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The media needs to do its homework: Inflation and your investments. (Part 2)

|Includes: Ford Motor Company (F), GLD, PFE

Currently QE2 is affecting China, since they are the source of the liquidity trap. A liquidity trap occurs when money leaves the system causing a drain on the liquidity stock. In the worst case scenario it causes deflation which is Ben Bernanke’s concern. To understand this concern you have to know how we got here and why we acted the way we did. Prior to the decoupling of gold from the Greenback, economies gained from trade at the expense of their trading partners. This “beggar thy neighbor” occurred because liquidity was fairly ridged; as goods came into a country, payments needed to be made, which caused a drop in the country’s liquidity. This drop in liquidity caused deflation in the importing country, and inflation in the exporting country. Eventually the importing country’s currency would revalue relative to the exporting country’s currency and they switched roles: The importer becomes the exporter and vice versa.  Notice this is a zero sum game.  When Nixon moved the US to a fiat monetary system, the US being a key reserve currency became the source for infinite liquidity. The international trade relationship that resulted was that the US would be the source of patentable technology and liquidity; Japan would use that technology to create practical technology; the Asian tigers would then make fabricated technology and China would assemble goods for export to the US. Money would flow to China, where China would pay their bills and invest the proceeds back into the US. This reinvestment in your trading partner eliminated the liquidity trap. With the ability to expand the monetary base, China could continuously expand as long as the US was willing to accommodate them. Currently with lackluster returns in the US and more focus on domestic spending their surplus, and the money the fed creates stays in China. The inflation is going to occur when the liquidity trap is fixed; this occurs when the Chinese move to a floating exchange rate.  When this occurs the FOMC will aggressively tighten the money supply, by increasing the overnight rates, selling bonds to drive up lending rates and in an extreme case forcing banks to have high reserve ratios.  When this happens the yields on bonds will increase which effectively destroys value for bond holders, since the face value has declined with the purchasing power. Commodities investors will also suffer since the increase in saving will hurt consumption which accounts for about 70% of GDP.  Gold will be affected the most since there is almost no demand for it as anything other than an inflation hedge.  Although there is not a strong correlation between lending rates and the return on gold, the last time interest rates were in the high teens the market for gold collapsed. I always invest in companies with unique products, strong balance sheets and cashflow; they tend to be the least affected by a high rate environment. Generally companies that have a unique product can pass on inflation to customers, thus limiting impacts on margins and earnings. If the product is demanded the same regardless of price (inelastically demanded) then there will be almost no impact on earnings. Companies like Pfizer who benefit from many barriers to entry, sell products protected by patents where costs can be passed on without much loss in demand for some products. Lastly be aware of how much debt a company has and if they can do business without the need of revolving debt issuance. Ford has a lot of debt, and is more vulnerable to fluctuations in lending rates than other less leveraged companies.

Disclosure: I have no positions in Pfizer, bonds or gold. I am long Ford. I will not be liquidating any of my holdings in Ford within the next 7 days.