From jobs to inflation: between a rock and a hard place.

DURING 2002 and 2003, the world's central banks--the US Federal Reserve in particular--laid the groundwork for significant inflation as they desperately tried to revive faltering economies and prevent the onset of deflation. But as the economic recovery began to take hold, investor attention has quickly turned to the potential for inflation.

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ONE ONLY NEEDS to look to the significant rises in all manner of commodity prices to see that reflation is taking hold and will eventually work its way into consumer prices. And once inflation takes hold, it just can't be turned off overnight. This implies an extended period of rising interest rates that the US market is already trying to discount.

The US market is now between a rock and a hard place. If US job growth were to actually accelerate to the levels ostensibly needed by George W. Bush's reelection campaign to ensure a win in November, the Fed would quickly change its tune about being "patient" on interest rates and its monetary policy stance--particularly because the bond market would lead the way--selling off by discounting the next stage of price rises seen in commodity markets to the next level of the supply chain. Indeed, the blowout US jobs number for March sent shock waves through the US bond market that are still being felt. Investors feared that the Fed would move to a tightening mode at its FOMC meeting in May. Moreover, this will be only the first volley in the coming war on inflation.

US bond yields have fallen from their peaks in 1999, the year before the tech bubble burst. US bond yields already bottomed out in May 2003, and they are now making their way to more "normal" levels (i.e., levels that assume inflation, not the deflation that was such a concern in 2003). An overheating stock market was soaring in 1999 with rates at 6.8 percent, so interest rates per se, especially the first or second tightening move, probably, will be more of a vote of confidence by the Fed in the US economy than a sign of trouble.

But the assumption that the FED is poised to move on rates is incongruent with another assumption, which is that the global economic recovery is nearing a peak. This has investors fearing that a significant slowing of China's rapid domestic expansion and voracious appetite for basic materials will spoil the party in the materials and the shipping markets, possibly derailing not only Japan's economic recovery but the OECD's as well.

China's government has promised to clamp down, and is moving to tighten monetary policy. But outsiders are skeptical that Premier Wen Jiabao's goal of lowering GDP from 9.1 percent to 7 percent this year can be achieved without a possible bursting of the China bubble. Many believe that provincial and city officials around China will ignore Beijing's efforts to deflate the growing China bubble.

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Investors and the Chinese government are afraid that excessive growth will lead to inflation, shortages of commodities and electricity, and perhaps a bursting of the bubble when government efforts to slow growth do kick in. If this is true, then industrial metals like copper are a sell. Shipping companies have seen their shipping rates skyrocket because of Chinese demand.

Shipping and interest rate fears

Soaring shipping rates actually loop back into the discussion about US interest rate fears. Freight rates are giving clear warnings about the impact of higher rates on financial markets. A further decline in the indices should lead to lower commodity prices.

Gold prices, which often lead other commodity prices, first peaked in January 2004 and hit a double top in April. Gold prices are more sensitive to US interest rates than industrial commodities because of the strong investment demand (futures positions) that have supported gold prices. Additionally, the fear of rates is finally beginning to bite into the US real estate segment. The Dow Jones REIT index, after a late rally that tacked on some 20 percent in April, has rapidly retraced all the gains made since last November.

Liquidity-driven markets in 2003 created some strange bedfellows. Gold and mining stocks were soaring while the bombed-out TMT stocks rallied, and the housing sector as well as REITs continued to do well. Normally, soaring commodity prices and shipping rates would have meant noticeable upward pressure on US interest rates. Instead, while the Fed's all-out reflation efforts to restart US growth hit the US dollar, efforts by Japan and other Asian countries to limit the appreciation of their currencies led them to purchase massive amounts of US treasuries, thereby keeping a lid on US rates.

But global investors are now beginning to suspect the party from the global liquidity cycle is ending. The International Monetary Fund said in a late-April report that the abundance of funds globally and low interest rates were big threats to financial sector stability. Indeed, the $1.5 billion the United States needs each day to fund its massive current account deficit is now looking more bubble-like and unsustainable, with the Fed perceived to be on the verge of raising rates.

Japan has now stopped its massive interventions, effectively removing support for US bond prices. Ironically, the dollar rally has probably been exerting more pressure on the bond market than fears of credit tightening by the Federal Reserve would normally warrant. All of this is occurring as some investors have been operating on the suspicion that the US rally in 2003 was an excess liquidity-driven fluke and that the American market could continue to produce sub-standard returns for many years to come.

