How Much Inflation Will We Have to Endure? 31 comments
-
Font Size:
-
Print
- TweetThis
The battle is over. Structural inflation has won. The question now becomes, how much inflation will we experience before this trend exhausts itself?
As I’ve stated before, historical benchmarks and references no longer apply in predicting upcoming economic changes. Familiar risk/reward scenarios will not work.
De-leveraging from debt is occurring in the US economy from unprecedented heights. This is witness by the continuing fall of home prices. The latest S&P/Case-Shiller index reported a 14.4% decline from a year ago March.
Once upon a time, inflation and de-leveraging did not occupy the same space. However, recent monetary policy, coerced by the credit derivatives melt-down, prompted the Federal Reserve Board to lend to non-commercial banks, the first since the great depression, through the discount window. Massive amounts of liquidity have washed across the country’s banking system since last August, triggering inflation speculators to hike the price of oil in the futures market.
Globalization has also led banks in Australia, Europe, and Canada, to become victims of the US sub-prime fiasco. Increased domestic and international energy requirements are affecting the market psychology, more so, than supply/demand elasticity, thereby pushing the price of oil to recent highs to $135.00 a barrel.
This sudden price shock in petroleum has shifted global wealth from the West to Russia, the Middle East, and Latin America, causing a stampede in the buying of US assets by foreign investors and newly created sovereign wealth funds. U.S. commercial and investment banks exposed to tens of billions of dollars in write downs, from Collateralized Debt Obligations (CDOs), exchanged equity with these government-backed institutions to remain in business.
The devalued US dollar, losing over 30% of its purchasing power since the beginning of the Iraq War, which closed on May 30th at .643 to the Euro, 105.70 to the Yen, and allowed equity indices to finish the month, such as the S&P 500, at 1,400.38; NASDAQ at 2,522.66, the Dow Jones Industrial Average at 12,638.32, among others, to cling near their recent highs.
The invasion and continued occupation in Iraq, continues to drain our treasury, by billions of dollars each week, not to mention lost of life.
Agriculture commodities’ steep price increases has produced financial hardship and even scarcity in the most improvised nations, leading to hoarding, and in a few cases food riots, while the volume of distilled ethanol from corn is growing to reduced our dependence on oil. As we look forward, these trends will recast investment formulas and dynamics, thus returns for this century starting the next decade.
In the 1970s, the last period of rampant inflation, as gross mismanagement by the Feds (through tepid and faulty action, combined with the coupling of wages to production and profits and widespread regulatory authority and enforcement) provided white-collar workers a certain congruency to price increases and personal income.
Likewise, unionized workers, at their apex of power in this same period, received negotiated cost-of-living wage and benefits adjustments in union contracts to modestly moderate the effects of structural inflation.
Over the last 30 years, the continued separation of net income and production and business deregulation has created a line-item effect on corporate asset valuations and personal income. To be fair, technology has played an important part in lowering the cost of production and the retail price of goods and services. Cheap foreign labor has also provided relief as a major input in the price of manufactured goods exported to America. Technological advantages and global labor, as positive inputs, are reduced as crude oil prices levitate.
In the first part of this decade, price declines in goods and services fell at differing rates. And so did the cost of money. After the 2000 – 2002 equity bear market, which subtracted approximately 8 trillion dollars in household net worth from our economy following 9/11, the feds lowered short-term rates to 1% to mitigate the probability of a deep and protracted recession.
Until the most recent real estate bubble began to burst, this low interest environment added 5 trillion dollars in real estate equity, thus re-inflating household net worth. We essentially exchanged one bubble for another, in hindsight.
Today, the extreme fears by investors of the invisible danger lurking throughout capital markets have kept treasury yields low. All, save the 30-year Treasury bond, has been below 4%, throughout the spring. That is changing, as the 10-yr Treasury note, closed at 4.065%, the highest yield it’s been since 12/31/2007, the last business day in May. Surprisingly, the Treasury market has, so far, ignored the gathering inflationary clouds.
Historically, the 30-year bond was the bellwether for future inflation. This time around, so far, it is behaving as a lagging indicator, closing May 29th, at 4.785%, its greatest level since 10/17/2007, when the Light Crude, July ’08 contract, closed the week ending, 10/19/2007, at $81.74, a barrel. The second half of 2008 will almost certainly show an increase in prices across the board, effecting the month over month, and the year over year, CPI and PPI figures. The next six months of this presidential election year is quite possibly a preview trailer for an economic horror movie, Son of Inflation, which may run for the next five years, or more.
