How Much Inflation Will We Have to Endure?

Inflation

The battle is over. Structural inflation has won. The question now becomes, how much inflation will we experience before this trend exhausts itself?

As I’ve stated before, historical benchmarks and references no longer apply in predicting upcoming economic changes. Familiar risk/reward scenarios will not work.

De-leveraging from debt is occurring in the US economy from unprecedented heights. This is witness by the continuing fall of home prices. The latest S&P/Case-Shiller index reported a 14.4% decline from a year ago March.

Once upon a time, inflation and de-leveraging did not occupy the same space. However, recent monetary policy, coerced by the credit derivatives melt-down, has prompted the Federal Reserve Board to lend to non-commercial banks, for the first time since the great depression, through the discount window. Massive amounts of liquidity have washed across the country’s banking system since last August triggering inflation speculators to hike the price of oil in the futures market.

Globalization has also led banks in Australia, Europe, and Canada, to become victims of the US sub-prime fiasco. Increased domestic and international energy requirements are affecting the market psychology, more so, than supply/demand elasticity, thereby, pushing the price of oil to recent highs of $135.00 a barrel.

This sudden price shock in petroleum has shifted global wealth from the West to Russia, the Middle East, and Latin America, causing a stampede in the buying of US assets by foreign investors and newly created sovereign wealth funds. U.S. commercial and investment banks exposed to tens of billions of dollars in write downs, from Collateralized Debt Obligations (CDOs), exchanged equity with these government-backed institutions to remain in business.

The devalued US dollar, losing over 30% of its purchasing power since the beginning of the Iraq War, closed 05/30/2008 at .643 to the Euro, 105.70 to the Yen, and allowed equity indices to finish the month, such as the S&P 500 at 1,400.38; NASDAQ at 2,522.66, and the Dow Jones Industrial Average at 12,638.32, among others, to cling near their recent highs.

The invasion and continued occupation in Iraq continues to drain our treasury by billions of dollars each week, not to mention lost of life.

Agriculture commodities’ steep price increases has produced financial hardship and even scarcity in the most improvised nations, leading to hoarding, and in a few cases food riots. The volume of distilled ethanol from corn is rapidly growing to reduce our dependence on oil. As we look forward, these trends will recast investment formulas and dynamics, thus, returns for this century starting the next decade.

In the 1970s, the last period of rampant inflation, gross mismanagement by the Feds (through tepid and faulty action), combined with the coupling of wages to production and profits, and widespread regulatory authority and enforcement provided white-collar workers a certain congruency to price increases and personal income.

Likewise, unionized workers, at their apex of power in this same period, received negotiated cost-of-living wage and benefits adjustments in union contracts to modestly moderate the effects of structural inflation.

Over the last 30 years, the continued separation of net income and production and business deregulation has created a line-item effect on corporate asset valuations and personal income. To be fair, technology has played an important part in lowering the cost of production and the retail price of goods and services. Cheap foreign labor has also provided relief as a major input in the price of manufactured goods exported to America. Technological advantages and global labor, as positive inputs, are reduced as crude oil prices levitate.

In the first part of this decade price declines in goods and services fell at differing rates. And so did the cost of money. After the 2000 – 2002 equity bear market, which subtracted approximately 8 trillion dollars in household net worth from our economy, following 9/11, the feds lowered short-term rates to 1% to mitigate the probability of a deep and protracted recession.

Until the most recent real estate bubble began to burst, this low interest environment added 5 trillion dollars in real estate equity, thus re-inflating the average household net worth. We essentially exchanged one bubble for another, in hindsight.

Today, the extreme fears by investors of the invisible danger lurking throughout capital markets have kept treasury yields low. All, save the 30-year Treasury bond, has been below 4%, throughout the spring. That is changing, as the 10-yr Treasury note closed at 4.065%, the last business day in May, at the highest yield it’s been since 12/31/2007. Surprisingly, the Treasury market has, so far, ignored the gathering inflationary clouds.

Historically, the 30-year bond was the bellwether for future inflation. This time around, so far, it is behaving as a lagging indicator, closing 05/29/2008 at 4.785%, its greatest level since 10/17/2007, when the Light Crude, July ’08 contract, closed the week ending 10/19/2007, at $81.74 a barrel. The second half of 2008 will almost certainly show an increase in prices across the board, effecting the month over month, and the year over year, CPI and PPI figures. The next six months of this presidential election year is quite possibly a preview trailer for an economic horror movie, Son of Inflation, which may run for the next five years, or more.

