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July 7, 2008

The Outlook For Inflation and the Likelihood of $60 Oil

John P. Hussman, Ph.D.
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Market internals deteriorated significantly last week, with major indices breaking below their March lows. Stocks are clearly oversold on a short-term basis, and that sort of price compression often invites a fast, furious, prone-to-failure rally to clear that condition.

One factor that's problematic here is that tradable bear market rallies tend to feature clearly falling interest rates, and are typically initiated by something of a selling capitulation. Now, the point isn't that we have to see a capitulation for the sake of capitulation. Rather, there remains a significant segment of analysts and investors who reject the premise that the U.S. economy is in recession. That segment creates downside risk, because if (and in my view, when) further evidence emerges to confirm a recession, their change in perspective could prompt some significant liquidation. Earnings disappointments (particularly second-half guidance) could feed into that risk as well.

There's nothing magical about, say, a high volatility index. The issue is that there will probably be more safety in accepting market risk (even a moderate and short-lived amount of speculative risk) once an ongoing recession is taken as common knowledge.

While we always take our evidence as it arrives, if I was to venture a guess, it would be that we'll observe a tradable bear market advance from lower levels, on weaker economic news and a reversion to declining interest rates. One hopeful theme that will eventually give a bear market rally legs (even if it fails later) will probably be the idea that a well-recognized recession is a fully discounted recession. Equally important, I would expect that deepening economic difficulties are likely to put commodity prices into a downtrend within a few months, and that will also tend to feed some speculative tendencies in stocks at some point, most likely benefiting consumer-related stocks and refiners.

For now, we don't have evidence to lift hedges or accept significant speculative risk. Given the still suppressed level of option volatility, we did place a small fraction of one percent of the Strategic Growth Fund into out-of-the-money call index options, just as a contingent against any need to lift hedges in response to a meaningful reversal in market action. Ideally, we'll have an opportunity to remove a good portion of our short call options on weakness rather than strength, but the low level of option premiums gives us some added flexibility in setting our hedging positions.

The outlook for inflation and the likelihood of $60 oil

Any discussion of inflation should begin by noting that the bulk of recent inflation has been restricted to food and energy. Outside of those groups, the year-over-year change in the CRB commodity price index is already negative.

The main factors influencing the outlook for broad inflation are that the U.S. economy is most likely in a recession, consumers are unusually strapped because of both mortgage debt and tight budget constraints, international economies are beginning to weaken, and credit concerns remain endemic. We should not exclude China from the risk of economic weakness, particularly given that the Shanghai index is already down by well over half since last year's highs. Stock markets typically don't drop in half without economic repercussions. Meanwhile, U.S. government spending, while still undisciplined, is relatively stable and not expanding rapidly.

Given this context, we have a combination of weakening demand for most goods and services as a result of consumer restraint, accompanied by a generally firm demand for currency and Treasury securities (particularly short-dated bills) as safe havens from credit risk. That combination is disinflationary, and it is likely that we'll observe further downward pressure on inflation outside of the food and energy groups over the coming quarters.

On the subject of oil prices, it's clear that elevated gas prices have been a factor in the terrible consumer confidence numbers recently. Still, my view remains that broadening economic weakness and an unwinding of speculative pressures will combine to produce steep declines in commodities prices, most probably by the end of the summer season.

It's sometimes suggested that hedge funds, commodity pools and speculators don't actually drive up the price of oil, because they don't actually take delivery of the physical product – instead rolling their futures contracts over indefinitely or until they close out their positions. From an equilibrium standpoint, however, this argument ignores the zero-sum nature of the futures market. Producers have an interest in selling their output forward to lock in a predictable price. Similarly, bona-fide hedgers (such as transportation and industrial companies) have an interest in buying their oil forward so they can plan without concern about future fluctuations.

To the extent that the speculators begin to take one-sided trend-following positions, their purchase of a futures contract crowds out the purchase that a hedger would otherwise be able to make from a producer.

It doesn't matter that the speculator has no intent to take delivery. What matters is that if the speculators are unbalanced on one side, the producers will have satisfied their need to pledge future delivery. Moreover, because they can lock in a high price, they will be inclined to sell more for future delivery than they otherwise would. Meanwhile bona-fide hedgers will be inclined to buy less on the forward market than they otherwise would. You can see this combination of effects in the commitments data, as a tendency for commercials as a group to become net short following significant price increases in oil.

When it comes time for the speculators to roll the contracts forward, they have to sell their existing contracts either to someone who is willing to take delivery, or to a producer who sold the oil forward and can now clear that liability without actually producing the stuff. Given relatively high spot demand and tight supply, these rolling transactions have worked fine to this point, without driving prices lower.

