Where inflation is higher than interest rates, liquidity will flow

In the world of stock, commodities, and real estate investing, it is common knowledge that capital flows to where inflation exceeds the cost of borrowing. Clearly, if you can borrow at 4% and inflation is 6% it pays to borrow money and speculate in the appreciating stocks, commodities, and real estate. This is the situation in many developing nations today, especially in China, India, and some other countries in Southeast Asia and Latin America; borrowing costs are less than the commonly accepted “true” rate of inflation. Additionally, companies and industries are growing, and this makes stocks in those countries doubly attractive.

In much of the world, investors have learned that government inflation statistics are inaccurate, almost always erring on the side of understating inflation. Thus, it is no surprise that China, India, Malaysia, Singapore, Thailand, Indonesia, and the Latin American countries that we favor may be recipients of substantial capital inflows in coming months. Their growth is creating inflation and their central banks, for the most part, are being too cautious about raising interest rates to reign in this inflation. This is a green light for investors who are pouring money into the stock and currency markets for these countries. In many cases, the countries have no choice but watch their currency rise and watch their stock market rise as large inflows augment the local capital. The capital ends up in commodity or growth-related stocks as investors try to preserve or grow the buying power of their money.

It is not hard to see the course of action that these markets will take if you just put yourself in the shoes of the local investor with money. In many cases, they cannot get money out of the country easily. They can buy gold, real estate or stocks, and some bonds may be available from their bank.

For example, if you are a Chinese citizen, and local inflation is 5% but your bank account is only earning 3%, you will buy some stocks so that your money can keep up with the cost of living. You have already been buying real estate to do the same thing, but that is getting harder, especially after you get beyond your 2nd home. Therefore, you are looking elsewhere and are considering buying gold bullion and Chinese stocks.

World commodity prices reach highs in U.S. dollar terms

Corn, wheat, soybeans, sugar, cotton, gold, silver, and copper are all doing well, as are some other commodity prices, especially meats. The prospect of money printing (QE) by the U.S. and other nations along with tight supplies, are both responsible for the price moves. However, can we not say that tight physical supplies exist because many investors have purchased and stockpiled commodities to hedge against the inflation they believe is approaching, thus precipitating such an eventuality? The shortages are occurring as industrial and commercial users increase their stockpiles. This is one reason that we have long argued that commodity prices, especially food and precious metals would move higher. They have been moving, and we believe we are in the middle stages of their moves. In the press you will undoubtedly hear shouts of ‘bubbles’ from those who have missed the price moves or who have been short.

Continuous Commodity Index (Last Five Years)

(Commodities included in the Continuous Commodity Index are: Energies 17.64%, Grains 17.64%, Livestock 11.76%, Softs 29.40%, Metals 23.52%.)

The long process of China’s ascent to an economic power continues as more bonds denominated in the renminbi are being floated China has dropped some of its exchange controls with Hong Kong, thus the flotation of Chinese renminbi denominated bonds is moving ahead in Hong Kong. This is creating more of a Chinese bond market. It also allows other non-Chinese organizations to float bonds in the Chinese currency and tap the Chinese market for investors. The Asian Development Bank and McDonalds Corporation are two recent issuers of these bonds, and more will be coming. As Chinese capital controls are being loosened, bond floatations that would previously have occurred in U.S. dollars, euros, or Japanese yen will be more frequently issued in renminbi.

Key players at the U.S. Federal Reserve begin to promote higher inflation target

Ben Bernanke and Charles Evans are both prominent figures at the U.S. Federal Reserve, and they along with other Fed members have been arguing in recent weeks that while printing money will be helpful, what will be much more helpful is inflation targeting. Specifically, they want to target inflation at a rate in excess of the current inflation rate. This is a change of policy that bears close watching. For decades, the Fed has worked to keep inflation down and to keep inflationary psychology under control. Now that deflation is a potential problem in the U.S., a serious problem in Japan, and possibly other parts of the developed world, the Fed want to do the opposite. They are actually going to try to convince people to believe there is some inflation, so that they will invest as if they needed growth, spend rather than save, and pay down debt.

Although the nation is over-levered and needs to cut spending, the Fed’s hope is that companies and families begin to invest more to create economic growth and more jobs. They have created a new jargon for the plan to increase inflation. They call it the mandate consistent inflation rate and they will set it initially at 2%. If inflation exceeds 2% they will tolerate this as long as it is providing a pick-up in economic activity. Selling to the public the concept that inflation will be rising is the technique that they are using in an attempt to avoid the stagnation and deflation that Japan has suffered over the last 20 years.

This is positive for gold

There may be no wiser person about global economic and financial events than Jim Sinclair who runs the web site and is a well known gold mining CEO and entrepreneur. Jim and I spoke about this issue and he points out that the Fed and its principle officials will have to make a lot of speeches about this plan and try to sell the concept of inflation to the U.S. population, and to the world. The more they sell it, the more the public will see the need for targeting inflation at a rate higher than the current rate and the more the public will shift into a program of protecting their assets from inflation by purchasing gold, commodities, stocks, and income earning real estate. This is also positive for stocks, commodities and other investments, but is bad for bonds.

While cost-cutting is needed, it is deflationary; Business and employment growth should also be incentivized

In the U.S., many voters are notifying their representatives to push an agenda of cost cutting. In Europe cost are being cut and retirement ages increased. People have been slashing costs and trying to balance their personal budgets and they want their government to do the same. We agree that cost-cutting and waste reduction are important and needed on a national scale in many developed countries. Yet it is important to also realize that these actions are deflationary.

If costs are cut, some benfits are realized. For best results, changes to spending patterns must also be made by businesses. Businesses must be incentivized to grow and to create jobs; without such emphasis on increasing employment by incentivizing growth, the economy will head into a prolonged depression/deflation in the developed world. In order to avoid such an outcome, it is necessary to encourage the spread of the psychology that more inflation, let’s say 2% or 3% will be tolerated (and in fact encouraged) in developed countries. It is also important to reinstitute some kind of incentive, tax incentive, reduction of bureaucratic obstacles or otherwise for new industries to be created and encouraged to grow; much like the changes in regulation and taxation for investment promulgated by the Reagan administration in the early 1980’s in the U.S. These eventually gave rise to many technological, medical, and associated industries… which eventually provided the government with huge tax receipts.

Summary and Recommendations

We still like the same themes and investments we have been discussing. Our current recommendations are:

Investors should continue to hold gold for long-term investment. It will move to $1500 and then higher. Traders sell spikes and buy dips. Gold-related news: South Korea decided this week to increase the percentage of gold in their investment portfolio.

Investors should continue to hold oil. Oil-related news: positive, U.S. onshore inventories are neutral and offshore inventories held in tankers have declined substantially. A negative news event is that there will be an increasing supply from Iraq.

Currencies: For long-term investment, we do not like the U.S. dollar, Japanese yen, British pound or the euro. We do like Canadian, Australian, and Singapore dollars, the Thai baht, Malaysian ringgit, and Indonesian rupiah. We would use the current pull-back in these currencies as an opportunity to establish long-term positions.

Investors should continue to hold shares in India, China, Singapore, Malaysia, Thailand, Indonesia, Colombia, Chile, and Peru. We would use any pull-backs as an opportunity to add or initiate positions for long-term investors.

Investors should continue to hold food-related shares such as grains, wheat, corn, soybeans, and farm suppliers.
Continue to hold U.S. stocks for a further rally. Long-term U.S. liquidity formation through QE will create demand for many assets, including U.S. stocks. Short-term U.S. stock market indices are near resistance areas, traders can consider taking profits.

Thanks for listening.