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In continuing the rant on the possibility of the US entering a stagflationary environment, as was hinted by Alcoa's (NYSE:AA) quarterly report (see "Is My Warning of the Risks of a Stagflationary Environment Coming to Fore?"), I have decided to graphically illustrate the historically most successful inflation hedges.

Click graphic below to enlarge.

inflation_correlation.png

For those "gold bugs" who have never ran the numbers, gold offers less inflation protection than your house does. The same goes for WTI crude and probably most other categories of oil.

The number one inflation hedge appears to be apartment buildings, followed very closely by other classes of commercial real estate, with MSCI emerging markets coming in a close second. I can assure you that the supply/demand imbalance, credit environment, fundamental and macro situations will prevent apartments (oversupply and softening rents from condo conversion competition among other things, driving up cap rates) and most CRE from taking off anytime soon. The short to medium term direction for most of that stuff is down (see CRE 2010 Overview for the 42 page white paper).

So, if the traditional inflation hedges do not point to inflation, but input costs are going up while real assets are deflating, what do we have?

From " Economic contractions AND rising prices, dare Reggie utter the "I" word - Enter a global phenomenon", we get:

Stagflation is an economic situation in which inflation and economic stagnation occur simultaneously and remain unchecked for a period of time.[1] The portmanteau "stagflation" is generally attributed to British politician Iain Macleod, who coined the term in a speech to Parliament in 1965.[2][3][4] The concept is notable partly because, in postwar macroeconomic theory, inflation and recession were regarded as mutually exclusive, and also because stagflation has generally proven to be difficult and costly to eradicate once it gets started.

Economists offer two principal explanations for why stagflation occurs. First, stagflation can result when an economy is slowed by an unfavorable supply shock, such as an increase in the price of oil in an oil importing country, which tends to raise prices at the same time that it slows the economy by making production less profitable.[5][6][7] This type of stagflation presents a policy dilemma because most actions to assist with fighting inflation worsen economic stagnation and vice versa. Second, both stagnation and inflation can result from inappropriate macroeconomic policies. For example, central banks can cause inflation by permitting excessive growth of the money supply,[8] and the government can cause stagnation by excessive regulation of goods markets and labor markets;[9] together, these factors can cause stagflation. Both types of explanations are offered in analyses of the global stagflation of the 1970s: it began with a huge rise in oil prices, but then continued as central banks used excessively stimulative monetary policy to counteract the resulting recession, causing a runaway wage-price spiral.[10]

John Maynard Keynes wrote in The Economic Consequences of the Peace that governments printing money and using price controls were causing a combination of inflation and economic stagnation in Europe after World War I. Stagflation was also a very serious macroeconomic problem in the 1970s. In contrast to central bank responses to the oil price spike of the 1970s where similar policies were pursued on both sides of the Atlantic, the 21st century began with America going one way to fight recession and Europe going the other way to fight inflation.

From the "The Butterfly is released!":

The decline in consumer spending has compelled many companies to reduce production. Toyota Motors Corporation (NYSE:TM) reduced its auto sales forecast for 2009 to 2.1% from 5.6%. The company projected auto sales to be 10.4 million vehicles in 2009, but rising gasoline oil prices are likely to dent demand. Toyota expects sales to decrease 10% in North America, its biggest market.

The cost of most inputs has risen sharply in the last one year. Although prices have come down from record highs and are declining m-o-m, they continue to remain high on a y-o-y basis. Prices of iron and steel, which are essential components of manufacturing, increased 16.1% y-o-y in August 2008. Prices of other commodities also rose globally, leading to a sharp rise in input costs. Various indices in the UK are pointing toward a trend of declining sales. The non-store retail & repair index fell 3.2% m-o-m in July 2008. Falling sales are further pressurizing the margins of industrial companies.

image007.png

Source: Government Website

The price of crude oil, one of the major inputs for manufacturing companies, increased at a rapid pace in 2007. Although the price has cooled down (falling 44% from its all-time high) as of September 11, 2008, it continues to remain high (37.4%) on a y-o-y basis. The increase in crude prices has pushed the cost of production higher.

The high cost of production can be passed by the manufacturer to the retailer only in certain cases. Various companies are evaluating the extent to which they can pass higher prices to end-customers. However, industrial companies would be affected in both cases-higher prices would weaken demand, while the increased cost of production would hurt margins. In such a scenario, maintaining a fine balance between the two is an extremely challenging task for industrial companies. Decline in sales due to increased cost (input and borrowing) is exerting pressure on industrial companies.

The article above is about a year old, but still drives home valid points. This material is a pre-cursor to the subscription material I will be releasing to subscribers illustrating the concentrations of sovereign risk around the globe. Remember, just because you transfer private risk to the government doesn't mean it disappears. There are pockets of risks in the usual suspects, but certain banks in certain areas have actually acted like sponges, concentrating risks in places where nobody really wants it. Now, back to the stagflation rant...

eu_inflation.png

As you can see, UK inflation is trending down, but you can rest assured that many input costs will trend up, as in the diagram from the "butterfly". Spain, Ireland and Switzerland suffer from outright deflation, but will probably not be spared higher input costs as well.

eu_employment.png

Economic growth doesn't look very promising in any case. The EU is a dead-zone for the time being.

eu_unemployment.png

Very few in the EU can afford the result of higher input costs on the back of sagging GDP. The jobs just aren't there.

eu_cds.png

Does the CDS market see what I see?

So, what about the US and North America?

na_gdp.png

GDP is expected to increase, but relatively anemic compared to other so-called recoveries. Some expect a double dip recession, I believe the recovery is really just the masked effects of the government literally purchasing GDP points, paying $1 for every 30 cents worth of recovery.

na_unemployment.png

You can see, as in the EU, we cannot afford price spikes in anything. Higher input costs will simply lead to lower profitability, for price in-elasticity is here. People couldn't afford to pay more if they wanted to. Credit and income are way, way down. This means that companies will have to eat higher input costs since they can't pass them on. Translation: those sky high S&P earnings forecasts are fantasy, at best. Even if fantasy were to transform to reality, the stock market has already priced in la la land.

na_inflation.png

Inflation is expected to be tame. Stagflation is the threat.

I will walk through all of the world markets in the next week or so, and culminate the study with the banks that I feel are most at risk from the weakness in various sovereign states. The most "at risk" banks will be for subscribers, but there are quite a few that I will share publicly.

Disclosure: no positions
Source: Deflation, Inflation or Stagflation?