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

1. Temperatures Rising in the East. Riots in China. It is interesting how unrest keeps popping up here and there around the world. Is this the summer of our discontent?

Tunisia, Egypt, Vietnam, China, and a host of other countries have seen inflation escalate, driving the prices of basic real goods to unbearable levels. People don’t seem to enjoy being squeezed between stagnant wages and rising prices. The easiest way of communicating this, and one that offers instant gratification, is giving voice to those frustrations and taking to the streets.

Of course, here in the west the only thing causing riots is the Bruins winning the Stanley cup and agitating the expectant Canuck fans (a dozen cars overturned or burned and at least 7 stab wounds, along with your everyday looting of course). Wait until that group of strongly testosterone-driven hoodlums has something serious to be upset about!

We saw this in the summer of 2008. Commodity prices spiraling higher each day, driven in part by monetary measures (unnatural causes) and in part by supply and demand constraints caused by weather (natural causes). The question many investors ask concerning the raising of rates and the squelching of inflation is two-fold 1) when will it begin? And 2) how quickly will the inflation cool?

This is the problem with excess liquidity, creating it is easier than controlling it. Releasing it is a straightforward and controlled action, like tipping a pitcher. Controlling the liquidity as it flows proves more difficult, and plays directly into the misallocation of capital in the investment markets driving speculative manias, as well as pricing the masses out of a living wage.

China has tightened credit. China has raised bank reserve requirements (more times than you can count). China is “getting tough on inflation,” yet it isn’t enough. At least they are trying to cool something off, unlike the United States.

The Chinese governmental authorities’ efforts are intended to keep a current 5.5% inflation problem from accelerating. That would be a hard enough task if 5.5% was the real inflation rate. However, the rates of inflation experienced “on the ground,” so to say, are quite different, and quite a bit higher – two to three times higher by our measure.

So when a banker pats him- or herself on the back for whipping inflation, they should first verify whether what they are fighting is the legitimate number or one conveniently lowballed so as to assure the easy victory lap. The problem is that people don’t believe the government stats and are attempting to ignore the propaganda by taking matters into their own hands. If Big brother can’t protect them, then they must see to it themselves. With the same trend of rising inflation here in the U.S. (up again in May to 3.6%), Americans will ultimately follow suit.

Gold imports into China for 2010 rang a new bell at 245 tons, nearly four times the number for the previous year. And in the first four months of 2011, the World Gold Council estimates 200 tons have already moved east, putting the year-end import number at three to four times last year’s gold imports.

Remember that China is also the largest gold producer in the world, with nary an ounce that leaves the “land of the sleeping giant.” Current domestic gold production is over 300 tons.

Why labor over the gold import figures? Quite simply because the riots this week tell you that a certain segment of Chinese society knows that inflation is killing them, and they won’t volunteer for destitution. They will take to the streets because they don’t have the means to do anything else. Meanwhile, the part of Chinese society that has some – even if modest – means, is buying more gold, the inflation hedge of old. Annual gold consumption is marching towards an annual 1,000 tons.

Remain cognizant of interest rates surpassing the real world inflation rate, because only then will reward outweigh risk and justify allocation to a broader selection of paper assets. The distance rates need to travel to suffocate this inflation monster (and impact the gold price negatively) are great, to say the least. When Chinese bank deposits pay 10-15%, you may begin to see an end to Chinese inflation, and an end to rioting thereafter.

When rates in the US stretch past 11%, our own inflation problem will be closer to resolution. Until then, individuals have begun, and will continue, to take matters into their own hands and protect assets via tangibles. Let’s hope inflation remains under control in the low double digits. Odds are that by 2014 we will see protests over rising prices here in the U.S. By that time, you might just see local interest in gold finally catching on.

2. Separating the Gold from the Wheat. With the markets oversold from last week, several factors were in play for their rebound – although you couldn’t classify any of them as long-term positives. In addition to hitting some key technical support levels, the markets were buoyed once again by central bank promises to contain debt issues in both the U.S. and Europe.

For the week, the S&P 500 gained 0.34%, the Dow 0.72%, and the Dow Transports 1.76%. All three indexes have yet to touch their 200-day moving averages. The Nasdaq continued to struggle, however, falling 0.48%, with earnings momentum in focus.

Commodities languished, with the CCI index off 2.96%, led by crude, which dropped 5.77% on news that U.S. crude supplies expanded yet again to levels not seen since 2008. Treasuries were mixed, with the 30yr up 2 basis points to 4.20 and the 10yr falling 3 basis points to 2.93. On the whole, though, Treasuries still benefit from the “risk off” trade when stocks tank.

U.S. Economic data continued to slide. Industrial production, manufacturing surveys, Michigan confidence, and retail sales levels all came in lower than expected and lower than previous-month figures. CPI and PPI also rose more than expected in May, but this might reverse in the short run as the economy decelerates. Housing starts and permits for May improved mildly, but why anyone would count this as a positive is beyond comprehension, as adding supply to an already saturated market only serves to depress prices further.

Bernanke spoke from Washington in a series of meetings hosted by Vice President Joe Biden, to address the U.S. debt ceiling and coinciding budget cuts. Bernanke, in a self-serving manner, in our opinion, stated that holding the credit ceiling hostage is the “wrong tool” to force the hand of budget cuts.

What he truly means to say is that we are already defaulting on our debt, so let’s not waste any more time bickering over budget cuts. We still agree with the Republicans, raising the debt ceiling without cuts ensures only that cuts will be postponed indefinitely. The Senate did cut 6.4B from the defense plan this week, still an easy target relative to the much larger and less productive social programs. What’s the old adage? “Guns will make you stronger; butter only makes you fat.”

Overseas, Japan is rebuilding, making their, our, and China’s manufacturing data look a bit better than it otherwise would under current global conditions. UK retail sales slid under already pessimistic forecasts, weakening the pound.  Germany and France, though not seeing eye to eye on the Greece issue (France wants to be more lenient), may reach an accord with EU and Greek officials soon.

The U.S. dollar continues to be the port in the Greek storm when indecision arises over this matter. On the other hand, Italian, Spanish, Portuguese, and euro credit costs rise, indicating that if a solution is not found soon, there may be no saving the rest of Europe. The credit contagion is set to spread. Greek CDSs rose to record levels again this week, now pricing in a 74% chance of default.

Gold separated from the commodities pack this week, as the alternative investment choices associated with economic progress (or the lack thereof) narrowed around the globe. Gold is holding nicely above its 50-day moving average. Other commodities, such as wheat (-9.13%), corn (-8.53), coffee (-3.76) and rice (-6.14), fell for the week.

On the other hand, copper, aluminum, and steel have been holding their ground – mainly due to the Japanese rebuilding efforts. We get the question as to why we don’t invest (at least on a long-term basis) in agriculture or oil. Some commodities become their own worst enemies, hurting the very economic progress they hope to prosper from.

Gold mining shares have been performing poorly as of late, to our chagrin. Partial correlation to the general stock market, political issues overseas (Peru), and relatively high oil prices have been obstacles. But given all of that, the miners have continued to show progress in revenue and/or profit growth on a fairly consistent basis – to no avail. At some point though, perhaps in a manic stage for the metals, Wall Street will have a hard time ignoring the miners, as they will be among the few generating earnings and dividend growth as inflation proliferates.

Have a great weekend!

David Burgess
VP Investment Management

David McAlvany
President and CEO