2011-12-22 / Business News

The big tug of war

jeannetteSHOWALTER, CFA

There ain’t no bigger tug of war in the financial markets these days than the opposing forces of inflation and deflation.

And which is winning? Well, it depends upon what day it is. “As the World Turns” was once a hit TV soap opera; it is now capital markets’ reality as we live in very uncertain, volatile times in which major decisions about our future are seemingly being made at the meetings of the world’s central bankers, oft held weekly.

The word inflation engenders fear in many… unless, in the same breath, you whisper its polar opposite: deflation. That word can send shivers through most mortal central bankers. In fact, the Federal Reserve Chairman Ben Bernanke has said that he would throw money out of a helicopter rather than endure deflation. Hence, before being known as “The Bernank,” he was known as “Helicopter Ben.” And if elected officials do not shudder at the thought of deflation, it might be because they really don’t understand its very painful consequences.

Inflation is a rise in prices and can be caused by monetary actions or by changes in supply and demand with monetary factors held constant. Goods and services in an inflationary-spiral cost more and more. Deflation is the opposite, meaning the fall in prices of goods and services. Most stats use the CPI as a measure of inflation/deflation.

Wms While there are many reasons why government statistics are not to be trusted, these still remain the de facto measures. The CPI basketb includes: housing, food, fuel, transportation, ps clothing, medical, etc. (See www.shadowstats.com for presentation of CPI measuredm according to 1980 and 1990 definitions, which suggests that inflation is really a lot higher than the U.S. government would declare.)

Most people understand that a variety of factors (endogenous to the U.S. and exogenous to the U.S.) impact supply and demand and thereby influence the pricing of goods. Higher natural resource prices (often caused by increased worldwide demand) can be translated into higher gas pump and raw material prices; lower crop yields (reduced supply) can translate into higher food costs, etc.

Most understand that there is an abundance of international labor — movement of factories off the U.S. shores and outsourcing of services (such as call centers, lab technicians, doctors, economists), has become a standard for cutting costs. Between that and unemployment at 9 percent, it is hard to imagine wage inflation in the U.S. any time soon.

But the current inflation/deflation tug of war being played out in the volatile, worldwide capital markets is not necessarily focused on the demand/supply for good and services; it is focused on monetary actions that have been taken and might be taken by the world’s central bankers. More specifically, the tug of war can be traced to actions already taken to devalue a currency so as to permit their respective country to become more prices competitive in the international market place and thereby engender growth in GDP; and possible future actions to monetize their respective country’s sovereign debt. Monetization allows the technical repayment of the debt but with a paper currency of lesser value.

Most recently, at the EU Summit on Friday Dec. 9, the world got some rather startling news. It seemed that the agreement needed to create an EU bank was NOT to be found; instead, Germany drove an agenda of austerity. And the markets do not think that is a viable option, in my opinion.

Why won’t austerity work? It is woefully hard for it to work in a highly leveraged country that has known an abundance of wasteful spending. A fall in the countries’ GDP can make repayment of debt impossible.

If GDP weakens, tax revenues are generally lower and the ability to pay off debt is diminished.

It seemed that Germany wanted Britain, Switzerland, Finland, etc. to agree to austerity measures that would be adopted by 17 EU countries already in this currency mess. Britain didn’t like the idea and vetoed that proposal. Beyond that, the summit gave approval for the European Stability Mechanism’s bailout funds to be capped at some $650 billion…and the market took it as a drop in the EU’s “bad loans bailout bucket.”

So, the world got this surprising news and feared a full blown or mini-deflation in Europe (spreading into the rest of the world). And many capital markets went topsy-turvy.

What to do? Embrace a fully diversified portfolio, diversified far beyond just equities and bonds, and consider the merits of alternative investment assets that are not correlated to traditional portfolios and which allow both long and short positions to be taken. As always recommended, consult with your investment adviser. ¦

— Jeannette Showalter, CFA is a commodities broker with Worldwide Futures Systems, 571- 8896. For mid- week commentaries, write to showalter@wwfsystems.com.

— An investment in futures contracts is speculative, involves a high degree of risk and is suitable only for persons who can assume the risk of loss in excess of their margin deposits. You should carefully consider whether futures trading is appropriate for you. Past performance is not necessarily indicative of future results.

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