Spend, Spend, Spend!

It’s been another gut-wrenching week, as seemingly unrelenting declines culminated in the S&P 500 closing at its lowest level since 1997 on Thursday. And things looked bleak earlier today until a spectacular rally took hold in the latter half of the afternoon. The Dow Jones Industrial Average and S&P 500 both gained more than 6 percent on the day, while the Nasdaq was up more than 5 percent; a nice pullback from what appeared to be sure losses.

Despite sharp moves upward, there was no making up the losses from earlier in the week: the Nasdaq was off 8.7 percent from a week ago; the S&P 500 tumbled 8.4 percent; and the Dow Jones Industrial Average lost 5.3 percent.

Inflation concerns are beginning to ease, mainly because plunging food and energy costs are pushing down various inflation gauges. The producer price index (PPI), a measure of the prices manufacturers and wholesalers pay for materials, plunged 2.8 percent in October on a month-over-month basis--the largest decline since tracking began in 1947. Excluding food and energy, the PPI crept up another 0.4 percent, showing that falling raw material costs have yet to feed through to other products.

The consumer price index (CPI) also declined, falling a greater-than-expected 1 percent for much the same reason. That again sets another record, marking the largest drop since tracking began in 1947. The so-called core CPI, the Fed’s preferred inflation gauge which excludes food and energy costs, declined an unexpected 0.1 percent, its first decline since 1982.

Both inflation measures remain elevated on a year-over-year basis. The PPI rose 5.2 percent and the CPI was 3.7 percent; excluding food and energy the increases were 4.4 percent and 2.2 percent, respectively.

These sharp declines, coupled with slowing pace of inflation over the past few months, have begun to raise worries about deflation. That comes just as the idea that we’ve reach peak credit, the point at which there’s essentially no more money to lend, is beginning to gain traction. Despite a falling London Interbank Offered Rate (LIBOR), banks are opting to hoard cash rather than lend it out. In a way, that makes sense: Most consumers are already so overextended that the last thing they need is more loans and, in an environment of falling demand and consumer spending, there’s little reason for most businesses to borrow money to expand.

So how do we check deflation? Inflation is typically fairly easy to fight assuming demand remains relatively constant; you raise interest rates to discourage borrowing, and governments issue bonds to encourage saving. Hence you have fewer people and their dollars chasing the same amount of goods.

Deflation, on the other hand, is much more insidious, particularly in this environment. Many banks still don’t want to lend and consumers are hesitant to spend, favoring instead to hang onto cash or pay down debt. In a healthy economic environment that’s exactly the type of behavior that should be encouraged, but facing a recession with deflation nipping at its heels, it’s a recipe for disaster.

As distasteful as it may be, from both a political and economic standpoint, the best answer right now is for the government to spend, spend, spend. And that shouldn’t be too hard; that’s what governments, or at least ours, tend to do best.

Perhaps one of the easiest ways to do that is to issue direct rebate checks to taxpayers, as the government did earlier this year. Unfortunately, although a lot of that money did make its way into circulation, a large portion went to paying down debt or just getting socked away and not really serving the hoped-for purpose.

A better way to get money back into the hands of the people is through benefits to the neediest people. For instance, this morning President Bush signed an extension of jobless benefits, none too soon given this week’s jobless numbers. Initial claims spiked to 542,000 from a revised 515,000 in the prior week, with the data showing job losses across wider spectrum of industries and states. Continuing claims also rose, despite being forecast to decline, up to 4.012 million from 3.903 million. That puts jobless claims at their highest levels since 1992.

Extended benefits make sense from a political standpoint--it’s never popular to let people starve--and from an economic perspective: If you’re giving out cash, give it to those who need it most and are most likely to send it right back out the door.

Other benefits we’re likely to see boosted as the Congressional regime changes and a new presidential administration takes office are federal spending programs such as Social Security and or the Dept of Agriculture’s food stamp program. Welfare-like programs such as food stamps are a mixed bag politically, but giving more money to seniors is almost always popular--at least with a key voting block. It also puts money into the hands of those most likely to send it right back out the door.

