[Texgreen] The US economic prognosis for 2007

Thu, 28 Dec 2006 08:47:22 -0600

[Stagflation. As an economic policy wonk, this all seems pretty  
reasonable to me. Not that it will necessarily play out this way, but  
it beats the other scenarios I've seen. I have decided that Asia  
Times has the consistently best grasp of geopolitics of any source I  
know about and its all made public. They must have a fantastic  
editor. -- Roger, Austin]

<http://www.atimes.com/atimes/Global_Economy/HL23Dj01.html>

Global economy faces a dangerous year
By Jephraim P Gundzik

Rising inflation and falling home prices are likely to push the US
economy into recession by the second half of 2007. Gathering economic
weakness, combined with negative real yields on US Treasury
securities and growing political pressure to weaken the dollar will
lead to significant dollar depreciation against most currencies.

Economic growth in Asia, Europe and Latin America will also weaken in
2007. Slowing global economic growth will be very bad news for equity
markets around the world. Dollar depreciation and rising
international energy and grain prices will be good news for precious
metals.

Impact of instability on commodity prices

While global geopolitical instability has ratcheted higher every year
since the terrorist attacks on the US in September 2001, global asset
markets have hardly responded. In 2006, many of the world's stock
markets, including America's, reached record highs. As geopolitical
instability increases further in 2007 the probability of major
disruptions in energy supplies will grow.

Instability in the Middle East and Africa is very likely to increase
in 2007. Intensification of Iraq's civil war, conflict between
Washington and Tehran, escalating war between the Israelis and
Palestinians, and growing domestic pressure on Lebanon's US-backed
government will heighten instability in the Middle East. This
instability will help fuel growing unrest in Sudan, Chad, Congo and
Somalia, provoking significant military conflicts in Africa.
Afghanistan's insurgency is also expected to become more violent,
prompting the gradual withdrawal of NATO forces.

Unprecedented global geopolitical instability will have its most
obvious impact on international commodity prices. More frequent
energy supply disruptions in the Middle East and Africa, combined
with accelerating natural oil production declines in the world's
largest oil fields, will keep crude oil and natural gas prices
buoyant. Slower than anticipated global economic growth will not push
oil prices lower in 2007.

Production discipline - much greater than generally understood -
among the world's major oil exporters will ensure oil supply growth
remains below demand growth. The continued rise of global energy
prices in 2007, paired with growing demand for renewable energy, will
produce further strong increases in international grain prices. In
2006, corn and wheat prices in the US jumped by 70% and 60%
respectively. Much of this jump occurred between September and December.

Rapid growth of ethanol production capacity worldwide has contributed
to this leap in corn and wheat prices. Prices for soybeans and other
oilseeds have also begun to head higher on the back of rapidly
growing global demand for biodiesel fuel. The substantial increase in
petroleum-related energy prices since 2001 is only one factor behind
growing demand for biofuels. Increasingly stringent environmental
regulations, energy security concerns and targeted levels for
alternative energy use in many countries is also driving demand for
biofuels.

Inflation and recession

The growing use of corn, wheat, soybeans and other grains to produce
biofuels is expected to nearly double prices for these commodities in
2007. In addition to grain-related foods, prices for other food
staples that are grain-dependent, including meat and milk products,
will also head higher in 2007. The result will be much higher than
expected US inflation. Consumer price inflation (CPI) in the US is
already significantly higher than CPI in Germany, Switzerland, the UK
and Japan. In 2007, US inflation will accelerate, widening the
inflation gap between it and other countries.

By every measure, inflation in the US has clearly accelerated since
2004. In 2005, the Federal Reserve's preferred measure of inflation,
the personal consumption expenditure (PCE) deflator exceeded 2% for
the first time since 1995. The core PCE has continued to accelerate
in 2006, and will likely top 2.5% by the end of the year. This is
significant because the Fed's stated aim is to keep core PCE between
1.5% and 2%. The steady acceleration of core PCE shows that inflation
from rising energy prices has penetrated the broader US economy.

