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Bursting The Inflation Bubble


Cure for high prices may be high prices.

"We appear to be entering a period of serious stagflation with sharply rising expected and actual inflation combined with large downside risks to growth and employment."

"I would argue that what we are seeing is an acceleration of expected consumer price inflation in the context of a sharp expansion in global liquidity. It is hardly surprising that the prices of those commodities, such as oil, for which the short-run price elasticities of supply and demand are low move upwards strongly when there is a rise in expected general inflation. The oil market is a very convenient vehicle to speculate on expectations of higher levels of general price inflation. Hence my view is that the 40% jump in oil prices that has occurred over the past few months - roughly the period during which financial conditions have been loosened sharply - is a reflection of the expectation of either an acceleration of global inflation, or a depreciation of the U.S. dollar, or some combination of the two."

- Malcolm D Knight, General Manager, Bank for International Settlements

It was only five years ago that the central bankers of the world, and especially the Fed, were worried about deflation. Ben Bernanke's famous helicopter speech, about how the Fed could deal with a deflationary environment, introduced him to the world at large.

Who would have thought that what passed as humor to a group of economists would be taken so seriously by the rest of the world?

Today, inflation is wreaking havoc with the markets, and it's the central worry for investors and central bankers alike. In this week's letter, we ask whether we should be worried about inflation, take a mid-year look at the economy, muse on the stock market malaise and offer a very contrarian method of giving a positive shock to the world.

But first, a very quick commercial: In the current market environment, there are money managers who have faltered, and others who have prospered. If you're an accredited investor (i.e. have a net worth over $1.5 million) and would like to look at hedge funds and other alternative fund managers (such as commodity traders), I suggest you sign up at If you're a U.S. citizen, someone from Altegris Investments in La Jolla will call you; if you're in Europe, expect a call from Absolute Return Partners in London. If you're in South Africa, someone from Plexus Asset Management will give you a call.

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If you are an investment advisor, all of my partners will work with you to assist you in providing your clients exposure to alternative investments and managers. Obviously, if your clients are high net worth, then you'll want to work with Altegris or ARP; if your clients need lower minimums, then you should work with CMG. If you have any feedback or comments, feel free to write me. And now, back to our regular letter.

Inflation, Deflation and Stagflation

The quote at the beginning of this letter is from the managing director of the Bank of International Settlements -- in other words, from the central banker to the central bankers of the world. (Many thanks to Simon Hunt for the quote.)

Stagflation is a strong word to use, but Knight is surveying a world that is increasingly looking like it's in trouble. A recent study from Morgan Stanley (MS) suggests that 50 countries (or over 3 billion people) worldwide have inflation running at 10% or more.

Almost all of those countries have negative real interest rates, or interest rates that are below inflation (as is the case here in the US). Central bankers are slowly applying the brakes and raising rates, but they're going to be under increasing pressure to do so.

Knight therefore suggests that global growth is due to slowdown even as inflation is rising.

A quick sidebar: I'm often asked what I think about the inflation numbers produced by John Williams of Shadow Government Statistics, which suggest that U.S. inflation is over 11%. That certainly corresponds to what it feels like to watch our food and energy prices continue to rise. If you're bearish, a high inflation number makes your case easier.

But let me make a few of you mad. I think what Williams's numbers actually do is show U.S. that his methodologies, which date to the late 1970s, are outmoded. If inflation were actually 11.8%, then that would mean that the Gross Domestic Product had declined 6%, and that the U.S. would have been in a recession for the past several years. That's obviously not the case. A quick look at corporate profits and tax receipts shows U.S. that the economy has been growing for the past five years.

In fact, the recovery after 2003 was robust, corporate earnings were solid and tax collections went through the roof after the Bush tax cuts. That simply wouldn't happen in a high-inflation environment.

That being said, let me make two observations. For much of America, inflation is much more than the headline consumer price index (CPI) of 4%. If you make $40,000-60,000 annually for a family of four, inflation's effect on the cost of food, gas, medicine, insurance and other necessities is substantially more than 5%.

CPI reflects the inflation of all items, but your personal inflation rate depends on what you actually buy. A lot of necessities are running well north of 4% inflation.

