Inflation Has Escaped

Despite the S&P 500 equities index setting a new 52-week high and finishing up nearly 3.5% for the month, February was a nerve-racking and at times sleepless month. But things could have been a lot worse.


Last month we spoke about how unrest in Egypt and Tunisia could spread to more strategically important oil producing countries and produce 1979-like inflation. Well the unrest spread and commodities prices rose– WTI crude oil topped $100; gold, cotton and food indices made all-time highs; silver multi-decade highs, etc., etc. (see CRB commodity index chart at right ). Despite widespread unrest and rapidly increasing energy prices, it appears that extraordinarily loose monetary policy led by Quantitative Easing in the US, but implemented by most developed countries’ Central Banks, has helped mitigate any negative impact on developed equity markets.


However, loose monetary policy is proving to be a double-edged sword and inflation is on the precipice of spiraling out of control. Not necessarily because central bankers have pushed it too far or because the US dollar is in a downward death-spiral as many doomsayers predict, but because of wildly unpredictable factors beyond the control of central bankers and government officials alike.


Which makes me think of Jurassic Park. Bear with me...


Jurassic Park, a novel by Michael Crichton and movie by Steven Spielberg, is “often considered a cautionary tale on unconsidered biological tinkering. [Jurassic Park] uses the mathematical concept of chaos theory and its philosophical implications to explain the collapse of an amusement park showcasing genetically recreated dinosaurs.” (http://en.wikipedia.org/wiki/Jurassic_Park)


Rearrange some of the characters and you could be talking about our current predicament: inflation (the dinosaurs), quantitative easing (biological—read economic—tinkering) and unrest in the Middle East (chaos). Central bankers have successfully engineered inflation designed to stimulate growth, reduce unemployment and increase consumption. However, now that they have succeeded, their creation appears to have taken on a life of its own; chaos has set in; the beast has escaped from the park!


With that said, our portfolios are now firmly biased toward inflation risk. As recently as mid to late-2010 we were on the fence between deflation/inflation and our portfolios reflected our lack of conviction. Starting in late 2010, we progressively began adding and/or increasing allocations to securities that should outperform in an inflationary environment (and the resulting rising interest rates)—TIPS, precious metals, energy, agriculture, infrastructure, and floating rate bank loans.


Furthermore, we are closely watching the USD index for a clear break below its long-term resistance (see chart below). While we already have significant non-USD exposure through non-US equities, should the dollar index make a significant move lower we will move excess cash and cash-equivalents into a basket of non-USD currencies.


Bottom Line: Inflation is a major and growing risk. The rapid accent of energy prices has the potential to reverse economic progress made since ‘08/09, which will be negative for equities, however positive for most real assets as long as the rise is orderly.