Sunday at the presidential palace in Caracas. “If any adjustment comes, it will be in September, towards the end of the month.”

But whatever Chavez decides to do, his remedy is likely to fall short, analysts say. That’s because the parallel rate is not the problem – it’s actually a symptom of flawed economic principles. The restrictive price-and-exchange-rate controls, government expansion, and political obtuseness that Chavez has made the cornerstones of his economic policy will continue to conspire against Venezuela until there is reform.

“We always said the situation was only tenable for the government if oil prices not only remained high, but also rose constantly. But that has not happened, and the fall in oil income is now clearly in evidence,” UCAB’s Ochoa told Inter Press Service News Agency. “That’s the first factor contributing to stagflation, to which are added price and exchange controls and restrictions on hard currency availability, which harm supply and investment, and thirdly, the policy of nationalization.”

Venezuela’s Crude Oil Slick

In the years leading up to the financial crisis, Chavez used PDVSA’s growing revenue to finance large social programs, as well as the nationalization of other industries.

Spending on social programs soared 340% from 2000-2005, according to the Center for Economic and Policy Research. It rose even higher as oil prices soared into 2008, boosting purchase orders and fueling a spending spree among even the poorest Venezuelans.

But since the financial crisis eviscerated commodities prices, Venezuela’s oil bounty has all but evaporated. Oil brought in $22.8 billion in the first six months of 2009. That’s less than half of the $52 billion it brought in during the first half of last year. For 2008 as a whole, oil generated about $90 billion in revenue for Venezuela.

Meanwhile, FONDEN – Venezuela’s development fund – has already committed all but $3 billion of the nearly $20 billion it had available at the end of January, as the government used most of the money in the first half of the year to sustain fiscal spending.

And while Venezuelan oil traded at an average of $53 a barrel in the second quarter, up from $40 a barrel in the first three months of 2009, that’s still a far cry from last year’s levels.

That means borrowing has had to rise to compensate for the decline in revenue.  Venezuela’s domestic debt jumped 44% during the first half of the year to $20.42 billion from $14 billion at the end of 2008.

“Public spending keeps rising and is financed by more public debt, which increases spending in a vicious circle, while the government defers or postpones workers’ demands, which is itself another sign of the approaching recession, although the government seeks to deny it,” economist Domingo Maza Zavala, a former head of the Central Bank told the IPS.

Calculations based on official figures suggest domestic and foreign debt repayments will total about $19.6 billion between the second half of this year and 2011, the Latin American Herald Tribune reported. Roughly $10 billion of that total will be due on foreign debt, with the remaining $9.6 billion destined for the domestic account. Total state debt is estimated at $50.3 billion.

What’s the government figures don’t include is the cost of compensating private companies that have been taken over or bought out under Chavez’s nationalizations and expropriations.

Chavez’s government earlier this year seized the assets of more than 70 foreign and domestic oil service companies after conflict erupted over nearly $14 billion in debt owed by PDVSA.

PDVSA demanded that service companies accept a 40% cut in their bills; when they refused, the Venezuelan government seized at least 12 drilling rigs, more than 30 oil terminals, and about 300 boats.

The demonstration was a pointed reminder of a 2007 incident, which is still playing out in the international courts. Two years ago, Venezuela forced six oil majors to hand over equity stakes of 60% or more to PDVSA. However, Exxon Mobil Corp. (NYSE: XOM) and Conoco Phillips (NYSE: COP) opted to walk away from their contracts rather than accept a minority role.

This conflict is still being disputed, and last year Exxon won a court order to freeze $12 billion in assets from PDVSA as compensation for its lost projects. Additionally, Chavez’s heavy-handed policy has cost the country untold billions worth of oil-related investments, as many oil majors now refuse to operate there

“There is the uncertain outlook over how the extensive nationalization pursued over the past 12 years will pan out,” Alvise Marino, an analyst at Ideaglobal, told The Wall Street Journal. “Based on the government’s unimpressive track record on the economic management front, we tend to take a less-than-optimistic view.”

The Colombia Conundrum

In addition to alienating foreign oil majors, Chavez has also sequestered Venezuela from many of its neighbors, especially Colombia. Chavez has ordered his country to prepare for an outright “rupture of relations” with Colombia after that country gave the United States permission to use its military bases.

The United States says access to the bases will help it fight drug trafficking, but Chavez has his own theory. He says American use of the bases could be used as a launch point for an invasion of his oil rich nation.

“Those seven military bases are a declaration of war,” Chavez said last week. “We must prepare for the rupture in relations with Colombia. There is no possibility of a return [to normal relations] with Colombia, an embrace.”

However, cutting off ties with Colombia poses yet another economic hurdle for the Venezuelan economy to overcome. Colombia provided about $6 billion in products to Venezuela in 2008, or about 15% of Venezuela’s total imports, according to Venezuela’s government statistics institute INE.

In fact, when Chavez closed the border for three days in 2006, there was shortage of food in Venezuela.

Chavez can turn to other South American countries, but his credit extends only so far.

