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Markets: Inflation Surprise
New York: June 11, 2007
By John R. Stephenson

It was all going so well. Investors had grown accustomed to steady economic growth over the past few decades, with little, if any, inflation. Inflation (rising prices) is a scourge that can ravage your savings and erode the value of a dollar. For decades, the world's central banks seemed to have the situation well in hand. Deflation, rather than inflation, was the problem for most of the past decade. Then something happened. Investors en masse started to panic that inflation had returned. They sent stock and bond markets into a tailspin as they sold their stocks and bonds, fearful of slowing corporate profits and higher interest rates to come.

Over the last few weeks, bond yields have been creeping up as investors have been selling bonds. Last week, the yield on US Treasuries rallied more than 0.16 percent to 5.13 percent, the largest single day move in three years as investors' concerns over inflation and the likelihood of rising interest rates took center stage. If investors are correct and inflation is back, interest rates are sure to rise. By raising interest rates, central banks make it more costly to borrow. If it costs more to borrow, then individuals and institutions spend less, which slows the economy and allows prices to fall back to earth.

Figure 1: Bonds Plunge As Inflation Worries Mount

While rising interest rates may slow and even stop inflation, it isn't a free lunch. The stock and bond markets tend to suffer in a rising interest rate environment. Stocks suffer because with higher interest rates, business spending slows and it is more expensive for businesses to borrow. Bonds suffer because their coupon payments are fixed. Why buy a bond with a 4.25% yield when newer bonds offer more? The only way an investor will buy an existing bond with a lower coupon than the prevailing interest rate is if the price of the bond is discounted to reflect those differences. Higher interest rates also mean higher borrowing costs on everything from credit cards to mortgages.

Inflation is here because of several persistent supply side problems that will likely shape our economy for decades to come. Supply is struggling to keep up with demand in energy, metals, grains and in workers. With too much demand and supply struggling, these sectors are witnessing strong price appreciation, which is fueling the rise in inflation. There appears to be no let up in sight.

No commodity is more important than crude oil. That's because oil is a miracle fuel. It is the only fuel that is capable of powering everything from your lawn mower, your car or the local power plant — cheaply. In the 1990's, big oil (Exxon Mobil et al) bet their future on prolific oil fields in Venezuela, Nigeria, Russia and Angola. So far, the bet has gone sour, as these nations have become increasingly hostile to western oil companies. With demand from Asia on the rise, the oil industry needs a win badly, although it isn't looking good so far. In the last forty years, the industry has been unable to find a single elephant oil field (a field that produces a million barrels of oil a day or more). Supply continues to struggle at a time when demand shows no sign of abating. So much for lower energy prices any time soon!

In the metals the story is much the same. In the last four years, millions of Asians have entered the ranks of the middle class by buying cars, homes and appliances. All those new homes and cars require a boatload of copper, aluminum and nickel to produce, which has sent the price of base metals through the roof. Through most of the eighties and nineties, the mining industry was in the doldrums. Today, the industry is booming as demand continues unabated and supply remains constrained, as there are far too few projects, people or stable regions of the world from which to source the necessary base metals.

The rapid industrialization of Asia, coupled with a push for alternative fuels in North America, has led to another supply shortage that has driven the price of grains, most notably corn and soy beans, higher. China's imports of soybeans have soared from 10 million to 33 million tons over the past six years, as consumers are demanding protein in their diets. Not only is the price of soybeans on a tear but so too is the price for eggs, meat and poultry. As people get richer, they tend to eat more meat and other foods rich in protein. The consequence of a rapidly industrializing Asia is higher food prices for the foreseeable future.

Lastly, we have been experiencing wage pressure in the economy for the first time in decades. This is a function of demographics. For years, the North American worker has been the victim of layoffs and outsourcing. But now, for the first time in a long while, workers, particularly skilled workers, are in short supply. Whenever supply is tight and demand is either constant or rising, then prices will rise as is the case today with labor. The supply of workers has ebbed because birthrates have been plunging across the western world. Amongst the OECD countries, the United States is the only country where the birth rate is at the replacement rate (2.1 births per female). In all other OECD countries, the birthrate is below the replacement rate, meaning that soon, there will be far more retirees than workers. At current European and Canadian fertility rates, each new generation's workforce is roughly half of its predecessor's. Clearly, this has huge implications for the future social cohesion of these countries.

With labor, energy, base metals and food all trending higher, is it any wonder that inflation is on the rise? For our money the answer is no.

Investors looking to profit from the fundamental changes in the economy and the markets should consider increasing their exposure to the base metal producers as well as energy companies with supply basins in stable regions of the world. Gold will also likely be a beneficiary in the years to come as the U.S. dollar should weaken as the U.S. economy faces several headwinds in the form of a struggling financial system (sub-prime loans, rising interest rates), moribund auto industry and rising inflation. The financials and technology stocks will likely be the laggards in the market if inflation continues unabated. Savvy investors who recognize that inflation may not be such a good thing should avoid banks which are over-exposured to both derivatives and the coastal housing market.

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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