Here’s the news of the week – and how we see it here at McAlvany Wealth Management:

Markets Defy Gravity

Stock bulls (and/or the Fed) continue to propel the markets higher despite domestic and worldwide evidence of margin squeezes from existing inflationary dynamics. This astounds us. In beating a dead horse on this subject, we have provided (toward the end of this message) several stories of interest from this week’s news headlines that highlight the growing, if not parabolic, shift toward destabilizing economic (inflationary) trends – global in scope.

We are heading toward “out of control” price increases in commodities crucial to the cost of living. Many necessities are now becoming too expensive for the masses. But evidenced by his testimony to the House Banking Committee, this is still of little concern to Bernanke. He maintains that we are still running at rates below his 2% inflation target, and uses low levels of employment as a scapegoat for further QE efforts. It apparently doesn’t matter that employment may be low because of inflation rather than the lack thereof.

The markets continue to advance in a style and format reminiscent of the manic behavior in the late ’90s. However, the “wealth effect” project now underway has a few wrenches in the works that may keep it from making anyone particularly rich. An article in the Wall Street Journal titled “Inflation Worries Spread” (Feb 9th) not only made mention of the obvious price increases now at hand, but also the inability to pass on these price increases to the consumers.

Essentially, we are being pinched, and the Fed couldn’t care less. We are beginning to see the effects in corporate America, first in higher ticket items such as housing and autos (Ford was punished recently), and second at the lower end of retail – where the likes of “Dollar Stores” are thriving. For now, the effects are not broad enough to keep the markets on hold, but they are rapidly building toward a grinding halt in speculation in the future – in our opinion.

As we have said repeatedly before, commodities are still advancing faster than most areas of the market, and this is not normal during bull markets or expansions. What is of great concern to us, and what Bernanke is not considering, is that investors will not opt for savings accounts that sport negative real rates of return. In other words, by holding rates below the rate of inflation, Bernanke is promoting continued and escalating investment in areas of the market that have higher returns – in this case, commodities. Adding to the problem is the “spread” between these two asset classes. Short rates are less than 1% and returns in the commodity sector can range between 10% and 90% per year. As China is learning, rates must be raised a long way before it’s possible to discourage speculators from this once-in-a-lifetime carry trade.

Gold and silver continue to be shunned, as thoughts of a presumptively improving economy outweigh the need for protection. But this may not last for long, and money printing in this case has a tendency to float all boats – the inflationary impact of which is always put off for several months. We are now well into gold’s fifth corrective month, but it has yet to be set back any more than 7% off its highs. That is not a typical correction, which indicates the metals are strong. Stay tuned…

In the news…

-CSCO was crushed for 15% on Thursday. It did not win at beat-the-number, and communicated a weaker outlook for the months ahead (this is a $40B-per-year-in-revenue company, folks). The company cited lower spending from Federal and State governments and intensifying competitive pressures. Microsoft and Akamai Technologies traded off in sympathy, while Cisco’s competitors were chased higher (i.e., Juniper and F5).

-Consumer price inflation in Germany, Europe’s largest economy, was higher in January than originally estimated because of higher food and energy costs.

-LONDON – U.K. factory-gate inflation accelerated to an eight-month high in January, adding to the price pressures that could prompt the Bank of England to raise interest rates in the coming months.

Vietnam devalued its currency 8.5% Friday to help arrest mounting economic problems.

Bank of England Loses Control of Inflation.

-Inflation fears intensified Tuesday after the U.N. Food and Agriculture Organization said drought in the five Chinese provinces that account for two-thirds of China’s wheat production is endangering this year’s crop.

Consumers see more inflation ahead. That view puts them at odds with Federal Reserve officials and private sector economists. According to Friday’s consumer sentiment survey released by Reuters/University of Michigan, inflation expectations have been rising since late summer. Back in September, U.S. consumers expected the inflation rate one year out to hit 2.2%. In early-February, the one-year expected inflation rate is up to 3.4%.

-U.S. Commodities: Grains, Soybeans Surge to Highest Since 2008.

-Cotton soars (up 15% this week) to record on mounting concern demand to top supply.

-Peru plans tax cuts to spur growth and cool inflation.

-Problems with PIIGS: Portugal’s interest rates rose to record levels on solvency and inflationary pressures.

-Fed governor Kevin Warsh announced that he was leaving his position as of March 31st – so now he can be replaced with someone even more reckless. There will now be two empty seats on the board to fill.

-Treasury auctions have ceased for the time being – Fed monetization of that market will now commence.

-Obama is discussing the possibility of bailing out weak state governments (New York Times article, “Obama Offering to Rescue States”). Illinois, California, Michigan, New Jersey go bust.

Kraft Foods warned of impending cost push inflation dynamics – reports a 25% drop in profits.

-Brazilian government reported Tuesday that inflation is accelerating. In Brazil, higher bus fares and food prices boosted inflation in January. The government said Tuesday that its main consumer-price index in January was 5.99% above year-earlier levels.

-The odds of a Fed rate increase have now increased to 100% by December, up from just 25% a week ago.

Have a great weekend!

David McAlvany
President and CEO

David Burgess
VP Investment Management