Second, I believe that some of the statistical methods used to gauge inflation, such as hedonic measurements, are quite suspect. Just because the computer I buy today is twice as powerful as the one I bought three years ago does not mean that the price of a computer has been halved. I still spend about the same amount on my new computer; it's still the same percentage of my budget.

If we used the European methodology, for example, U.S. inflation would be somewhat higher; I would find such a number useful, if only for comparison's sake. But let's get back to main thought.

Louis Gave recently wrote an interesting essay on inflation. There, he makes a point I have often made: If you look at adjusted monetary-base growth, the Fed hasn't really increased the money supply over the past four years, despite the fact that M2 and other measures of money supply have skyrocketed.

So what gives?

Two things: One is the extraordinary growth in credit offered by banks around the world, which caused true inflation in financial assets of all types. Second (and this is less intuitive) the U.S. consumer, via a massive trade deficit, has been a large supplier of money to the rest of the world. We have seen trillions of dollars flow into world markets.

Now, let me offer a hypothetical series of events which could change the current picture, and which might even bring back the specter of deflation.

The U.S. trade deficit has been roughly 6% of GDP for the past four years. Only a few years ago, less than 30% of that was for oil. Now, approximately 60% of our trade deficit is spent on oil, much of it going to countries that are not necessarily our friends.

In terms of GDP, the U.S. consumer has cut his spending on non-oil items by almost 40% over the past few years, and the trend is clearly down every quarter.

Financial assets are deflating, and banks are cutting leverage as aggressively as they once expanded their balance sheets. Even though the data shows that bank assets (i.e. lending) are increasing, that's because they've been forced to put assets on the balance sheet that were never there before. That trend's going to reverse - and with a vengeance.

We're also watching home values decline both here and abroad, which will put European banks under even more pressure. That's serious wealth deflation.

I've been pounding the table for over a year, saying that financial stocks are going to continue to show losses at least through the end of this year. Dividends will be cut, more shares will be sold and further dilution will be inevitable for many banks in both the U.S. and Europe. Trying to find the bottom in financial stocks is like trying to catch a falling anvil.

Their distress means distress for businesses and individuals who need to borrow money. The effect of all this is deflationary. It's a strange world indeed: Two bubbles are bursting, but inflation is the headline topic of every financial medium.

One source of inflation is clear: rising food costs. World demand for grain is growing at 1.2% a year, yet yield increases are growing at only 1.1% a year. The developed world uses large part of that supply for bio-fuels. Areas where production could be increased, such as Africa, suffer from poor infrastructure and inferior production methods.

Everyone now believes that food and energy costs are going to increase and the dollar will continue to fall. But let me offer a contrarian scenario.

Farmers around the world are going to respond to high food prices: By this time next year, we could see a rise in supply that more than meets the demand. Prices might begin to actually fall.

Energy prices have risen so much that demand destruction is beginning to happen. U.S. drivers are using less gas; when Asia lifts its subsidies, demand will fall still further. Oil prices could drop over the next year.

If oil prices drop, the U.S. will export far fewer of our dollars, which will raise their value and further lower the cost of commodities.

In a world of decreased leverage, debt and housing deflation, along with lower food and energy costs and a more valuable dollar, inflation could drop below 2% by this time next year. Maybe more.

Farfetched? Maybe. But it's a possibility that few are considering. Even in the inflationary commodity boom of the 1970s, there was a 30% correction - which most people don't remember. And we don't have the wage pressures and inflation that we did in the 1970s. Everyone was convinced that commodity prices could only go one way.

The cure for high prices is high prices. High prices stimulate production and reduce demand. I see no reason that this couldn't happen again.

I'm therefore a long-term commodity bull: I think oil could indeed go to $200 or more in the next decade. As a developing world increases its need for commodities of all types, I see growing demand and prices.

Stagflation on a worldwide basis is going to have an effect on demand in the short term. I would be cautious about long-only commodity funds. While I don't expect anything to change abruptly, I would be more vigilant. I'd recognize that trends which look good now can change.

I'm not suggesting that you get out - just pay attention to supply and demand figures coming out of the developing world.

