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Economics : Inflation - Up, Up and Away?
New York: April 13, 2004
By John R. Stephenson

A week ago, the jobs report out of Washington was a pleasant surprise with some 308,000 new jobs being created. The market took notice with bond traders taking the market higher. The logic? That job creation was the only missing piece of the economic recovery puzzle and with strong job growth now in evidence, the Fed would have little choice, but to raise interest rates to stamp out a likely rise in inflation (rising prices). But does the evidence support this inflation expectations theory?

Possibly — but in our view not likely. For inflation pressure to mount in the US, consumer spending will have to stay strong. The question is, can it? With much of the consumption in the US being driven by a policy of strong stimulus, which is likely to wear off by the end of this year or early next year, will there be enough fuel for the fire? I don't think so. Not only will demand likely recede once the stimulus wears off, but it is quite possible that economic growth will fall below trend (currently estimated at 3 to 3.5%). If economic growth is below trend, then factory utilizations will drop and it is unlikely that manufacturers will be able to introduce any meaningful price pressures into the economic system. With wage growth almost nil, where will upward pricing pressure come from?

Not only is the probability of weaker economic growth likely in the latter half of the year, but, we have a gathering economic storm on our radar screen in the form of a changing demographic. Later in this decade the ageing of our population should start to reduce overall demand for most goods and services (including housing), which will further reduce the ability of companies to raise prices for their goods and services, not to mention the fact that US producers are going to be increasingly competing for market share with cheap foreign imports —mainly from Asia.

To get a sense for what might lie ahead for the US as the coming demographic tidal wave begins to hit our shores, why not consider a great leading economic indicator —Japan. Japan has had to deal with the aftermath of an asset bubble as well as a demographic trend (way too many old people) that kicked in around 1995. Although exports to China of electronic gadgets have caused a resurgence in the Japanese economy, the overall downdraft is continuing. With bank lending on the decline in Japan and a shrinking workforce, the likelihood of inflation expectations in Japan is remote.

Europe, and in particular Germany, is another case in point. With an aging, grumpy and inflexible workforce, the conditions are set for weak demand going forward. The European Central Bank ("ECB") seems to be unaware of the demographic shift as their interest rates are too high and fiscal policy too loose. With a populace used to six weeks of vacation a year and totally resistant to structural reform, it seems hard to imagine that the economic prospects for Europe could be anything but mediocre.

So what to do? If you've joined the new leisure class of currency speculators you could consider shorting the Euro and possibly long the Yen. Of course, the US dollar isn't looking so great, which might mute your returns on your Euro short with the massive U.S. current account deficit and continued uncertainty about the attractiveness of stocks overhanging the currency. The US dollar might still fall further. Get out of homebuilding stocks while there's still a little life left in the names and open up the war chest and buy a few more gold stocks.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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