SPENCE Asset Management

What About Inflation? April 2009

In recent weeks we have seen increasing signs of stability in the U.S. equity markets. In fact, March 2009 was the best month for U.S. stock prices in six years.

So many times we have suggested in these newsletters that investment capital tends to flow to three primary areas: income producing real estate, businesses (common stocks), and interest bearing instruments. We remind ourselves of these primary areas because the world economy is a living, breathing creature that exhibits capital flows in good times as well as in bad times. This global recession is no different than others in that excess capital is still being generated. And from a macro-economic standpoint, the great questions that the incessant daily financial news channels report on each business day are the directions of capital flows and the resulting price action.

Although determining the direction of capital flow is key to successful investing, the resulting price action cannot be ignored. Thus, investors are beginning to wonder about the outlook for inflation. With embattled Federal Reserve Chairman Ben Bernanke announcing in mid-March the Fed's implementation of "quantitative easing" the inflation question becomes a much more legitimate intermediate and long range concern.

Whenever we dare to take on the task of inflation projecting we are reminded of a book we read many years ago called, Secrets of the Temple, How the Federal Reserve Runs the Country. In this excellent piece, author William Greider thoroughly explained the inner workings of the Federal Reserve Board, and how the government and then the Fed executed poorly on the inflation front during the 1970's.

Strangely enough, at this point in history we are forced to take note of our Fed's "buying" of treasury bonds while its older brother (the U.S. treasury department) is selling them. One must wonder why the Fed doesn't simply lend the money to the treasury directly rather than hold silly auctions. The answer of course is pretty simple; "quantitative easing" is government economic jargon for the printing of money out of thin air. We were happy to see Mr. Bernanke admit as much in a television interview last month and we certainly do not blame him for the current pickle. But such drastic "money printing" will have its own consequences.

At this point in the cycle, after both major U.S. political parties joined hands last September to yell "fire" in the proverbial crowded American economic theater, we should hasten to add that we are sort of hoping an inflation scare will eventually work its way onto the horizon. Before the reader gets too upset with the idea that we are suggesting we will return to the dangerous world of high inflation, let us explain. What we mean by this bizarre hope is simple yet complicated. First, it is important to know that the government is pumping fiscal and monetary stimulus, all it can muster, into our economy. And at this point the problem is not too much stimulus but the lack of velocityÉÉ..the rate at which money changes hands.

Why is the velocity of money a problem you ask? We must go back to the fall for the answer. In September of 2008 we were told by our "leaders" in congress and at the White House that IF the government didn't begin to throw billions of dollars at our most poorly run institutions, the world would come to an end. While these lamentable scare tactics supplied congress and President Bush the political cover they needed to throw money at irresponsible commercial banks, investment banks, and one notable insurance company (AIG), unfortunately all that disaster talk also scared the heck out of every consumer on the planet.

So here we are, six months later, with our government officials now trying to increase the velocity of money that the government itself destroyed last fall when it was busy issuing all those irresponsible dire warnings of imminent catastrophe.

We too are hoping for an increase in velocity. Or put another way, we are hoping that spending patterns return to something that might pass for semi-normal so that the government can move on to the next problem, which yes you guessed it, is likely to be inflation.

However, before we start worrying about inflation, we should take note of the gradually improving market signs that are starting to emerge. The inflation danger is not at hand just yet. Once everyone else is pretty sure the world isn't coming to an end, we can begin to worry about inflation. But we won't wait for everyone else before we begin assessing the affects of inflation on the businesses that we own.

—Jim Spence, Eric Walton

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The views expressed here are those of Spence Asset Management and are subject to change with market conditions. The information contained in this newsletter is derived from sources believed to be accurate. You should discuss any legal, tax, or financial matters with the appropriate professional. Neither the information presented nor any opinion expressed constitutes investment advice or a solicitation for the purchase or sale of any security. Market forecasts cannot be guaranteed. Past performance does not guarantee future results.