Market Observations with Jaime E. Carrasco, BA, CFP

Jaime Carrasco

Inflation Is Unavoidable

by Jaime E. Carrasco, BA, CFP, Macquarie Private Wealth. December 24, 2008

What the rational investor has to understand is that the coming inflation is inevitable. It is a catch-22 situation for the US Government as money printing is the only thing the government can do to keep the system going, and this will only result in inflation. The longer we wait for inflation to start, the bigger the reward as it just means that more money entered the system. It's a conundrum that will make those properly positioned very wealthy, but it requires patience.

As for when? I think sooner rather than later, though I do not expect the media to mention it for quite a while. The market is already starting to give signals that are very encouraging. Gold is signaling it, as every high and low is higher and its price has strengthened above $800. As a matter of fact, gold is outperforming against all currencies except the Yen and the $US, and is definitely one of the best performing asset classes this year. Furthermore, gold producers stock prices have strengthened, and they are just starting to reflect much higher gold prices. Agnico Eagle is a very good example having hit a low of $28 in late October and is now at $52. Likewise, other precious metal prices are moving higher, also anticipating greater inflation. We are also witnessing these same movements in the agriculture sector where grain prices are showing nice gains off their lows, and the producers are catching up to reflect higher commodity prices.

On the currency front the $US’s recent increase from a low of $71 of late July to the high of $87.88 in October seems to have run out of steam. As of today the US Dollar Index is at $82 and the decline over the last two weeks seems to have momentum and might just keep going. However, these things are never linear and we might just have to test the high once more, but this will just delay the inevitable demise of the US Dollar, allowing more stimulus to enter the system and creating greater inflation. What is important for the rational investor to understand is that the decline of the US$ is inevitable, as it is the only way for the US Government to really deal with their debt problems. It is because of inflation that we no longer discuss the Russian Debt Crisis or the Asian Crisis; these problems are always solved through inflation. This fact again creates an opportunity for the rational investor as any decline in the value of US Dollar will also increase the value of commodities as they are priced in this currency. Many forget that one component that accounted for the increase in commodity prices from 2001 to 2008 was the fact the US Dollar declined from $120 in 2000 to a low of $71 in July of 2008, and this declining trend will continue for many years.

Lastly, it seems irrational to be lending the US 30 year TBonds below 2.5%. Having mentored as a bond trader under some of the best “bond vigilantes” of the 70s and 80s, I was taught to understand the balance between borrowing costs and the ability to pay. In this context I would never have believed that the worlds' largest creditor would have been able to get 30 year credit at below 2.50%. This just confirms that the US is monetizing their debts as Bernanke told us he would; I think they call it "Quantitative Easing" this time around. These low rates are needed so that the Fed can extend the maturities of all these mortgages for as long as possible prior to the needed depreciation of the dollar. Furthermore, these low yields are great for inflation, especially when it is the US buying their own debt with money they are printing. Ever wonder who is selling? These rates will not last and their reversal will mark the beginning of a long lasting cyclical trend of rising interest rates. As the decline of the US Dollar accelerates yields will increase very quickly as the reality bites all those investors sitting in low yields.

Energy prices do not seem to have found a bottom yet. If one agrees with the Wall Street Pundits that oil is going back to $8.00 I guess one should be selling. However if one thinks that current oil prices will not stay down here for long, then this is an awesome buying opportunity. The first thing to keep in mind is that the $US Dollar Index (USDX) is reversing, and that before this winter is over the $US will once again be declining and commodity prices will follow. As mentioned earlier, gold and grain prices are very much off their October lows, and the producers are now playing catch up to much higher prices than were being projected. Currently, oil companies have stopped going down and are finding some strength even though the commodity's price keeps declining. Furthermore, by spring we should start to feel the next fundamental imbalance to support commodity prices; supply shock. With regards to oil, by spring OPEC's cuts and the loss of production from many other projects around the world will start to have their intended effects. Lastly, by the time economic growth starts to pick up we will wake up to the reality that it will be very hard to bring on new supply due to under-spending and depletion rates of global oil reservoirs, as the IEA has warned us.

As you can see, the cracks are starting to appear in the dam, and once it bursts the US will have unleashed one of the biggest inflationary waves ever created. Going forward I urge the interested investor to monitor the value of the US Dollar as the key signal, once it crosses through $71 on the USDX the trend is set. By that time however, commodity prices should have already corrected in relation to the US Dollar, and likewise the producers will have already corrected from much lower anticipated prices that never materialized. What is important to understand is that these changes will only reflect changing patterns in the purchasing power of the US Dollar. The proceeding phase will begin when we start to see the supply shock that is being caused by the lack of liquidity available in the system. Huh? You ask. The cost for having taken away trillions of dollars from the global economy and low commodity prices means that we have not been producing much of anything, and the lack of supply will start to show by next summer.

What is important for the rational investor is how to benefit from this situation. The way I see it there is a major tsunami coming our way that will over flow over our island, one can either sit there and hope for the best, or wait for it in the ocean and ride it to profitability. In this environment Canada will benefit greatly for a number of reasons; we have all that the world needs, hardly any exposure to US Government debt, the strongest fiscal position of all G7 nations, and a Government based on strong democratic values. In my future writings I will review the investment considerations offered by Canada that will best benefit from the coming inflation.

In closing, I would like to thank you for the great feedback I got on my first piece, and to extend my warmest regards this Holiday Season and my hopes for health, happiness, and prosperity.

Jaime Carrasco

© 2008 Jaime Carrasco

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Jaime E. Carrasco, BA, CFP | Investment Advisor, Macquarie Private Wealth
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