Inflation Rearing Its Ugly Head?

Secular Trend Implications

By Chris Puplava, March 28, 2007

Fourth quarter 2006 personal income data was released yesterday, which showed a 1.2% increase in the fourth quarter and an increase of 6.3% for 2006. This was up from the 5.2% rate seen in 2005 and marked the strongest annual growth rate so far in the current economic expansion.

Figure 1

Source: Moody's Dismal Scientist

It's not surprising to see employee compensation rise after falling to an extreme low in late 2001 on a year-over-year (YOY) rate of change basis. Since the economic expansion began, the YOY % change in employee compensation has been playing catch-up with corporate profit growth which has remained at double-digit rates year after year. While corporate profits are resting at cyclical highs, employee compensation has a ways to go to its cyclical high.

Figure 2

Source: Moody's Economy.com

There are far reaching implications for a rise in unit labor costs (ULC, employee compensation) as the trend in the Consumer Price Index (CPI) follows the trend in ULC very closely. With ULC showing a clear uptrend, how long is it before the CPI accelerates upwards after decelerating over the past year?

Figure 3

Source: Moody's Economy.com

While many financial pundits have been calling for a bottom in housing, which is far from over, many have also called for the bursting of the commodity bubble. The source of this accusation that many draw upon is the decline in energy prices, gold, and the correction in the CRB Index (Reuters/Jefferies CRB Index). However, while we were drenched in daily Dow record news flashes on CNBC, what is not as widely circulated is the new all-time seen in the CRB Raw Industrials Spot Index. Looking at Figure 3 below, the Reuters/Jefferies CRB Index (blue line) has clearly corrected while the CRB Raw Industrials Index continues to soar to new heights. (Notice the similarity in the indexes to that of the 1970s where the start of the decade saw a surge in the CRB index followed by a sideways consolidation in the middle of the decade before the next up-leg to close the decade at nearly a 350% rise. The CRB rose roughly 100% since 2000 and is now going through a sideways correction/consolidation in the middle of this decade.)

Figure 4

Data: Bloomberg.com

The reason for the dichotomy between the Reuters/Jefferies CRB Index and the CRB Raw Industrials Spot Index stems from the fact that there is a higher energy weighting in the Reuters/Jefferies index than in the Raw Industrials index. Both indices trend closely together and either the energy concentrated Reuters/Jefferies index is headed higher or the Raw Industrials Spot index is headed lower. Owing to the bounce in energy prices and the tight supply of gasoline inventories, which has led to a surge in refining margins (Figure 4, red line), the Reuters/Jefferies index is likely headed upwards pointing to higher inflation in the pipeline.

Figure 5

Data: Bloomberg.com

Adding insult to injury, AccuWeather released its initial hurricane outlook ("Hurricane Threat Looms for US Energy Production and Gulf Coast in 2007: Last Year Was Just a Breather"), which calls for another strong year of hurricanes. AccuWeather.com Hurricane Center Chief Forecaster Joe Bastardi's comments are provided below:

We'll see storms on the prowl in the Gulf again. The entire region - including New Orleans and other areas that are still rebuilding after Katrina - is susceptible to landfalling storms. Of concern to consumers everywhere is that there is so much oil and natural gas drilling and refining occurring in the Gulf. This year's stronger storms are likely to cause the kind of disruption that will be felt in wallets and pocketbooks.

Bastardi's predictions should not be taken lightly as the article points out his track record.

Bastardi, who in March of last year correctly forecasted that the region would get "minimal" attention by that season's hurricanes, said that this year, "the Gulf and Florida face a renewed threat, and we will see more powerful storms across the board. We will not get anywhere near the amount of storms that we did in 2005, but it is the intensity of the storms we do get that will be of major concern."

Last year, Bastardi forecast that the East Coast would be far more likely than the eastern and central Gulf to see hurricane activity, and indeed, most of 2006's ten storms tracked farther east than in 2005 - including Ernesto, which caused a half-billion dollars in damages in the region from North Carolina to New Jersey.

