23 June 2008

UP AND DOWN WALL STREET  

No Place to Hide

By ALAN ABELSON

A seasoned pro sees a global shakeout in equity markets.




THIS ISN'T THE 1970S; ERGO, INFLATION IS NOT A WORRY.

We find that sentence freighted with interest, and not only because we wrote it. What's intriguing, as well, is that it contains two clauses, one of which is indisputably true, the other as clearly a non sequitur as you could ever hope to come across.

What's also striking about the sentence is that it offers a striking example of how economists think (or, at least, make a pretense of doing so) and why their perceptions are often so alien to what's actually going on.

There's no record of the brilliant soul who discovered this isn't the 1970s, so we can't offer our congratulations. Too bad, really, because it matches in perspicuity the venerable observation that when people are out of work, unemployment results.

Except for the calendrically challenged or the hopelessly infected with incurable nostalgia, no one would likely take exception to the remarkable insight this is not the '70s. Somehow, though, it doesn't ineluctably follow that because this is 2008 and not, say, 1978, we needn't shiver before the specter of inflation.

In fostering that notion, its numerous proponents, whether leaning left or right philosophically, triumphantly cite as proof labor's present emasculated state compared with the prowess it possessed three decades ago to score huge wage increases that provided tinder for the inflationary flames.

No quarrel that globalization in particular has exerted enormous competitive pressure on working stiffs from their counterparts who labor for a pittance in faraway lands, compelling once truculent unions to ask rather than demand at the bargaining table. Nor that, in consequence, paychecks are not, as in the '70s, spiraling wildly upward.

But so what?

Where, except in standard economic texts, is it written that inflation comes in only one flavor? That without exploding wage costs, what naifs like us call inflation doesn't meet the definition of inflation?

As it happens, our trusty dictionary, in fact, defines inflation as: "A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of goods and services."

Granted that dictionaries are the handiwork of people who are exacting about words and their meanings and not by professional economists, for whom even their native tongue is always a second language. But that quote perching in the paragraph above is not a bad description of what's happening out there in the real world, in contrast to the fantasy land where denizens of academe, Wall Street and Washington cavort and gambol.

We'll forgo once again listing the various and sundry conjuring tricks used to make inflation officially invisible and content ourselves with brief notice of a few of the more egregious ones. Like, of course, banishing oil prices from the anointed inflation measure -- the sacred mythical core -- because they're too "volatile."

Volatile means wide and frequent changes up and down. The price of crude has risen for six and a half years in a row, from $20 a barrel to $135 barrel, and during this extended span it experienced only one rather brief and relatively modest decline worthy of mention.

That's volatility?

Food prices -- which you may have noticed have been on a tear for quite a spell now and, according to the latest consumer-price index, rocketed upward in May alone -- are also conveniently excluded by that purposively myopic crew from their pristine reckonings of inflation because of volatility.

Add to the more serious sins of the no-inflationiks a tendency to overlook or shrug off the inexorably mounting cost of health care. Analyst Shiria Sum of Goldman Sachs, however, in a commentary released on Friday makes no bones about the painful bite rising health-care costs are taking out of the increasingly pinched consumer.

Last month, medical services were up an unhealthy 4.7% over the same month a year earlier. Moreover, Sum points out, anyone unlucky enough to have to check into a hospital had to fork over as much as 8.3% more than a year ago. And together with prescription drugs, hospital services account for nearly half John and Jane Q.'s medical outlays.

But, hey, the consensus among any number of economic wise men who are never in doubt and rarely right is that there is no inflation. And, on reflection, we're forced to concede that maybe there isn't -- unless you're one of those silly types who insist on driving, eating or getting sick.

DENIAL WILL GET YOU ONLY so far. That's true for inflation (even Ben Bernanke, of all people, is turning a bit green these days at the mere mention of the word). It's true of the economy at large (even President Bush seems to have vaguely sensed that the economy isn't what he cracked it up to be). And, as last week made emphatically clear, denial -- much less delusion -- just won't cut it when you're confronted by a big bad bear breathing fire from its flaring nostrils and nary a tree in sight to climb.

