Oslo, Norway

Is it too premature to worry about inflation?

Since March, investors have shifted away from deflation fears to future inflation expectations. Commodities, stocks and other risky assets that are typically fueled by rising inflation have skyrocketed since the March 9 intermittent low.

The problem with this price action, however, is that inflation is nowhere to be seen. It’s not in earnings, not in consumption and not in wage growth. Gold prices have gained just 3% since March 9. The only segment of credit expansion underway this year remains tied to massive government spending; and that won’t be enough to lift spending and domestic consumption because consumers are now hunkering down and becoming thrifty again.

This rapid change in mindset and future price expectations is too premature. Corporate earnings remain blinded by weak demand and consumers in the West are now focused on debt reduction and balance sheet repair. In no way do these trends portend to a rapid increase in inflation any time soon.

The chart above depicts the break in long-term inflation that began in July 2008 as credit, commodities and other financial markets collapsed. Housing remains in a severe bear market with more than 12 months’ worth of supply delaying a recovery. Personal income declined in Q2 and consumer spending has not recovered from its pre-crisis high in 2007.

The United States, Europe and several countries in Asia, including even China are now suffering from modest to severe deflation or falling consumer prices.

Ireland is in the midst of the worst deflation since 1960 with prices down 5.4% year-over-year. In the United States, CPI declined in June for the fourth straight month. It’s the same story for many other countries whereby price pressures are not only subdued but still falling.

The markets have rewarded earnings mainly because companies have successfully trimmed redundant labor while rebuilding depleted inventories. This explains the recovery in global manufacturing since Q1. That’s a nice gimmick in a deflation but not enough to keep the earnings momentum on an upwards trajectory. Worse, monetary policy in the United States and Europe has been a failure thus far with broader monetary aggregates unable to grow as credit demand remains anemic.

The bulls now paint a sunny picture since late July following the confirmation of Dow Theory whereby the Industrials and the Transports have hit new 2009 highs. It’s the same story for most international bourses, too. Technicians have gone stir crazy since July 23 and popped the Champagne on August 3 when the S&P 500 cracked 1,000.

Technical analysis is indeed a useful tool. Yet is fails to address fundamentally important trends in the broader economy such as bank credit growth, consumer spending, unemployment and rising personal and corporate bankruptcies. In my book, technical analysis is a nice framework to confirm where prices have already crossed but almost useless in rendering the future or the big picture.

If you feel tempted to play this huge bear market rally following a 50%-plus gain off the March 9 intermittent lows then make sure to cover your long exposure; this is not the environment to throw everything at risk based assets. Deflation remains alive and kicking in 2009 as governments have yet to defeat their arch monetary nemesis.

More “bubbles” are being created this year in commodities, emerging market stocks and junk bonds. What’s more, governments are creating other asset bubbles by keeping interest rates super low and encouraging investors to dump near-zero percent savings accounts and money market funds for stocks and other risky assets.

Did we not learn anything from the worst destruction of credit and personal wealth over the last 24 months? Apparently not.