04-20-07

...the next step may be for people to treat everything they hear about inflation from politicians and central bankers as a fraud. The step after that will be to assume a naturally accelerating inflation rate year after year - and finally to expect ever-higher wages to compensate for these ever-higher prices. In other words, a return to the inflationary mentality of the 1970s and early 1980s could soon be on the cards.
  – Anatole Kaletsky, FT, "Is it too late to tame the Inflation Monster?"

Wow. This Kaletsky guy sounds worried. And why wouldn't he be, with the dollar doing an off-key rendition of Tom Petty's Free Fallin'.

We've all heard these sentiments before... but there are some notable catches here.

First, Mr. Kaletsky isn't your typical anti-government, pro-gold, anti-inflation conspiracy theorist (not that there's anything wrong with that combo). He has been notably bullish on the global economy these past few years, and loudly dismissive of the bear case.

More interestingly, Mr. Kaletsky wasn't talking about the United States in that excerpt. He was talking about Britain.

Say what? Isn't the British Pound soaring to new heights with the Euro? Didn't the Pound just reach its highest level in 15 years or so, ever since George Soros "broke the Bank of England" back in 1992?

Furthermore, isn't Britain supposed to be a counter-example of fiscal conservatism, where consumers are more restrained and borrowing is kept in check? It's supposed to be all good in merry old England: housing bubble calmly resolved, sanity restored. God Save the Queen, fish and chips, stiff upper lip, cool Britannia and all that.

Guess not.

Apparently some well-informed folks (like noted economist and well-to-do hedge fund adviser Mr. Kaletsky) fear that Britain's economy is in danger of swirling down the inflation toilet bowl. Based on current data, it's possible that fiscal tightening measures will prove too little, too late for the UK. When workers and businesses turn the expectation of higher prices into a self-fulfilling prophecy, the trend is nearly impossible to stop. Hello seventies! Stagflation, mutton chops, leisure wear, woo hoo!

Meanwhile, back at the American ranch, Uncle Sam has his cowboy boots propped up on the desk. The economic establishment remains comfortable in the belief that "inflation remains subdued." Light the cigars and whisper of goldilocks, ‘cause the latest Consumer Price Index says everything is hunky dory.

Of course, this week's tame inflation reading was a product of the "core" CPI, which excludes food and energy prices. (Given $4 corn, $3 gas and crude on its way back to $70, that makes perfect sense let me tell you.)

So what's wrong with this picture? Let's recap.

A normally cool-headed observer is deeply worried about inflationary trends across the pond, even as the British Pound gives its strongest showing in years and the UK economy appears robust enough to handle interest rate hikes. Yet here in the good old USA, the situation is too wobbly to raise rates... 45,000 square footmansions are going up in Greenwich on spec... the dollar is falling through the floor... and Wall Street remains as relaxed on inflation as an off-duty roadie at an Allman Brothers concert.

That is some good stuff the street is smoking, let me tell you.

But it's all okay, you see, because the financials are still making money hand over fist. Just look at JP Morgan. They caught a huge bid this week on a 55% rise in first quarter earnings, and financial stocks across the board have put on a fresh happy face. Moody's, Washington Mutual, Wachovia, Citibank... all these guys who were supposed to be hammered by subprime are suddenly coming up roses.

Goes to show that there are no problems right? It's all good. Everything is fine.

The only problem is, decent first quarter earnings merely underscore the fact that everything was fine yesterday. Whether everything is fine tomorrow... or right now, for that matter... is a different kettle of fish.

The markets are supposed to be forward focused--discounting future earnings streams and all that--but that's a dirty little secret of Wall Street. It can focus on whatever it wants. Sentiment leads, rationalization follows. It's enough to make your cynical editor quote a British gangster flick.

Tommy: Who took the jam outta your doughnut?

Turkish: You took the jam outta my $#@% doughnut, Tommy. You did.

Okay, I understand why the mood is celebratory right now. The bulls have a couple big victories to celebrate. In a nutshell, those victories are these:

• The dollar is declining in semi-orderly fashion.
• Subprime hasn't turned into a grade-A disaster just yet.
• Emerging markets are remarkably strong.

