Baby New Year 2005 - Set to Deliver Knockout Punch

(SEATTLE) 12/31/04 – While there has been quite a bit of speculation concerning the effect of the weak dollar on US corporate profits and employment, specific evidence has now emerged—and the result isn’t what many expect. Indeed, US stock markets have rallied significantly through the fourth quarter--in the face of a dollar that has fallen since October.

Since the dollar has fallen, there has been little sign of a noticeable pickup in hiring. What’s going on? The best answer comes from US companies—and is outlined in a “Special Question” in a recent Federal Reserve report. (1) That question asked the effect of a falling dollar on business. According to the report, over half of the respondents said higher input prices would have “some” or “substantial” negative effect on business. Moreover, the net effect of a lower dollar leaned towards negative, not towards positive, as many stock enthusiasts believe. Keep in mind, many input prices have been run up to historically high levels, due in part to an extended period of low US interest rates.

As well, a case in point--on December 30th, Alcoa Inc., a Dow Component, got an earnings estimate cut of over ten percent for the current quarter, based on “high energy, resin, and caustic soda prices as well as the significantly weaker U.S. dollar.” Yet Alcoa is likely only the first of many disappointments in store—a number of other Dow companies have supply contract and hedging arrangements, which expire with the New Year. How are companies responding to increased costs? Well, according to the December 30th Chicago ISM report, input prices were still at lofty levels--even while the employment sub-index contracted.

So clearly, a notion that inflation is running jobs out of the US is supported by not only multiple business surveys, but by the direct example of Alcoa. Moreover, the problem of inflation is suddenly multiplied with the New Year, as companies other than Alcoa are suddenly subject to higher prices as hedging run out. But trouble doesn’t stop there. Many companies, including the likes of General Motors and Caterpillar, rely on finance profits, which in turn are precipitously balanced on low interest rates and low inflation. These companies are so dependent on finance, in fact, Baby New Year is poised to deliver a “one, two” knockout punch to corporate giants, wearing only the “newborn gloves of economic reality.”

The 2005 baby stops crying abruptly, however…to a lullaby of sharply higher interest rates. Without that, he is sure to grow quickly into a terrible delinquent.

(1) Philedelphia Federal Reserve Bank, 12/2004

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