24 Mar 2005 Inflation – Probably Overdone

Since our last Brief a couple of weeks ago, inflation has taken center stage as the new hand-wringer.  On March 2^nd oil blew through its most recent high of $52.88 reached on October 26^th.  It now stands at $56.62 per barrel.  But the economy seems relatively unfazed.  That is until recently.  It now appears that businesses are beginning to pass along their commodity and labor prices to consumers.  On Tuesday, Greenspan seemed to confirm what many had been worrying about for months; that inflation is creeping back into the economy.

But we believe on the strength of our market and economic experts that the reactions are very much overdone.  We believe that inflation is not going to be a major problem from here and that interest rates are closer to their tops than is widely believed.

Yesterday, the government released its Consumer Price Index and it confirmed that prices were indeed on the rise as the measure was up the most in four months.  The stock and bond markets were down both days, but not so much for the news that inflation was picking up, rather it was the Fed’s statement that many took to indicate that future rate increases might be of the half percent variety rather than the quarter-point up-ticks we have grown accustomed to over the past seven months.  Moreover, the target percentage rate the Fed is working toward, whatever it will be has likely increased from what it might have bee a few weeks ago.

One of the offshoots of the near unprecedented low rates offered up by the Federal Reserve following September 11^th is that theU.S. economy has become much more interest rate sensitive.  Increased debt has been used in virtually every corner of our economy.  Businesses have employed debt increasingly in their business models.  Companies like General Motors, Caterpillar, and General Electric have significantly enhanced their profits of late by financing the large capital goods they sell.  Home buyers refinanced their homes to the limits of equity requirements.  Those with adjustable rates will soon see increased mortgage payments in the coming months.  Combined with higher prices for gasoline, heating oil, and imported goods, economists worry that the consumer might take that long-awaited spending pause.

But let’s keep things in perspective on inflation.  On a year over year basis inflation now stands at 3%.  It reached a low of 1.1% during June of 2002 when the economy was recovering from recession.  If you look at the graph on the following page you will see that inflation is just nearing the levels it held throughout much of the 90’s.  Moreover, a peak in inflation is likely near.  Two of the major future indicators of inflation, gold and commodities have technically peaked and are headed down.  The CRB (commodity) index is down almost 6% in the last two weeks.  Gold, an excellent predictor of inflation, has failed to make new highs since its peak of 457 at the end of last year.  It is down 7% from those highs and currently stands at $425 an ounce. 

Also suffering price declines were emerging markets countries.  As interest rates rise, some fear investors’ appetites for risk will wane.  Global indexes for the past five days are down three to six percentage points with Latin American countries suffering the worst declines.  However, a more thorough investigation of many emerging markets countries reveals that their assets far exceed their liabilities in stark contrast to crisis periods such as the Asian credit crunch of 1998.

As we’ve said recently, we look for 2005 to be a rather lackluster year as many economic and fiscal questions remain to be answered.  However, stock valuations look very attractive now which should substantially limit near-term downside risk.

Beyond this year, the outlook for stocks improves substantially.  One of the experts we follow is Don Hays of Hays of Hays Advisory.  He makes a fascinating comparison of the time following the 1929 crash and the present aftermath of the NASDAQ crash.  Here’s what he had to say:

“The period immediately after the horrendous 90% collapse in the Dow Jones Industrial Average of 1929-32 closely mimics the 90% collapse (and ensuing birth of the new bull market) in the NASDAQ 100 in these last four years.  Both indices were the best proxy for the cultural revolutions of the time (Industrial vs. Technology.)  Here’s the equivalent chart showing the two indices on the same percentage for the equivalent time lines—then for the Dow, now for the NASDAQ 100.”