Paulsen's confident premise that higher mortgage rates will be a reflection of higher growth and higher wages (rather than a Fed-engineered effort to deflate a housing bubble) seems dubious at best. His projected $40 oil price is a "non-speculative-trader, non-political-unrest premium, non-weather-related" one, and his reading of labour income and employment growth and consumer confidence is more sanguine than the consensus. No disputing his identification of the refi phenomenon as the new ingredient which has kept the economy growing - to date. ------------------------------------------- The Bionic Recovery
Interview with Jim Paulsen, Chief Investment Strategist, Wells Capital Management By SANDRA WARD Barron's October 17, 2005
STOP WRINGING THOSE HANDS. The longtime chief investment strategist of Wells Fargo's Wells Capital Management, the institutional investment-advisory firm of the bank that manages $165 billion in client money, sees plenty of reasons why economic growth will stay surprisingly strong and the good times will keep rolling. This view, of course, isn't widely shared. But then Paulsen's career has been distinguished by a brave individualism and a knack for knowing when the economy would zig while others predicted a zag. He's proven to be an ace at forecasting interest rates, was early in discussing the merits and risks of deflation to the U.S. economy, and correctly turned bullish just as the bear market was bottoming in 2002. He's not been so right about the direction of the long bond. But, hey, he's only human -- and an economist to boot. Nonetheless, strong profits, solid balance sheets and a still-sturdy consumer keep this nearly 25-year investment veteran singing a happy tune
Barron's: Were you surprised that the Fed raised rates after Hurricane Katrina?
Paulsen: Not at all. If you look beyond some of the short-term developments related to Katrina, the undertow of this economy is very strong. At 3.75%, the federal funds rate has finally retraced the crisis discount that had existed. Earlier in the decade, the configuration of the yield curve moved from around 3.5% to 1%, and that was clearly out of bounds in its relationship to the long-bond yield in the post-war era. The only thing comparable is the Great Depression. After the Great Depression short rates went up for 10 years without long rates even moving.
Part of the reason long rates haven't responded is because the Fed hasn't really been tightening for the last year, just retracing. The Fed now has short rates where they normally go in the pit of a recession. Now is when the tightening begins. We've got some inflation indicators. We've got 3.5%-4% real GDP [gross domestic product] growth, and 15%-20% profit growth, almost 2% job growth, 9% to 10% retail sales growth. The Fed will want to raise rates again, given what's happening to headline CPI [consumer price index] numbers. They are going to go way up. In the next few months, we'll probably have a year-over-year CPI rate that's 4%-4.5% to 5%, which means the entire Treasury yield curve from three months to 30 years could have a negative real yield. Everybody worries that the Fed is being overly tight and restrictive, and within a month or so, we can have the entire yield curve at a negative real yield. It's hard to say that's restrictive. Even the funds rate at 3.75% is a negative real-funds rate.
So, what about the slowdown that's supposed to be coming?
The problem with the slowdown story is it seems centered on two things: oil prices and Fed tightening. Not that they aren't negative forces, but they are way overestimated in terms of their restrictive impact. There is a huge missing element to this interest-rate cycle, which is unlike any other, at least in the entire post-war period. No one mentions it very often. The Fed can do all it wants to the short end of the curve, but it hasn't moved long rates at all.
That's the "conundrum," isn't it?
It used to be three steps and stumble. We're already 11 steps and going, and what's the deal? In the past, you have to ask, was it the Fed raising short rates that shut the cycle down, or was it the fact that when the Fed raised short rates, long rates went up also, killing the cycle? If the latter is the case, then in essence we haven't done a darn thing to shut this economy down.
What's different this time?
The one variable in the past 15 years that has been the most important and dominant driver of the economy is mortgage rates. The word "refi" didn't exist prior to 15 years ago. And here we are, worrying about a little move in the short rate from 1% to 3.75%, still negative in real terms, when we haven't done anything to the rate that matters: the mortgage rate. It tells me there isn't much check to the cycle here. There's $350 billion of fiscal stimulus in the system, with another $50 billion-to-$100 billion coming. There is still a dollar 25% to 30% lower in the last two to three years and that's feeding through to the trade numbers. Oil prices are a negative, but they are less of a negative when you look at the historical record. Energy costs in consumer budgets are about two-thirds of what they were in the late 'Seventies; they're 5.5% or so versus 8.5% of budgets then. Also, in the past, oil spikes didn't kill you. It was everything else that happened when oil went up. Today, you pay your $2.50-$3 for gas and you are kind of mad at that as you go back to your vehicle. But, as you are driving home, you go, 'Gosh, look at these new auto-sticker discounts,' and then you stop off at Best Buy and buy a new digital camera for $19.99. You stop by your mortgage broker and refinance, and by the time you get home, you're way ahead. The OPEC crisis of the 'Seventies didn't shut the system; it was that when gas was going up, mortgage rates were also going up, and prices of consumer goods were going up, too.
