2010Nov21 Week In Review: Inflation? Not Here, Not Yet

"I am for doing good to the poor, but I differ in opinion of the means. I think the best way of doing good to the poor, is not making them easy in poverty, but leading or driving them out of it. In my youth I travelled much, and I observed in different countries, that the more public provisions were made for the poor, the less they provided for themselves, and of course became poorer. And, on the contrary, the less was done for them, the more they did for themselves, and became richer." -- Benjamin Franklin
 
Economy:
 
Every action has a reaction, and the Fed’s quantitative easing is no exception. Its devaluation of the US Dollar has contributed to rising commodity prices. The most significant impact is in food prices within emerging markets where rising living standards increase demand for better food grains and meats. Except in the US, food inflation is already problematic. Floods in Pakistan and lower rainfall in global grain production areas have reduced supplies. US farmers are being paid more for soy beans, corn and wheat. 
 
As feed grain costs rise, ranchers increase slaughter rates. Increased supply of retail meat partially mitigates the inflationary impact on CPI. Further, food and energy as a share of budgets have declined in the past four decades and will not materially change US inflation next year. However, this problem is much too real in other parts of the world.
 
Looking beyond food and energy, deflation continues its relentless march. Core CPI just hit its lowest reading since the mid-50s. US inflation is up 0.6% over a year ago leaving the Fed with continuing difficulty in accomplishing its tasks of a stable economy and full employment.
 
Real Estate:
 
If Congressional pressure persuades Mr. Bernanke to not extend the current monetary commitment, we expect bank closings to rise and residential foreclosures to accelerate. Mortgage restructurings have generally failed to keep owners in their homes. Now, with mortgage rates rising, qualifying for a new mortgage will be more difficult increasing the probability of foreclosure. The employment situation will not find relief from housing with starts falling 11.7% last month.
 
Stock Market:
 
S&P500 earnings fell 92% from the 2007 high to the 2009 trough. Third quarter earnings season is essentially over with a recovery in earnings only dreamed of eighteen months ago. From a level not seen since the Great Depression, earnings have exceeded the level of the tech bubble. Only the Credit Bubble has had better earnings, and those came with a price we would have preferred to not pay. This has been reflected in the developing breadth of improving strength in the US stock market. Over the past ten weeks, economic and market indicators have been surprising on the upside. That is good news for longer term investors.
 
The new General Motors initial public offering was deemed a success. One per cent was acquired by China’s Shanghai Automotive Industry Corp. Normally, a stock offering provides a company with cash for future expansion. Not this time. The company did not get the money. The “successful IPO” does not account for the cost to taxpayers of the bailout, Cash for Clunkers, the Volt or the billions rescuing GMAC now operating as Ally Bank. Frankly, taxpayers cannot afford this type of success.
 
We continue emphasizing non-dollar investments due, in part, to Mr. Bernanke’s continuing commitment to devalue the US Dollar. In an academic world, it would be nice to transfer growth from emerging countries to developed ones. It is much more difficult to do so in the real world where excesses have been encouraged by our policy makers, and the time to ante up draws near.
 
The price of safety is rising in the bond market. First, the doubts about European debt repayments are rising again. As a benchmark of fiscal irresponsibility, European PIIGS are losing their lowly standing to various states here at home. Risk premiums for Illinois and California are now higher than for Spain. Premiums for Michigan, New Jersey, New York and Nevada are higher than for Italy! It is no surprise to us that municipal bond values have been crashing.
 
Muni investors should be very careful. States have used the Build America Bonds as an escape from hard budget decisions. The public’s disdain for an increasing debt ceiling combined with a new Congress will likely result in the BAB program’s end. Fiscal austerity is beating a path to legislative agendas at every level of government. Bankruptcy is an option. Voices of protests over program and job cuts will enter the news cycle with increasing frequency.
 
Deleveraging by consumers and businesses and increased savings necessitated by the Boomers proximity to retirement are the dominant macro-economic drivers for our country. Seemingly few governmental budget committees grasp the trajectory of their revenue streams. Investment policy requires flexibility that fell out of fashion during the 80s and 90s. Safety in today’s world is having a defensive game plan rather than blindly holding a portfolio of bonds where risk has stealthily risen.
 
“When the facts change, I change my mind. What do you do, sir?”  - John Maynard Keynes
 
Our plan is “the plan will change.” What is your plan?
 
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