“Nobody wants to sell to Venezuela if payment isn’t made in advance,” José Rozo, president of Fedecámaras Táchira, the region’s main business association, told the Latin American Herald Tribune

About 70% of trade activity in Venezuela depends on imports from Colombia, Rozo said, adding that the only country that had been willing to export on credit had been Colombia.

Without Colombia, Venezuela will have to settle for trade terms that heavily favor its partners.

For instance, Argentine President Cristina Fernandez de Kirchner made a visit to Venezuela last month, and signed no less than 22 accords. Virtually all of the deals were in Argentine’s favor, the Tribune reported.

“We’re going to drive a horse and cart through all the regulations if they want to do business with us,” an Argentine official told the paper prior to the signing of the deals. “Prompt payment. Simple procedures. Fewer controls. Less bureaucracy. No delays. Hard currency. I’ll tell you the rest when I’ve thought of them.”

That means if Venezuela wants to keep doing business with Argentina, it’s going to have to pay more.

And that will fuel inflation.

“The cost of purchasing in Argentina is higher, and that means that prices will be higher in Venezuela,” Abelardo Daza, an economics professor at Caracas-based IESA business school, told The Journal.

Source: Is Venezuela’s Stagflation the Beginning of the End for Chavez?

This has been a tough quarter for companies. Compared to last year’s second quarter, profit is down roughly 31 percent and revenue is down even more. Wall Street thought it was going to be even worse. So in one of the worst quarters ever, the market has rallied.

Investors learn all the wrong lessons from a rally like this. Nothing about it makes sense. The smallest companies are outgunning the biggest one. The most heavily shorted stocks are doing better than the least shorted stocks. The companies with the worst analyst ratings are outshining the ones with the best ratings. Everything about this rally is backwards.

Over the past 37 years – from 1972 to 2009 – these “best of breed” companies have made shareholders 2.3 times more money than the stock market as a whole. For every $100 you made from the stock market, you would have made $230 from these “best of breed” companies.

That’s not just slightly outperforming the market. That’s lapping the market and then some. And it’s even more impressive when you take into account everything this period covered. It’s been an eventful 37 years of embargoes, stagflation, a savings & loan crisis, an Asian economic crisis, a Russian national debt default, a near collapse of the Mexican peso, 9/11, two gulf wars, the bankruptcy of the Long-Term Capital Management hedge fund, the dotcom rise and fall, a bursting of the housing bubble, credit bubble and spending bubble. Forgive me if I’ve left some “minor stuff” out like the fall of the “Iron Curtain” and the rise of China.

Through all this, these companies gave their shareholders a steady and rising stream of revenue and a return that, as I’ve said, was more than 2.3 times what the markets gave. Who wouldn’t want that?

Everybody would. And that’s a big problem for all those mutual funds which don’t touch these companies … and for the hyper-active Wall Street press which makes a fuss over a dozen things every day but somehow misses the biggest story of all…

The existence of a class of companies which know how to put ever-increasing amounts of cash into the pockets of their shareholders, year in and year out, decade in and decade out.

Almost as bizarre as our junk rally are dividend-paying companies that can do no wrong. The ones strong enough and confident enough to raise dividends are going up in price. And the ones that are cutting dividends? Many of them are going up too.

Shareholders have recently been accepting smaller checks without protest and without selling their shares. They are evidently willing to take the hit today so the company can grow profits tomorrow. It’s easier to do when investors think that some kind of recovery is around the corner. If that recovery doesn’t materialize, these shareholders will be showing much less forgiveness to dividend cutters. I don’t want to own these companies when that happens.

If I were an investor in any of those companies, I’d sell my shares right away. The whole point of investing in the “best of breed” companies is that you get paid no matter what.

Everybody is cutting costs, the strong and weak companies alike. But not all dividend companies are cutting their dividends. Just slightly more than half are these days. It pays to invest in the dividend hikers, not so with the cutters. Let other investors be forced to rely on a recovery to reverse their portfolio losses.

You should be and can be making money even if the economy remains weak. As long as there are “best of breed” companies still raising their dividends, there’s no reason why you should sacrifice your pay “for the good of the company.”

The scary thing (for us and the Fed) is that low-interest rates aren’t speeding up the recovery. People aren’t willing to borrow. And banks aren’t willing to lend. The amount of money floating around the economy is pretty stagnant. The Fed should be pretty discouraged. They have $2 trillion on their balance sheet. And all they have to show for it are some banks which should have gone under but are instead giving its employees million-dollar bonuses.

Dividend companies are getting a little respect again. They may even have become the “new fad” according to the UK’s Telegraph. Here’s the money quote…

Few professional investors are banking on a return to the super-charged capital gains we have seen from equities in the past. Rather, the new fad is for companies capable of delivering reliable sources of income. Historically, dividends have been responsible for more than half the return on equities. In the more risk-averse environment which is the new norm it may be rather more than that.