That creates opportunity for us as investors. Knowing that these types of moves by the government are likely and that commodity prices are falling, it makes companies such as Kraft Foods (NYSE: KFT), Campbell Soup (NYSE: CPB) and General Mills (NYSE: GIS) even more appealing from an investment standpoint. As consumer staples, they tend to exhibit a bit less price volatility, would most likely see increased sales with the expansion of federal spending programs and will enjoy improved margins going into the first quarter of 2009. They all pay at least a bit of a dividend to boot.

There was a bit of goods news from the manufacturing sector in October, with industrial production rising 1.3 percent and capacity utilization at 76.4 percent, up 0.9 percent. Unfortunately that’s not indicative of production growth, instead reflecting the effect of refineries getting back up and running and the breaking of the strike at Boeing (NYSE: BA).

Further signs of a tightening supply in real estate over the coming months came out this week, with both housing starts and building permits falling in October. New starts fell by 37,000, with construction beginning on 791,000 new homes nationwide. Issued building permits, a measure of construction set to begin over the next few months, fell by 12 percent, down to 708,000 from 805,000 in September.

Mortgage applications fell 6.2 percent during the week ending Nov. 14, despite falling interest on fixed-rate mortgages. The average rate for 30-year fixed-rate mortgages fell to 6.16 percent from 6.24 percent; 15-year fixed-rate mortgages declined from 5.9 percent to 5.87 percent; one-year ARMs rose to 6.8 percent from 6.77 percent.

Finally, the Conference Board’s leading indictors gauge fell 0.8 percent, and six of the indicators 10 components declined, suggesting that both consumers and businesses have been cutting back. Consumer confidence and housing sentiment were the largest drags, as respondents don’t expect housing prices to recover anytime soon and remain worried about their employment prospects.

The overall data continues to show extreme economic weakness, though opportunity remains. And plenty of opportunity continues to lie abroad, as my colleague Yiannis Mostrous wrote about in the latest issue of his free e-zine, Growth Engines:

The most positive story of late has been the massive stimulus package China announced recently. I posted initial comments on the plan to the At These Levels blog. As I’ve mentioned here quite often, China is trying to bolster its own economy and can’t save the Western financial system and cushion it against the changes it’s going through.

It’s clear that the turn toward socialist-oriented solutions forecast here and here is now becoming reality. US authorities are in full socialization mode, where the capitalist model is being thrown out of the window. Look at the actions, not the words. The more irresponsible a company or individual has been during the past 10 years, the better its chances of being saved. Even the grotesque US automakers will be bailed out, for the nth time.

Market mechanisms were only used on the upside, with the US Federal Reserve providing the proverbial punch bowl during its “golden days” under the charismatic leadership of the Maestro. The results are well known now, and the state has to come to the rescue.

True, we’ve reached a point where very few alternatives are available, and the state hasn’t many options. But being an advocate of free markets, it’s been devastating for me to witness that free market mechanisms weren’t given a chance to adjust the exuberance of the past eight years.

That said, every major market bottom has seen social changes taking place, and the present will prove no different. When we’re done with this crisis our economic life won’t be the same.

The importance of the China package is that the country’s leadership has finally acted in a synchronized way to make sure the economy will be cushioned on the downside.

The repeal of the credit quota system will allow banks to lend again, even though the economic slowdown will hurt some of the potential credit demand in the short term.

It is therefore good to see that loan growth ticked up last month in China to 14.6 percent to USD27 billion for the month of October.

The prevailing thinking these days though regarding China is that the “story is over” because the country won’t be able to withstand a global recession next year, and that its growth will collapse as exports suffer.

But China is following through on a plan that was mapped out years ago. In the short term, Chinese authorities are stepping in to support consumption and have committed to infrastructure spending as a means of keeping growth in 2009 of around 7-8 percent.