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December 2007

Last update on: Sep 23 2019

December 17, 2007 3:05 p.m. The Specter of Inflation Rises

Friday’s inflation report brought to the forefront something we warned about for some time: The threat of rising inflation is not dead. We are not living in the disinflationary and potentially deflationary era of the 1990s. Global growth and easy money policies around the world in the 2000s have made inflation more of a threat than deflation.

The headlines and many analysts focus on the potential effects of the subprime mortgage meltdown, credit market freeze, and a slowing economy. They pushed to the back of most investors’ minds is the risk of rising inflation. There are two reasons to give inflation greater consideration than investors gave it before Friday.

One reason is that few investors worry about it. That means the markets are priced for steady or declining inflation. Rising inflation would surprise many investors and result in a re-pricing of assets. The other reason is that the central banks would have difficulty dealing with slowing economies and credit market problems if inflation also is rising. Lowering interest rates, increasing reserves, and other measures that help a slowing economy would be risky if prices also were rising.

Very few people have been expecting higher inflation, and that means hedging against it is a contrarian position. Slow economic growth with rising inflation is a scenario few portfolios today could handle. What are the risks of inflation continuing to increase?

First, the factors that caused steadily declining inflation since 1982 are dissipating.

Imports no longer are cheap and getting cheaper. The dollar is declining, which pushes up the prices of imports. In addition, prices for Chinese goods are rising at a steady clip as demand for them increases.

Productivity growth still is strong, but the growth rate is not as high as in the 1990s. Again, higher productivity allowed businesses to keep prices down while raising profit margins. I expect productivity to continue to be above its long-term rate. But productivity growth will be lower than in the recent past, and that will make it harder for businesses to restrain price increases while maintaining profit margins.

Economic growth around the world also is increasing the prices of many items. Prices for most commodities and raw materials are rising sharply. Businesses must either raise prices or accept lower profits to the extent they cannot increase productivity.

The biggest surprise is food prices. These are rising rapidly in China in particular but also in other countries. Economists typically say that we should ignore the food and energy portion of CPI. The theory has been that those prices are volatile month to month but fairly stable over the long term. The monthly volatility does not affect the underlying rate of inflation. That theory might need some revision. Food prices are rising globally, and those price increases seem to be real and not due to short-term factors.

Some economists point to rising gold and other commodity prices as signs that inflation is on the way. I suspect these price increases are due more to economic growth and the falling dollar than a flight to hard goods. But those prices increases make it more difficult for businesses that use the commodities to hold down retail prices.

There still are forces favoring low inflation. Central banks are on alert not to commit the mistakes of the 1960s and 1970s. Globalization also ensures competition that keeps prices down in many industries. Yet, on Oct. 3 The Wall Street Journal ran an article explaining how food makers are having trouble passing on their cost increases. Food prices have been rising rapidly over the last year. Some of this is due to economic growth, and some to the push for ethanol, which is made from corn.

But it is not a sure thing that inflation will remain 2.3% or lower, as the Fed and most investors expect. Instead of higher consumer price inflation, we might see lower earnings growth and profit margins as businesses are unable to pass on their raw goods costs. Alan Greenspan said as much in Friday’s The Wall Street Journal.

These are reasons to maintain some balance and hedging in your portfolio. It also is another reason why we believe income investors are not being paid enough to own long-term bonds and other interest-rate sensitive investments.

December 12, 2007 02:40 p.m. It’s What We Don’t Know That Matters

It would be nice if yesterday’s headlines marked the bottom of the housing and credit crises. The bad news certainly was extensive.

UBS, a major global bank considered to be conservative in its operations, announced that it would write down its mortgage holdings by $11.5 billion and sell parts of itself to Asian and Middle Eastern investors to shore up its capital position. Washington Mutual, long considered one of the best run banks and mortgage lenders, announced a dividend cut, job cuts, and a preferred stock offering to shore up its capital. Columbia Management, a well-regarded money management subsidiary of Bank of America, closed an “enhanced money market fund” marketed to institutional investors. Florida continued to announce problems with the cash fund it runs for local governments in the state.

Unfortunately, an investor must be very optimistic to believe these events mark the bottom of the crisis.

The key quote from Tuesday’s news was one issued by UBS when announcing its actions. The “ultimate value of our subprime holdings…remains unknowable,” the bank said according to The Wall Street Journal.

Most financial firms still have not marked down their assets by as much as the indexes tracking those assets have declined. UBS revealed its own markdown approach in reporting the new, and let it be known that it relies on models that make assumptions about defaults and foreclosures. It announced the new writedowns because those factors have been worse than anticipated. But the new assumptions used by UBS probably do not reflect how quickly the situation is deteriorating. The same is true at other firms. Announced writedowns by financial firms do not match the decline in the markets for mortgages. The firms are hoping that the market situation is a temporary and extreme response to a crisis, and that the market for these assets will return in time.

A brave investor will assume that the bottom is at hand or near and invest accordingly. Investors who are tempted to take that approach should review the aftermath of the technology bubble in 2000-2002. At various points during that period investors believed that the worst was over and the tech companies were about to resume their growth. But that point was not reached until late 2002 and early 2003, after many tech firms disappeared and a number of investors lost significant capital. Investors who are assuming that the recent bad news marks a bottom should remember that many investors and analysts said the same things after the firms announced third quarter writedowns.

The first rule of successful investing is to avoid large losses. Assuming that the worst is behind us is taking the risk that more bad news will be announced and cause more losses in aggressive investments.

December 4, 2007 05:15 p.m. Time to Buy, Especially Financials?

Is it time to jump back into the stock market in a big way? Financial stocks look especially tempting to many investors now. Financials generally have declined 25% or more since the beginning of the mortgage and credit crises. Latching on to comments from the Fed chairman and vice chairman that indicated more rate cuts might be on the way, investors snatched up stocks last week. The Dow led the markets with a 3% increase for the week. The S&P 500 rose 2.8%, and the Nasdaq 2.5%. The financial services sector led the way with a gain of about 5% for the week. Citigroup gained 9%, Merrill Lynch 17%, and Countrywide Financial 25%.

Investors are hoping for an opportunity similar to Citibank in 1990. The bank was thought to be almost bankrupt. Its value at the time was a split-adjusted $1.39. Those who bought then did quite well. Big investors are showing faith in the major financial institutions by purchasing shares of Citigroup, Freddie Mac, Countrywide Financial, and others.

But things are a big different today.

Today the economy is not in a recession; interest rates are not high; profit margins are not low; and the real estate crunch is not nearing a bottom. That means things easily could get worse from here as the economy continues to slow; profit margins become smaller; and the housing decline continues.

Most importantly, the credit and mortgage crises continue. Most importantly, the Libor interest rate increased last week. Most adjustable-rate mortgages and other variable rate debts are tied to this rate. The increase indicates that banks and investors still are wary and risk-averse.

Banks have to clean up their balance sheets by the end of the year. They also are in a steady period of deleveraging from the credit boom.

While stocks overall seem relatively inexpensive, the decline in the overall P/E ratio is largely attributable to the decline in earnings from financial services companies. I think those earnings have further to fall. Also, earnings for basic materials companies and other related to the global boom are priced for perfection. A little slowdown in the global economy will hurt their earnings.

Stocks are cheaper than a few years ago, but they still aren’t safe. Let’s follow the investment philosophy of the managers at Third Avenue. Buy only when things are safe and cheap.

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