Pointing out that it’s not just the quantity of hurricanes that matters but also the severity, and supporting Bastardi's point that "it is the intensity of the storms we do get that will be of major concern," are comments from Ken Reeves, AccuWeather.com Director of Forecast Operations. When asked about the diminished number of tropical cyclones compared to 2005, Mr. Reeves pointed out the following:

Keep in mind that in 1992, a year with very few storms, we saw one of the most destructive in recorded history - Hurricane Andrew. This year is shaping up to be one that features some potentially very powerful storms, so whether or not the quantity is there, the danger certainly is.

Not only is the recent trend of rising energy prices likely to persist, which would lift the Reuters/Jefferies CRB index, but the CRB Raw Industrials Spot index is likely to continue setting price records as base metals and agriculture commodity's continue to march northward, with inflationary pressures baked into the pipeline.

Of the six agriculture and soft commodities listed below, only sugar has corrected meaningfully, though it is still displaying a strong upward trend over the years. Looking at the commodity charts below shows why the CRB Raw Industrials Spot index is putting in new highs.

Figure 6

Figure 7

Figure 8

Figure 9

Figure 10

Figure 11

Data: Bloomberg.com

Not only are agriculture and soft commodities displaying strong upward trends but so are base metals, as London Metal Exchange (LME) stocks remain at historical lows for most metals. The figures below show dramatic price increases in base metals beginning in 2001-2003 (coinciding with a surge in China's & India's GDP, Figure 10), with copper already retracing most of its recent decline.

Figure 12 � China GDP Y/Y % Chg

Figure 13 � India GDP Y/Y % Chg

Source: Bloomberg.com

Figure 14

Figure 15

Figure 16

Figure 17

Figure 18

Figure 19

Data: Bloomberg.com

Secular Trend Implications

As mentioned above, the CRB index from 2000 to today resembles the pattern seen in the 1970s (Figure 4). The environment that characterized the 1970s that led to a rise in commodities was surging inflation due to falling productivity. Rising inflation led to falling consumption, rising savings rate, rising interest rates, and three recessions.

One of the causes of falling productivity during the time period, which really began in roughly 1960-1965, was population dynamics. This can be seen by taking the ratio of the U.S. population age group of 35-49 relative to the 20-34 age group. As the ratio of the more experienced older age group fell in relation to the younger, less experienced group, productivity fell (Figure 20).

Figure 20

Source: Moody's Economy.com

This trend in a rising younger population relative to the older population continued through roughly 1980 as did the trend of falling productivity, with the trend in falling productivity coinciding with rising inflation (Figure 21, inflation inverted) and a falling trend in GDP (Figure 22).

Figure 21

Figure 22

Source: Moody's Economy.com

Another pattern that emerges when looking at Figures 21-22 is that the period between 1980 and 1982 marked a secular turning point. One important development that occurred in that time frame was that the Baby Boomer population were entering the work force out of college with a few years under their belt. As the Baby Boomer population began to age they became more experienced in their careers and the overall population age group of 35-49 relative to 20-34 expanded, leading to an upwards trend in productivity (Figure 20), which in turn led to a falling trend in inflation (Figure 21). The proof of the period between 1980 and 1982 marking a major secular point in the economic and financial markets can be seen in the figure below.

Figure 23

Source: Moody's Economy.com

As the aging of the Baby Boomers and their entry into the workforce (gaining work experience and knowledge), marked a major secular turning point between 1980 to 1982, is makes sense that the retirement of the Baby Boomer population and their exit from the workforce that is beginning currently will lead to another secular turning point. In reference to Figure 20 again (presented below), the year 2000 marks a peak in the ratio of the age group of 35-49 relative to the 20-34 year age group. The projected population over the next thirty years is given below by the Census Bureau (red line), which shows the relative age ratio falling through to 2012. What is also shown in Figure 20 is that productivity is rolling over. The last time both ratios peaked was the period between 1962 to 1965 that marked a secular turning point of falling productivity, rising inflation, higher interest rates, and rising commodity prices that characterized the 1970s.

Figure 20 (repeated)

Source: Moody's Economy.com

The fact that both productivity and the relative age ratio are rolling over will have far reaching implications on both the economic and financial landscapes. The secular trend from 1962 to 1980 saw consumers cut their consumption as personal consumption expenditures (PCE) as a percent of income displayed a declining trend as interest rates rose to combat inflation (Figure 24), and consumers increased their savings rate (Figure 25).