But why be satisfied with just a “reliable source of income” when you could get income which is both reliable and growing. Perhaps the Telegraph doesn’t realize that with “best of breed” companies, you can have your cake and eat it too. But the Telegraph isn’t the only newspaper or media outlet that doesn’t “get it.”

Nobody is talking about these companies providing reliable revenue to shareholders for decades (yes, I said decades) and increasing their dividends at rates of 25-40 percent every year. Yes, I said 25-40 percent every year.

Do the math. A company raising its cash payments to you by 25 percent every year will double the money it pays you every three years! If you’re getting $10,000 in cash every year from a company now, in six years you’ll be getting $40,000.

These aren’t junk bonds. They’re not risky derivatives. They don’t depend on a bull market. These payments come from some of the safest and strongest companies in the market. When companies provide rising cash payments for decades and generate plenty of cash with above average profit margins, they qualify for “best of breed” status.

Actually, some people out there do “get it.” One of them is Hersh Cohen. He has managed the Legg Mason Partners Appreciation fund for the past 30 years. Over these three decades, his fund has done better than the S&P 500, the dividend-company benchmark index and the average return for large-capitalization stock funds. Cohen, who holds a doctorate in psychology, says he focuses on companies with “superior balance sheets and rising dividends.”

Cohen says his academic training helps him when the market goes to extremes. During such times he likes to go against the flow, cutting back when the market is euphoric and increasing his bets when others panic “and stuff is being given away.”

I’m not a fan of mutual funds. I think they’re terrible instruments, trapping investors into very narrow styles of investment long past the time when those styles made a buck. And I don’t think mutual fund managers are the sharpest tools in the investment shed. So when I see an exception, I try to point him out. Cohen is an exception.

If you’re interested in doubling your money every three years with very little risk, there’s only one way to do it. Invest in “best of breed” companies.

To your investing success,
Andrew

Source: Why ‘Best of Breed’ Investing Is No Passing Fad

Notes can reveal that the pre-meeting booklet for the meeting is predicting “either a prolonged, agonising depression that dooms the world to decades of stagflation, decline and poverty – or an intense but shorter depression that paves the way for a new sustainable economic world order, with less sovereignty but more efficiency.”

The environment we are headed into – and the view Mr. Market seems to (perhaps) be acknowledging now – is a classic combo of wearisome economic stagnation and creeping paper-fueled inflation. One acts as a fearsome headwind, blowing in the face of consumer-oriented names reliant on economic recovery to justify their newly bid-up valuations. The other acts as a powerful tailwind, further bidding up the price of inflation hedges and hard assets.

Justice’s trading service, Macro Trader, has a special recipe for this environment. If you’re interested in following Justice’s trading advice more closely, read on here.

Good day… Yesterday was a big day in St. Louis as President Obama came to visit on his 100th day in office. I can’t believe it has been 100 days since the inauguration. Time sure does fly! I’m sure Obama and the rest of his administration would like the calendar to move even faster as this recession will likely last through the end of 2009. While the government has thrown trillions of dollars at the markets in an attempt to turn them around, the key ingredient for recessionary cycles to reverse is time. There is now ‘quick fix’ for the problems we are in, and the policies the administration has begun will take time to have an impact on our shrinking economy. Obama said as much in his nationally televised press conference last night.

Speaking of shrinking economies, US GDP showed an even steeper contraction in the first quarter than that predicted by economists. US GDP fell 6.1% compared to the 6.3% fall during the last quarter of 2008. This drop confirms that we are now in the worst recession since the Great Depression. There report showed a record slump in inventories and further declines in housing. But another report released by the Commerce Department showed a surprising 2.2% gain in consumer spending in the first quarter, the most in two years. So we have consumers who increased their spending and confidence, while the US economy was contracting at near record pace.

Another report which didn’t get much press was the GDP Price Index and the Core PCE which are measures of price inflation. These numbers rose more than expected, with the GDP price index rising 2.9%, nearly doubling economists predictions of a 1.8% increase, and substantially higher than last quarters .5% rise. This sets up the possibility that we could see what many consider the worst case scenario, falling GDP with rising inflation (STAGFLATION). With inventories at very low levels, a slight increase in consumption can lead to a very quick rise in prices. But the Fed doesn’t seem to be bothered too much by that scenario, as they continue to focus on efforts to get the economy growing, with no apparent concern about inflation.

The Fed’s Open Market Committee voted unanimously yesterday to leave its target interest rate unchanged at between 0 and .25% (they really can’t go much lower!!). They also voted to continue to their purchases of long-term Treasuries and housing debt which they began last month. The FOMC statement said the contraction has slowed and the outlook “improved modestly” but the economy may “remain weak”. Job losses and a very tight credit market will likely inhibit consumer spending in the coming quarters.