Despite the obvious acceleration of inflation, the Federal Reserve
shifted monetary policy into neutral in late summer. The Fed has
justified more accommodative monetary policy in the face of rising
inflation by suggesting that slowing US economic growth will
eventually mitigate inflation. This is a huge gamble because US
inflation is being pushed higher by supply-driven energy price shocks
rather than demand. In 2007, continued energy supply shocks are
likely to feed a grain supply shock, stoking a sharp increase in food
price inflation and further acceleration of core PCE.

The stated logic behind the Fed's monetary policy change is spurious,
to say the least. A 12-year-old child could grasp the idea that
energy supply problems are pushing US inflation higher and that these
supply problems are likely to intensify in 2007. This suggests that
another explanation must be behind the Fed's shift to more
accommodative monetary policy. The most likely seems to be growing
concern among Fed policymakers over  ncreasing systemic problems for
the US financial system arising from the collapse of the US housing
market.

Between 2001 and 2005, very low interest rates in the US, combined
with the proliferation of non-traditional mortgage products and easy
credit access, allowed many American households to convert
substantial home price gains into income gains through cash-out
mortgage refinancing. Cash-out mortgage refinancing accounted for
about 50% of all mortgage refinancing between 2001 and 2004. In 2005,
cash-out mortgage refinancing accounted for 73% of all mortgage
refinancing. In the first half of 2006, cash-out refinancing
accounted for a staggering 87% of all refinancing.

Home price appreciation in the US slowed sharply in the first half of
2006. In the third quarter of 2006, home prices began to fall
steeply. According to data from the US Census Bureau, new home prices
dropped nearly 10% in September 2006 from the same period in 2005.
This marks the sharpest fall in US home prices in 35 years. Rising
inventories of unsold homes have been pushing home prices lower.

Recently, America's largest home builders and home sellers have begun
trying to convince investors and home buyers that the housing market
has stabilized. Falling long-term interest rates have reduced
mortgage rates, encouraging a very small number of buyers to return
to the market. However, the housing sector's weak pulse is very
likely to vanish again in early 2007 as confusion over Federal
Reserve policy mounts, the pace of inflation quickens and financial
markets in the US swoon.

America's economic fairytale has turned into a nightmare and very few
investors realize it. In addition to producing a sudden and sharp
decline in household income by eliminating the prospect of new
mortgage refinancing for many Americans, declining prices for new and
existing homes will have a strong negative impact on the US financial
system, severely restraining credit growth. Falling home prices,
especially in what were once the hottest housing and mortgage markets
in the US, have caused mortgage default rates and foreclosures to
surge higher.

The combination of rising defaults, foreclosures and falling
collateral values is beginning to weaken the balance sheets of
mortgage lenders, including several of America's largest banks.
Growing weakness in the banking sector is very alarming. Banking
sector and economic crises in many countries over the past 25 years
can be traced to overly enthusiastic credit growth used to finance
either capital investment or real estate speculation, or both. Japan
offers a stunning example of what can happen after a real estate
bubble bursts.

The Federal Reserve appears determined to let financial markets "self-
correct" in order to adjust interest rates to changing expectations
for economic growth and inflation. Self-correction is a defining
feature of financial markets. However, with the Fed rudderless, it is
very unlikely that this self-correction will occur in an orderly and
gradual manner. Rather, such self-correction will be sudden and sharp.

Dollar devaluation

Growing concern at the Federal Reserve over the impact of rapidly
rising mortgage defaults and foreclosures on the US banking system
will prevent it from tightening monetary policy in 2007. Inflation in
the US is already substantially higher than inflation in Europe and
Japan. Rising energy prices joined by rising food prices will have a
greater impact on inflation in the US than in Europe and Japan
because dollar depreciation is expected to partially offset rising
dollar-based commodity prices in 2007.

In addition, inflation will rise from a much lower base in Europe and
Japan than in the US. As a result, US inflation will be much higher
than inflation in most other countries in 2007. More importantly,
real yields on US Treasury securities, which are only marginally
positive now, are expected to become negative in 2007 as US inflation
climbs higher and the Fed begins to cut interest rates.

At the same time, real yields on European and Japanese government
bonds, which are already higher than real yields in the US, are
expected to move higher. The growing real yield gap between the US
and other countries will place enormous downward pressure on the
dollar. Waning Fed credibility and increasing political pressure in
the US for dollar depreciation will speed the dollar's decline.

