For fans of contrarian thinking, the ultimate draw these days is inflation.
reported here, the current debate on Wall Street is overwhelmingly focused on the deflationary threat. Almost no one is considering the inflationary alternative. In congressional testimony Wednesday,
Chairman Alan Greenspan said low levels of inflation were one reason the central bank cut rates on Nov. 6 by 50 basis points, rather than 25, as "insurance" against unforeseen economic weakness.
Key contributors to the "inflation is dead" scenario are trends in the most commonly watched inflation indicators. As of September, the Consumer Price Index's annual growth rate was 1.5%, up from the 38-year low of 1.1% in June, but still well below levels considered worrisome. The Producer Price Index was up 0.6% on a year-over-year basis in October, after posting its largest rise in more than three years on Friday, and vs. a 50-year low of negative 2.7% in May.
Given those figures and the economy's tepid recovery, "fiscal or monetary policies that stand to elevate inflation risks going forward" are necessary and prudent, observed James Padinha, economic strategist at Arnhold & S. Bleichroeder in Los Angeles.
Nevertheless, a smattering of Wall Street observers believe the inflation threat is real -- certainly, that the deflation threat is vastly overstated. Furthermore, a series of indicators support that view.
First, the CRB/Bridge Index, a measure of 22 industrial and agricultural commodities, is up 19% in the past 12 months and a host of individual commodities have posted even larger gains, as the following tables indicate.
This is Deflation? Part 1
Similar to agricultural commodities, most notably wheat, many industrial commodities have bucked the presumed deflationary trend. These include rubber, up 44% in the past year and scrap steel, purportedly a favorite indicator of chairman Greenspan, which is up 33.1%.
This is Deflation? Part 2
Second, while CPI was up just 1.5%, the core CPI -- which excludes food and energy -- was up 2.2% on an annual basis through September and the Cleveland Fed's median CPI -- a more accurate indicator -- was up 3.3%. (Furthermore, it has been argued
here, among other places, that it's in the government's interest to drive the CPI down.)
"I would argue that we have an inflation problem relative to the level of interest rates," said Jim Bianco, president of Bianco Research in Chicago. "No one is saying we're going to see 5% or 6% inflation, but at 1.25% the fed funds rate is too low" relative to present-day inflation. Since inflation is a monetary phenomenon, the current negative real fed funds rate (fed funds adjusted for inflation) means the Fed is trying to ferment inflation with extremely accommodative policies.
In other words, inflation could result from too much money -- due to the Fed's easy policies -- chasing too few goods, due to low capacity utilization rates, , which came it at just 75.2% for October, the government reported Friday. For example, the low fed funds rate and corresponding low mortgage rates have helped spur demand for residential housing, driving prices substantially higher. In addition, cash-out refinancings are approaching $300 billion this year vs. a range of $25 billion to $50 billion in the 1990s, according to Economy.com. That money is unlikely to sit under (new) mattresses.
If inflation does rise a little and the economic recovery takes hold, "the first thing the Fed does is double the fed funds rate to 2.50%," Bianco predicted. "That will look like a big deal psychologically and why I think the inflation story is a worry."
Given that, Bianco is "bearish" on long-term Treasuries but even more concerned about the short end of the yield curve (which itself is positively sloped indicating the bond market's expectation of positive economic growth rather than a deflationary downward spiral).
Betting on Inflation
Thomas McManus, equity portfolio strategist at Banc of America Securities, recommends a 20% bond allocation largely earmarked for corporate bonds (both high yield and investment grade). McManus no longer recommends TIPS, suggesting they performed "too well" in the past year and have probably peaked.
Additionally, he recommends overweight positions in stocks that "can pass along rising costs more easily," as well as basic materials/energy names, including insurer
, chemical concern
, oil driller
, and food products giant
. (Banc of America has done underwriting for all, save Patterson-UTI, in which it makes a market.)
"I think the risk investors face
going forward is the risk of inflation, although it's clear today's issue is disinflation run amok," McManus said.
One reason for his recent optimism about stocks, and corresponding concern about future inflation, is the presidential election cycle. In the final twoyears of presidential terms, the
Dow JonesIndustrial Average
has produced a total net gainof 722% for 42 administrations since 1832 vs.appreciation of 252% in the first two years of the terms,according to
The Stock Traders Almanac
Given Republicans' newfound control of Congress,McManus expects President Bush to push for a series ofspending initiatives, as well as additional tax cuts."There's a trade-off between job creation and electionsuccess, and
fiscal discipline," he said.
In addition, "war is inherently inflationary,"McManus said, more especially when it affects energyprices as with the current belligerence with Iraq.Furthermore, "it doesn't matter how cheap a DVDplayer" or other consumer electronics get when itcomes to inflation, he argued. What matters are thecosts of basic needs such as food, shelter andhealth care, which have all been rising.
More theoretically, the strategist observed that following boom periods such as in the 1990s, a bust inevitably occurs due to overcapacity and steep price competition, evoking the "creative destruction" theories of Austrian economist Joseph Schumpeter.
But "when enough companies go out of business, theremaining companies will get pricing power," McManus said. As competition is reduced, surviving firms can pass along increases in their raw material costs (see above), he continued, suggesting that juncture is at hand or, at least, not far off. "The time to worry about the bust is during the boom, not during the bust. Now, investors should be preparing themselves" for the next upturn in economic growth and inflation.
Confession of an Inflation Hawk
As longtime readers may recall, this column wasnot concerned about deflationary threats at the heightof the boom. Furthermore,
subsequent worries about inflationin 2001 also proved off base. Had I been a fundmanager, I would have missed the historic rally inbonds but participated in the simultaneous rally ingold and related shares.
So what's different this time? According toBianco, one of the prime sources for those
prior stories, the"simple answer" is that inflation concerns provedwrong, to date, because of the reverse wealth effectspurred by the stock market's collapse and the recession."If those reasons are removed, maybe inflation is donegoing down," he said.
Finally, no discussion of potential inflationwould be complete without at least a passing mentionof the dollar, which is down 9% for the past 12 monthsbased on the Dollar Index. A continued, steepening,drop in the dollar will cause import prices to rise,further eroding the buying power of U.S. consumers.(Through October, import prices are up 2% on ayear-over-year basis, due mainly to higher energyprices, the government reported Thursday.)
One hardcore bear forecast an as-much-as 80% swoonin the greenback in the coming year, which will cause"Americans' standard of living to implode" asforeigners stop funding our yawning current accountdeficit. That's the inflation-driven corollary to the1930s-style deflationary spiral.
Compared to those scenarios, an expectation for alittle higher inflation along with a stronger economyis unfettered optimism, something I've often accusedof being unable to muster. One qualm is financialmarkets are ill-prepared for that "upbeat" outcome, much less the stagflation (i.e. higher inflation and lackluster growth) I still believe the most likely long-term outcome.
On that point, note that while the Economic CycleResearch Institute is now foreseeing a "window ofvulnerability" on the double-dip recession front, itsFuture Inflation Gauge is simultaneously rising at an24.1% rate vs. a decline of 16% in December 2001.
Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to
Aaron L. Task.