As I said earlier, there was no mention whatsoever of an exit strategy on how the Fed plans to pull in the record amount of money supply it has unleashed on the economy. The Fed said they will continue to monetize the debt at an unbelievable pace: as much as $1.25 trillion of mortgage-backed securities, $200 billion of federal agency debt, and $300 billion of Treasuries. They are making these purchases in an attempt to keep interest rates at below market levels to fabricate a refinancing boom. While they have been somewhat successful in keeping rates lower than they would be under normal market conditions, these purchases are extremely inflationary and won’t be easily reversed. But the FOMC believes they will have plenty of time to worry about inflation and have decided to basically ignore it for now. Problem is, inflation can spike pretty quickly, and the FOMC will be hard pressed to raise interest rates just as the economy is starting to pull out of recession. I just don’t believe they will have the guts to be proactive with inflation, and will probably see a major spike in prices on the other side of this recession.

Inflationary concerns are at the forefront of the ECB as they prepare for next weeks policy meeting. ECB President Jean-Claude Trichet has imposed a gag order on council members as they argue over what to do next to rescue the European economy. Some members had been taking their cases to the media recently in an attempt to push the ECB into following the UK, US, and Japan down the quantitative easing path. But more conservative members don’t believe the ECB should use these untested methods, and are worried about the eventual inflationary impact of them. The ECB cut rates less than expected in April, and pushed a decision to use other methods off to next week’s meeting. Germany’s Axel Weber wants to make 1% the floor for the benchmark rates, and is against buying debt to pump additional money into the economy, while other council members want to begin asset purchases to force rates lower.

Data released this morning show Europe’s unemployment rate rose to the highest in more than three years, and inflation held at a record low, which will increase pressure for the ECB to continue to cut rates. The March unemployment rate jumped to 8.9% in the Euro area, and inflation held steady at .6% in April. Other reports released this week suggested confidence in Europe is stabilizing which could counter some of the pressure to take additional measures. Chuck will bring you the details of the ECB meeting, which will occur a week from today.

The dollar sold off on safe haven reversals, but then moved back up in European trading. So after a bit of a roller coaster ride, we are pretty much right where we started yesterday morning. But the overall market sentiment seems to be shifting back to dollar negative. Two separate reports released by currency trading desks yesterday revised their currency forecasts down for the US$. Bank of America (NYSE:BAC) – Merrill Lynch revised their forecasts for the dollar, yen, euro, and pound on the ‘rising probability’ the global recession has passed its lowest point. Their report stated the euro would recover faster than previously predicted as the global economy turns. A separate report by Citigroup said the dollar would fall if/when the 10 year Treasury note yields rise above 3.06%. Technical analysts at Citigroup (NYSE:C) wrote that past trading patterns look like they are repeating. “Buying the dollar and US Treasuries was the trade of choice toward the end of 2008 and is now unraveling,” they said.

Global deleveraging pushed investors back into US$, but as the global economy recovers (led by an increase in consumption in China), investors will move these funds out of this safe haven. Yield differentials will again determine investment direction, and growing economies will be able to attract more speculative capital. The US$, which has benefitted from the global downturn, will be sold. In order to protect your portfolio, investors should have some exposure to the currencies and metals.

One currency which has turned in one of the best performances vs. the US$ this week has been the Canadian dollar. The loonie touched the strongest level in two weeks on a move up in the price of oil. Equity markets are up, as investors have become much more confident regarding a global turn around. This confidence has carried over to the commodity markets, where oil and some of the industrial metals have been rising again. Canada relies on shipments of raw materials including oil, natural gas, copper, and lumber for more than half of its export revenues.

A report released by TD Securities, a large Canadian trading desk, predicted the Canadian dollar would appreciate by as much as 14 percent by November if it breaks through a key technical level. If the US dollar breaks below 1.1764 CAD$/$ (or above .85 UScents/CAD$) the upside opens up hugely over the next few months. The report puts a target of 1.04 CAD$/US$ (or .9615 US$/CAD$) for the loonie, a 14% increase from today’s levels.

As I touched on above, the commodity currencies turned in one of their best performances in weeks as the price of oil shot back above $50. Both Norway’s krone and the Australian dollar rallied along with the Canadian dollar. The AUD$ actually rose to the highest level in more than six months against the US$. The Norwegian krone, Australian dollar, and Canadian dollar are three of the best four currencies vs. the US$ on a YTD basis. The top performer vs. the US$ in 2009 has been the South African Rand, but recent rate cuts there may start eating into its recent strength.

South Africa cut its benchmark rate a full percentage point, the fourth reduction since December to help spur their economy. New Zealand’s central bank also cut rates to a record low yesterday. Reserve Bank Governor Alan Bollard reduced the overnight rate by 50 basis points to counter the nation’s worst recession in more than three decades. He indicated that rates may go lower, and will stay down for the foreseeable future. The kiwi sold off after the announcement.

Good economic news out of Japan has been rare, so yesterdays report that Japan’s factory output rose for the first time in six months was a surprise. And even more surprising was the fact that the pace of the output rise was nearly double that predicted by economists. Factory production climbed 1.6% in March from February, when it dropped 9.4%. In a separate report, the Bank of Japan said the world’s second largest economy will resume growth in 2010 after shrinking 3.1% this fiscal year. But I still caution investors regarding investments into the yen. The Japanese yen benefitted from the reversal of the carry trade, but global markets seem to be substantially less leveraged than before. The Japanese yen is not going to be able to benefit from another large push by additional deleveraging.