In the next decade, labor, materials, energy, and capital, will cost more. The benefits of deflation, we enjoyed the last 20 years, as we transitioned from an industrial/serviced based economy, to an informational/digital based world, will grow smaller, watching it disappear in our rear view mirror, as the form and manifestation of inflation appearing before us, now grows more and more discernable. This macro overview of economic trends, both past and future, is important to review. Managing wealth for the conservative, fixed income investor is most successful, when short term trends are discernable from long term themes in the marketplace. Downside risk to debt, correctly diagnosed, from market and credit exposure, can actually be converted into an upside opportunity, for investors. Growth of income, in an inflationary environment, is as important as sustainability of income is, in deflationary times.
Income and cash flow is the wholesale beneficiary of deflation. With rising inflation, fixed income becomes a vulnerable asset. Harnessing variable rate income is a tricky proposition. Investors living off a fixed income portfolio can watch their purchasing power decline, while variable rate investing, an actively managed exercise, can produce level results. Different investment vehicles must be considered in a changed, inflationary climate, to preserve a client’s current purchasing power.
Since every first world economy is shackled to oil, as we approach $150 dollar per barrel, the seeds of mounting inflation tomorrow, are being currently sown. Without the price for oil, returning to below $100, before the November elections, it will not do so. By 2010, 8% to 10% inflation will be embedded in our goods and services, and psychology.
A weaker dollar prevents a return to lower price levels. And, if OPEC replaces oil pricing in dollars, with the Euro, or a basket of currencies, then, inflation will expand even higher.
Now for the bad news; we have entered into a protracted recession. This parallel universe, of inflation and recession, will feed off one another, unless a conscious decision by the federal government to allow depression to occur. This, however, is a political improbability. Although, the government may inadvertently back into economic depression, either outcome is financially horrid, extremely painful, with, heretofore, untold, harmful consequences.
This bleak assessment is being offered, as the sub-prime fiasco continues to ravage, financial institutions and central banks, around the world. Over $380 billion dollars, in write-downs, have been announced, so far. The International Monetary Fund estimates that worldwide, that number could reach 1.2 trillion dollars. Even if the final number is only half, how much more battering can our financial institutions take?
Investment banks, beginning last summer, experienced the first wave of the credit crunch. And, each quarter, fresh admissions of write-downs and losses shakes the confidence of Wall Street. These unending losses by banks, combined with future regulatory changes in capital requirements, will reduce overall consumer liquidity, by way of lower available credit card and home equity, credit lines and higher underwriting standards.
The appetite to spend by the consumer, and their capacity to manage personal cash flow, will be significantly suppressed. The consumer’s inability to support the economy through spending will assume the lead during the next wave of the liquidity crunch.
The Conference Board Consumer Confidence Index fell to a reading of 57.2, down from 62.8 in April, marking the lowest figure since October 1992. A softening job market will also depress consumer psychology going into 2009 and 2010.
In summary, while various inflationary inputs are more than likely accelerate to the upside, the trajectory of economic growth will diminish to a flatter curve, or, may even significantly contract, near term.
Municipal bond investors are standing on the precipice of fundamental economic change. For me, the canary-in-the-mine-shaft is the coupon size of newly issued debt. When the 5.5% coupon threshold is crossed, for the highest quality municipal bonds, we shall have fresh, direct, evidence that greater inflation has began infecting the municipal bond issuance marketplace. Until that signal is flashed, there are no superior alternatives for high net worth municipal bond investors to pursue.
The current taxable equivalent yield of 7% +, from holding long term municipal bonds, is still the highest ground for conservative investors. But, this safe haven, to preserve capital, has a shortened shelf life.
US Treasury Inflation Protection Securities [TIPS] is conservative tool, with which, to diversify a bond portfolio. Like a regular treasury, the interest is paid twice a year and is exempt from state taxation. Additionally, an inflation factor, based on the CPI, is applied to both the principal and interest. Appreciation of the principal is taxed as a capital gain in the year it occurs.
This July, the Treasury Department will auction the 20 year TIP. In October, as they did in April, a 5 year TIP will be offered. I recommend reallocating 5% of your bond portfolio into these to securities, in equal weight. In 6 months, we will review the state of the economy and assess inflation
Related Articles
|
Find People on SA
-
The Seeking Alpha 100
See allThe top 100 stock
market authors
selected for publication
Seeking Alpha 100 » -
Fastest Climbers
Authors with the largest
increase in followers
in the last 7 days-
1
David Fry
-
2
Philip Davis
-
3
Bill Gross
-
4
Tyler Durden
-
5
TraderMark
Fastest Climbers » -
1
-
Top Commenters
Top commenters,See all
as ranked by their peers
Top Commenters » -
Top Instabloggers
The 100 most activeSee all
Instabloggers.
Top Instabloggers » -
Top StockTalkers
TopSee all
StockTalkers.
