Wednesday, May 17, 2006

Two Parts to the Inflation Story

Inflation is ticking up a bit and is at the high end of a "comfort zone." The major factor in "headline" inflation was higher energy prices...where's the surprise here?

YOY, core inflation is up merely 2.3%, however, three- and six-month annualized changes in core inflation are over 3%...some acceleration from the last few months.

In my view, the recent inflation experience should be thought of in essentially two parts: 1) A short term adjustment of "pass through" inflation. Energy and commodity prices have risen mostly due to "shocks" mostly politically related. Part 2: Secular inflation. This relates to falling productivity and rising wage pressures. This is the more vicious of the sources of inflation in my opinion and the part that seems to be reasonably well contained.

As to Part I Inflation, my guess is that we are in late innings of a speculative blow-off especially in metals like copper. Energy as well seems to be ignoring the current inventories and has already wiped out, at least mentally, a lot of refining capacity and energy production from hurrican season. Who knows what the weather brings, but it seems to me that most of the bullish arguments are specious if not paranoid.

As to Part II Inflation, productivity gains in the first quarter had slowed to the mid 2% range from a long period of mid-3% gains. Nevertheless, productivity gains continue to undermine the prospects for long term inflation pressures. Average hourly wages are starting to show some upward pressure but, in manufacturing, unit labor costs are down about 1.6% YOY. I am more nervous about the dollar's decline and the potential for significant cost pressure from imports. But overall, there seems to be little evidence that we are in for a vicious wage-price spiral, one of the most destructive forces in economics.

Despite the backdrop of panic and fear that I saw today, it is important to remember that in economic terms, the planet is doing very well. For the first time in some years, the world economy is in a synchronous recovery. Global profitability should be in decent shape.

As I have suggested, don't forget about international stocks in your allocations! Some of our international holdings were down for seemingly no reason today and I believe represent excellent value. Allianz (AZ) and Aegon (AEG) have provided decent earnings results recently, are cheaper than their North American analogs and got hit for 5% today.

Disclaimer: I, my family and clients have current positions in Allianz and Aegon.


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