"Future Inflation - Not 'If', but 'When'"

Sydney M. Williams

Thought of the Day

“Future Inflation – Not ‘If’, but ‘When’”

May 4, 2010

Complacency is largely absent from the behavior of equity investors and, in fact one might argue – given the low level of money flowing into domestic equity funds – that fear still grips many individual investors. Nevertheless I feel somewhat squeamish about the persistent low cost of money and the impact of these negligible costs on assets, and would suggest that complacency is surviving (if not thriving) in the realm of cheap money.

Asset inflation, in the form of home prices, played a critical role in bringing down the house of cards that served as our financial system in 2007-2008 and it seems to be playing an important role in driving the rush into Treasuries and other fixed income securities. Is 3.7% adequate compensation over ten years for a currency that is likely to be debased by inflation, as our national debt expands? The yield on Investment Grade Corporates is lower than the earnings yields on stocks, and is 50 basis points lower than it was in March 2007, at a time when we were cocooned from the tumult going on around us.

Bond market gurus tell me that the yield on High Yield Corporates still look attractive, but it seems to me that a yield decline on the FINRA-Bloomberg Index from more than 25%, at the end of November 2008, to 8.25% is indicative of a pretty good ride. In this environment, stocks look relatively attractive. The margin requirement on stocks is less than that on bonds (2X leveraged versus 4X leveraged for corporate bonds and 20X leveraged for Treasuries.) The fact that stocks have been in a bear market for ten years suggests one should not become overly bearish. Despite the fourteen month rally, stocks have benefitted less than bonds from this period of loose money, though valuations indicate they are not exactly undiscovered.

It is perhaps premature to conclude, but this concern of future inflation seems reflected among consumers in an attitude of “live well today for tomorrow we die.” The Advanced First Quarter GDP numbers suggest that consumers resumed their propensity to spend and reluctance to save, as consumption increased 3.6% and savings declined 2.7%.

While Congress and the Administration seem intent on ramming through social legislation, they appear to have little appetite, despite hundreds of televised hearings, to confront the root causes of the credit crisis, in part, I am sure, because it would implicate members of Congress and their co-conspirators, the Regulators. The Federal Reserve, which failed to see the asset bubble developing in securities and home prices, under the Dodd Bill, gets increased powers over consumer matters. Fannie Mae and Freddie Mac, which largely created and packaged mortgages, appear exempt from reform under any of the Bills in Congress. It is still unclear what will happen to derivatives, such as CDSs and CDOs, in spite of the obvious problem of insurance (CDSs) being written against assets in which buyers often have no economic interest. At the very least, all derivatives should be subjected to what Justice Lewis Brandeis termed sunshine being “the greatest disinfectant”. Existent regulatory bodies, especially the SEC, do not appear to have been scrutinized for failure to enforce existing laws, such as naked short selling so prevalent during the fall of 2008.

There is little question in my mind that inflation will be the ultimate result of the enormous deficits we are currently creating by ramming through social programs and the failure to account for the unfunded portions of Social Security and Medicare. As one wag recently put it, the analogy of Congress spending money like a drunken sailor would be appropriate, except that it insults sailors. Forthcoming inflation is no longer a question of “if”; it is a question of “when.”
…………………………………………………………………………………

Regarding Fannie Mae and Freddie Mac, I would urge everybody to read an op-ed on the two GSEs in today’s Wall Street Journal by Robert Wilmers. His piece is fact-filled and chilling in its depiction of the crony capitalism that exists between Congress and these two government agencies. Bob, who I knew forty-odd years ago when he was married to a friend of my wife’s, is the chairman and CEO of M&T Bank Corp. in Buffalo. The link is below.

http://online.wsj.com/article/SB20001424052748704342604575222110918360260.html#mod=todays_us_opinion