The Inflation Tipping Point

Investing StrategiesTHE INFLATION TIPPING POINT

By John Butler

The Fed, already deep into a dilemma largely of its own making, is about to find itself facing an even more unpalatable choice before long: Accommodate the surge in demand for real goods with a continuing easy money policy or, alternatively, slam on the brakes sufficiently to force an end to the incipient behavioral changes behind the growing stagflation, thereby running the risk of causing another acute round in the ongoing financial crisis.

So what is the Fed going to do? Take responsibility? Well that would be rather out of character given that the Fed so far has steadfastly denied any blame whatsoever for the credit (or asset) bubble that it created with a prolonged period of excessively easy monetary conditions in 2003-07. More likely, the Fed will simply hope that somehow inflation will rise moderately to a level which helps to reduce the real debt burden on the economy and then stabilize. But if an inflation tipping point is soon reached and consumer price inflation ratchets sharply higher this year, no doubt the Fed will deny that such inflation is in any way a monetary phenomenon, notwithstanding the analysis above and Milton Friedman’s famous dictum to the contrary.The Fed’s denials will by no means stop there. They will also deny that this inflation is harmful, using a range of arguments such as “Price increases are indicative of firming economic activity,” or “Recent spikes in volatile food and energy prices are isolated to those markets and not indicative of rising core inflationary pressures.” No doubt the Fed will take comfort that real wages are likely to remain stagnant or even decline, implying that their preferred, arbitrary measure of “core” inflation remains low. But for people who work for a living, the combination of rising food and energy prices on the one hand and stable or declining real wages on the other will not be cause for comfort, rather the opposite.

We mentioned briefly above that the current surge in global commodity prices is now comparable to the first half of 2008. It is easily forgotten that the global economy grew extremely rapidly in 2006 and 2007, thus entering 2008 on the verge of overheating. It is easy to attribute the sharp slowdown in economic activity in 2008 and early 2009 to the US-centered global credit crisis but history demonstrates that sharply rising commodity prices–a classic indicator of economic overheating–have preceded all major modern recessions, including those of 1973-75, 1980-82, 1991-93 and of course 2008-09. So to dismiss the role played by soaring commodity prices in the most recent case would seem inappropriate.

Given recent developments, this should give investors cause for concern. As one overheating economy after another raises interest rates–China, India, Brazil, Russia, Indonesia and South Korea belong to this group–the risk of a general, global economic slowdown increases and with it the possibility that equity and commodity prices are heading for a major correction. Indeed, the US and European equity markets are beginning to look like the outliers in a global trend toward lower equity market valuations. The Chinese stock market has been in a gentle downtrend since November and, for those who enjoy technical analysis, has formed a bearish, so-called “reverse head-and-shoulders” pattern. The Indian and Brazilian stock markets also peaked in November and declined sharply in January. Is this telling us something significant?

We believe it is. As these regions now comprise the more dynamic part of the global economy, their softening stock markets might well be leading indicators of looming downtrends in developed-market equities. And it would be entirely consistent for commodity prices, in particularly those for cyclical, industrial commodities, to follow along. Defensive investors should take note.

As we write frequently in the Amphora Report, in a world of general fiat currency inflation and devaluation, commodities provide an alternative, superior store of value. While many investors consider gold and silver ideal in this regard, there is no reason why other commodities cannot also serve an important role, in particular to provide additional diversification benefits. Agricultural commodity prices, for example, have risen strongly over the past year but have remained largely uncorrelated to gold and silver. Yet while industrial commodities have risen particularly strongly of late, these are also the most exposed to a sharp correction. At this point in time, heeding the growing signs of slowing emerging market economies, we would be underweight industrial commodities.

Thinking farther ahead, we remain confident that, in the event of a general, global economic slowdown, policymakers in heavily-indebted developed economies will continue to follow generally inflationary policies in order to support growth, notwithstanding the evidence, both historical and contemporary, that such policies are at best ineffective and, at worst, counterproductive. We lean toward the latter view. Yes, a correction in equity and commodity markets may be coming, but so is another subsequent wave of freshly printed fiat money. Just where it is going to go, and how long it will take to get there, is anyone’s guess. But we know from where such “money” is ultimately being covertly taken (stolen): The earnings and savings of working people the world over. While it is the responsibility of investors to grow wealth when conditions are favorable–and at least protect it when not–we should all remember that inflation is not merely a monetary phenomenon but, much more importantly, an immoral one.

From www.dailyreckoning.com

John Butler has 17 years experience in the global financial industry, having worked for European and US investment banks in London, New York and Germany. Prior to founding Amphora Capital he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, where he was responsible for the development and marketing of proprietary, quantitative strategies. Prior to joining DB in 2007, John was Managing Director and Head of Interest Rate Strategy at Lehman Brothers in London, where he and his team were voted #1 in the Institutional Investor research survey. He is an occasional contributor to various financial publications and websites.

The Van Riper Company

The Van Riper Company