2008: A Challenging Year of Inflation versus Deflation

``You also know that rising stock prices mean lower future rates of return and falling stock prices mean higher rates of return. So I was much happier in the summer of '02 when you buy everything on sale than I was in the Spring of 2000 when a lot of things were super-expensive…My view, instead, is that the evidence is overwhelming that most people are too risk averse. And that therefore they should be taking a lot more risk than they feel like is right. The problem is that real risk and perceived risk are two different things. And that's where people get into trouble, because they perceive risk to be high when prices are low, and they perceive risk to be low when prices are high. That's the psychological problem that most people have.”-Bill Miller manager of Legg Mason Value Trust

At the start of this year we projected that the Phisix would range by (+/– 5%) in the light of a US economic downshift and based on the mean reverting tendencies of markets. Apparently while indeed the US has seen some semblance of a slowdown, the strong run-up until the third quarter by global equity markets has proved our projections as inaccurate (Phisix is presently up 18% year-to-date and most likely will end up during at the yearend-with a few sessions to go― unless another August like shock erupts; like all of our earlier projections we tend to be too early).

Nevertheless, such outlook should be carried over for next year, specifically the Phisix and the Peso could correct (the Phisix could retest the 2,800-3,000 before recovering at the close of the year as well as the USD-Peso could bounce to the 45 level before a resuming its strength), as the strains of credit turmoil remains unresolved coupled with heightened risks of a US recession spilling over to a downdraft in global economic growth. Remember, if remittances have underpinned the virility of the Peso, as mainstream experts suggests, then a US recession-global growth slowdown should affect employment and migration trends enough to ease or even reverse the tempo of the Peso’s rise.

By our own measure, capital flow trends into Asia should determine the fate of the Peso in 2008. A moderate slowdown could exacerbate capital flow trends into Asia while in contrast any shock (similar to August) could result to massive unwinding of leverage positions.

The ensuing uncertainty described above will likely be accompanied by a concerted easing by global central banks in spite of today’s backdrop of magnified inflation. The TAF and the recent easing by the Bank of England and the Bank of Canada alongside with the US Federal Reserve is a prologue to the next year’s activities.

Besides, given the mean reverting proclivities of the markets where no trend goes in a straight line, this means secular or long term cycles will always be interrupted by countercycles.

Yes, speaking of inflation in spite of the deflationary developments rapidly unfolding in the frontiers of the financials, the world appears to be experiencing an onslaught of rising inflation (as measured in producer/consumer prices), mostly seen in energy and agricultural or food prices. Doug Noland writes in his Credit Bubble Bulletin,

``U.S. Consumer Prices were up 4.3% y-o-y in November. Our Producer Price index registered a 7.2% y-o-y surge. November Import Prices were up 11.4% from a year earlier. Euro-zone inflation jumped to 3.1% y-o-y, the strongest rate since May, 2001. German consumer inflation rose to an 11-year high (3.3%). Chinese inflation was at an 11-year high of 6.9% in November. Score of countries and regions – including Australia, Russia, Eastern Europe, and the Middle East - now confront heightened inflationary pressures, in what has developed into a powerful global phenomenon.”

Mr. Noland is right when he says the inflation is ``in the process of significantly limiting the Fed’s flexibility and capacity to orchestrate another Wall Street bailout.” But as we have always argued, for as long as the menace of deflation deepens, the likely thrust by global central banks is to err on the side of inflation and work to defer on the day of reckoning. No central banker would like to have a recession in their résumé, hence the inflationary boom-bust cycles.

Yet while we remain bullish on the Phisix and the Peso over the long term, 2008 poses to be a year of significant challenge where we think the performances of Gold and Oil as best guide in the ongoing battle between the forces of deflation and inflation.

The recent strength of the US dollar could be indicative of emergent deflationary forces as shown in Figure 5.

Figure 5: Stockcharts.com: US Dollar Rallies Signals Deflation?

So with global indices including the Phisix (above), Dow Jones World (pane below main window) and the US S & P 500 (lowest pane) on a clear downtrend, marked by lower highs at the onset of a rallying US dollar (main window-circle) amidst modest actions by major Central Banks, we are looking at potentially more downside volatility as financial market losses make themselves more apparent. The blue vertical line shows how global equity markets have become “synchronized” anew.

We have seen how central banks have employed “creative” (FHLB, M-LEC, TAF) options to defuse the unraveling crisis. We should expect intensified activities from them for as long as markets persist to exhibit an enduring loss of confidence. Or as the losses percolate or worsen, their accompanying actions are most likely to culminate into more aggressive rescue packages or face the risk of a full-blown crisis.

2008 will likely hallmark a tug-of-war between inflation and deflation.