Figure 24

Figure 25

Source: Moody's Economy.com

As Figure 20 shows the productivity and the relative population ratio marking a major secular turning point, we see similar signs in other areas. Interest rates, as seen in Figure 24, were at half century lows and are showing a rising trend much like they did at the 1962 to 1965 secular turning point. Notice also that consumption as a percentage of personal income is at an all-time high and also appears to be in a topping process. Another record, though an all-time low--not high, is the U.S. savings rate, which is currently negative. With a negative U.S. savings rate and consumption levels at an all-time high, which direction do you think they are likely headed in the years to come?

It is very likely that the retiring Baby Boomer population will create another secular environment like what was seen in the 1970s that saw dramatic inflation and rising commodity prices. This time around might display even more dramatic inflation and commodity prices as we began 1962 with a 9% savings rate, and 80% PCE to income, while the current circumstances present a far more bleak picture with a negative savings rate and a record 86% PCE to income.

Brian Pretti from ContraryInvestor.com, who co-writes the Friday WrapUp, wrote about U.S. household liquidity in his January 25th article, "We're Swimming In Liquidity, Aren't We?," notes the dire state of the Baby Boomer population. His comments and chart are presented below.

Figure 26

Source: Brian Pretti, "We're Swimming In Liquidity, Aren't We?"

Boom, Boom, Out Go The Lights?...So why is all of this discussion about household liquidity important? What does it mean to our investing activities ahead and the broad economy in general? Although this is somewhat of a generic comment, we believe the significance of these trends find their meaning in demographics. In very simple terms, we know that the baby boom generation is moving full speed ahead into retirement years. Point blank, assuming the boomers in aggregate actually do retire, their need for real liquidity will be meaningful. Very meaningful. Remember, we're referring to a baby boom generation who has "learned" to become relatively dependent on asset inflation (real estate, bonds, stocks) for a good many years now to generate household "liquidity". Asset inflation that has truly acted to underpin consumption. Unless we can bank on asset inflation continuing (forget housing inflation), implying that asset inflation will "fund" boomer retirements, just where will retirement funds/liquidity come from? This is the issue, and it's clearly of longer term importance as opposed to being something influencing the open of trading tomorrow morning. Can the Fed fund boomer retirements by simply printing money and inciting ever greater household asset inflation? Can the boomers "borrow" their retirement lifestyles by taking on ever greater leverage?

Given that we are looking at over 75% of household assets in real estate, tangibles and bond/cash assets, again, where does future liquidity come from for the boomers ahead? Of course the most obvious answer is the sale of financial assets. Not necessarily proactively, but by sheer default. It's no wonder demographers such as Harry Dent are painting an outright nightmare economic/financial market outcome starting literally in five years. (For any familiar with Dent's work, you already know he has very quietly mentioned the word depression a time or two in his outlook).

The Baby Boomer retirement picture discussed by Brian does not pose an encouraging thought when comparing the current starting point of a secular turn compared to the 1962 to 1965 period. To make the overall environment worse, the 1970s did not have the emergence of two developing economic powers as we see today with China and India (Figures 12 & 13), which are both consuming ever increasing quantities of base metals and energy products, dwindling LME stockpiles (Figures 14-19).

The commodity boom that began this decade is likely to keep going as China and India both continue their strong growth, leading to rising commodity prices and inflation. The rising inflationary prices of commodities, as well as rising wage inflation (Figure 3) will support the bull market seen in precious metals as was seen in the 1970s, which will only be exacerbated by the rampant global money printing currently present. As seen below, money growth in major countries around the world are experiencing double-digit growth rates as countries compete to devalue their currencies to lift exports. Debased currencies and rising inflation levels are two strong ingredients that lead to the increased value of physical assets as paper assets are devalued.

Figure 27

Data: Bloomberg.com

In summary, the current demographic picture points to a major secular shift that will have far reaching economic and financial consequences. In response to Brian Pretti's question above:

"Can the Fed fund boomer retirements by simply printing money and inciting ever greater household asset inflation? Can the boomers "borrow" their retirement lifestyles by taking on ever greater leverage?"

