Download OCM 2012 Spring Folio - Q4 Wealth Management

Spring 2012
With the economy strolling forward, employment in North America making a SCUBA diver’s ascent, and the
Greek debacle slumbering, at least for now, investors’ nerves, perpetually frayed over the last few years, have
calmed.
So rather than focus this Folio on soothing clients’ immediate concerns, often stoked by media, we’d like to take
the opportunity to gaze forward, to the rest of 2012 and beyond. And, we’d like to do so with a particular focus
on inflation and gas prices, two issues sure to be front and center in the upcoming US presidential race.
Too-high inflation and its ability to choke-off economic growth always makes for good, alarming copy. Less
discussed, but also a reason for concern, is too-low inflation’s ability to cause problems (housing is a great
example). What’s rarely mentioned in either case, but important for our purposes, is that inflation is rarely
global.
When most of us think of inflation, we think of what it costs to buy cereal, a condo, or a tank of unleaded, and
what we pay for services like dry cleaning, breakfast at the local diner, or catching the latest blockbuster at the
multiplex. Of these, only one is a universal inflation item. (The answer in the paragraph after next. Hint: It’s not
the Cheerios.)
With housing cost and the associated inflation, for example, location has a bigger impact than just the macro
numbers. Housing in all of North Dakota is difficult to come by and prices are rising rapidly, while in Stockton,
CA you can find homes selling well below what they would cost to build. We see the same pattern within
individual states. In Texas, Austin housing is appreciating and supply is tight, but homes in Dallas are readily
available at depressed prices. Most homes in Canada are holding their value or appreciating, while a few
hundred miles south, in cities like Chicago, Detroit, Cleveland and Seattle, house prices are still down over 25%
from their prerecession levels. There appears to be no quick solution to the low home prices, but it does come
with a silver lining. Affordability is at the highest level since recordkeeping began back in 1970.
As you likely guessed, the universal inflation item from the previous list is…bum-bum-bum…the tank of
unleaded. But even that is subject to varying factors that make the price differ, often greatly, between locations.
Local taxes and distribution fees are often a significant percentage of the final consumer price. For example, the
average price per gallon in the US (April 2, 2012) varies between $3.54 in Tulsa, OK and $4.51 in Chicago, IL. In
Canada, the price per liter ranges from $1.11 in Edmonton to $1.44 in Vancouver. Where you live matters every
bit as much as the actual price of raw material crude oil.
Here’s an analogy you’ve likely heard or may hear in the lead-up to the U. S. Presidential election: with the slow
economic recovery, higher inflation, and rising prices for crude oil, we’re in a situation similar to the 1970s. A
truly dismal time when high inflation coupled with stagnate growth created “stagflation.”
There are two principal explanations for how and why stagflation occurs. The first explanation states that
stagflation can occur when an external and unfavorable supply shock, such as the OPEC induced shortage of
the mid 1970s, causes prices to rise, slowing an economy by making production more costly and less profitable.
This unexpected spike in oil led not only to long lines to fill the gas tank (odd or even days), but also affected
aspects of the economy such as transportation costs to move products to stores and around the globe, the cost
of plastic (an oil product), heating cost, the price of tires (another oil product), and even clothing (remember the
nylon, polyester and rayon fabrics of the 1970s?).
The second explanation of how stagflation occurs is that inappropriate macroeconomic policies, like artificially
keeping interest rates low and growing the money supply while increasing regulation of products and labor can
cause a slowdown in economic activity while not appropriately keeping inflation under control. This was more
than evident in the decade of the 70s when the Nixon era price controls (an attempt to fight rapidly increasing
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labor and consumer product prices, inflation) were coupled with the easy Fed policies and increased spending
of the Carter administration (an attempt to stimulate economic growth, stagnant economy). Throw fuel on the
fire (pardon the pun) with the OPEC-induced oil shortage and you have classic stagflation.
The comparison to the 1970s is not necessarily an egregious one. Currently, we see very low interest rates
that are coupled with deficit spending (increase in the money supply) and we have the rise in oil and other
commodity prices. However, in order for stagflation to appear, these factors need to be onerous enough to
choke off the economic recovery we’ve witnessed over the last couple years. The big difference is today’s
increases in oil prices aren’t enough to derail the economy. Roughly 40 years ago, with inflation already present
and with an easy money supply, the oil shock led to an expectation of even greater inflation. This caused
companies and individuals to buy out of concern that more inflation was on its way, a self-fulfilling prophecy.
All the while economic activity was being stymied by the Nixon administration’s cost controls and additional
inflationary pressures caused by the Carter administration’s increased government spending.
Unlike the stagflation years of the late 1970s, today we have an underutilized work force (unemployment in
Eurozone at 10.2%, the US at 8.3%, and 7.5% in Canada), no real cost controls (artificially keeping prices low and
demand high) and an economy still in the early stages of recovery. While oil prices have risen, it has had more
to do with the threat of disruptions in oil supply caused by Iran’s recent saber-rattling. If the situation in Iran
escalates, the facts point to a short-term price disruption, followed by increased production by others in order
to make up for any shortfall. Remove the tensions in Iran and factor in the welcome slowing of the economic
expansion in China, and oil prices would be much lower and stimulated growth in the world economies would
be the outcome.
It could also be argued that these times more resemble the second cause of stagflation: poor macroeconomic
policy, artificially low interest rates, growing deficits and increased regulation stifling economic growth. While
one could debate policy endlessly, we don’t see any reasonable scenario where governments around the world
(we think they have at least temporarily learned their lesson) would recklessly or unintentionally stimulate
inflation with money growth while clogging the economic engine needed to repair the damage caused by
the 2008/2009 financial crisis. World governments need growth with austerity measures to fully emerge from
current conditions. With the slow growth economies of North America and Europe, inflation will not allow
countries to deflate their obligations without serious risk of stagflation.
The calm most investors are experiencing right now is warranted and should only increase during the
remainder of the year and beyond. These are good times, and they’re getting better. As is par for the course, the
coming election season will bring a tidal wave of hyperbole and rhetoric. Don’t be swayed.
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