Top StockTalkers »
This article has 31 comments:
Yields greater than 10 % are common and if in Roth, would yield another 2.4 % for taxes. They have a potential capital gain as well so the real return could be over 25%. Try Lehmans research or SA for MLP,s. There have been several good SA articles seekingalpha.com/artic.... My personal favorites are PWE, TPP, APL,WPZ,ETP,EPD,LINE,O...
The US is greatly unprepared for the realities of the energy markets. Prices of gasoline, utilities, food, etc. will continue upward.
TIPS do not seem the way to go. However, the author only recommends a 5% allocation, which limits damage if they go against you. A more significant question is what do you do with the other 95%.
The difference between the annualized rate (AR) 6-month in the CPI and the AR 18-month CPI is rolling over. This number always ends up in negative territory during economic weakness.
If asset inflation really were the future, wouldn't the solution be to borrow a large fixed amount now and to buy US assets? The dilemna is that broad-based asset inflation is not what we are faced with in the US (or overseas). What we are really seeing is a process of diversification from traditional passive assets (stocks and bonds and real estate) to a broader range of assets. In the short term, there is some enthusiastic overbidding for the new class of assets.
Commodity asset prices won't stay at this level for too much longer; they have been inflated by speculation and you can count on high prices to produce more supply in a free market. Malthus was wrong in the past and his disciples are wrong today.
As for the dilemna of US mandates (income replacement for older working wealthy, and high technology medical care at levels undreamed of ten years ago) that can be resolved politically without eroding necessary safety nets.
And if we really needed new income sources for our overreaching government, there are reasonable solutions which will cause a lot of squawking, but raise the money.
LordDarley
To keep it short and simple, inflation is based, today, on one overwhelming fact: the price of Oil!! Until we get this under control and down to a reasonable level, inflation will continue to escalate. Additionally, until we clean out the gang of 535 that occupies the Congress and screws up everything they touch, nothing of significance will happen in the war on inflation.
The American electorate has the power to begin this task in November by voting-out the entire House of Representatives and a good portion of the Senate. However, the replacements had better understand the mission they will be charged to accomplish by We the People and get to work on it when they take office in January 2009. Significant progress on energy independence must be completed by March 2009. If we are to dig out of the mess that the Democrats have manufactured since taking control in 2006, we must start in November.
Although, the Republicans in Congress have been ineffective since 2006 (some would argue long before that date) they are starting to stir, once more. They are stopping the programs of the Dems to join the nonsense of the global warming wackos and the kowtowing to the UN wonks. Additionally, they are pushing their program of “Drill Here, Drill Now!” and are attracting the support of the vast majority of the citizenry. If they stick to their guns and make significant progress, we may allow some of them to remain in place in November. If not, out they go!
One last point. The author of this article, Marvin Clark, bemoans the expenditure of billions of dollars in the Iraq War. Tell me, Mr. Clark, how many billions would be spent if the terrorists were able to, directly, attack this nation? As with the liberals who oppose the war, your insights and criticisms are too narrowly focused and completely disregard the consequences of your proposals. I believe a high colonic would work wonders on clearing your vision.
one reader mentions investing in MLPs - PWE and some others are not MLPs, they are Canadian Income Trusts
livingoffdividends.com.../
Stock averages are not falling more than 10% - 20%, before rallying back up, because foreign investors will buy US stocks at huge currency exchange discounts. Too many dollars...
". .Growth of income, in an inflationary environment, is as important as sustainability of income is, in deflationary times.
Income and cash flow is the wholesale beneficiary of deflation. With rising inflation, fixed income becomes a vulnerable asset. Harnessing variable rate income is a tricky proposition. Investors living off a fixed income portfolio can watch their purchasing power decline, while variable rate investing, an actively managed exercise, can produce level results. Different investment vehicles must be considered in a changed, inflationary climate, to preserve a client’s current purchasing power."
I did not separate out the MLP from the Canroys but instead tried to refer the reader (of the very good article) towards a vechicle that would have capital appreciation AND income without going into all the tax implications (other than Roth) between a "Distribution" and a "Return of Capital". I just lumped them all together and I should have realized some cannot see the forest for all of the trees in the way. Mr. Clark does make a lot of sense in his well written article. If you take the time to research the probable total return of the "MLP"/CanRoys for a tax exempt/differed account, I think you will find most would be in excess of 20 %. Lets see, most are energy related/pipeline/elect... power/compression/products, etc. . . .wonder how they might do if Tampons become more expensive?
Also, remember as late as February 2001, The treasury Dept. suspended the issuance of the 1 yr t-bill because of the balanced budget in those years.
Even if a new solution is engineered to balance the budget the temptation to cut taxes or re-distribute wealth will arrest its existence.
This article may well be the mantra for which all future scribes will merely mimic.