In my view, the problem will emerge a few months from now, as a) economic demand softens further, b) planned production hikes actually emerge, and c) weakening price momentum encourages speculators to close long positions instead of rolling them forward. At that point, I expect that net speculative positions will plunge by 10-15% of open interest and we'll see a sudden glut on the market for spot delivery. It should not be surprising if this speculative unwinding takes the price of crude below $60 a barrel by early next year.

None of this means that prices can't move even higher over the short term. As I've noted repeatedly, once prices go into a vertical spike, very small changes in the date of the final peak imply significant uncertainty about the ultimate high. Still, I continue to believe that the often extreme cyclicality of commodities has not suddenly become a thing of the past.

[Geek's Rule o' Thumb: When you have to fit a sixth-order polynomial to capture price history because exponential growth is too conservative, you're probably close to a peak.]

In over 25 years in the financial markets, starting at the Chicago Board of Trade, I've heard a lot of talk about holding onto one asset class or another as a “long-term diversification,” and a lot of reasons why this factor or that has permanently changed the investment landscape (I have a Pets.com sock puppet in the office as a reminder of one of those times). Believe me – nothing shakes people out of their “long-term investments” faster than steeply declining prices. In commodity markets in particular, price trends feed on themselves in both directions, so we see pronounced cyclicality, and much more persistent trends – once set in motion – than we typically do in the equity and bond markets. It may be difficult to identify a peak in oil when it occurs, but most likely, the fallout from that peak will be spectacular.

A primer on inflation

Gven the recent concern of investors about inflation, I thought this would be a good opportunity to lay out some basic economic principles that are helpful in understanding what actually drives price changes, beyond simple statements about “too much money chasing too few goods,” and misconceptions such as the idea that economic growth causes inflation.

To understand inflation, it helps to know a little bit about “marginal utility.” The typical way I used to teach my economics undergraduates was to get them thinking about ice cream. The first cone might give you a lot of happiness. But if you eat a second cone, you'll get a little less enjoyment. The third cone might be just slightly enjoyable. You might be indifferent toward the fourth, and are likely to be averse (negative marginal utility) to eating a fifth. So as you increase the availability of a good, the “marginal utility” – the value you place on an additional unit – declines.

The same basic principle holds for the economy as a whole. Suppose that given the economy-wide supply of ice cream, the marginal utility of ice cream is six smiley faces, and the marginal utility of a pencil is two smiley faces. Given that, the price of an ice cream cone, in terms of pencils, will be just the ratio of the marginal utilities, so an ice cream cone will cost you 3 pencils.

Exactly the same holds true for money itself. If you hold a dollar in your wallet, you might be giving up some potential interest earnings, but you're willing to hold it anyway because that dollar of currency provides certain usefulness in terms of making day-to-day transactions and so forth. If that dollar is held as reserves against checking accounts at a bank, that dollar is implicitly providing a certain amount of banking services. So a dollar bill has a certain amount of marginal utility, by virtue of legal factors like reserve requirements on checking accounts, and convenience factors like the ability to buy a nutty sundae with cash at the ice cream truck.

As a result, the prices of various goods and services in the economy, in terms of dollars, will reflect the ratios of marginal utilities between “stuff” and money. The dollar price of good X is just the marginal utility of X divided by the marginal utility of a dollar.

So how do you get inflation? Simple.

•  increase the marginal utility of “stuff”: This happens either if the supply of goods and services becomes more scarce, or if the demand for goods and services becomes more eager

•  reduce the marginal utility of dollars: This happens either if the supply of dollars becomes more abundant, or if the demand to hold dollars becomes weaker.

But wait. I've noted frequently over the years that longer-term inflation is not primarily driven by the growth of money, but rather by the growth of government spending. Isn't that view at odds with what I just described? Isn't it at odds with the whole of economic theory?

Not at all, the importance of fiscal policy in determining inflation is immediately apparent if we stop thinking in terms of “partial equilibrium” (the supply and demand of one item at a time) and think instead in terms of the full or “general” equilibrium imposed by a government budget constraint.

See, if you're a banana republic and want to run a huge government spending program, you're not likely to go through the etiquette of issuing government bonds or setting a proper marginal tax policy. You'll just print up pieces of paper. Friedman's first dictum that “inflation is always an everywhere a monetary phenomenon” is largely a reflection of a long history across many countries that a heavy government spending financed by printing money predictably leads to inflation. In particularly unproductive economies, it leads to hyperinflation.

