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Supply-Side Quantitative Strategies: 3Q2005By Dr. Arthur B. Laffer In last quarter's quantitative Strategies paper (4/5/05), we highlighted four issues that have recently been the focus of attention: the high price of oil, inflation, the trade deficit and the weakness in the value of the dollar. Each of these issues is often treated as a unique distinct threat to the health of our economy, but in fact they are all directly related with oil prices being the "golden thread" connecting all of them.
As we expected, we have seen stabilization in the value of the dollar. In fact, over the past three months the dollar has appreciated 3.5% and 7.5% versus the yen and the euro, respectively. This stabilization will continue-the fall in the value of the dollar is done. In addition, over this same period we have seen modest declines in the rate of inflation (from 3.0% to 2.8% year/year) and the trade deficit (from $58.1 billion to $57.0 billion). Yet the price of oil has risen (from $57.01 to $60.73), so these measures have not yet benefited from the "double whammy" effect that will occur once the price of oil begins its inevitable decline. Oil is a globally traded commodity that is no different that any other, and therefore its price reflects the relative strength of currencies. Yet the effect of the recent strength of the dollar on the dollar-measured price of oil is being masked by other factors, keeping the price of oil sky high. From my perspective, oil prices are way above their long run equilibrium levels; however, that doesn’t mean they can’t stay way above for a long time. While the $60 per barrel price is the highest ever in nominal terms, it was a lot higher in real terms in the early 1980s (see chart).
But at the prices we're seeing today, substitution effects are starting to take hold. Consumers, intermediate producers and basic producers are all trying to figure out a way to economize on the use of oil. They will succeed. Suppliers are also trying to figure out how to augment supplies of oil. They too will succeed. The longer the high prices persists, the bigger will be the markets reaction and the further the oil price will fall once the fall begins. In the meantime, we have to wait. There are two issues I'm concerned about regarding oil. First, what will be the U.S. GDP effect of continued high oil prices? I don't think it will be all that great, but I am concerned, especially, if we don’t see some relief in the next few months. I don’t want demand for oil reduced because of a recession! But believe me, a recession would drop the price of oil like a stone. Just look at what happened in the early 1980s. Second, I worry about the effect on expensive oil on China. China is the world's high volume, low cost producer of products, and as such oil costs are a larger share of total costs in China than they are in the U.S. Prolonged high oil prices and stupid U.S. policies, such as an appreciated yuan or tariffs on Chinese imports, could significantly impact China’s economy and destabilize a country that is critical to our efforts to secure global peace. Fortunately, on fronts other than oil, things couldn’t be better. Read GDP has grown at 3.0% or higher for eight straight quarters; we are experiencing record profitability; low interest rates and falling inflation expectations are providing an environment conducive to growth; and government revenues are beating all expectations.
Focus on Equity Classifications Policies impact asset values. Macroeconomics matters for investors of all shapes and sizes. Classifying equities into policy-driven and economic-driven categories yields a powerful portfolio management strategy. Exchange rates, tax policies, regulation, interest rates, etc., all have profound impacts on a stock's value. Macroeconomic events may at first appear far removed from the everyday practical world of companies, products, profits and stock prices, but those who choose to ignore the effects of taxes, inflation, exchange rate changes and the like do so at their own peril. Knowledge of various equity classifications and how they react to macroeconomic shocks can lead to superior investment performance. The stock market may be significantly undervalued at present, but a decision to increase one's equity allocation is only the first part of the investment process. Knowledge of the behavior of the various equity classifications can lead to increased portfolio returns. (See Macro-500 Stock Forecaster, page 5). Republican control of all seven "political power positions"
and the numerous pro-growth policy actions that are being considered
for the next three years are very bullish for the stock market and
pro-growth stocks in particular. We continue to heavily favor economic
growth stocks as we enter third quarter 2005. Despite the fact that
the dollar has stabilized and even strengthened over the past six
months or so, given the shift in the U.S. terms-of-trade and the
resulting remarkable decline in the dollar that occurred over the
past two years, it is inevitable we will soon see a dramatic decline
in the U.S. trade deficit as U.S. goods and services become more
competitive in the global economy. A shift in the U.S. terms-of-trade
of the kind we have seen will dramatically benefit traded goods
industries and import substitute industries relative to non-traded
goods industries. In addition, given our forecast of long-term interest
rates to continue to trade in a narrow (low) band, we are neutral
with respect to falling and rising interest rate stocks. Finally,
we are continuing our moderate weight on small cap stocks. |
