Summer's Market Issues Jude Wanniski June 23, 2004

The latest concern about getting a corporate tax bill passed by July 23, when Congress breaks for the Democratic convention, is the arguments being raised at the White House that it might be better to let the process gridlock through Election Day. With legislation having passed both houses, it should be going to a conference committee by the end of this week, thus giving enough time to work out differences. However, both parties now are thinking of how to maneuver for political gains in the presidential as well as congressional elections. We are relatively sure that the hurdles ahead are hurting the equity market, which we think have discounted the near certainty of the bill’s enactment, given the World Trade Organization (WTO) penalties that continue to pile up every month.

The markets will not collapse without the legislation, but enactment would bolster the demand for liquidity and fairly quickly dispose of the arguments that inflation is still cooking. Gold should be at $385 or lower if odds favored enactment by July 23 –- not $395 –- and the economy would continue growing at a pace that would further promise benign inflation statistics through the summer. We should not mind a minor deflation resulting from tax cuts that increase productivity, and one or two quarter-point increases in the funds rate during the next year would not be calamitous. By far, the best way to curtail inflationary impulses is by increasing the demand for liquidity through tax and regulatory measures that invite economic growth, not interest-rate increases aimed at choking off growth deemed inflationary. 

Right now, the December Fed funds contract is pricing in 100 basis points of rate hikes by year-end. If higher rates that come as fast as the futures market now predict do weaken the economy, they might more than offset the expansion still underway. Demand for liquidity would slide, pushing the dollar/gold price up and inviting calls for even higher rates to stamp out inflation. All the chatter we hear on Bloomberg about “a natural” funds rate of 4% makes us uneasy, because it is utter nonsense and yet seems to have the attention of a number of Fed governors. Today’s yield curve is practically ideal and could be held indefinitely. Japan finally is on a growth track, even as its overnight rate still is close to zero.

The second big summer issue -- the price of oil –- is linked to the first. The Bureau of Labor Statistics (BLS) separates out food and energy prices as "core inflation." They had to make this arrangement after the dollar floated in 1973 because commodities move too swiftly to be meaningful for policy guidance. Yet every item counted in "core inflation" has an energy component that cannot be stripped out by statisticians, and $37 oil will be in the CPI for many months. With gold under $400, oil has to come down eventually to regain its traditional relationship at 15:1. It does not work the other way, because the dollar/gold price is almost entirely determined by the Fed and the oil price is a derivative of that.

The temporary gap in the ratio will close by a few dollars if geopolitical risks subside this summer, hopefully with better news from the Iraqi oilfields and relief from concerns that al-Qaeda has penetrated the Saudi Aramco organization. The remaining problem is the tiny excess world capacity. If the Saudis extract all the oil that they pledged to produce, the only excess capacity left in the world will be out of government petroleum reserves. With rapidly increasing demand, there is no reason to expect any substantial price relief in the very near term. The higher price, though, will steadily cut into demand, as businesses and households around the world cannot afford to consume as much energy. Marginal businesses fold and households switch to substitutes -- lower thermostats, heavier clothing and smaller cars.

George Yates, an independent producer in New Mexico and a longtime Polyconomics client, sees a similar picture on natural gas in the period ahead for the U.S. market: "I expect gas to sell for the btu equivalent of oil plus a premium based on weather (hot weather will cause electric demand at the same time that the LDC`s are trying to fill storage). If the weather is hot this summer, we could see a substantial spike. The only mid-term relief to this are substantial imports of LNG which are constrained by the same groups that will not let us drill on non-park public land and a pipeline from Alaska, which will not provide much relief until the end of the decade. Of course, any decline in oil prices will affect the gas market as well." The price ratio of oil to natural gas is 6.0/bbl. to 1 million cubic feet (mCBF).

The political conventions this summer could provide fresh influences on the direction of Wall Street. If so, they would have to begin with more inspired platform planks at the Democratic convention in Boston than we have seen so far from the Kerry campaign. His most specific commitment on economic policymaking so far is to raise the minimum wage to $7 per hour from $5.35, but even there he waffles by saying the $7 would not take effect until 2007. If the economy continues to grow at its current pace, a $7 minimum would have little effect by 2007 as few employers would be able to attract workers for less than that rate. However, this proposal is indicative of the cautiousness in the Kerry campaign on economic issues, now that he sees the economy is not falling into the pits as Democratic economists predicted several months ago.

We have not seen any big new economic ideas surface from the Bush Administration yet, but we detect some background noise that big new economic ideas are being pondered. On his book tour, President Clinton was asked what his biggest policy regrets were in his eight years. He was quick to reply that he failed to reform health care and Social Security. These are issues out there for both parties, but neither have been seriously addressed yet, except in the most vague terms. One supposes that they will be in these summer months along with all of the above. In any case, after all the slicing and dicing of the issues, we still believe that the market will move higher in this period as the positives still outweigh the negatives.

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