It sure looks like the answer to that question is 'yes' as rampant monetary creation (Figure 27) is clearly the global phenomenon. Under this environment asset inflation will predominate, though what matters is not nominal values but real values. A chart is presented below by Brian Pretti (Market Observation, 02.06.07) to make this point clear, where the secular period from the late 60s to early 80s showed the Dow trade sideways in nominal terms (red line), but when corrected for inflation (blue line) it crashed.

Figure 28

Source: Brian Pretti, ContraryInvestor.com, Market Observation, 02.06.07

For this reason, gold and gold stocks, as well as energy stocks will display strong asset returns as inflationary hedges, and will rise in both nominal and real terms to be the strongest performers this decade as they were in the 1970s. As seen by the figure below, this indeed looks to be a mirror image of the 1970s in terms of gold.

Figure 29

Source: BCA Research

TODAY'S MARKET - Economic Reports

MBA Mortgage Applications Survey - Week of 03/23/07

Mortgage demand fell 0.2% last week led by a 0.5% decline in refinance applications while purchase applications witnessed a small increase, rising 0.1%. The contract rate on the 30-year FRM decreased 2 basis points to 6.04% while the 1-year ARM declined 3 basis points to 5.84%.

Source: Moody's Economy.com

Durable Goods (Advance) - February

February new durable goods orders rose 2.5% in February, less than the consensus (Thomson Financial) estimate of 3.1%. Shipments fell 0.8% while inventories rose 0.2%, leading to an increase in the inventory-to-shipments (I/S) ratio to 1.44, the highest level since late 2003. The 2001 recession was preceded by a peak in new orders and a bottom in the I/S ratio. A similar picture is occurring presently and both will have to be monitored closely for any recessionary warnings.

Source: Moody's Economy.com

Oil & Gas Inventories - Week of 03/23/07

Crude oil inventories fell 0.9 million barrels last week, well above expectations of a 1.6 million barrel increase. However, gasoline inventories fell 0.3 million barrels, less than expectations calling for a 1.8 million barrel decline. Distillate inventories also fell less than expectations, falling 0.7 million barrels while expectations were for a 1.2 million barrel drawdown. All three energy levels are below last year's levels, with distillate inventories down the greatest (-5.1%) followed by crude oil (-4.0%) and gasoline (-1.9%). Refinery activity increased as well for a third consecutive week, rising to 87.0% from the prior week's level of 86.3%.

Source: Energy Information Agency (EIA)

Source: Moody's Economy.com

The Markets

Stocks fell today on comments from Fed Chairman Bernanke's testimony on Capital Hill. Mr. Bernanke commented that while core inflation slowed "modestly" in the later part of last year, recent inflation readings are still "uncomfortably high." This is in contrast to the rally that was staged last week as the markets misinterpreted the Federal Open Market Committee (FOMC) statement with the removal of the inflation bias.

The Dow, S&P 500, and NASDAQ were all down on the day with the Dow posting nearly a triple-digit loss, falling 96.93 points to close at 12300.36, the S&P 500 fell 11.38 points to close at 1417.23, and the NASDAQ gave up 20.33 points to close at 2417.10. Investors sold Treasuries today with the 10-year note yield at 4.62%, rising 1.7 basis points. The dollar index was up on the day, rising 0.06 points to close at 83.07. Advancing issues represented 34% and 31% for the NYSE and NASDAQ respectively, with up volume representing 23% and 20% of total volume on the NYSE and NASDAQ.

Energy prices were mostly up today based on a greater than expected decline in crude inventories with WTIC oil rising 1.83%, gasoline falling 1.01%, and the biggest move coming from uranium, up 5.56% and nearly pushing $100/lb. Precious metals were all up with gold rising $1.94/oz to $666.35/oz (+0.29%) and silver finishing up $0.08/oz to close at $13.3551/oz (+0.60%). Base metals were mixed with tin showing the greatest strength on the day (+1.42%) while aluminum displayed the weakest performance (-0.51%).

Overseas markets were mostly down with China's Shanghai proving the exception, up 1.09%. Brazil's Bovespa and the Korean Kospi index were the worst performers on the day, down 1.60% and 0.93% respectively.

The move in the markets was broad based as all ten of the S&P sectors were down, with the utility and consumer staples sectors displaying the greatest strength, down 0.06% and 0.16% respectively, while the telecommunications and financial sectors showed the greatest weakness, down 1.21% and 1.20%.

Chris Puplava

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