Inflation according to the dictionary : Economics, a persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency, the act of inflating, the state of being inflated.
Three separate factors stimulate the dreaded inflation bogeyman. A change in the value of resource costs of a good. A change in the 'price of money' to it's intrinsic value. And a currency depreciation resulting from an increased supply.
There are three major types of inflation. 'Demand -pull' caused by increases in aggregate demand due to increased private and government spending. 'Cost-push' or 'supply shock inflation' caused by a drop in aggregate good supply or potential output. And 'Built-in' induced by adaptive expectations and linked to price/wage spiraling. We may get a taste of all three before long.
Many other theories of 'cause and effect' circulate - but the results are usually nasty. Social unrest, hoarding, lowered living standards, and hyperinflation to name a few. We may eventually experience the worst of all worlds - Stagflation. A period of low or no growth combined with high interest rates. Let's hope not!
Cause: In less than 8 weeks the second round of US Quantitative Easing that saw the the Fed sink US$600b of tax payers money into buying up unwanted treasuries to hold down bond yields will end - and the 'political' rationale for doing so will be hotly debated for decades. Following the great credit debacle the central bank (Dec '08) cut over night interest rates to almost zero and purchased almost US$2+ trillion in mortgage backed securities and government debt. The total gross monetary base (bank reserves) exploded over 300% in the next two years. Money stock surged. Exceptionally easy monetary conditions prevailed for those who were 'deemed' credit worthy. Cheap US dollars have now effectively funded the global carry trade. Freshly inflated currency washed over the financial shores like a Japanese Tsunami. Financial markets recovered almost all their catastrophic losses. World wide global equity markets doubled - adding almost $30 trillion in market value. And most importantly - economies recovered. So far so good.
Effect: The US Real Broad Dollar index (inflation adjusted and trade weighted) vs a basket of currencies as reported by the Federal Reserve Board has just broken into new all time low territory. The extreme weakness of the dollar reflects both weak demand for dollars and the Fed's concerted effort to liquefy the world and stimulate the economy. The bond markets have thankfully held recent low territory for now. All bets are definitely off if those levels are breached.
The US Government balance sheet now combines all the elements of a Hollywood nail biting thriller and slasher horror show - let's hope it doesn't turn into a tear jerker! Zero political will exists to rectify errors in fiscal judgement. Employment is improving slowly. Housing is hoping to bottom. The national debt clock is now turbo charged. A dynamic plan of remedial action is but a romantic notion. The Fed is now essentially the world's biggest hedge fund.
The possibility of another round of supportive QE III appears politically unlikely - but not impossible. If not, who will continue to buy low yielding long term unsecured treasuries from the US Government is even a greater mystery? The spectre of rising interest rates is now all but guaranteed. Most key 'unstimulating' countries have recognized the threat and have preemptively begun to raise the cost of borrowing. China is currently experiencing 3-4% inflation with Europe & England reporting 5-6% increased prices. The ECB is the first major central bank to blink with a 25 basis point move higher. Portugal has officially surrendered to the IMF. The 'don't worry be happy' US Fed officials reported a subdued 'transitory' 3% inflation number and are only mildly concerned. The US government officially runs out of funds tomorrow while leadership can't even agree on US$30B (3%) of budget cuts on a $1.6T structural annual deficit. A new and improved US$15 trillion debt ceiling is in the offing. And I was worried about the Leaf's making the playoffs?
Result: When too much money chases too few goods prices indeed go up. The price sensitive Commodity Research Bureau (CRB) spot commodity and raw industrials index has blasted through the previously extended 2006-7 level like a hot knife through butter. The 'real' inflation adjusted CRB is now approaching 1970 and early 80's levels - a very difficult era of double digit inflation and 20% interest rates. The three large canaries in the coal mine continue to squawk. Oil is challenging US$110, Gold US$1,500, and Silver US$40. It looks like US$4+ per gallon unleaded will be a summer time reality. Soft commodities and grains are spiking and farmers struggle to keep up with surging demand.. Food processors are already raising prices to offset significantly higher input costs. I suspect it will not be long before all goods will be reported in 'real' inflation adjusted dollars as opposed to nominal current levels. The threat of inflation rearing it's ugly head domestically has been raised to Def con 3. The inevitable and considerable rise in interest rates is not a nice thing to even think about.
Equity markets in the US continue to soldier on. A new post Middle East crisis and Asian earthquake high has been registered by the DJIA but not the S&P. Above expected earnings continue to roll out and corporate M & A activity continues at a frenetic pace. Texas Instruments offers an eye popping $7.7 b or 80% premium for former dot com darling National Semiconductor. Pimco announced a newly minted $600m REIT to scoop up discounted residential mortgages signalling a potential bottom in home prices. The broad markets remains fairly priced but many glamor growth stock P/E's are at rarefied & dangerous nose bleed levels. Major markets are fairly priced on an earnings basis. The DJIA is almost 800 points over it's rising 200 dma. Relative strength weakness is appearing on the charts and could be a represent potential problem. The Wilshire 5000 Index which includes small cap issues has led the recent charge recording new recovery highs and may portend a traditional distribution type scenario.
The inflation loving TSX has run back to February high levels but has appeared to have lost some short term momentum. The Canadian dollar has almost hit US$1.05. The cross border currency advantage had disappeared and will now represent a significant drag on the vulnerable industrial base. The Lundin/Inmet/Equinox/Minmetals chess game continues. The heavily weighted financials are no longer cheap and are due for a meaningful (inflation adjusted) correction. Senior gold and oil issues are significantly diverging from record bullion/commodity prices and look temptingly cheap on a relative basis. Gold stock capitalization is currently less than 1% on the NYSE with pension funds having little or no inflation protection. There is lots of room to rally. Few care about the pending TSX-LME merger and less about the May 2nd Federal election.
North American market consolidation continues to be the order of the day. Upside momentum could quickly return pending positive economic news. However, rising interest rates and a falling bond market may reveal current market action to be distributive in nature. Seasonal factors may also take effect if we have returned to more normalized conditions?
Bottom Line: It sure is hard not to get overwhelmed by current fiscal and monetary issues. Goldman Saks believes that Portugal is the end of meaningful European sovereign debt concerns and I sure hope they are right as usual. A sinking Spain and Italy would certainly overwhelm the monetary system. Japan is hardly out of the woods and 9,000 Nikkei must hold but I have my doubts. The threat of inflation is considerable and higher interest rates could easily upend economic growth and destabilize global conditions. I remain cautiously bullish due to excessive liquidity levels, strong income statements, and healthy balance sheets - but with tight firm stop loss levels in place.
Let's hope the Easter Bunny doesn't leave us rotten eggs!
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