Got to go now, as we have our quarterly officers meeting in a few minutes. Sounds like it will be all good news, as EverBank continues to hit on all cylinders. It really is another Great Day at EverBank!!

Currencies today 4/30/09: A$ .7289, kiwi .5666, C$ .8383, euro 1.3263, sterling 1.4812, Swiss .8790, rand 8.4585, krone 6.5931, SEK 8.0664, forint 218.38, zloty 3.323, koruna 20.125, yen 98.15, sing 1.4775, HKD 7.75, INR 50.035, China 6.8210, pesos 13.74, BRL 2.1796, dollar index 84.49, Oil $51.81, Silver $12.62, and Gold… $889.20

Source: Shrinking U.S. Economy Puts Pressure on the Dollar

This from Money Morning:

The U.S. economy is entering a recession. With each day that passes and each indicator we see, that eventuality becomes more and more clear.

Even so, we can take some real comfort in knowing that we’re likely going to avoid the “bottomless pit” of a Great Depression II. A substantial recession with accompanying inflation – roughly along the lines of the downturns of 1974 and 1980-82 – seems the most likely scenario we face.

The last two U.S. recessions – the 1990-91 downturn touched off by Saddam Hussein’s invasion of Kuwait and the subsequent recession in 2001 – were both short and shallow, and perhaps even unnaturally so. Gross domestic product (GDP) declined by about 1.5%, peak-to-trough, in the first case, and a mere 0.5% in the second.

In 1990-91, the tax cuts and other structural changes made by President Ronald W. Reagan had increased the trend growth rate of the U.S. economy, so only the artificial drag of the savings-and-loan crisis brought a modest recession. In 2001, the U.S. Federal Reserve was expanding the money supply so rapidly, and dropping interest rates so far below the level of inflation, that what might have been a substantial downturn after the 1996-2000 stock market bubble was turned into renewed recovery led by the housing sector.

The Portrait of a Downturn

Thus, our experience of the last two decades, when recessions have been both shallow and short-lived, is not necessarily what we should expect going forward.

This time around, it is fairly clear the recession will be deeper than in 2001, and perhaps even worse than its 1990-91 counterpart. Retail sales were down 1.2% in nominal terms in September and industrial production was down 2.6%, while unemployment has already risen from 5% to 6%, with payrolls dropping more than 600,000 since the start of the year.  That suggests that an overall decline in output of considerably more than 1.0% to 1.5% is highly likely.

At the other extreme, and very thankfully indeed, we are highly unlikely to see The Great Depression – The Sequel. Creating the first Great Depression required a horrific stock-market crash, followed by several major policy miscues. Key among them:

• A huge increase in tariffs (The Smoot-Hawley Tariff Act of 1930) at a time when world trade was already in a fragile state, and trade barriers were much higher than they had been before 1914.
• A 30% decrease in the money supply caused by bank failures, which made prices drop 20%, made real interest rates correspondingly high and was a major cause of real GDP dropping 25%.
• A major tax increase at the bottom of a deep recession, taking the top marginal rate of income tax from 25% to 63%.

This time around, we have already bailed out the banking system, are increasing the money supply at a rapid rate, and are fairly unlikely to enact a major tax increase in the trough of a recession. And even if protectionism revives, we are unlikely to see a re-run of Smoot-Hawley (in any case, world trade remains very robust, indeed).

All these differences are protections against Great Depression II, and they should be sufficient. That’s not to say we aren’t still looking at a nasty inflation problem, which is a separate question.

It’s High, It’s Deep – and It’s Gone

To figure out how deep the recession might be, look at a few factors in the U.S. economy that have changed or need to change. The housing decline has wiped out about $5 trillion of the nation’s wealth, and the stock market fall has eradicated an additional $8 trillion; taking a reasonably pessimistic view of both would suggest a total eventual wealth wipeout of about $20 trillion.

Past studies have suggested that there is a “negative wealth effect” in a market crash, with an annual consumption decline equal to about 3% to 4% of the wealth wiped out: In other words, for each $100 a consumer loses, they will reduce their outlays by $3 to $4. That translates into a consumption drop of about $600 billion to $800 billion, which equates to about 4% to 5% of our current GDP.

To look at this another way, the U.S. payments deficit is now around $750 billion per annum, or 5% of GDP, and will need to be eliminated – or nearly so – since foreigners won’t want to go on pouring that amount of money into the U.S. market. That also suggests a re-balancing of U.S. trade by about 5% of GDP. This rebalancing will probably come partly from decreased consumption, which itself will reduce imports, and partly from a decline in the value of the dollar, which will increase exports.

Finally, the abysmal U.S. savings rate is currently around zero, or maybe 1% of GDP, and has historically been around 5% to 6% of GDP. This also suggests a switch from consumption into saving of about 5% of GDP, although that’s realistically probably a very long-term change.

