The Hokey Pokey was a tune popularized by bandleader Ray Anthony in 1953 and played at school dances across the country for decades. Last September, a full three months before Christmas, Wal-Mart Stores slashed the price on Fisher-Price’s newest dancing doll (Hokey Pokey Elmo) a full 22% below that of its large competitors and well below the cost of smaller competitors. This caught Wal-Mart’s primary competitors (Toys “R” Us and Target) by surprise, but parents loved the lower prices. Let’s face it, we all love lower prices. Just think of how we surf the web for the cheapest airline ticket, hotel reservation, or computer. It’s all about cost vs. benefit. That’s why eBay is so successful. And why Wal-Mart is now ubiquitous!

THE WALMART ECONOMY

Last year, 82% of American households made at least one purchase at a Wal-Mart store. In household staples such as toothpaste, shampoo, and paper towels, the company commands about 30% of the U.S. market and analysts predict that its share of many such goods could hit 50% before decade’s end.(1) Suppliers’ growing dependence on Wal-Mart is a “huge issue” for the U.S. economy according to one retail consultant. To suppliers, Wal-Mart’s relentless pricing pressure is a mixed blessing. The company dictates not only delivery schedules and inventory levels but also heavily influences product specifications. Critics suggest that Wal-Mart’s intensifying global pursuit of low-cost goods is partly to blame for the accelerating loss of U.S. manufacturing jobs to China. Last year, Wal-Mart accounted for a tenth of total U.S. imports from China. According to a recent Wall Street Journal story, Wal-Mart “has been demanding rock-bottom prices and forcing factory bosses to cut costs any way they can in order to remain in contention for export orders.” But getting lower prices out of China hasn’t been that difficult over the past five years. Although China is one of the world’s busiest manufacturers, it still suffers from a lingering production glut. The high level of investment of the mid-1990s in China lead to a rapid expansion of productive capacity. (Fixed asset investment will exceed 42% of GDP in 2003). Although the decline of Asian currencies in 1998 caused export prices to fall, it is the Wal-Mart effect that has continued the trend of deflating consumer goods at U.S. stores.

THE CHINA SYNDROME

According to official statistics, China’s GDP in 2002 and thus far into 2003 has been growing faster than any major nation. However, GDP growth is estimated by some analysts to be considerably higher than the “official” numbers. This could be the reason that recent consumer inflation for China was its highest in six years (2.0%). October was the tenth consecutive increase of the index, driven by soaring food and healthcare prices. Lending growth surged year-over-year by 23.6% in October as well. Even though the People’s Bank of China instituted a sharp rise in short-term rates last summer, we believe that 2004 should be another year of excellent growth. As excess capacity is used up, it sets the stage for even higher rates of inflation and resulting changes in policy decisions. The current weakness in the dollar has exacerbated the Chinese inflation picture because most of the commodities it imports are denominated in U.S. dollars. And since the Chinese currency (yuan) is pegged to the U.S. dollar, the insatiable demand for imported goods is costing more than before. Eventually a decision should be made on the exchange rate regime. We believe a decision could be made as early as mid-2004 to begin a gradual revaluation of the yuan so that by the 2008 Olympics, the currency will float freely or be pegged against a basket of foreign currencies. (This does not mean that the yuan would necessarily float upwards vs. the dollar. The International Monetary Fund recently said that there is no evidence that the Chinese currency is substantially undervalued.) These moves will eventually reduce Asia’s accumulation of foreign exchange reserves and reduce their need to buy greenbacks in the form of U.S. Treasury debt. However, the recent U.S. protectionist rhetoric has caused China to cease buying our Treasury debt over the last few months.

As China’s internal inflation rises and as its exchange rate begins to float (probably upwards) vs. the U.S. dollar, the Wal-Mart effect will in essence be greatly tempered. U.S. import prices for consumer goods (excluding automobiles) have steadily risen over the last year. By 2005, import prices could be increasing by 1% in contrast to the small decline experienced over the last twelve months. By the time those product prices are marked up and paid for by the consumer, the increase might be 2%. The U.S. consumer price index is comprised of two key components: commodities (i.e. goods such as food and automobiles), which account for about 40% and services (such as medical care), which account for 60%. Over the last twelve months the services component increased 3.2% while the commodities component increased only .5%. (See Chart 1) Much of that low rate of inflation was due to a 4.3% decline for new and used motor vehicles and a 4.1% decline in information processing. Eventually, those commodity prices could be rising at the rate of 2% later next year and into 2005 as import prices and domestic prices begin to rise at faster rates. The last two lines of the lyrics of the Hokey Pokey refrain are “you turn yourself around, that’s what it’s all about”. And that’s what will happen to import prices. Will the same hold true for U.S. interest rates?

