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

1. Irrational Market Expectations:  What a curious week.  The Congressional Budget Office (CBO) gave the appraisal that, ”Unless policymakers restrain the growth of spending, increase revenues significantly as a share of GDP, or adopt some combination of those two approaches, growing budget deficits will cause debt to rise to unsupportable levels … a growing level of federal debt would also increase the probability of a sudden fiscal crisis during which investors would lose confidence in the government’s ability to manage its budget, and the government would thereby lose its ability to borrow at affordable rates.

It seems the writer is unaware that these events are a present reality, not just a future contingent event. Of course, investors have long observed that the government’s ability to manage its budget is a political impossibility.  It would take willpower and a real-world perspective on revenues and expenses.  Government has long been out of control.  As Nassim Taleb noted this last week, government debt is “ … becoming a pure Ponzi scheme … what broke Madoff is going to break governments. They need to find new suckers all the time. And unfortunately the world is running out of suckers.”

Leading Economic indicators over the past week suggest a double dip – if you thought we were in recovery – or merely a resurgence of the old trend.  The ECRI Weekly Leading Indicator is down again from -10.5 to -10.7.  Though not usually the first group in New York to proclaim a recession is nigh (they usually prefer to be in one before they call it one), their indicator has been prescient.  What lies ahead?

Institutional portfolio managers are on average at a 68% recommended allocation to equities.  That is an allocation that takes the average investor and either positions him for the next great bull market in stocks, or alternatively takes him and throws him under the bus. The second half of 2010 and the early part of 2011 are likely to upset the average investor.  ICI aggregates mutual fund data, noting that Equity mutual funds are invested just shy of their 2007 peaks (by 8.8%).  Cash to Asset ratios are about 3.5%.

What this means is that the public is positioned for a full and robust recovery.  If it doesn’t come, they are also positioned for painful losses.  Should the Dow break down from the current Head and Shoulders pattern, 8,000 is a reasonable first target.  Please recall that eight of history’s largest market reversals (to the downside) came in July, August, and October.

2. Inflationary Inflection Point? We know this is a hot topic of discussion among economists and the media: Will Fed easing and government tax/spend policies lead to inflation?  If so, when?  By the looks of it, both at home and abroad, we are beginning to see inflation emerge (remarkably, in government statistics) even while markets and economies are in decline!

To illustrate the point: in today’s release, U.S. Q2 GDP figures showed that the economy grew at a less-than-expected rate of 2.4%, personal consumption growth was cut in half to a 1.6% rate, while the rate of inflation measured by the GDP Price index rose 1.8%!  Previously, in Q1, the opposite trend was in effect with GDP growth registering 3.7% and inflation 1.0%.

The U.S. is not alone – similar dynamics are at work in several countries around the world.  Australia, Russia, India, China, the U.K., Brazil, Thailand, Korea, and Malaysia, just to name a few, have all begun to experience actionable rates of inflation.  The reaction thus far is mixed.  Some have begun to raise rates (several times); while others are attempting austerity measures to retain price/economic stability.

So far, these efforts have been gradual at best (very non-Volker), as there are still solvency issues that do not react well to central bank rate hikes.  Here at home, we have thus far been less exposed to these inflationary pressures because the demand for U.S. dollar-based assets (especially Treasury and agency debt) remains high.   Compared to the 1970s (the last inflationary cycle in the U.S.), when foreign purchases of U.S. assets amounted to a mere 4% of U.S. debt creation per year, creditors today consume almost 60% of new U.S. debt in any given year.

This is a massive difference, and highlights why we haven’t seen rates rise sooner than we did in the 1970s when gold prices rose alongside Treasury yields.  Without getting too technical here, it’s our observation that global inflation is choking both sides of the reserve system, making it increasingly difficult to finance both foreign purchases of U.S. debt and the creation of that debt.   When rates rise as a result, which we see happening in the not-so-distant future, cries of deflation will fade and economic growth will be postponed.

Have a great weekend.

David Burgess
VP Investment Management

David McAlvany
President and CEO