Those factors all tend to suggest a GDP decline of around 4% to 5%, top to bottom. That would be a little more than the recession of 1974, or the “double-dip” recession of 1980-82 – each of which equated to about 3.5% of GDP. However, as occurred in 1980-82, the anticipated decline is unlikely to happen in one leg, but will probably take a “double-dip” form. That’s because interest rates are currently very low, far below the rate of inflation. Hence, inflation will probably accelerate, alleviating the housing problem (because incomes will rise approximately in line with prices, making housing more affordable).

Once home prices have bottomed out, and the housing market has stabilized, banks will resume lending more aggressively and the economy will move into a full-fledged recovery mode.

Where Are You Paul Volcker?

At that point, since interest rates will have been far below inflation for several years, inflation will have accelerated, and will be accelerating harder. Hence, a change in U.S. Federal Reserve policy will be needed – probably one that pushes short-term interest rates far above the rate of inflation, as then-Fed Chairman Paul A. Volcker did from 1979 to 1982, a painful-but-effective assault on inflation, that sent pricing pressures packing for two decades.

That will inevitably cause a second “dip” in the economy, but by this stage the housing and financial sectors will have stabilized, and the second “dip” will be focused on corporate profits and the “real” economy. Profits’ share of GDP, which has been at an all-time high recently, will decline to more normal levels.

That is an unpleasant picture. It is bad news for stock prices and it may take five years to work through, albeit with a likely mild “bounce” in the middle.

But it could have been much worse. It’s nowhere near as bad as the nightmarish Great Depression, or the long, drawn-out and relentless rolling Japanese recession of 1990 to 2003, which led to that country’s “Lost Decade.”

And for that we must be grateful.

Source: The U.S. Recession Will Be Painful – But it Could’ve Been Lots Worse

This tighter credit environment is hitting money supply. Last month, money supply actually shrank – it grew at under the rate of inflation.

Charles Delvalle at Investor’s Daily Edge says this means investors should now expect deflation to hit asset prices.

This echoes Bill Bonner’s recent warnings about the risks of a coming deflationary slump in the U.S…

This from Charles…

Over the past few years our money supply grew at a double-digit pace. Money supply growth is, according to Austrian economics, inflationary since it is essentially more money chasing the same amount of goods.

But was the Fed sitting in some dusty room, turning the printing press just to flood the market with money? Not really. The Fed doesn’t actually print money. What they do is encourage banks to lend or not lend.

Sometimes they add temporary cash into the market by the use of short-term loans. Other times they increase the money supply by lending the government more money. But the biggest way they control the price of money is by adjusting interest rates to stimulate or discourage lending.

Earlier this decade, the Fed encouraged lending by dropping interest rates to dastardly low levels. This spurred banks and lending institutions to drop their interest rates to encourage borrowing.

But the Fed isn’t this all powerful institution. Sometimes what the Fed wants is very different from what lending institutions want. And what happened this past year is a perfect example of that.

Since August of last year, the Fed has dropped their target rate by 2.25 percent. And while prime rates (the rate banks charge their best customers) went down to reflect that Fed adjustment, mortgage rates and credit card rates (at least with my credit card companies) barely budged. Even highly rated corporate bond rates soared.

So even with a lower Fed target rate, it’s actually more expensive for a corporation to borrow money than it was when the Fed tried to discourage lending with the target rate at 5.25 percent.

Sounds crazy, right? Why would banks not lower their interest rates if the Fed is basically begging them to do that?

Because banks are losing way too much money. They need to protect themselves. And since they are in a riskier lending environment, it would make sense that they charge more in interest to make up for that risk.

So why am I talking about all of this? Because this lack of credit is starting to hit the money supply.

Last month, the money supply grew under the rate of inflation. In real terms, that means the money supply SHRANK. And let me tell you, inflation doesn’t last too long when the money supply is shrinking.

What we’re getting ready to see is not inflation at all… but deflation.

Now honestly, I came to this conclusion very recently. I’ve been one of the most adamant about the need to tighten up money. But as it turns out, the Fed didn’t have to tighten the spigot; banks did it by themselves.

And while I’m not saying that inflation will go away, what I am saying is that inflation should – so long as the money supply continues to grow under the rate of price inflation – definitely take a step back.

We already see this deflation hitting commodities, some of which have dropped 50 percent from their peak. We also see it in housing, which in some areas have seen drops of as much as 50 percent from the peak. And now, we’re going to start seeing it spread a little more and more over the entire economy.

Will consumer electronics become cheaper? Or maybe big ticket items like refrigerators and washing machines? It’s tough to say. My best guess is that anything that sold well during the housing boom will now see sales slow. As sales slow and inventory grows, prices will be slashed and the general vibe of deflation will take over.

Like I said before, inflation isn’t going away. It isn’t dead by any means. But the effects of deflation will soon begin taking the bite out of inflation and should help bring it back down over the next year.

