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

1. Oil and Gasoline Prices … Uh-oh: Of great interest to all is the rise of oil prices from $79 to $110/barrel. Of great concern are the implications of such a rise. First let’s look at the economic impact and then secondly the political impact.

The economy cannot sustain the pressure of oil remaining above $105.00/barrel. With these higher fuel costs comes the gradual re-pricing of goods and services by product manufacturers and distributors to recapture margins being squeezed. This increase in prices comes at a terrible time for the American middle class. The average consumer income has been flat for a decade, and with costs rising aggressively, you end up with “stagflation,” as it was called in the ’70s (stagnant wages and rising inflation – the precursor to full blown inflationary depression).

Oil acts as a feedback loop, a negative feedback loop to the economy. In a Bloomberg interview last week, I said, “If oil were to advance above $105, these nascent economic recovery stories would be squashed.” Indeed, this is the critical implication. While we hardly see a recovery, it’s the next $1 rise in gasoline prices that will derail the popular notion of recovery favored by the news media and clung to so desperately by the financial community. As both oil and gas move higher, the prospects of a new bull cycle in equities will appropriately dissipate. (Is this the trigger for a slide in equities prices? Perhaps.) Let’s consider the steep decline in demand for gasoline here in the U.S. as the consumer has already altered consumption habits in recent years.

The U.S. Department of Energy (see chart below) shows a sharp break from an uptrend in gasoline consumption between 2007 and 2008, followed by stabilization in demand at lower levels through 2010. From midyear 2011 to present we’ve seen another sharp break to the downside. With such a meaningful fall in demand, it’s difficult to make sense of the rise in gasoline prices, well beyond anything you’d expect at this time of year (the seasonal increase typically comes much later). This is troubling to politicians, who rightly conclude that a rise in gasoline prices serves as a brake to economic growth, and will certainly frustrate a broad cross section of voters.

We see the recent divergence between gasoline prices and demand as indicative of two things: 1) central bankers are inflating, and real assets are showing it, and 2) a growing group of investors/speculators see the need to hedge against central bank activity. Add to that the tensions in the Middle East, and you get a two for one bet in oil and/or gas – geopolitical fear factor + inflation protection.

Perhaps you read about Saudi output being cut. More than anything, this is the Saudis expressing displeasure over being cheated in the currency exchange (central bank liquidity thematic again). As central bankers devalue all over the world, those that can influence their destiny certainly will. The Saudis have done so, and so have investors that connect the dots between printing presses and pricing – they are called speculators (derogatory connotation). “They” are anyone that sees a trend in the making and either gets in front of it or gets out its way. They are not the cause.

This is the key point I’d like to make. Liquidity is being amply provided to the markets not because the markets are healthy, but just the opposite, because without liquidity intervention coming from the Federal Reserve, the ECB, the BOE, and the BOJ, we would already be in a financial collapse. That’s the good news (a temporary suspension of the inevitable); the bad news is the liquidity provided is not a benign factor in the economy. The more money and credit that sloshes around the system, the more assets re-price to reflect devaluation of the currencies in question (dollar, euro, pound, yen). For asset owners, this can be of benefit. For those without assets, there is a growing frustration with an inability to care for basic needs. This breeds anger, resentment, class warfare, political volatility, and many other things.

What are the political implications? The election could go either way with oil prices being high. The best liar will win by scapegoating and simplifying the issue down to something that is irrelevant but totally believable by the masses on the basis of the tone and tenor (rancor) taken when dealing out the verbal blows. The irony to us is that while politicians on both sides of the aisle seem to favor central bank accommodation, such accommodation could actually snatch their office away – depending on how the problem of higher costs is presented and who is ultimately held responsible for it. The dynamics change dramatically if we or Israel find ourselves in a conflict with Iran. That remains a wild card.

2. Trillions Still Needed, Not Billions: News of the Greek Bailout (or prospects thereof) and Chinese central bank easing buoyed the markets again this week, but just barely. It seems that the “deal” abroad still has fleas, while EU and Chinese stimulus packages may fall short of the cash needed to keep the momentum (the rally) in stocks alive. Thus, trading this week saw a subtle shift away from stocks into undervalued or safe haven areas of the markets. Stocks remained flat in the U.S. and in Europe, otherwise kept afloat by Chinese National Bank (CNB) injections, while bonds and commodities (led by gold) rallied handsomely to finish the week (see the box scores at right).

The Greek parliament will need to make somewhere near 38 specific changes to its budget in order to qualify for the EU-approved €130 billion rescue fund – if you can call it that. If Greece agrees to abide by the requirements, effectively retaining its membership among eurozone nations, it will be giving up a good chunk of its sovereignty in the process. Under the new terms, Greece’s spending will be micromanaged by outsiders and the new debt will be placed under English law (to be ruled upon in Luxembourg courts). Added to that, if the Greeks mess up the next time around (which is guaranteed, in our opinion), creditors will have the right to seize Greece’s gold reserves (this aided gold to the upside this week). Given this, we think it’s more likely that Greece will decide to leave the eurozone – a distinct possibility German lawmakers are now preparing for.

In Asia, Japanese and Chinese economic issues (partly stemming from Europe) have spawned another effort to stimulate. Japanese surpluses have turned to record trade deficits, while Chinese manufacturing and real estate markets have decelerated to politically dangerous levels. In reaction, the Bank of Japan has stepped up measures to monetize its debt, and the CNB has begun to loosen reserve requirements, freeing up cash ($64 billion thus far) for lending purposes. The reaction in Asian markets is following standard procedure. Stock markets have been on a tear, while respective currencies (the Yen) have been in a freefall. Keep in mind that the CNB has been actively tightening since October of 2010, holding their markets back, whereas the opposite has been true here in the States and in Europe. So naturally we should see some progress to the upside in Asian stocks, but of course with inflation still running at 4% plus in China, one has to wonder how long the rally will last in the region.

Here in the States, news on the economy is mixed, depending on where you look. We continue to hold to the notion that the U.S. economy is on the brink of contraction, but sometimes it takes longer than one supposes. Economic data during the week was light. Homes sales, both new and existing, showed more improvement, holding to their best levels in a year, perhaps due to a seasonally warm winter as some have suggested. Jobless claims maintained the previous week’s level of 351,000, which was the only real help to stocks during the week. However, contrast this news with home builder Toll Brother’s disappointing earnings and a Gallup Poll showing that unemployment may rise to 9.0% (from 8.3%) and one has to wonder if they can seriously trust the data.

At the corporate level, record earnings are due to change. U.S. corporations have scaled back their earnings forecasts at the highest rate since 2009. European demand and higher commodity prices may finally be taking their toll on corporate margins. We would add that the benefit of reversals (of “big bath” restructuring charges taken in 2008 and 2009) has also run dry.

Regardless, more printing (QE) by the Fed may not be forthcoming until an accident befalls the stock markets. FOMC minutes from the January 25th meeting states that the Fed is “unlikely to launch a third round of quantitative easing unless the economic outlook deteriorates.” Other Fed officials have said that Wall Street obsession over another round of QE amounts to nothing more than a “fantasy.” Anyway, what we do know is that the monetary easing in effect in both Europe and Asia still may not keep global markets (especially in the U.S.) rising to even greater highs unless the Fed joins the party. After all, the net effect of QE overseas amounts to billions when markets here are accustomed to multiple trillions…

Best regards,

David McAlvany
President and CEO

David Burgess
VP Investment Management