Periscope: Deflation or Inflation?

A & I Financial Services LLC Newsletter

For the Week of

September 2, 2011

Greetings!

This week, I attended a debate between two brilliant investment managers. Here's a great story I heard from them. In 1950, a dime bought a gallon of gas. The same dime, today, would still buy a gallon of gas. In 1950, the dime contained real silver, worth approximately $3 to $4, or approximately a gallon's worth of gasoline. More on this in a minute.

Phil Ferguson is Co-Chair of the University of Texas $26 billion endowment and former CIO for AIM mutual funds. He believes inflation is ahead of us: every year, everything we buy gets more and more expensive. David Wright runs Sierra Investment management. He believes we have deflation ahead of us. He believes the dollar will increase in value.

What do you think?

Over the last 50 years, we have had zero deflation and a fairly low official inflation rate. Mr. Ferguson says this understates the problem, because we keep changing the inflationary measures. We have something called the substitution effect - where technology replaces what used to be in the measure. We have something new called "housing equivalent" that looks at rents (which haven't increased much) instead of housing prices. We discount for increased quality of the goods we buy, and a "hedonic" measurement says that we get more pleasure from items that are less expensive than before.

Had we stuck with the 1950s measurement of inflation, 2010 inflation rate would have been 11.2%!

Given this set of facts, it seems that the argument for deflation is academic, but not so. Most folks think inflation is the problem - and that's one of David's points. Taxi cab drivers don't know investments and if they tell you all the reasons the dollar is going to decline, they're probably wrong. Deflation happens when we have a decline in demand, when we have major declines in the costs of production, and when we have "adverse monetarist changes."

Mr. Wright argues that we have a structural unemployment problem, and that the jobs people are getting are paying less than they used to. Furthermore, we have a permanent decrease in the costs of production. But mostly, he's arguing that deflation is in our future because of the "money problem." We have printed money like crazy, but the velocity of that money has declined due to hoarding by companies, financial institutions and families (as much as we can!). The evidence of this, he says, is in the interest rates. Even at ZERO, we have houses we cannot sell, the government faces cut-backs due to revenue declines, and consumer thrift threatens the economy further.

The answer, say both of them, is selective active management.

We are in a currency debasement race with other countries, and the winner is the biggest loser who can "inflate away" their country's debt. We want our future dimes to buy as much as a penny. If, over the next 50 years, it declines in value as much as it has over the last 50 years, perhaps our future debt will not be so bad after all. It's our standard of living that suffers, not the public coffers.

Weekly Economic Update

COULD SEPTEMBER BRING ANOTHER STIMULUS?
Could we see a QE3? Maybe. While Federal Reserve Chairman Ben Bernanke made no mention of a plan to aid the economy at last week's Fed symposium in Wyoming, he did refer to "a range of tools that could be used to provide additional monetary stimulus" and noted that the Fed "will continue to consider those and other pertinent issues... at our meeting in September." September's FOMC meeting has now been lengthened to 2 days; make of that what you will. Bernanke said he expects improved GDP in the second half of 2011 and core inflation under 2%.(1)

NEW HOME SALES DECLINE, BUT HOME PRICES GO UP
The Census Bureau announced a 0.7% drop in new home sales in July; sales were up 6.8% from a year ago. The average sale price was $272,300, with 6.6 months of inventory on the market. Overall U.S. home prices rose 0.9% in June, said the Federal Housing Finance Agency (the best 1-month gain since September 2005).(2,3)

SURPRISE! DURABLE GOODS ORDERS RISE 4.0%
July figures from the Commerce Department far outpaced forecasts. Economists surveyed by Bloomberg News had expected a 2.0% increase. July saw an 11.5% gain orders for autos and auto parts - the biggest 1-month jump in demand since January 2003 - and a 43.4% leap in orders for commercial aircraft. Even with transportation orders factored out, orders for hard goods rose 0.7% last month.(3)

CONSUMERS PERCEIVE TOUGH TIMES
The final August Thomson Reuters/University of Michigan consumer sentiment survey came in at 55.7 - a bit of a rebound from the initial, abysmal 54.9 mark for the month. It is a long way from the high 80s (which is where the index routinely was before the Great Recession).(4)

BEST WEEK FOR STOCKS SINCE JUNE
Gold futures retreated, 2Q GDP was revised down to 1.0%, and stocks rallied. The 3 major Wall Street indices snapped 4-week losing streaks as follows: DJIA, +4.32% to 11,284.54; S&P 500, +4.74% to 1,176.80; NASDAQ, +5.89% to 2,479.85. (4,5)

Market Summary