Last week marked an important step in the history of this crisis. We had started the week calling our readers’ collective attention towards the consolidation that gold had witnessed on Friday, April 1st, and wrote that: “… we think higher highs are soon to come…”. Well,…the higher highs came and we fear, they came to stay.

If we had to define in one sentence the action last week and that which is to develop in the future, we would say it in actually one word, not even a sentence. That word is “stagflation”.  We truly believed stagflation would present itself to us later this year or even next year. However, we think it is here now.  This leaves us on the contrarian side, because almost everyone we read, hear or watch is telling us that “growth” (a misnomer used by mainstream economists, including those at the helm of the Fed, to refer to a higher GDP) will be high in 2011 and that the Fed will be forced to raise rates in 2012.

Before we go any further, let’s define “stagflation”. The easiest way is to refer to Wikipedia, where we are told that: “In economics, stagflation is a situation in which the inflation rate is high and the economic growth rate is low. It raises a dilemma for economic policy since actions designed to lower inflation may worsen economic growth and vice versa.” The description of stagflation is further elaborated and given within its historical context.
Ludwig von Mises, in Chapter XX (“ Interest, Credit Expansion and the Trade Cycle”), of his magnum opus “Human Action” writes that: “…It would be a serious blunder to neglect the fact that inflation also generates forces which tend toward capital consumption…” (p. 549, 4th Edition, 1963). And we think this is key to understand stagflation.

Why do we fear that we may be facing stagflation?

If you have been following energy stocks lately, particularly those in the TSX Energy Index, you will have noticed that as oil (West-Texas Intermediate) approached and passed $110/bbl, this group of stocks, collectively, did not make higher highs. Yes, on Thursday and Friday, their valuations improved, but oil closed above $113/bl after hours and these stocks have not really impressed us. In “normal conditions”, this should not have happened. The highs in this group were made when chaos unfolded in Egypt, at the beginning of the year. Now that the anarchy in the Middle East is to stay and oil prices are making higher highs every week, we should see energy stocks strongly outperforming. But this is not the case. Capital is not going to that sector as the price of oil should signal. This can only mean that in the future, with a lower stock of capital to produce oil, we will see higher oil prices. This can only point towards stagflation.

The same can be said even about gold mining shares and, in general, stocks collectively, as an asset class. Capital is being consumed! On the lending side of things, we don’t see anything but refinancings to take advantage of low interest rates, while they last, and to extend maturities. We, personally (not objectively) believe we are not seeing the same level of M&A that most market participants were expecting at this stage of the so-called “recovery”.

On the other hand, we still have big, unresolved macro issues:

-European Union:
We have, for a long time already, written that last week’s decision by the European Central Bank to raise rates is a big mistake. Since a year ago, we have been very clear on this: The survival of the Euro depends on its flexibility, and by this we mean, its ability to go lower, to depreciate. Right now, the opposite is taking place and it is only a matter of time until we see the political consequences of this move. We have patience.

-US fiscal deficit/QE2:
Last week’s debate on the US budget was a complete embarrassment and has exposed the challenges the Fed will face, if it really means to undertake an exit strategy.

-Inflation in EMs
Finally, we cannot expect high inflation to be confined to Emerging markets only. Most of these nations have sought to keep their currencies from appreciating against the US dollar, thereby increasing their supply and with it, inflation. These nations are net exporters. If wages in them increase, the developing world that imports their goods will see its purchasing power suffer.

 

Most likely, we are not telling anything new here, but we think it is good to remind ourselves of these issues, within the current context. Therefore, to dream of a Fed raising rates because of a “recovery” is to ignore important flags like a stock market that lags commodity prices, a worsening situation in Europe and the US, as well as a-soon-to-come impact from the emerging markets.

Of course, by the time the prices of imported goods will affect developed nations, mainstream economists will seek to convince us that the inflation is of a structural nature, because central banks in developed nations cannot influence prices in emerging markets. But our readers will know that that is a fallacy at best, and a lie at worst. The only structural thing about it all will have been the quantitative easing of central banks in the developed world.

 

Martin Sibileau