An Unrepentant Financial Sector

What's wrong with the economic picture as we get to the end of 2010? There's a wide divergence of opinions about inflationary expectations. Looking at economic statistics, we don't see where non-monetary, demand-induced inflation is going to originate. We've always looked at the core inflation statistics, namely excluding food and energy prices. However, research from the Cleveland Fed has shown that focusing on this series alone reduces the power of inflation forecasts. Its Median CPI, or trimmed CPI, shows inflation rates on a trailing twelve month basis at 0.5%. Taking their approach to extract the forecasts embedded in financial asset prices, they come up with an expectation of 1.5%. Again, there are no alarm signals here.

Yet, the Treasury market has really tanked in December, and it's been reflected in the breathtaking drops in some of the best known bond mutual funds, including Pimco Total Return and Harbor Bond, also advised by Pimco. Both funds employ the "shake hands with the Government strategy" taken early in the crisis by Pimco, and consequently both funds are replete with government obligations. In some measure, though, this is the reversal of a few weeks ago when Treasuries rocketed in the wake of the Irish debt crisis and a flight out of the Euro. This latest move down is seen as a signal of higher expected inflation, but it seems hard to read higher inflation in the tea leaves based on this latest move in bond funds.

So, we believe there is almost no pricing power for manufacturers in the face of diminished consumer interest and limited consumer buying power in developed markets, apart from those consumers buying Louis Vuitton (lawyers, investment bankers and Keith Richards). The financial sector is virtually unaffected post-crisis, and there is even some optimism for near-comatose patients like Citi. The Financial Reform Commission has been an abject failure, and both parties are supplying duelling narratives about what caused the crisis.

In the meantime, on the real side, companies remain flush with cash and there is talk about a strong M&A market in 2011, probably driven by foreign buyers in US and European markets. There is precious little investment in new manufacturing capacity to pursue future growth in profits and employment. Share buybacks get the CEO's headlines, and not investing in the core businesses.

We've said this for almost three years now, but until the financial sector stops wagging the dog and the US manufacturing sector reinvents itself, it's difficult to imagine what will drive a durable recovery, a reduction in unemployment or a meaningful acceleration of inflation.