The 2002-2006 bull market has recently moved to new highs, as have our portfolios, but our comfort level has actually diminished as a result of recent developments. Despite the positive momentum in the stock market and the plentiful liquidity supporting global economic activity and asset prices, it appears to us as though the risks in the markets are increasing. Our greatest area of concern continues to be the relationship between inflation and interest rates.
One only needs to look at a chart of the price of gold (up 25% in six weeks) to see that inflation pressures have intensified:
GLD 1-yr chart:
The Fed has discounted the inflationary signals from the soaring prices of other commodities (e.g. oil and industrial metals) by attributing their rise to a strong global economy, but that analysis does not work with gold.
Gold is unique among commodities. It is the only pure monetary commodity that provides a reliable barometer of inflation. Gold is rising sharply in all currencies, not just the U.S. dollar. This reflects the global nature of the current inflation problem and liquidity excesses.
To date, investors have largely bought into the Fed’s benign view of longer-term inflation risks, which has kept bond yields from surging and the stock market on an upward path. But the recent action in the price of gold may be warning that the market’s perception of inflation risks is beginning to change. Recent inflation data confirm the signal that gold is sending and point to rising inflation risks. Labor costs (easily the largest component of the expense structure of U.S. businesses) are growing at their fastest pace in five years, and record energy and other input prices are increasingly being passed through to end consumers.
Rising inflation and inflation expectations are toxic to bond prices, and to a lesser degree, to stock prices. The implication of rising inflation pressures is that interest rates at all maturities need to move higher.
After attempting to lay the groundwork for a pause in its tightening campaign, the Fed today hiked rates another quarter point to 5% and retained its bias towards further tightening. Even though the Fed unfortunately gives more weight to flawed government statistics on inflation than real-time market signals, at least the Fed appears to grasp that as long as gold and other commodity prices are soaring to new records, and the dollar is falling to 52-week lows, it has more work to do.