THE NEXT THREAT: INFLATION
The demise of Bear Stearns, failure of IndyMac Bank, troubles at US mortgage giants Fannie and Freddie and the housing debacle coupled with the nasty deleveraging process saw our markets and economy on tenterhooks. Each time we escaped with minor setbacks, clearly reflective of the resilient and agile nature of our financial structure. But something more ominous is gaining momentum which could potentially rattle the economy if kept unchecked: Inflation.
Economist John Maynard Keynes once said, “Inflation is a form of taxation which the public find hardest to evade and even the weakest government can enforce when it can enforce nothing else.” Unfortunately, not much light is being shed on this issue and our Fed is under the illusion that inflation is under control. Something very significant is about to unfold because a variety of factors could converge to drive inflation to disturbing levels.
A post analysis of the most vicious inflationary periods in recent history has shown that inflation primarily finds its roots when money supply increases dramatically. This creates a condition where more money chases the same goods and services, hence driving up price. But now, in addition to an oversupply of money, other factors like high commodity and agricultural prices, imported inflation, rising producer price index and a weak US currency will contribute to drive up inflation.
Money Supply Exploding: The Fed and the Treasury have our printing presses on overtime and money is being printed and pumped into the economy at an alarming rate. The sharp cuts in interest rates from 5.25 to 2 percent in a few months accelerated borrowing by banks and expanded money supply in the form of credit. Amidst all the turmoil, Congress approved a $150 billion stimulus package adding more money into the system now in the form of cash.
Lost in all this noise was a disturbing and vital piece of news which received no coverage. The Treasury/Fed decided to stop publicly releasing M3 money supply information. M3 is an extremely important number because it the broadest measure of money circulating in the economy which is tracked closely by economists. This number gives a clear picture of how much money is in the system. Having been publicly available for decades no rational explanation was given for this retraction. Although less accurate measures of money (like M1 and M2) are still available, it severely hinders the capability to quantify the amount of money in the system.
Imported Inflation: Textiles, electronics, furniture, toys and now even inflation is made in China. Many developing Asian economies which export heavily to the US are experiencing high levels of inflation. Central bankers and regulators in India and China are fighting vigorously to tame inflation, sometimes even at the cost of growth. But inflationary forces are still largely at bay in those economies and a significant portion of that inflation gets imported into the US through their exports.
This unfortunate phenomenon significantly affects our inflation rendering the US government helpless because this inflation is imported. This particular source of inflation is not about to drawdown anytime soon and has to be tackled.
Rising Agricultural/Commodity Prices and PPI: Significant price rises in commodities, agricultural and food products are inciting widespread agitation here and around the world. The producer price index (PPI) is widely considered a leading indicator of where consumer price inflation or CPI is headed. Measuring inflation in primary input articles for a wide array of manufacturers, the PPI reflects the rising cost of production and manufacturing which will eventually be passed on to consumers. Even this number has been on the rise, raising several red flags, which the Fed has chosen to ignore. There seems to be no reprieve for the PPI, which are disturbing signs going forward.
Misery Index: Many economists track the famous Misery Index (unemployment rate plus inflation) which is currently at 10.72 percent (unemployment at 5.7 percent and inflation at 5.02 percent). The appropriately worded indicator basically reflects the overall mood of the economy and the signs don’t look very sanguine going forward.
All these factors will converge and drive inflation to outrageous levels, so now is an appropriate time to look at your portfolio for asset re-allocation.
Your Money: Usually high-inflation periods result in super-low real returns when invested in the stock market (if stock market is up 15 percent, inflation is at 10 percent, your real return is 5 percent). This is primarily because of US Dollar devaluation and loss of purchasing power. Majority of local and dollar denominated investments will drastically underperform and here are some ideal avenues to park your funds in this situation.
1. Buying foreign currencies via ETN’s like CNY and INR or best, buying foreign currencies directly.
2. Investing in commodity rich country’s government bonds with high yields like Australia: Here you are positioned to gain from both currency appreciation and bond yields.
3. Shorting the US dollar via ETF’s like UDN.
4. Purchasing TIPS or Treasury Inflation-Protected Securities.
5. Purchasing significant quantities of gold, silver or other precious metals as a hedge.
6. Buying ETF’s, ETN’s and their options that track inflation.
7. Generally divesting from dollar-denominated assets.
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