Ripples Of Inflation Concern

By: Michael Ashton | Tue, Jan 18, 2011
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Another quiet, weather-dampened day as a minor ice/slush storm trickled across the Northeast. Traders easing back from the holidays defaulted to the recent, easy trade of buying stocks and selling bonds, which moved in their usual directions today.

Ostensibly, part of the reason for the rally was that "Euro-area finance ministers vowed to strengthen the safety net for debt-strapped countries yesterday, examining ways to give the 750 billion-euro ($1 trillion) rescue fund more flexibility without ruling out boosting its size..." (link to story).

It is very convenient that in this country we didn't have to look to any other European headlines to know whether to be long equities (heck, it isn't clear whether we need to look at news or data of any kind these days! Just buy, buy buy!). So, for example, we could blithely ignore the Wall Street Journal (Europe) headline that "Germans Remain Wary Over Boosting Bailout," (link to story here) which certainly makes one wonder how those other Euro-area finance ministers are going to avoid ruling out boosting its size.

Spain canceled a 10y and 15y bond auction that had previously been scheduled for this Thursday. The masterful spin is that they preferred to get the better pricing offered by a syndicate of banks for the €4bln-5bln issue (link to story). Yes, that's right: the story is that a group of banks are doing Spain a favor by paying more than the market would pay for a bunch of Spanish bonds. Is there any better sign that cynicism is in full retreat? It seems scarcely a year ago that banks were being flayed alive for their sins (actually, the Financial Reform Bill passed only seven months ago), and now we are expected to believe that in a spirit of generosity the gentle bankers are saying "shucks, there's no need to go to the market, Spain! We'll do it right here for you, out of the goodness of our hearts. Sure, we could simply bid in an auction but this is better for you, the client, and so it's good for us. Peace out, y'all." Right.

But I do detect a ripple of uncertainty, a tremor of doubt. Of course, it's easier when that doubt is in the Barron's Roundtable of this weekend's edition.

The panelists were generally bullish on stocks, but almost all of them acknowledged that the market was fairly "fully" or aggressively priced and most of them could conceive of at least a correction. But what was striking to me was the exchange between several luminary investors who mentioned 'concerns' about inflation. The quotes are below. Please note that I don't endorse any particular point of view here; these are just listed for the timbre of the comments:

Marc Faber: History has shown that giant countries on the way down are very dangerous because they are desperate...If you measure the stock market not in dollars but gold, it is down 80% since 1999. I no longer regard the U.S. dollar as a valid unit of account. People shouldn't value their wealth in dollars because one day, in dollars, everyone will be a billionaire.

Bill Gross: I agree with Marc on many things, though not everything. I don't know if the U.S. has reached a desperate point, but it is employing instruments and vehicles and policies that smack of desperation. We are not looking at a default here, but at years of accelerating inflation, which basically robs investors and labor of their real wages and earnings. We are looking at a currency that almost certainly will depreciate relative to other, stronger currencies in developing countries that have lower levels of debt and higher growth potential...

Marc Faber: It is much easier for a government to print money and default in the way Bill just explained than to come out and say 'we aren't going to pay half our debts.'...

Felix Zulauf: In the late 1970s and early 1980s, Paul Volcker crunched inflation by applying very high real interest rates for several years. Now we are getting the same process, just in reverse. Just as it took several years for the market to see that Volcker's policies would lead to declines in inflation and interest rates, it will take several years for the market to realize the Fed's current policies are highly inflationary...

And that exchange didn't even include Fred Hickey!

There are a few nuances I don't agree with here. For example, inflation doesn't really solve all of our problems like a default does; we will have to 'default' on some of the promises made for our grand entitlements of Social Security (maybe) and Medicare (almost certainly). But ignoring those nuances, this is an amazing series of observations from some very heavy hitters in the investing world. No wonder TIPS did well today despite an impending auction. No wonder the dollar dropped to 2-month lows!

Since we're talking about the viewpoints of Barron's Roundtable participants, I should take pains to point out the Outlook for Inflation piece I wrote over the weekend and which you may have missed if you were on holiday today. I also should note that my company specializes in inflation and can examine how industry- or region-specific inflation impacts your business. If you share my views, and that of many Roundtable members, about the medium-term course of prices, you should carefully consider your risks here.

Also note that we've just posted a new website for the Inflation-Indexed Investing Association as a companion to the LinkedIn group of the same name. The website (www.inflationinfo.com) is intended to become a hub where investors can access high-quality research on inflation and other resources. There is a lot of work to be done yet compiling the information, but if you're looking information on inflation this is a place you will want to look.

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Today's Empire Manufacturing report was in line with expectations but mostly ignored. Tomorrow's Housing Starts (Consensus: 550k vs 555k last) is not anticipated to move mountains. A sustained move of Housing Starts over 600k units is necessary before anyone gets too excited about the contribution of housing to growth; in the meantime, weak construction activity helps slowly clear the inventory (but it's very slow, since most of the inventory is in the much larger stock of existing homes, so 25k or 50k per year in housing starts isn't going to make a huge difference).

Bonds seem reasonably stable here, but I think we're all staring at the branch stocks are crawling out on and waiting for it to break. Some people are waiting for that break because they'd like to buy the market 5% lower, while some see a much more severe move and/or trend ahead. The question is moot while we all stare dumbly at a market which is sputtering, but sputtering consistently higher. I feel a little helpless. Experience tells me not to address the feeling of helplessness by trying to do something, but the fact that the market keeps inching higher is a sign that not everyone feels that way. In my mind, it's (still) time for waiting.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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