Now, all these points are true. It's good that the world's central bankers haven't started pitch-forking their hay bales of dollars onto the broad market. It's good that China and other emerging market countries sitting on a mountain of dollar-denominated assets remain willing, for now, to endure the pain of erosion as they ramp up trade with non-US sources and slowly wean themselves off the vendor-finance relationship.

But how long can this happy state of affairs go on? And where is it headed?

By championing a mix of rising equity prices and a falling dollar, one could say America is pursuing a "Zimbabwe lite" policy. The Von Mises institute reports:

The Zimbabwe Stock Exchange (the ZSE) is the best performing stock exchange in the world, the key Zimbabwe Industrials Index up some 595% since the beginning of the year and 12,000% over twelve months. This jump in share prices is far in excess of increases in consumer prices. While the country is crumbling, the Zimbabwean share speculator is keeping up much better than the typical Zimbabwean on the street.

Is that really where we want to end up? If new equity highs mean everything is okay, then the monetary policy of Zimbabwe is okay. If that's how the cookie crumbles, we could see Dow 36,000 this decade after all... along with $40 a bushel corn, $600 per barrel oil, and $30 per gallon gasoline. Those are exaggerations to make a point, not actual forecasts. But still, one has to wonder. (And you know how politicians are occasionally asked to guesstimate the cost of milk and eggs? Under "Zimbabwe lite," that discussion could take on a whole new meaning.)

It's also true that subprime hasn't turned into meltdown city just yet. We may yet tiptoe through without a blowup of spectacular proportions. But, that said, can we really put on the party hats for the financials at this late date, especially considering all the other problems still unaddressed? Isn't this like confirming that termites have eaten the foundation of the house, then celebrating because the electrical wiring hasn't caught fire yet?

And finally, emerging market economies are still indeed strong. This is a trend we believe in, and a true reason to celebrate in the long run. It's exciting stuff when three billion new capitalists get their groove on. But bright futures do not preclude the intrusion of volatility (as Shanghai is quick to remind).

Strong economic growth does not always translate to smooth sailing for investors. Just think back to America's history in the nineteenth and twentieth centuries (pre-1982). Riding the wave of global growth is like hitching a ride on a roller coaster: you're going to have some screaming highs and screaming lows along the way. Good entry points are important.

As this rant is focused on inflation, it's only natural to close with some thoughts on gold. Gold and gold stocks looked ready to make the breakout sprint this past week, but lost their mojo when the CPI number came in tame.

Meanwhile, that same CPI number--plus strong earnings and more buyout news--gave comfort to all the liquidity bulls ready and willing to plow grandma's life savings into the Blackstone IPO. The week's events also fueled fresh crazy talk of private equity firms setting their sights on already-leveraged financial companies. Imagine that! PE guys buying the institutions that lent them money to make deals in the first place, so they can buy more lenders and lend themselves even more... Hello? John Law, Mississippi Bubble? Anyone? Anyone? Bueller?

We say bah humbug. A pox on the new era of financial leverage run amuck. Nay to private equity gone wild.

Various shorting opportunities are gaining in appeal right now. On the long side, gold and gold stocks are a good bet, though the market appears constitutionally wimpy at times and ready to turn tail at resistance. (Marketwatch recently observed that it takes "nerves of steel" to trade gold. Does that mean it takes a golden touch to trade steel stocks? Just asking.)

Regardless, gold stocks will wipe their noses and make the big run again. Perhaps soon, if gold's renewed challenge of $700 is any indication.

The big fear for gold is the possibility of the Federal Reserve whacking markets via higher interest rates. A sudden liquidity contraction could hit everything hard in the short run, including gold. There are other measures the financial authorities can take to keep precious metals in check; in the long run, though, all such measures will prove futile. (Massive government interventions tend to prove futile as a rule of thumb.)

Maybe the Fed crackdown happens before gold hits $1,000 on its way to points beyond. Or maybe it doesn't. Unless you have the Rothschilds on speed dial, you just can't know. But that's why you set up an investing plan and you set up a trading plan. With investing, you make a point of anticipating and absorbing the swings from time to time. With trading, you make a point of moving very quickly if need be. It can be a lot of work keeping on top of this stuff... but that's why your occasionally cynical Macro Musingseditor is on the job.