This whole thing about deflation was something that Robert Prechter Jr. called in his book Conquer the Crash. Robert is very big into Elliot Wave Theory (the theory that markets move in cycles along with the social mood). According to his analysis, this credit boom was set to implode right about now. And the unwinding might last until the next decade.

In the end, the thing you have to realize is that deflation is a phenomenon in the money supply that will affect prices sooner or later. There is no dispute that in real terms, the money supply of the US is flat and moving lower. That, dear reader is the very essence of deflation.

Some may try and come back to me and say “Are you off your freakin’ rocker you long-haired scumbag?! The Fed is printing money through its Term Auction Facilities!”

Not so. Money supply has steadily dropped this year, despite those lending programs. The Fed is just trying to keep the system from completely locking up, not inflating the money supply.

Others might say that international growth should prop up the global economy, keeping deflation from taking hold. Well, where would China be if demand in the US and Europe both drop? Plus, last time I checked China was readying an economic stimulus package. Now, ask yourself this: Why would they need an economic stimulus package if their economy were humming along?

The only thing that will help prevent this episode of deflation from getting worse is if banks decide to start lending.

Source:  A Shocking Development in the World of Money

Bill says households are feeling the pinch of both consumer-price inflation and asset-price deflation, which both destroy wealth. But it looks as though the threat of a deflationary slump is becoming more real every day…

“Wall Street, central bankers, economists, politicians – and most investors too – are betting on a soft landing,” said a friend from New York. “A slowdown in world growth has taken the pressure off commodity prices. Slower growth will help keep inflation down, generally. And as long as inflation is no problem, the Fed doesn’t have to raise rates – which will keep the slowdown from hitting too hard.”

Monday’s International Herald Tribune echoed the good news:

“World economies catch US malaise…pain of slowdown spreads far and wide, threatening businesses and growth.”

The world was growing at about a 5% rate in 2007. It’s expected to slip below 4% next year, with the U.S. economy at less than 1% growth. Since the U.S. population grows by more than 1% per year, this means a lower standard of living for the average person – at least in theory.

Of course, Americans need to accept a lower standard of living anyway. They’ve been living beyond their means for a long time; now they need to live beneath their means to correct the situation. In an economy dominated by consumer spending, this practically guarantees a long period of sluggish growth or recession – no matter what.

But it would be a lot easier to correct the mistakes of the past in a growing economy. Rising incomes would give consumers more room to cut back without too much suffering. Cutting back on falling incomes, on the other hand, is doubly painful.

A correction is unavoidable. The question for us, here at The Daily Reckoning, is: what kind of correction it will be? Will higher prices reduce the value of the dollar – reducing Americans’ incomes, savings and their burden of debt? Or will recession reduce their incomes and the value of their assets?

Whenever we have posed those questions in the past, the answer we have always given was: yes – Americans will get hit both by the jabs of inflation and the haymaker of deflation. So far, that is exactly what has happened. Prices are rising while asset values and incomes are falling. The average consumer is staggered by the blows.

The latest inflation figures show consumer prices rising at 5.6%. And the latest figures for producer prices show them going up at nearly 10%.

What is remarkable is that even with these numbers staring them in the face, investors still buy 10-year Treasury notes yielding less than 4%. Typically, bond investors are the most sophisticated investors. They’re looking at the global growth figures and believe that inflation rates will go down too. Average Americans may expect rising prices for food and fuel. But investors seem to have no worries on that score. You’d think they’d want at least enough yield to protect their capital. But at present rates, an investor in a 10-year Treasury will lose about 1.6% per year. Apparently, he regards that as a small price to pay for protection from falling asset prices.

Oil has already fallen from $147 down to $112. Gold dropped below $800. And with a sluggish world economy, there will be little push from labor rates, he reasons. Bond investors are betting that inflation rates will go back to where they were a couple of years ago – around 2%.

They may be right. But to us, it looks like a bad wager. Where is the margin of safety? What if inflation moderates to an annual rate of 2%? The long bond investor – were he to hold to maturity – would still make only 2.4% on his money. On the other hand, if he is wrong and inflation stays above 4.4%, he earns nothing. If it goes higher, he could be wiped out in a matter of weeks. We’re just guessing here…but the odds that sometime in the next 30 years inflation will rush up above 6%..or 7%…or 10%…are probably greater than the odds that you’ll be able to collect 4.4% for 3 decades and come out a winner.

We’re looking at the big picture…trying to see the large trends before they’re history. We’ve never quite mastered the art of seeing things before they happen, but we’re still squinting, trying to do it…

What we see coming, one way or another, is a fall in living standards. It can happen in one of two ways: either people lose their jobs and their incomes in a deflationary slump, or inflation makes their incomes and savings worth less.

So far, “both” has been the right answer. Our guess is that it will continue to be the right answer.

Yesterday, we saw a big drop in the Dow, more than 200 points. Worldwide, equities have lost about 17%.

More evidence of the slowdown appeared in Atlanta – where unemployment has hit a 16-year high – and in Southern California, where luxury houses in San Diego and Los Angeles haven’t fallen so much in 10 years.

