August 2008 Edition

financial analysis

Déjà vu time

Country may be in another period of rapid inflation

By John Hummel

Seven years ago, I penned a piece entitled "The Coming Commodity Inflation Tsunami" since I was deeply concerned that inflation levels would rise. I was also concerned about the potential for a bull market in commodity prices, a weak U.S. dollar, rising long-term interest rates, and a compression of price/earnings ratios that would accompany a rise in long-term interest rates.

During that time, there were numerous minor market corrections in the commodity bull market. The first significant correction began in May 2006 and appears to have been completed in mid-August 2007.

The credit crisis and Federal Reserve easing in August 2007 ignited a second phase of the commodity bull market.

Not a ‘bubble’

While many pundits may refer to the current situation as only a "commodity bubble," I believe they are not well versed on the facts.

Inflation-adjusted commodity prices are nowhere near prior highs in the last century. The current advance, whether energy, metals or grains, likely is due to rising global demand and an inability of supplies to keep pace with demand. Although demand has been moderating in the most developed economies (e.g., the United States), developing-country demand growth has more than offset softness to date in the developed economies.

Scarce commodities are likely to dominate economic conditions for the next decade. Capital and labor remain in relatively greater supply than commodities.

In addition, the central banks, led by the Federal Reserve, will error on the side of promoting economic growth at the expense of a strong dollar or controlling inflation. The Fed will continue to talk tough on inflation but will ease anytime the U.S. economy exhibits evidence of stress.

Adding further stress to the above conditions is that world oil production may be at or close to permanent peak levels. "Peak oil" is not about running out of oil; it’s about the peak rate of production. It is not about total reserves in the ground but about the maximum rate at which it can be extracted.

Oil situation dire

Throughout this decade, discoveries have fallen well below current consumption in spite of improved technology and significantly higher prices. The world oil situation remains dire. Because oil is so critical to most aspects of modern economies, its price and availability impact the entire economy.

With developing economies becoming more affluent, the world is experiencing unprecedented demands. Consumers are likely to face rising expenditures for the items they have taken for granted throughout most of their lifetimes.

Technological substitution will develop but there can be no assurance that it will occur in a seamless fashion. Therefore, still higher prices for commodities and economic disruption may well be with us in the years to come.

Both the Federal Reserve and Congress will make policy decisions that will error on the side of monetary stimulation in order to prevent a deflationary spiral from developing.

Given the rise in commodity prices, the increasing inflationary expectations, and the weak dollar, one would have expected long-term interest rates to be higher than current levels. At a 4.5 percent yield, the U.S. Treasury bond does not offer an attractive reward/risk dynamic, given current and expected inflation rates.

However, it appears to have benefited from the flight to quality as other investment instruments have melted down. I remain convinced that long-term interest rates may eventually exceed 1981 double-digit levels.

Here’s the picture

My scenario calls for a steepening yield curve, with long-term rates rising more than short-term. I expect this to occur as the Federal Reserve maintains low short-term interest rates to stimulate the economy, while investors increasingly lose confidence in the long-term financial integrity of the dollar and the government.

Increased government involvement in the economy has dramatically changed the long-term inflation rate. After 200 years of periodic inflation, usually the result of wars, the economy would experience offsetting deflation. However, since the mid-1950s, Americans have entered an environment of continual inflation. The economy has oscillated between periods of rapid inflation and periods of milder inflation. As in the 1970s, it appears that our country may be in a new period of more rapid inflation.

I believe that gold may well reach significantly higher levels in the next several years, and I expect gold’s relative strength to continue for the foreseeable future.

Finally, my search will continue for unique equity investments, both domestically and in international markets. To qualify, companies will either have to be beneficiaries of the economic conditions I have described in this commentary, have a unique product or service that creates a new market niche, or be selling into one of the more rapidly growing developing economies.

John R. Hummel is president and a founder of AIS Futures Management LLC and AIS Capital Management LLC, a registered investment advisor. Hummel’s papers and published articles can be found at the website: www.aisgroup.com. His e-mail is jhummel@ais.com.

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