This note was originally published at 8am on June 27, 2011. INVESTOR and RISK MANAGER SUBSCRIBERS have access to the EARLY LOOK (published by 8am every trading day) and PORTFOLIO IDEAS in real-time.
“When one door closes another door opens; but we so often look so long and so regretfully upon the closed door, that we do not see the ones which open for us.”
-Alexander Graham Bell
Keith is both back home in Canada this week. He is taking some family vacation time at his cottage on Lake Superior and I’ll be back in Alberta with my family later this week as well. For the first few days, it will be Uncle Duty for me as I apply my risk management skills to babysitting my two nieces and nephew (ages 9, 7 and 5, respectively). After that I will be headed to my hometown of Bassano, Alberta to celebrate its one hundredth birthday. That’s also a long winded way of saying I thought it was apropos to start this morning’s Early Look with a quote from one of Canada’s most famous sons, Alexander Graham Bell.
While Bell received many patents during his long career, the most famous by far was patent 174,465. This patent was issued by the U.S. Patent Office on March 7th, 1876 and covered:
“. . . the method of and apparatus for, transmitting vocal and other sounds telegraphically . . . by causing undulations, similar in form to the vibrations of the air accompanying the said vocal or other sound.”
This was, of course, the patent for the telephone. The majority of us would consider this the second most important communication related invention after the iPad (that was a joke.)
The basis of Bell’s invention was that he replicated sound waves electronically. The precursor to this was discovering the nature of sound and how it travelled. Like many discoveries related to the physical sciences, the foundation of the telephone is based on certain immutable laws of physics.
The physical sciences of course stand in stark contrast to social sciences, in particular economics. While generally agreed frameworks exist for studying economics, immutable laws are much more difficult to come by. This is an important point to consider when studying statements from preeminent economists, especially those tasked with setting monetary policy.
As the Federal Reserve provides us more transparency with press conferences and in releasing their internal projections, the fallibility of economics has become increasingly obvious.
Our research team has spent the last few weeks meeting with some of our top subscribers around North America. As usual, the discussions were lively and thoughtful. One of the key ideas that we've been floating, which has generated a significant amount of debate, is the idea that the next move by the European Central Bank could be to lower interest rates, instead of increasing them. This view is actually in contrast to the most recent statements by the ECB.
On June 9, 2011 the ECB stated the following in their monthly statement prior to Q&A with ECB President Trichet:
“On balance, risks to the outlook for price stability are on the upside. Accordingly, strong vigilance is warranted. On the basis of our assessment, we will act in a firm and timely manner. We will do all that is needed to prevent recent price developments giving rise to broad-based inflationary pressures. We remain strongly determined to secure a firm anchoring of inflation expectations in the euro area in line with our aim of maintaining inflation rates below, but close to, 2% over the medium term.”
While this is only an excerpt, the gist of the statement overall is that the main risk to the European economy is in not being diligent on inflation. Therefore, the general consensus is that the ECB will continue leading the Federal Reserve in tightening monetary policy. The Hedgeye Consensus is slightly different.
While the Federal Reserve has continued to ease in 2011 via Quantitative Easing, in contrast, the ECB has both raised its benchmark interest rates by 25 basis points in April of 2011 to 1.25% and, as outlined above, continued to talk hawkish as it relates to future policy. From our perspective, there are a number of factors that will likely cause the ECB to alter their rhetoric and potentially cut rates this year. These are:
1) Accelerating sovereign debt issues – We’ve been early on global sovereign debt issues and continue to remain pessimistic on an orderly resolution, particularly in Europe. A Greek debt restructuring seems all but a foregone conclusion. Meanwhile, Spain and Italian yields continue to widen versus benchmark rates, specifically 10-year Spanish yields are now at 5.7% versus 4.5% a year ago and Italian 10-year yields are at 5.0% versus 4.1% a year ago. As it relates to Spain, the impact of the collapse of its real estate bubble continues to be felt and El Confidencial is reporting this morning that Spanish banks may have $50BN in unrecognized problematic real estate loans.
2) Inflation in Europe may be close to peaking for the cycle - Eurozone CPI was at +2.7% in May year-over-year, which was a sequential deceleration from +2.8% in April. While certainly only one data point, this sequential decline in inflation will be increasingly driven by a Deflation of the Inflation, as evidenced by the CRB Index now being down -0.8% for the year, and tough compares in late 2011 / early 2012. Collectively, CPI should gradually decline over the next couple quarters, and perhaps even start to look like deflation.
3) Economic growth set to sequentially slow – Similar to the Federal Reserve, the ECB provides economic growth projections for the Euro area. Also similar to the Federal Reserve, those projections have proven to be inaccurate and often backward looking. Currently, the ECB’s GDP projections for the euro area are for 1.5% - 2.3% in 2011 and 0.6% - 2.8% for 2012. From our perspective, these growth projections will likely have downward bias.
Collectively, we believe these factors will make it difficult for the ECB to raise rates in the short term and, if anything, we see bias to easing emerging. Of course, this does stand in stark contrast to ECB President Trichet’s recent statements, but as it’s famously been said about economists:
“The economy depends about as much on economists as the weather does on weather forecasters.”
Daryl G. Jones
Director of Research