Five years ago, everyone was worried about deflation. A lot can happen in a short time. Ben Bernanke may be dusting off his helicopter speech in a few years, as deflation once again becomes the concern.

The Slow Motion Recession

On October 5, I wrote a letter called "The Slow Motion Recession." The basic premise has been that we're either in a recession or in a lengthy period of very slow growth, and that this slow growth will continue for some time. The cause of this lackluster growth is the bursting of two bubbles: the housing bubble and the credit crisis. The Fed can't solve these problems by cutting interest rates - these will take several years to correct. In the meantime, these deflating bubbles will put pressure on consumer spending and thus on corporate profits.

At the end of the day, earnings drive the price of stocks. If earnings are under pressure, the stock market will continue to be under pressure. In a slow-motion recession, with growth depressed in the latter half of this year, it's going to be hard for the stock market to gain any real traction.

As I've been saying for some time, the U.S. stock market typically falls 30% or more during a recession. We're now down almost 20%. It therefore wouldn't be surprising to see the markets fall another 10%, at least from the perspective of history.

And inflation's not helping. It's often more damaging to stock prices than a slow economy: It eats into profits and can be hard to pass on to customers who are themselves under spending pressure. While inflation may slowly go away, it could be a factor for the remainder of the year.

Although we should see some rallies in July and August, I think the trend will probably be lower. As earnings projections come down, guidance is likely to be soft for many companies.

A slow-motion recession, a muddle-through economy and inflationary pressures aren't a prescription for a robust bull market.

The recent rise in consumer spending is largely attributable to the tax stimulus payments, and will largely be over by the middle of the next quarter. As gas and food prices eat away at the average U.S. consumer's ability to spend money on other discretionary items, there will be increasing pressure on a vast number of companies.

An Update on Myanmar

My good friend Ed Artis and a team of workers are currently in Myanmar, helping the victims of the recent hurricane. They're working to re-establish an orphanage, help farmers and supply needed food and medicine to families. His stories are heart-wrenching. The need is overwhelming, and he's going to stay awhile longer. He asked me to ask you, gentle reader, if you could send a donation to help purchase more supplies. So far, my readers have been very generous in helping to provide relief.

One of the real needs is for more water buffalo. They cost about $500 apiece, but allow a farmer to feed his family. Buying a buffalo isn't as easy as it looks. Many of the buffalo who survived won't work, because they're scared silly. "I never considered that as a possible problem," he writes, "But it is - BIG TIME." "Buffalo with posttraumatic stress disorder just stand there and stare into space."

Donations made via PayPal are best, since they allow quicker access to funds. Go to, scroll down and click on the Donate button. Ed adds: "We can also accept checks made out to Knightsbridge International, PO Box 4394, West Hills, CA 91308-4394, they just take longer to get funding to us here in the field."

These are the good guys. They're there on their own nickel. Not a penny goes to overhead or salaries. I cannot say enough good things about them. They're a small operation, but their efforts are very large indeed. They get in where other groups just can't.

Pony up some money for a buffalo.

New York

Tomorrow, Tiffani and I go to New York, where I'll be a guest on Larry Kudlow's show. Afterward, we'll get to have dinner with Larry and Charles Gave, co-founder of GaveKal.

We head out early the next morning for Philadelphia. My friend Thomas Fischer from Jyske Bank in Denmark is coming in, and we'll be going to see Steve Blumenthal and three of the mangers on the platform that I mentioned above. We'll be at the Bull and Bear for Happy Hour, so feel free to drop by.

I'm really excited about the lineup we have with all our partners. They (and I) do a lot of work looking for managers on behalf of our clients, and I think it's paying off. I'm proud of the work they do.

As my longtime readers know, I have an office that is physically in the Ballpark in Arlington. You can watch the Texas Rangers game from a balcony in right field. My lease is up on my office this time next year, and if we can get someone to take it before then, we'll move. Tiffani and I could each save about 200 hours per year by not having to commute. But I'll admit that tonight, with the Rangers playing Philadelphia outside as I write, I'm going to miss this place.

Of course, it's even better when we win 8-6. If only we had some pitching.
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