But what if the government spending is financed by issuing bonds? It's tempting to think that somehow printing money means an increase in spending power, while issuing bonds means that the government is taking something in return for what it spends, but it's important to focus on the general equilibrium. In both cases, regardless of whether government finances its spending by printing money or issuing bonds, the end result is that the government has appropriated some amount of goods and services, and has issued a piece of paper – a government liability – in return, which has to be held by somebody. Moreover, both of those pieces of paper – currency and Treasury securities – compete in the portfolios of individuals as stores of value and means of payment. The values of currency and government securities are not set independently of each other, but in tight competition. That is particularly true today, when bank balances are regularly swept into interest earning vehicles as often as every night.

To the extent that real goods and services are being appropriated by government in return for an increasing supply of paper receipts, whatever the form, aggressive government spending results in a relative scarcity of goods and services outside of government control, and a relative abundance of government liabilities. The marginal utility of goods and services tends to rise, the marginal utility of government liabilities of all types tends to fall, and you get inflation.

Contrast this with the Great Depression. Output declined enormously, but goods and services weren't scarce because of production constraints. Rather, output fell because of a major reduction in demand. So the marginal utility of goods and services most likely declined during that period even though production itself was down. In contrast, despite a rapid increase in the monetary base during the Depression, people were frantic to convert their bank deposits into currency, so even the monetary growth that occurred wasn't nearly enough. The frantic demand for currency, resulting from credit fears, translated into a major increase in the marginal utility of money.

So what happened to prices during the Great Depression? Think in terms of the marginal utilities: the marginal utility of “stuff” dropped, while the marginal utility of money soared. The result was rapid price deflation.

In short, inflation results from an increase in the marginal utility of goods and services, relative to the marginal utility of money. It can reflect supply constraints, unsatisfied demand, excessive growth of government liabilities, or a reduction in the willingness of people to hold those liabilities. Apart from commodity prices, which may take a bit longer to reverse, the pressures on marginal utilities are presently on the disinflationary side.

As a side note, it's interesting to observe that inflation typically picks up in late-stage economic booms, not because the economy is growing too fast, but rather because the economy begins to hit capacity constraints and is therefore not able to grow fast enough. The resulting increase in the marginal utility of goods and services is what the Fed often attempts to cool down by trying to make sure that demand growth doesn't outstrip the increasingly constrained level of supply. To the extent that you often get a recession a year or two later, and that Congress tends to respond to recessions by increasing government spending, it may appear that inflation actually "causes" government spending with a lag of about two years (an observation made by Ned Davis, discussing a chart from my June 9 comment). That's a result of the general pattern of the business cycle, but shouldn't be confused with the actual line of causality from sustained (say 4-year) growth in government spending to sustained inflation trends of similar duration.

Milton Friedman is widely known for two phrases, one which is half right, and one which is exact. The half-right dictum is that “inflation is always and everywhere a monetary phenomenon.” It's half right because a government spending expansion, regardless of the form, will tend to raise the marginal utility of goods and services while lowering the marginal utility of government liabilities. It's very true that the major hyperinflations in history have been triggered by currency expansion, but as long as a government appropriates goods and services to itself in return for pieces of paper that compete as stores of value and means of exchange in the portfolios of investors, you'll get inflation.

The completely correct dictum from Milton Friedman is this: “the burden of government is not measured by how much it taxes, but by how much it spends.”

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. While stocks are certainly oversold on a short-term basis, we don't presently observe features that have historically accompanied good opportunities to accept speculative risk. As noted above, tradable bear market rallies generally feature declining interest rates (there are certainly advances that have occurred in the face of rising rates, but they often end abruptly and so steeply that losses can quickly erase any gains).

Fortunately, option premium remains fairly inexpensive, so we've taken some small contingent positions (a small fraction of one percent of assets in the Strategic Growth Fund) to allow for the possibility of a sustained reversal. In any event, the prevailing Market Climate remains unfavorable, so while we can do a bit of work around the edges of our hedges, we don't have the evidence to remove a significant portion for now.

In bonds, the Market Climate remains characterized by relatively neutral yield levels and modestly unfavorable yield pressures. Credit spreads are widening again, which tends to put downward pressure on Treasury yields as investors seek safe-havens from default. On recent spikes in Treasury yields, we boosted the duration of the Strategic Total Return Fund to about 2.5 years – still relatively conservative given the generally low level of yields, but not as defensive as we were a few months ago when Treasury yields hit unusually depressed levels on a flight to safety. The Strategic Total Return Fund also continues to hold just over 15% of assets in foreign currencies.

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