The Struggle Between Inflation and Lending
I BELIEVE WE ARE IN A WAR BETWEEN TWO MAJOR ADVERSARIES. On the one side, we have the Fed (and other central banks) pumping liquidity into the system in a desperate attempt to support the asset markets and the economy. On the other side, we have the private sector, which is being forced to curtail lending due to heavy losses in the credit market and to fight the Fed’s reflation efforts by widening credit spreads.
Complicating matters is the fact that both adversaries have powerful allies. The Fed has the Treasury and the government, as well as the Wall Street elite, as allies. The government could implement massive tax cuts in order to stimulate economic activity; the Treasury could bail out financial institutions, which in reality should be punished by bankruptcy; and the moneyed Wall Street elite will ensure that politicians and the Fed make it possible for them to continue their con game.
The private sector has allies in the form of inflation, a weak dollar, and a dissatisfied public (declining consumer confidence and lack of trust in government, which is reflected in the strong showing of Ron Paul), all of which form a powerful phalanx when battling the Fed’s reflation attacks. Inflation is a powerful ally for the private sector, because it squeezes corporate profits and curbs personal consumption.
The war between the Fed and the private sector will, in my opinion, be very protracted. The Fed will win some battles, which — along with much brouhaha in the media — will see Pyrrhic victories such as the stock market rally of August-early October, which led in dollar terms to new highs, but failed to do so in euro and gold terms, and was followed in euro terms by renewed severe weakness.
Other battles will be won by the private sector, which through its contraction (recession) amid inflation will lead to sharp downward movements in equity prices. I am well aware that the Bureau of Labor Statistics and the Bureau of Economic Analysis will continue to use bogus figures when reporting inflation, and hence real GDP growth, but they won’t be able to hide the squeeze on corporate profits and the consumer from rising prices.
Cost of living increases vastly exceed the reported inflation figures and are squeezing the consumer, which leads to revenue pressure for the corporate sector. According to the Kaiser Family Foundation, health insurance premiums have risen 78% since 2001, while wages have gained only 19%. At the same time, corporations are faced with a squeeze on margins due to rising costs. Cost pressures contributed to the dismal performance of earnings in the third quarter of 2007.
For example, Starbucks increased coffee prices by an average of nine cents per cup in July. However, customer visits to U.S. stores fell 1% for the quarter ended Sept. 30. According to the CFO, “Unbeknownst to us, we saw economic head winds that, quite frankly, came up probably stronger than I thought.” Earlier, Starbucks’ CEO had remarked: “The consumer is being faced with rising costs in every sector of their lives, and so part of that is reflecting on us.” An informed friend of ours suggested that declining traffic at Starbucks stores in the U.S. is of particular concern, since Starbucks serves all income levels. Therefore, declining traffic is not just a “subprime problem”!
This rate of economic contraction would seem to be consistent with the impending slump in corporate profits, and with the observation that the U.S. economy is already in recession.
On one side of the new inflation war, the Fed is pumping liquidity into the system via rate cuts and repurchase agreements. On the other, the financial sector is withdrawing liquidity from the system via huge write-offs and newly timid lending policies. This war should lead to increased volatility. Ten percent market moves will be the order of the day.
As was the case in the 1970s, we can expect the stock market to sell off by more than 20%. At the time, the two adversaries facing each other were “easy monetary policies by the Fed” and “consumer price inflation.”
Nobody won that war decisively, since stocks in 1982 were at about the same level they had been in 1964. However, since U.S. equities had declined in real terms by 70% from their real 1966 peak to their real August low, one can now assume that the Fed lost that war. Today, the adversaries are the private sector, which with its inflated asset values now wants to deflate, and the Fed, which under Bernanke and Greenspan, never quite understood that larger and larger injections of liquidity into the system, leading to excessive debt growth, brings about a gross misallocation of capital.
I have no doubt that the Fed will lose this war as well — if not in nominal terms, then in real terms, or adjusted for the sinking value of the U.S. dollar. More to the point, the Fed has already lost this war: U.S. equities fully recovered after October 2002 and made an all-time high in October 2007 in dollar terms, but even at their recent highs they were down by 37% in Euro terms (measured by the S&P 500) and by 60% in gold terms.
Still, we have to be mindful that even if the present economic and financial environment doesn’t look particularly enticing, as was the case between 1964 and 1982 when the market didn’t make any headway, plenty of investment opportunities will present themselves from time to time for the nimble trader and for the long-term investor who will be positioned in the few asset classes that will perform well.
Moreover, it would be wrong to simply assume that recession and slumping corporate profits will inevitably knock down equity prices. Other factors such as negative real deposit rates and negative real yields on Treasury bonds because of the Fed driving down the Fed Funds rate, a weak dollar, and “bubbly” emerging markets could make U.S. equities a relatively attractive proposition compared to other financial assets.
With Bernanke at the Fed and Paulson at the Treasury, and a Euro that could face some problems (a breakup, some believe) because of badly deteriorating economic conditions in Italy, Spain, Portugal, and Greece — precious metals are likely to outperform financial assets for some years to come, resulting in the persistent decline of the Dow/gold ratio.
As Michael Berry remarked, “Gold is no friend to the world’s central bankers. The printing press is their friend.” In fact, I would be very surprised if the Dow Jones Industrials/Gold Ratio didn’t decline to between 5 and 10 within the next three years. Therefore, I should like to reiterate my recommendation to accumulate gold.
Other commodities that could come to life this year are sugar, cotton, natural gas, and palladium. Moreover, uranium is unlikely to disappoint the longs. In general, some special situations aside, I am not positive on industrial commodities in a slow growth or recession type of environment.
Among commodities and currencies, my preferred asset remains physical gold held outside the U.S., for the simple reason that — depression or inflation — it is very likely to outperform financial assets. For gold, I believe the best is yet to come!
March 4, 2008