07/06/2000 The 'Gunderson Effect' From Coast to Coast *

Not even a holiday shortened week could temper wild stock market volatility. The Semiconductors, for example, jumped 4% on Monday, dropped 9% on Wednesday, only to bounce back with 4% gains both yesterday and today. Today, indicative of unusual trading and despite all the talk of an economic slowdown, the S&P Retail Stores index surged 8%. For the week, the AMEX Biotech index surged 10%, increasing its year-to-date gain to 85%. Also for the week, the Dow and S&P500 gained about 1%. The Transports added 3% and the Utilities 2%, while the Morgan Stanley Consumer and Morgan Stanley Cyclical indices had slight advances. The small cap Russell 2000 added about 1%. The NASDAQ100 increased 1%, although the Morgan Stanley High Tech index had a slight decline. The Semiconductors dropped about 2%, while The Street.com Internet index sank 5%. The financial stocks rallied strongly, with the S&P Bank and Bloomberg Wall Street indices jumping 4%.

The gold stocks dropped 4% as gold sunk about $7. Crude oil declined $2.22, leading to a significant decline in the commodity indices. The CRB index dropped 2%, and the Goldman Sachs Commodity index declined 4%. The credit market rally continues, with 2 to 10-year yields falling between 7 and 8 basis points. The key 10-year yield declined 3 basis points. With spreads continuing to narrow, the implied yield on the agency futures contract sank 10 basis points. For the week, the benchmark 10-year dollar swap narrowed 7 basis points, while mortgage spreads narrowed about 5. The yield on the benchmark Fannie Mae mortgage-back dropped 7 basis points to 7.82%.

“The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansions, or later as a final and total catastrophe of the currency system involved.” Ludwig von Mises, Human Action

“What matters is that there is an inflow of newly created credit. If the banks grant more credits to the farmers, the farmers are in a position to repay loans received from other sources and to pay cash for their purchases. If they grant more credit to business as circulating capital, they free funds which were previously tied up for this use. In any case they create an abundance of disposable money for which its owners try to find the most profitable investment. Very promptly these funds find outlets in the stock exchange or in fixed investment. The notion that it is possible to pursue a credit expansion without making stock prices rise and fixed investment expand is absurd.” Ludwig von Mises, Human Action

Second quarter leveraged bank loan syndication numbers are in from Security Data Corp. Bank of America jumped into first place, arranging 228 loans totaling $42.9 billion. Chase Manhattan, the perennial leader in high-risk credits, dropped to second place with 122 loans totaling $37.2 billion. Due to a slowdown in mergers, total leveraged lending declined about 4% to $177.7 billion during the first half; not much of a pullback. Meanwhile, with liquidity returning to the credit market, the junk bond sector is once again getting geared up to sell paper. Apparently, the amount of junk deals in the pipeline has surged to about $40 billion, nearly double the low established in March. At the same time, the most recent Bloomberg listing of bank loan syndications are certainly indicative of a return to aggressive lending, with $34 billion new offerings posted last week.

And while our view certainly flies in the face of conventional analysis, we believe that the recent sharp decline in interest rates is strong evidence of the continued failure of Federal Reserve policy. Despite spots of tempering demand, global growth is accelerating and the US economy remains desperately overheated. As such, our analysis sees heightened inflationary pressures that require both higher market interest-rates, as well as a significant reduction in credit availability; only this combination will engender the curtailment of demand necessary to ward off escalating inflationary imbalances.

However, the Greenspan Fed founders as it “fights the last war.” After the tightening cycle in 1994 – with a near debacle in the credit market/leverage speculating community – the Fed has found it preferable to ensure heightened system liquidity while moving to raise the cost of short-term borrowings only marginally. Apparently, the timid Fed sees it expedient to pamper Wall Street and the markets. And, likely, it views this strategy as its best hope for orchestrating the coveted soft-landing. Instead, this policy only guarantees a greater debacle down the road. And while the overheated economy cries out for a dramatic tightening of credit conditions, Fed policy is not a monetary tightening at all. By accommodating heightened liquidity, while cautiously managing rates, this only provides the green light for perpetuating systemic financial and economic excess. Unbelievably, and much to the satisfaction of the over zealous and drunken financial sector, the Fed keeps the party going with a full (somewhat less potent?) punchbowl.

Last week we highlighted the historic real estate bubble that runs out of control in California. Indeed, we see the Golden State as a bastion of inflationary pressures. And like other trends from this most-influential state, inflationary pressures will continue to fan out throughout the rest of the country. For years the US labor force has been rightfully praised for its extraordinary mobility. Now we will see how this mobility can also be a disadvantage for the economy, as it fosters the rapid transmission of wage pressures around the country. In many respects, we don’t think one can overstate the role of the Golden State in the present U.S. bubble. Indeed, from the most recent available GNP data, California would have ranked as the 8th largest country, just below China but above Brazil, Canada, and Korea. Almost 1 in 5 dollars of Fannie Mae’s mortgage exposure to real estate in California, and the financial sector’s total exposure to California credits is truly massive. Furthermore, California has also traditionally led the country in political trends.

