Stocks - April 2008

Inflation? We Don’t See No Stinkin’ Inflation!
Economic data continues to point toward a rapidly slowing economy. At the same time, however, circumstantial evidence seems to be pointing to a resurgence of inflation. Not a good combination — a soft economy and rising inflation. It’s enough to take us back to the days of disco, bell bottom pants and Jimmy Carter’s lusty heart.

Back in the 1970s the term “stagflation” was coined. It neatly tied together the era’s stagnant economy with the rising prices that eventually led to most of us baby boomers paying upward of 14 percent on our first home mortgages. Today, the term stagflation is once again being tossed around. But are we really in for a repeat of the 1970s?  Maybe not, and here’s why:

The clearest parallel between today and the 1970s would be the surge in prices of real assets — things, stuff — otherwise known as commodities. Gold, oil and any number of hard assets were the investment plays — indeed some would argue investment bubbles — of the era. Once again a number of hard assets, oil and gold in particular, have been on a tear. But does that mean that prices across the board are on the verge of exploding as they did 30 years ago?

The Economic Cycle Research Institute  maintains a future inflation gauge measure, and that measure has been steadily pointing lower in recent months. ECRI has a terrific pedigree and stellar record at reading the economic tea leaves. It was founded by the late Dr. Geoffrey Moore, who was Alan Greenspan’s lead economics professor at Columbia University, and the man who invented the concept of leading economic indicators to call cyclical turns in the economy.

If ECRI’s future inflation gauge is pointing to lower inflation pressures, why then are so many hard assets continuing to rise in price? To comprehend this phenomena, you have to understand the FED’s response to a number of monetary crises over the last several years. In 1998 there was the collapse of Long Term Capital Management hedge fund; the Y2K scare; the collapse; and the attacks of 9/11. In response to all of these crises, the FED responded by flooding the financial system with liquidity. This abundant liquidity had consequences. The easy money prior to Y2K led to the tech bubble. The easy money after 9/11 led to the housing bubble. The easy money of today is finding its way into commodities, the only game left in town for speculators to play.

We know this current rise in commodity prices is being driven by speculators and not by an underlying inflation problem because the commodity classes rising in prices are the commodities that have exchange-traded contracts associated with them — the very contracts that speculators trade. There is a whole group of other commodities that have no exchange-traded contracts associated with them (rubber, burlap, etc.), which have hardly risen in price at all. If underlying inflation were a real and systemic problem, all commodities would be surging, not just the ones with financial contracts associated with them.

The current national housing bust is actually boosting the reported CPI. One of the components in the CPI is shelter cost, or as the government calls it, “owners imputed rent.” According to ECRI, during the housing price bubble of the last few years, rents have been depressed because easy credit made it simple for so many former renters to buy. Now, however, rents are rising with the reluctance or inability of so many to buy. As housing prices fall due to the inability of so many to buy in today’s economy, rents are rising. All of this has resulted in an artificially low CPI during the housing bubble and an artificially high CPI during this current housing decline. But believe me, a soft nationwide housing market is anything but inflationary. Declining home prices, if anything, are deflationary.

Will we continue to see surging readings of the monthly CPI? Unlikely. Commodities that do have exchange-traded contracts behind them such as oil and gold have obviously already risen to current levels. Even if oil holds in the current $100 range over the next 12 months, the annual increase would be zero.

We’ve seen this confluence of circumstances before. The 1989–1990 period offers many economic parallels to today’s environment. During the real estate downturn and recession of that time, the CPI index did in fact surge early on to 5 percent. It then dropped markedly as the initial underlying surges no longer continued in subsequent months. Today we again have a soft economy, a struggling nationwide housing market and a basket of commodities that have been driven up to current levels on the back of speculation. All of this adds up to suggest that looking toward the end of the year, expect the CPI index to be cycling down.

What would that mean for investors who need their portfolios to generate income? What do you do in a world of 2 percent interest rates? Well, if you do not need to spend the principal anytime soon (I would suggest five years at a minimum) and can tolerate a bit of near term volatility (which is not to be confused with risk of permanent loss), I’ve always been a fan of well-managed companies that have a demonstrated record of paying and regularly increasing dividends. For example, there are a number of monopolistic, regulated utilities that have current dividend yields well in excess of 5 percent and have a history of regularly increasing that dividend check to the shareholders over time. Bank stocks have also traditionally served as a source of dividend income. While the large nationwide banks are still caught up in the throes of the housing and credit crisis, a number of publicly traded local banks that aren’t suffering the troubles of the large national concerns offer current dividend yields in excess of 5 percent. There’s also an entire world of preferred stocks that offer handsome dividend payouts without taking an unacceptable amount of risk. As long as inflation does not spiral out of control, these are a few thoughts on how an investor can maintain a reasonable stream of income in a 2 percent world.

Bo Billeaud has been president and chief investment officer of a Lafayette-based money management firm for the past 17 years.