Even more telling, bank lending has jelled to the point that the money supply is no longer increasing at the pace it had been. Until April, it was running at about 20% per year. Then, suddenly, the river dried up. Currently, the money MZM (a measure of the money supply) is only increasing at a 5% rate.

These circumstances have changed the headlines. Inflation is no longer making the news; now deflation is the story every paper tells. Inflation is yesterday’s news. Deflation is today’s.

For tomorrow’s headlines…we’ll have to wait a day…

Source: Spreading the Slowdown

“Inflation is way too hot and with housing way too cold, we have the opposite of a Goldilocks economy,” Joel Naroff, president and chief economist of Naroff Economic Advisors, said in a note to clients after two separate U.S. government reports were released.

The Labor Department announced that the producer price index (PPI) increased 1.2% in July on a seasonally adjusted basis, after an increase of 1.8% the month prior. Even more troubling, the year-over-year increase for PPI was 9.8%, the highest level in 27 years.

“It’s not a pretty number,” Stuart Hoffman, chief economist at PNC Financial Services Group Inc. in Pittsburgh, told Bloomberg News. “Today’s PPI is a bit of an echo and maybe a little bit of a rude reminder of how much of a problem inflation was in July.”

Even disregarding volatile food and fuel prices, so-called “core” wholesale inflation gained 0.7% in July, demonstrating that price increases are expanding beyond commodities and becoming more pervasive and widespread.

In a separate report, the Commerce Department announced an 11% decrease in housing starts, the lowest level in 17 years, with building permits seeing a similar decline.

Applications for new building permits, seen as a leading indicator of future construction, came in well-below economists expectations at an annual rate of 937,000. It was the lowest level since March 2008 and an indication that the housing market is still far from a recovery.

“It can be seen as a payback in June from the building code change in New York City. We may see another decline in August,” Dana Saporta, an economist with Dresdner Kleinwort Securities LLC, told Reuters. “The underlying trend is still downward. The fundamentals in housing are still poor.”

While the troubling inflation number would seem to indicate an interest rate raise is called for from the U.S. Federal Reserve and Chairman Ben S. Bernanke, the housing report underscores the softening U.S. economy.

“We all know what Mr. Volcker did in 1980-1981 when inflation got out of control: He nuked the economy by driving the funds rate to 20%,” said Naroff. “No one expects that to happen now, especially with commodity prices having come down quite sharply from their July highs.”

The recent dollar rally-fueled pullback in commodities won’t be enough to calm inflation worries, as it will likely take several months for the recent movements to lead to price declines in finished products.

A persistently weak economy will likely remain the focus for the next meeting of the Federal Open Market Committee, scheduled for Sept. 20.

Source: Soaring PPI Coupled with Plunging Housing Starts Spotlights Struggling U.S. Economy

They are basically a leveraged bet against inflation, says Bill. And as oil and food prices drop, this may be a good bet. Then again, it may not be

Either way, professional and amateur investors seem to agree on one thing: Stocks are a bad bet right now…

The yield on a 10-year Treasury note is barely above 4%. This puzzles us.

People are buying Treasuries for safety. Money markets, which hold short-term Treasury bills, are at record levels. We understand why you might want to have money in a money market fund…but where’s the margin of safety in a 10-year note paying less than the rate of consumer price inflation? Even in the money market funds, you’ll lose money when the dollar goes down – whether it goes down against other currencies or against consumer items. And what do you get in exchange for the risk? Not much. The 91-day T-bill rate is only 1.66%.

Currently the inflation rate – according to official statistics – is near 5%. Buying a 10-year note at a full percentage point lower is not a safe investment – it is a speculation, a bet on the direction of rates in the future. If they go …the value of the T-notes goes down.

Lately, that’s begun to look like a reasonable bet.

“Falling prices ease worries about stagflation,” says a headline in the International Herald Tribune. Oil is down about 15% from its peak. Food has fallen a similar amount. Could it be that inflation has topped out? Could it be that the “civil war” between inflation and deflation is finally reaching a conclusion…with deflation the clear winner?

Could be. Then again, it could not be.

“The question for investors is whether the slump in oil and commodity prices will last or is simply a temporary retreat brought on by overstretched increases,” continues the IHT. If the increase in prices won’t last, we can all forget about girding our loins for the fight against inflation. We can simply buy Treasury notes and wait for the current downturn to pass, right?

Maybe. Maybe not.

Meanwhile, investors are selling stocks short at record levels. The pros think stocks are a bad bet. This puts the stock market under a lot of tension. A rally to the upside can be explosive, as the shorts need to buy in order to cover their positions. On the other hand, the pros may be right; deflation is a big threat to stocks. The amateurs may be right too – they’re moving to cash and bonds.

Cash is probably a good move. You’re protected against defaults and write-downs. And you can take cover if inflation gets worse. Moving to bonds is another matter. They are a leveraged bet against inflation. And yes, for all we know inflation is dead forever. But we wouldn’t want to bet on it.

Source: The Daily Reckoning