Recessionary Inflation Equals Stagflation

By: Paul_J_Nolte

Recessionary inflation – it used to be called stagflation, but this time around the growth seems to be heading lower while inflation is rising all the way to modest levels. The CPI report showed that inflation was higher than expected, for both the “core” (without the unnecessary food and energy) as well as the “all in” kind. One key report next week will be the Producer price report that should show whether companies are able to pass along their higher prices to consumers. So far, companies have generally been eating the higher costs. Another key report is the income and spending report, here we are looking for spending to be below income growth and too, whether the income gains will be above that of the inflation rates.

Again, history has shown that the consumer has little problems spending beyond income gains. Commodity prices continue to gain headline space, as oil prices cross above $100/bbl for the first time ever and gold (the glittery kind) continues to march toward $1000 an ounce. The dilemma in the financial markets remains whether to believe commodity prices (worldwide economic growth remains strong) or economic data (weak and likely to push commodities lower). It just may be that investors are piling on the commodity bandwagon, there just isn't room for everyone – and prices are soaring.

We have been looking for the markets to begin showing signs that a bottom is at hand, however precious little data supports this thesis. Volume has been modestly higher when the market is advancing, however the overall trend of volume has been lower. We are also seeing an expansion in the number of stocks declining – the most on both markets since the big bottom at the end of January. The OTC market looks more vulnerable than the SP500, as it is bumping along its 200-day average price – something that it has not closed below since mid'04.

The SP500 is above 4% above its respective average, while the Dow is nearly 8% away. As we have outlined in prior newsletters, the markets have been taking the “down stairs” since October, as each rally falls short of the prior peaks. The SP500 has been in a range between 1310 and 1400 for a month and a break of that range with above average volume should signal that a new trend is developing. While our bet is that it breaks lower, we saw that a bit of good news on Friday is enough to rocket shares higher. Unfortunately for investors, this is a trading market – make a few bucks and run. While there are some bargains around, long-term profits will be harder to come by.

Sounding like a sandwich order at lunch, the discussion in the bond markets is all about spreads. First the yield spread – the difference between short and long-term rates has been widening for a year and is now at its largest spread in three years. Credit spreads – the difference between safe treasuries and riskier corporate bonds has too been widening. This is an indication of investor's willingness to take on risk – the narrower the spread, the more risk investors are willing to take, while the wider the spread, the more investors are paid to take risks. Our model is pointing to still higher rates and given the current conditions, spreads are likely to widen even further.

By Paul J. Nolte CFA
http://www.hinsdaleassociates.com
mailto:pnolte@hinsdaleassociates.com

Copyright © 2008 Paul J. Nolte - All Rights Reserved.
Paul J Nolte is Director of Investments at Hinsdale Associates of Hinsdale. His qualifications include : Chartered Financial Analyst (CFA) , and a Member Investment Analyst Society of Chicago.

Disclaimer - The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

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