Foreign investor bullishness

The latest survey of global investors by Merrill Lynch shows Japan as the market that most global investors want to overweight because of perceived attractive valuations relative to other markets, a better corporate profit outlook than its peers and an undervalued currency in the yen. Yet most investors also believe that China's economy is more likely to weaken than strengthen over the next 12 months, and while they are still skeptical about US growth, inflation concerns dominate. The positive correlation between the Nikkei 225 and US treasuries would suggest that rising interest rates in the US are actually positive for Japanese equities.

This increased caution on the US market with virtually unmitigated bullishness on Japan causes one to wonder if the bullishness on Japan may have gone to far. The shift to a tightening bias in the US, as we are already seeing, will be positive for the Japanese market initially, and probably means good relative performance through June.

However, the Bank of Japan will eventually have to consider their own shift of monetary policy gears, and the Japanese market will react in a similar manner, suffering an interim correction as the froth of the liquidity cycle eventually gives way to sustainable value.

But if one subscribes to the scenario that we do, which is that Japan's recovery is not a fluke and is not only driven by external demand, then the rally seen in 2003 and so far in 2004 is just the first act of a secular recovery in the Japanese economy and stock market. Japan may not be poised to rule the industrialized world (as was implied many years ago), but it is now in the best position in perhaps the last 10 years to shed the pall of the "Heisei Malaise." Moreover, compared to European economic fundamentals, Japan still looks better. Global investors are underweight in markets like the UK in favor of Japan.

Japan's shipping ready to tumble

Still, fear of inflation and higher interest rates in the US cannot be ignored, nor can the prospects of a slowdown in China. What it means is that investors will need to become more selective in the Japanese market.

For example, global shipping companies are seeing boom times, propelled by firm dry-bulk freight rates and robust tanker earnings. Recent data from Clarksons Research Studies shows that spot earnings per day have shot up to $70,692 versus $30,727 a year ago for Capesize vessels in the dry-bulk category. Though this rate is marginally lower than $71,700 of a month ago, it is still 105 percent more than its five-year peak. In addition, freight rates are double their five-year highs for other vessels such as Panamax and Handymax.

The firmness in the dry-bulk freight rates, witnessed since the past six months, is expected to persist by those in the shipping industry, unless the global economic recovery really sputters. Because of shipping capacity, pricing and quality issues, average hauling distances have become longer, implying that the factors that are currently causing increased demand for ship tonnage will not dramatically change.

The lack of supply of vessels vis-a-vis demand is being attributed to under-investment in the dry-bulk sector. Moreover, as Europe phases out its single hull vessels on environment concerns, their demand for double hull ships have only accentuated the demand-supply gap. Industry insiders say up to 25 percent of the world's bulk shipping capacity is now tied up in port queues. While new deliveries will take time, most of the shipping yards are booked till the first half of 2006-07.

With this shortage expected to persist, freight rates are likely to remain firm, shipping companies believe. In the tanker segment, spot earnings for April have increased to nearly $54,000 per day, versus $51,000 per day a year ago for very large crude carriers, and represent an improvement of some 18 percent over five-year highs.

But earnings from crude carriers (tankers) and those in the dry-bulk category have slipped from their recent highs, while Baltic dry freight rates for Capsize carriers have plunged, and along with these rates, stock prices of shipping companies around the world. Moreover, stock prices, as a leading indicator of economic fundamentals, seem to have already discounted the good news to a large degree.

In 2003, stock prices of Japan's shipping companies such as Mitsui OSK and Kawasaki Kisen more than doubled. So far, the bad news about falling freight rates has not significantly hurt the stock prices of Japanese shippers, given the extreme bullishness of global investors regarding the Japanese market, and the fact that Japanese management are still giving upbeat messages to their investors.

Their Asian peers, however, have been hit harder in March, after stock prices literally exploded from the onset of 2004. Given the sharp fall in dry bulk freight rates, the writing appears to be on the wall regarding the end of the big rally in shipping companies.

Darrel Whitten is owner of Whit Consulting, LLC, and is editor and publisher of JapanInvestor.com. A veteran investment analyst, he has been following Japan's financial markets for over 20 years. Please mail comments to: [e-mail]