With this in mind, it is worth noting that last week California governor Gray Davis signed the state’s $95 billion budget for next year. This budget, reportedly, calls for a stunning 18% increase in spending over the current budget. According to local papers, the budget is “packed with pork.” From the SF Chronicle, quoting an assemblyman, “It’s completely out of control. The governor has become Santa Claus for every legislator with visions of boondoggles dancing in their heads.” Outside of what we would consider “pork,” the budget includes a 16% increase in rates paid to doctors caring for the poor. According to the San Francisco Chronicle, the new budget includes “more than $2.4 billion in incentives for teachers, students and school administrators, including higher starting pay and better benefits for educators…the state is trying to attract and keep quality teachers to meet its demand for 300,000 more teachers over the next decade…” It is not that we have an issue with how California is spending its huge current revenue windfall, but we do view as significant the trend of aggressive spending programs developed in state capitals from Sacramento to Albany, as well as in Washington D.C., both for fueling a continued economic bubble, and with increasingly problematic inflation.

The new California budget provides wage increases throughout, including 12.5% pay increases for Superior Court judges. And since Los Angeles City and County council salaries are tied to judges’ pay, this 12.5% increase will be added to the 6.5% pay increase these public servants received less than one year ago. Throughout California and the nation, strong revenues allow municipalities to increase wages for its employees. Even Orange County, bouncing back from bankruptcy, recently passed a budget with “sweeping pay raises” for its 4,200 employees, “including hefty increases of up to 19%” for top officials, according to the LA Times. Reorganization at the Los Angeles Unified School District is “significantly raising the salaries of top executives, with the new superintendent and top department heads seeing salary increases of between 30% and 40%.” Last month the sheriff, public defender and Orange County counsel received salary boosts of $20,000. In Anaheim, firefighters recently won a 15% pay increase in arbitration. We could go on and on.

At the University of California, clerical workers are demanding an 11% raise. In Oakland, teachers just agreed to a new pay package that provides an immediate 4.8% pay increase, with an additional 13% this fall, and 5% more next year. Teachers from the San Francisco Unified School district are currently asking for a 30% pay increase. San Francisco has already agreed to build new subsidized housing for teachers that have been priced out of the housing market. Striking examples of wage inflation are certainly not limited to California. Recent reports have Long Island policemen receiving 20% increases, as police forces across the country fight to fill vacant positions. New York City, in particular, is struggling to retain policeman, teachers, administrators and government employees generally. There is overwhelming evidence that municipalities and businesses throughout the country are finding it increasingly difficult to retain necessary manpower. We sense that current wage pressures are the strongest in many years, and if this environment continues to be accommodated by money and credit excess there will be an inflation shock.

What began as wage inflation for CEOs and corporate executives, technology employees, Wall Street professionals, pro athletes and entertainers, has made its way to nannies, fast food servers and janitors. From San Francisco, Seattle, New York and Boston, wage pressures have made their way to Baltimore, Cleveland, Milwaukee, Wichita and Buffalo. All the same, today we had another “weaker than expected” report from the Labor Department. And despite the bulls’ wishful contention that this is more solid evidence of an imminent “soft-landing,” the June report did show businesses adding 260,000 jobs after May’s mysterious decline of 165,000. The available labor pool declined to 9.8 million, a 30-year low. Hourly earnings increased .4% and aggregate hours .3%. Incredibly, government data continue to put annual wage inflation at only the 3.5% range.

Recently, the Financial Times ran a story, “Law Wars in San Francisco Dotcom Start-Ups – Law Firms Have Been Forced to Double Salaries to Stop Attorneys Quitting.” The article began by highlighting the fortunes of a recent law school graduate who saw his starting salary increase by $30,000 to $125,000 even before graduation. His “unsolicited raise is part of what is now commonly known in the US legal profession as the ‘Gunderson effect.’” This is a particularly interesting example, unmistakably demonstrating how wages (among other things) are an inflationary tinderbox waiting for a spark.

“It began when Gunderson Dettmer Stough Villenueve Franklin & Hachigian, a small Silicon Valley firm that had lost 10 associates to internet start-ups in 1999, announced in December it was raising salaries across the board by 45% to prevent mid-level associates from going to dotcoms. Within a month, a national salary war ensued among law firms in San Francisco as well as ones in New York, Washington and Chicago.”

From a Boston Globe article during this period: “This week’s news that starting salaries for associates at some local law firms will range from $125,000 to $150,000 this year has shocked Boston’s legal community…What began Monday as a rumor turned into fact when Testa, Hurwitz & Thibeault announced it had raised first-year associates pay to $140,000 per year, a 40% increase over 1999 rates. A day later, Hale &Dorr said it had increased new associates salaries from $100,000 to $125,000, with a maximum bonus of $30,000. Soon enough Skadden Arps Slate Meagher & Flom noted that it, too, had raised starting salaries from $107,000 to $140,000, excluding bonuses. In a state where the median annual income for lawyers was $62,000 in 1998, the initial buzz over the soaring salaries has grown to a roar…Much of the furor began several weeks ago when California firms raised their base salaries to $125,000 to retain young talent.”