GREENSPAN’S GREENBACK

One of the great mysteries of economics is how to forecast foreign exchange rates. There are so many moving parts that economists have had difficulty in making accurate projections. Suffice it to say that relative growth and relative interest rates are the key variables. But psychology also plays a role. A few months after 9/11, just after the President’s 2002 State of the Union address, the U.S. dollar began to weaken vs. the euro and the yen. As we mentioned in our January 2003 commentary, (see ‘The Good, The Bad, and The Ugly’), there are immediate benefits to the bottom lines of U.S. multinational corporations due to foreign exchange translation effects, i.e. a weaker dollar. Furthermore, there are international competitive advantages that accrue with about a two-year time lag. So a weak dollar is not all bad. On the other hand, a weakening dollar can change the demand preferences for U.S. Treasury debt. With the U.S. running a record current account deficit on the order of 5% of GDP, we are more dependent on the world for capital than at any point in the last fifty years. Most central banks (other than the Bank of Japan) have been recent sellers of U.S. Treasury debt. Japan continues to be the major purchaser of our Treasury debt in order to support the yen, but this policy should eventually give way to a neutral yen policy. Some analysts (Goldman Sachs) believe that the dollar could fall 20% from current levels (it has already declined 10.5% since its peak). At some point the Treasury may suggest to the Federal Reserve that it should defend the greenback by raising short-term rates. This probably won’t occur until 2005, but at that time it will then become Greenspan’s greenback

THE HIDDEN INFLATION

Over the past few years inflation has been relatively dormant. When one looks inside the index, however, a different picture emerges. As we mentioned before, the commodities (or goods) part of the CPI accounts for 40.8% while the services component accounts for 59.2%. Just 13 years ago, the services component accounted for 54.7%. By 2010, it could account for 65%. And this is a critical “index creep” that should not go unnoticed. In January of 1999, the Bureau of Labor Statistics introduced a geometric mean formula for calculating most of the components of the CPI. This allowed the Bureau to combat the effect of “substitution bias” in the index. The geometric mean formula is more appropriate for use in categories in which the consumer may alter his or her spending in response to changing prices within that category. Additionally, the Bureau is updating expenditure weights every two years and is scheduled to do so again next month. We suspect the “service” weight will be increased then and again in 2006. Let’s see why this could be important.

CONSUMER PRICES INDEX (CPI-U)
Year/Year Change

If we presume that the falling dollar and/or foreign inflation will impact import prices for these goods to some degree, it will (eventually) impact commodity prices. If those three industries, which account for almost 38% of commodity prices were to revert to mid-1997 inflation rates (assuming a 1.1% decline for communications (computers) which was not being measured at that time), then the overall inflation rate would have been 2.3% in October. If commodities were to revert to their 1992-2001 average inflation rate of 1.9%, and the weighting for services increased to 61% by 2005,then overall CPI would increase to 3.0%! The prospect of such an event would certainly get the Fed and the “bond vigilantes” worrying.

The CPI has been helped over the past few years by a strong dollar, the trend to foreign outsourcing, and incredibly good labor productivity at home that translates into declining unit labor costs. There have been no cost pressures to “push” prices higher, but that may be coming to an end. The primary driver of commodity type CPI prices has been unit labor costs. (See Chart 2). We expect these unit labor costs to rise from -1.3% this year to +1.1% by 2005 and that will put modest upward pressure on that portion of the CPI. In the longer term, however, as the demand for services increases (and its relative weighting within the CPI increases), there could be significant cost-push inflation by the end of the decade. The outlook provided by one analyst was that “goods and services that retirees want - notably in the health care, leisure and services industries - probably will experience material inflation. And these higher costs should be reflected in higher wages, which will be needed to attract workers to the professions that serve the expanding population of retirees.” (2)

POST ELECTION BLUES

As investors discovered in 1994, it is not the inflation rate that should be feared, but the fear of inflation. It wasn’t until the fourth quarter of 1993 that the Federal Reserve Board began to raise short-term rates. Inflation never became an issue before, during, or after this period of rising rates. It was the fear of inflation and the very positive yield curve that left the market exposed. The relationship between anticipated inflation (tracked by the Philadelphia Fed) and BAA corporate bond yields is at a low point, so there is room for expectations to increase before interest rates experience any upward pressure. On the other hand, we do believe that over the next six quarters, long-term interest rates could move up 100 basis points or more for corporate bonds with an even larger increase for Treasuries. (This equates to a 13% price decline, some of which would be offset by interest income.) However, nothing of significance will occur until Greenspan feels comfortable about raising the Federal funds rate. We don’t believe there will be a significant upward bias until after the October 2004 election. By 2005, the Fed will then have enough information to warrant raising rates again.

John K. Dolan
Brian E. Schaefer

S&P 500: 1064
December 10, 2003