As we've been muttering aloud it seems like forever, the recession far from being over hasn't really gotten up a head of steam yet. The credit crunch, crush, crisis -- whichever you prefer -- is still very much with us and, by whatever name, doesn't give the slightest indication of packing it in. Very much the contrary, as the fresh drubbing administered to the banks, brokers and other assorted and often sordid financial outfits strongly suggests.

Credit for at least two decades has been what made our world go 'round, and suddenly somebody pulled the plug and it was gone. And gone, too, are the fabulous bubbles and booms that it so generously fed, leaving a horrible mess that we're nowhere near mopping up.

What the stock market is belatedly waking up to is that the much-heralded and more fervently hoped-for second-half recovery isn't going to happen. That housing may have another ugly, maybe longer decline ahead of it before it's close to a bottom. That unemployment, despite all the gimmickry used to disguise the real numbers, will continue its doleful push higher.

And as if all that weren't enough to make you hop the next shuttle to the moon, comes now S. Dewey Keesler to warn that "the global bear market in equities" triggered by our very own subprime credit mess "is now entering its next phase." A phase, he thinks, that will see the emerging markets transformed into submerging markets, an unwelcome change that will encompass the so-called BRIC quartet -- Brazil, Russia, India and China -- as well a full complement of the smaller fry.

Dee, as his intimates call him, is an extraordinarily bright and low-key chap, who has under his belt about 25 or so enormously successful years as a global investor. He was a founding partner back in 1986 of Oechsle International Advisors, which, as its moniker subtly hints, invested abroad, primarily for big institutions, including the endowment funds of top-notch (read: rich) universities. He eventually left to form his own shop, Boston-based SDK Capital.

Emerging markets are an accident no longer waiting to happen but very much in progress, he says, and while the severity of the further declines vary (Shanghai, for example, already down 50% from its peak, still has a long way down to go), they're all vulnerable. In the months ahead, he warns, "the concept of global economic decoupling will be thoroughly exposed as a naive fantasy." And we say amen to that.

He blames misguided monetary policies that tied the developing countries' currencies to the U.S. dollar and prevented them from controlling their interest rates. Thanks to the Fed's serial rate slashing in its effort to stave off a cataclysmic credit collapse, inflationary pressures were mightily increased in the developing world. Negative real interest rates and burgeoning money supply, Dee cautions, are destined to stoke overheated economies and kite inflation still higher.

To make matters worse -- which is what governments universally do when they find themselves in a pickle -- efforts to keep the masses calm in the face of rapidly rising food and energy prices have proved costly and counterproductive, yielding shortages in gasoline, diesel fuel and food (so what else is new?). This approach, Dee reports, is being pretty much abandoned, which, in the short run, is sure to mean more inflation.

There's no way out for developing nations, he believes, but to adopt more stringent monetary policies, "which means higher interest rates and stronger currencies" and, inevitably, a sharp economic slowdown.

Investors who have been counting on more of the vigorous earnings growth that attracted them to emerging markets in the first place are in for a very big disappointment. Such expectations, Dee declares, "will be crushed." The great unwinding of emerging markets has just begun, he avers, "with much carnage still forthcoming."

For financial markets in developing countries the vicious cycle he sees unfolding will bring pain aplenty issuing from lower multiples on lower earnings. As we intimated, Dee knows foreign markets, and especially the emerging ones, inside out, and he has come up with more than his share of winners to prove it. We haven't the slightest hesitation in urging you to pay close heed to his forebodings.

We might add that given the big chunk of U.S. corporate profits that flows in from the rest of the world, the prospect of a global shakeout doesn't exactly dissipate our own, more parochial forebodings about the market back here at home.


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