Democrats will take control of the US Congress in January 2007.
Democrats have a strong history of economic intervention and are very
likely to use trade and exchange rate policy changes in an attempt to
reinvigorate rapidly slowing US economic growth. Asia's economic
giants, Japan and China, are likely to take the brunt of any economic
policy changes engineered in the US Congress.

Legislation in the US aimed at prying open export markets in Japan
and China is likely to inflame already substantial trade tensions,
especially between Washington and Beijing. Meanwhile, the implicit
change in US exchange rate policy that will precede such legislation
will increase downward pressure on the value of the dollar against
all major currencies, particularly the yen.

The dollar is likely to depreciate by at least 20% against the yen,
the Swiss franc, the euro and the pound in 2007. The dollar will also
depreciate against the currencies of emerging market commodity
exporters. Finally, Beijing will probably allow the yuan to
appreciate about 10% against the dollar. Rather than political
pressure from Washington, continued high energy prices and soaring
grain prices will motivate the revaluation of the yuan.

Sliding stock markets

Economic growth in China is likely to slip towards 6% in 2007.
Beijing's enormous fiscal latitude will ensure that ramped up fiscal
spending will partially offset significant weakness in China's US-
oriented export sector. Accelerated yuan revaluation against the
dollar will help offset the inflationary impact of rising energy and
grain prices. Economic growth in Japan will probably fall below 1.5%
in 2007 due to export sector weakness. In addition to importing all
of its energy needs, Japan relies on imports of US corn for
sustaining domestic meat production. This reliance on energy and
grain imports will encourage the Bank of Japan to push the yen higher
against the dollar to contain inflation.

Economic growth in Korea should slow towards 1% in 2007. Growing
tensions between Washington and Pyongyang will undermine private
consumption and investment while much weaker US- and China-bound
exports will slow export sector growth. Like Japan, Korea is also a
major importer of US corn. Won appreciation against the dollar will
be limited by growing security concerns. As a result, inflation will
accelerate, further undermining the won.

Economic growth in South and Southeast Asia will also slow sharply.
In addition to slowing US economic growth, increasing global
geopolitical instability will lead to more frequent and violent
terrorist attacks, especially in India, Indonesia, the Philippines
and Thailand. These attacks will produce further political and social
instability. Foreign capital flight, driven by much slower than
expected economic growth and a sharp correction in US equities, will
make these countries Asia's worst investment performers in 2007.

Economic growth in Latin America will also suffer from the US
downturn in 2007. Mexico, where political and social instability are
expected to increase substantially while US-bound exports grind to a
halt, should follow the US into recession. Capital flight will weaken
the peso, preventing exchange rate appreciation from offsetting the
impact of sharply higher corn prices on the domestic food industry.

Economic growth in Brazil, Colombia and Peru will also slow sharply
in 2007. Brazil's export sector will benefit from soaring grain
prices, while Colombia and Peru will suffer from the same. Equities
in all four countries will follow US equities downward. Economic
growth in Venezuela, Ecuador and Argentina will benefit from soaring
commodity prices. This will not prevent equity market correction, but
should underpin exchange rates in all three countries.

With the notable exception of Turkey, economic growth in Europe
should suffer the least from slowing US economic growth in 2007.
Monetary policy in the EU will tighten further, underpinning currency
appreciation. Economic interdependence between EU members will
insulate the region somewhat from slowing economic growth in the rest
of the world. Russia will benefit from rising commodity prices.
Despite more promising economic prospects, equities across Europe
will follow US equities in a sharp correction.

Bond markets around the world are likely to be very volatile in 2007.
Rapidly changing economic growth and inflation expectations will
produce wide price swings. This volatility will be led by US bonds,
which will see falling yields in early 2007 be replaced by rising
yields in mid-2007 as inflation increases and foreign capital flight
accelerates. Spreads on emerging market bonds will widen with falling
equity markets around the world. Commodities, including energy,
grains and precious metals, will probably perform much better than
traditional investment assets as both investors and central banks
speed diversification.

Jephraim P Gundzik is president of Condor Advisers. Condor Advisers
provides investment risk analysis to individuals and institutions
worldwide. Visit www.condoradvisers.com for more information.