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

1. Fed Past is Prologue: This week was quiet unless you were in Tripoli. The Middle East has captured headlines, and appears to be the driver in the equity and metals markets. We disagree. The monetary and economic backdrop define the period, with news acting as punctuation, but not the core thematic. We’ll look briefly at the region at the end of our remarks.

When you compare the national fear of deflation here in the U.S. (stemming from the depression era, in which deflation was a terrifying reality) with the national fear of inflation in Germany from last century’s dual hyperinflations, you can see that various central banking biases are cultural in nature. Tragedy scarred the minds of several generations. These tragedies were not just economic, but human and deeply personal. There were actions taken then that have rough similarities to actions being taken now.

Monetization is not new. As long as the Federal Reserve Bank has had access to capital, they’ve been filling gaps, when necessary. If the market isn’t interested in the IOUs being offered, the Fed can smooth this over so prices are not negatively impacted. This was true in 1936, and is true today as well.

We can always glean insights from the past, and this is an important one. A crisis is the bond market followed the early monetization in that era. Following the monetization of debt, inflation became a noticeable issue as soon as 1937. When inflation became pronounced, consumers retrenched and companies at the same time faced a squeeze in margins. This has been a regular theme (with the present in mind) in our comments for several months now, as we have an echo from the past in the market today. What we have not yet seen, but are likely to see, is the impact of these factors in the marketplace. In the fall of 1937, stock prices dropped by nearly 50%. Will the fall of 2011 resemble the fall of 1937? Probabilities are rising.

Consumer retrenchment is notable in the Walmart sales figures, just out. Total sales were down, with new store sales down 2.8%. That marks the 7th quarter of decline. Bill Simon, the CEO, noted the increasing use of government assistance programs to pay for goods. This implies that sales in the retail space would be worse still if not for government spending (food stamps now required by 43 million Americans, in addition to other assistance programs). We are grateful that suffering is less severe than in past periods of economic crisis, but are reminded that any notion of recovery is artificial at this juncture.

Markets are set for downside volatility in coming months. Investors today are scouring the news for confirmation of a new growth trend. Any suggestion to the contrary is near blasphemy. From Cisco’s candid discussions of lower expected growth, to Hewlett-Packard’s lowered revenue projections for 2011, you find the market quite punishing when positive expectations are not met. In both cases, shares sold off from 9% to 12% on the day. The underpinnings of this market are weak. Liquidity remains the primary driver. Sentiment remains strongly positive, but it’s ungrounded and always fickle. Catalysts abound these days for a reversal.

Because of the enduring influence of the 1930s, in the U.S. we continue to focus on the specter of deflation, while the European Central Bank is looking to inflation as the crisis du jour. This fixation with the past is hurling us toward an inflationary outcome, where the Fed, fixed in mortal combat with a deflationary foe, is driving a stake not through the heart of the intended enemy (deflation), but inadvertently through the heart of the middle class, and ultimately corporate America.

2. Regimes Change, Oil Remains: Our comments in recent weeks on the Middle East have been conspicuously absent. Not because we are uninterested, but because the changes are too rapid and evolving to pin down all country specific issues and their implications.

To summarize: the changes we are witnessing in the Middle East are massively significant to the commodities complex, regional stability, and of course American hegemony in the region.

The supply constraints on the oil market may be temporary, but until new regimes have replaced the old, and clarity on what ideologies the new regimes represent is gained, you will see fear premium factored into the energy complex (this raises the input costs to finished goods and pressures your agricultural commodities higher as well).

This is a separate scenario than the longer-term and more deeply systemic oil supply issues (not considered a real issue before 2015). An oil spike is not necessary to upend economies or cause a drop in equities; sustained high levels (70-90) will do that. A spike in prices simply moves the clock forward. We are very concerned about the balance of power, which has been destroyed over the last seven years, and is becoming more complex all the time.

Regional stability is far more important than the country-specific issues currently in the news (this is admittedly an American perspective). That stability shifted at the outset of the war in Iraq when the Iran/Iraq balance was upset, and the non-permanent U.S. forces filled the gap. Now, in addition, we have long-established alliances and relationships being destroyed. Some countries that are not formal allies have at least been predictable and quantifiable actors on the stage that we have taken for granted in our foreign policy script – again, predictability is a thing of the past. Our foreign policy in the region now faces the challenges of the chef unscrambling the eggs of an omelet.

American hegemony in the region has shifted. We once looked at our military presence in Saudi Arabia and the close relationship we have with Israel as all-important, stabilizing factors. It has been decades since so much has been in a state of flux in the Middle East and so little has been solvable by phone calls and through private negotiations. Our State Department is at the mercy of the crowds.

We are in the awkward position of having “pitched” democracy as the greatest idea in town, without regard for its various forms or grass roots promoters. Again, the issue at hand is one of adjusting to a regional shift in power where we may or may not have the influence we once had. We will wait before offering final judgment, and hope that Middle Eastern democracy shares compatible characteristics with our own system of government.

For the global observer, we have proved what many have long suspected: our “friends” are conveniently supported or dropped and our support of dictators or autocratic regimes can adjust with the blowing of the wind. That matters more today to the Saudi Royal family than ever before. As the Sauds focus their attention on Bahrain (far more important than Libya) and Algeria, there is an unanswered question – will U.S. support be maintained if the Saudi regime comes under populist pressure? Before waiting to find out, King Abdullah has announced an immediate disbursement of $36 billion in extra benefits to lower and middle income Saudis, with a promise of $400 billion in new education and healthcare spending by 2014. Desperation abounds.

World attention gravitates to these issues and allows for other geopolitical realignments. Russia benefits immensely by the enhanced significance of its oil flows to Europe, and can thereby push for greater political influence in the years ahead. Power vacuums are quickly filled, and Russia has aggressively asserted itself, repositioning for future growth. European natural gas from Libya, and of course crude moving through the Suez, are also issues to bear in mind. These are, however, symptoms of a deeper issue waiting to be resolved (back to the balance of power theme). We’ll follow these issues closely in the months ahead.

In summary, the instability reigning supreme in the Middle East today is a byproduct of the global monetary expansions. The subsequent explosions of popular unrest are due to rising food prices (see the BBC article on Delhi protests over high food prices – it’s not just a Middle East phenomenon!) pressured higher by our central bank mandarins and exacerbated by higher energy costs.

This is a world unhinged. Caution is required. But we would remind you: All great investments begin with a purchase at rock bottom values. The present circumstances are quite similar to past environments where those buying opportunities emerged and were reserved for a select few. Keep a defensive posture in your investing, and you may get to participate.

Have a good weekend…

David McAlvany
President and CEO

David Burgess
VP Investment Management