Last month, from the Pittsburgh Post-Gazette, “When Michael Zanic began his law career at Kirkpatrick & Lockhart in 1989 he earned $54,000 in his first year. Now, as a hiring partner, he’s promising lawyers $100,000…Area law firms can thank Silicon Valley for the soaring level…” An Associated Press story began, “For his job as the nation’s top-ranking federal judge, Chief Justice William H. Rehnquist earns $181,400. Yet his own law clerks could beat that salary next year simply by joining a major law firm…Federal judges are not amused.” This situation is noted as an example of one of a myriad of distortions popping up in our distressingly imbalanced economy.

And while the spark my have been ignited by the Internet and Silicon Valley bubble, it now spreads like wildfire from law school graduates to undergraduate English majors. Today, the National Association of Colleges and Employers (NACE) released the results of their latest national survey of starting salaries. “We’re seeing substantial increases in starting salary offers for all types of students,” says Camille Luckenbaugh, NACE employment information manager. “Not only are engineering and computer science grads getting big offers, but students in the business disciplines are doing exceptionally well, and liberal arts graduates are also seeing significant jumps in their average offers.” According to the NACE national survey, information system graduates are seeing starting salary increases of almost 11% above 1999; computer science 10%; computer engineering grads almost 10%; electronic engineers 8%; and industrial engineers 6%. Beginning pay for business administration grads has jumped almost 7%, accounting 7%, and marketing 5%. “Although media attention has focused on the job market for graduates with technical degrees, the current economy has also been good to liberal arts grads. For example, the average offer to English language and literature graduates is up a whopping 10.5%…political science/government graduates are also getting extraordinary increases: Their average offer has leaped 11.8%…Consulting firms, one of the top employers of new college graduates, have helped push up the average offer to history graduates by 9.5%…”

Moreover, it should be recognized that this is not a one-year phenomenon, as can be gleaned with a look back to the NACE report from 1999. “The class of ’99 enjoyed a good year, thanks to the economy and tight labor market…overall, recruitment activity was strong and steady, and starting salaries for many graduated increased substantially. However, this year wasn’t marked by the frenetic pace we saw a year ago, when starting salary offers were spiraling into the double digits in some cases.”

More corroboration of the extraordinary tight labor market came today from placement firm Challenger, Gray and Christmas, complements of Market News International. “While some interpret government labor data as showing signs of loosening, they apparently failed to talk with desperate human resource executives who spend their days scouring the nation for skilled workers. The labor shortage may in fact be worse than it was even a few months ago. “ According to Challenger, Gray and Christmas, layoffs during the month of June fell to a 17,241, a decline of 73% from a year ago, to a 36-month low. Year-to-date, layoffs have dropped 42% from last year.

And while the unrelenting “New Paradigm” crowd will somehow spin that obvious wage pressures will not lead to higher general inflation, there is increasing evidence quite to the contrary. Numerous anecdotes of rising prices are now supported by a lengthening list of surveys and indices indicating rising inflation. Yesterday’s Wall Street Journal “Business Bulletin” column ran the headline, “Going Up? More companies expected to raise prices in the months ahead.” This data should be quite alarming to both the Fed and the financial markets. According to a survey of 221 companies by the Financial Executives Institute and Duke University’s Fuqua School of Business, “Nearly 75% of corporations plan to raise prices an average 4.7% in the next 12 months…” Recent polling demonstrated “a progressive willingness to raise prices.” For comparison, last year’s survey had 60% of firms expecting to raise prices by 1.3%. Six months ago, 71% planned to increase prices by 3.1%. No matter what the spin, pricing power is back, and inflation psychology is festering. Also today, the Economic Cycle Research Institute reported that its June report on inflation increased from May and remains only slightly below the 11-year high established in April. Quickened job growth was sighted as adding to expected rising inflation.

Admittedly, with the financial sector expanding credit aggressively, liquidity has returned to the credit system, at least for now. Capital markets are once again increasingly accommodating security issuance, extraordinary bank lending growth runs unabated, and the GSEs are apparently back in the credit excess game. And, of course, the bulls will celebrate and dream of soft landings. The truth of the matter is, unfortunately, that the present course is headed squarely toward the worst-case scenario. Extraordinary pricing disturbances, previously isolated to stock prices and Internet companies, for example, are being accommodated by reckless money and credit excess. In what is truly a charade of price stability, we are at the stage of a long period of excess where money and credit growth will now feed directly to higher prices, severe economic distortions, and continued disastrous trade deficits – evidence of which is in great abundance already! And, as has always been the case, inflation begets only higher inflation. The longer the Fed allows this unhealthy boom to endure, the more devastating the impact. Repeating the great words of wisdom from Mises, “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansions, or later as a final and total catastrophe of the currency system involved.”