In the next decade, labor, materials, energy, and capital, will cost more. The benefits of deflation we have enjoyed the last 20 years, transitioning from an industrial/service to an informational/digital base economy, will grow smaller, disappearing in our rear view mirror, as the form and manifestation of inflation appears, growing more discernable through our windshield. This macro overview of economic trends, both past and future, is important to review.

Managing wealth for the conservative, fixed income investor, is most successful when short term trends are distinguished from long term themes in the marketplace. Downside risk to debt, correctly diagnosed from market and credit exposure, can actually be converted into an upside opportunity for investors. Growth of income, in an inflationary environment, is as important as sustainability of income is, in deflationary times.

Income and cash flow is the wholesale beneficiary of deflation. With rising inflation, fixed income becomes a vulnerable asset. Harnessing variable rate income is a tricky proposition. Investors living off a fixed income portfolio can watch their purchasing power decline, while variable rate investing, an actively managed exercise, can produce level results. Different investment vehicles must be considered in a changing inflationary climate to preserve a client’s current purchasing power.

Since every first world economy is shackled to oil, as we approach $150 dollar per barrel, the seeds of tomorrow’s inflation are being sown today. Without the price for oil, returning to below $100, before the November elections, it will not do so. By 2010, 8% to 10% inflation will be embedded in our goods and services, and our psychology.

A weaker dollar prevents a return to lower price levels. And, if OPEC replaces petro-dollars, with the Euro, or a basket of currencies, then, U.S. inflation will expand even higher.

Now for the bad news; we have entered into a protracted recession. This parallel universe of inflation and recession, will feed off one another, unless a conscious decision by the federal government to allow economic depression to occur. This, however, is a political improbability. Although, the government may inadvertently back into depression, either outcome is financially horrid, extremely painful, with, heretofore, untold, harmful consequences.

This bleak assessment is being offered as the sub-prime fiasco continues to ravage financial institutions and central banks around the world. Worldwide, over $380 billion dollars in write-downs have been announced, so far. The International Monetary Fund estimates that that number could reach 1.2 trillion dollars. Even if the final number is only half of 1.2 trillion dollars, how much more battering can our financial institutions absorb?

Investment banks, beginning last summer, experienced the first wave of the credit crunch. And, each quarter, fresh admissions of write-downs and losses shakes the confidence of Wall Street. These unending losses by banks, combined with future regulatory changes in capital requirements, will reduce overall consumer liquidity by way of lower available credit card and home equity loans, personal credit lines and higher underwriting standards.

The appetite to spend by the consumer, and their capacity to manage personal cash flow, will be significantly suppressed. The consumer’s inability to support the economy through spending will assume the lead during the next wave of the liquidity crunch.

The Conference Board Consumer Confidence Index fell to a reading of 57.2, down from 62.8 in April, marking the lowest figure since October 1992. A softening job market will also depress consumer psychology going into 2009 and 2010.

In summary, while various inflationary inputs are more likely to accelerate to the upside, the trajectory of economic growth will diminish to a flatter curve, or, may even significantly contract, near term.

Municipal bond investors are standing on the precipice of fundamental economic change. For me, the canary-in-the-mine-shaft is the coupon size of newly issued debt. When the 5.5% coupon threshold is crossed, for the highest quality municipal bonds, we shall have fresh, direct, evidence that greater inflation has began infecting the municipal bond issuance marketplace. Until that signal is flashed, there are no superior alternatives for high net worth municipal bond investors to pursue.

The current taxable equivalent yield of 7% +, from holding long term municipal bonds, is still the highest ground for conservative investors. But, this safe haven, to preserve capital, has a shortened shelf life.

US Treasury Inflation Protection Securities [TIPS] is a conservative tool, with which, to diversify a bond portfolio. Like a regular treasury, the interest is paid twice a year and is exempt from state taxation. Additionally, an inflation factor, based on the CPI, is applied to both the principal and interest. Appreciation of the principal is taxed as a capital gain in the year it occurs.

This July, the Treasury Department will auction the 20 year TIP. In October, as they did in April, a 5 year TIP will be offered. I recommend reallocating 5% of your bond portfolio into these to securities, in equal weight. In 6 months, we will review the state of the economy and assess inflation.