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The consumer will likely stay okay until somebody raises mortgage rates. It's been proven pretty convincingly that you can take away the stock market, jobs and tax cuts, screw up health care and Social Security, and do whatever you want to the consumer -- just don't mess with his mortgage rate. Until somebody does, the consumer will continue to be fine. In some ways, the consumer might be stronger now than in the rest of the entire cycle.
What? What about plummeting consumer-confidence?
Prior to Katrina, levels were about as high as those measures get, with the notable exception of the dot-com boom. The level of consumer confidence is about the same as it was at the high-water mark from 1970 until the late 1990s. Consumer confidence is plummeting now, but how could it not be after watching 24/7 coverage of Louisiana? Those confidence measures should pop back up. Outside of consumer confidence, annual real labor compensation saw 6% growth in the last year. There's been record high household net worth, with or without a house. We've got retail sales that are at the upper end of the last 15 years, with year-on-year growth close to 9% to 10%. Unemployment pre-Katrina is under 5%. Almost 2½ million jobs were created in the past 12 months, more than we've had in many years. There is a lot to like there. Not only that, but the consumer has proved over and over again since 2000 that he is not on his deathbed.
Do you expect mortgage rates to stay low?
Well, no. They will go up. But it won't be as if they go up and the consumer dies the next day. It will take a while. Also, mortgage rates don't go up in isolation. They go up because growth is better. If mortgage rates go up, wages will, too. If mortgage rates go up so will job creation, so will income growth. Once they're up, that's when higher rates could start to create more issues for the consumer down the road.
What's the other surprise that will keep this recovery going?
Corporate balance sheets are phenomenally strong. I'm looking at some of the best balance-sheet ratios for Corporate America since the early 1960s. They have tons of cash flow. They are sitting on a boatload of dry spending powder. There is this asset on the books of Corporate America that could be spent, which could drive a capital-spending boom at some point.
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And you're expecting oil prices to drop?
Yes. Oil went up $20 in the two-three months prior to Katrina. Once Katrina hit, oil didn't go up anymore. Indeed, it came off and that tells me oil prices were already speculatively overextended going into that crisis. Rita blew through and didn't wreak as much damage as people feared and now oil is lower still. I'm not an oil expert. I don't intermittently know the supply-and-demand parameters of oil within the world. But I have looked at a ratio of the price of oil to non-oil commodities and that ratio, at least in the 'Seventies, 'Eighties and 'Nineties, was in a nice, fairly tight range. What we've done is blown far above that in this last cycle, and oil is much more extended relative to other commodities than it has been historically. If it were to trade back into that range, oil could be supported in relation to other commodities at about $40. That's what I would guess is a more fundamentally based price of oil. That would be a non-speculative-trader, non-political-unrest premium, non-weather-related price of oil. That would still be up substantially from where oil has traded, and it is up for the reason people suggest: better global growth. But the fact that no one has built capacity for years is the same story that could be told about any of the industrial commodities -- copper, tin, steel scrap, aluminum and so forth -- and they're all up, too. just not as much.
There are decent odds that the oil and energy complex comes off, and we will still be quite a bit higher at the end of the day like other commodities. That could improve the consumer story and it could have a direct positive impact on equity markets because of the strong negative correlation of oil prices and stock prices throughout this cycle. The other surprise is: The Eurozone economies pick up. The beautiful thing about this recovery compared to the one in the 'Nineties is that the U.S. isn't the growth leader, nor is it the sole engine anymore. This recovery looks much more sustainable to me than the one we had in the 'Nineties for that reason.
Why Europe?
The Eurozone is growing at about 1% in real GDP terms, down from about 2% a year ago. The question is why did it slow and why might it speed up? The Eurozone slowed in the last year because they raised long rates and tightened the money supply, and the currency got stronger in the previous year. Now, long-bond yields have gone down, money supply has accelerated and the euro has weakened.
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