Sagflation Likely Challenges All

Initial unemployment claims increased 12,000 to 465,000 last week, above expectations of 450,000. Existing home sales in August increased over 7%. The Index of Leading Indicators increased 0.3% in August, above the estimate of 0.1% and improving from 0.1% in July. Industries benefiting from low borrowing costs, like the auto sector, seem to be improving while industries hurt by low interest rates, like some financial sectors, I fear are struggling or taking on excessive risk to meet sales targets.

As I argued in my "sagflation" post on August 27, the U.S. economy may be entering a period of higher price volatility coupled with slower economic growth. On the positive side, I believe the flexibility of the U.S. economy to restructure and rationalize capital is quickening the pace of healthy long-term economic changes. However, I would argue that this is still a multi-year trend due to the amount of excess capital mis-invested over the past few decades. Exasperating the economic weakness is an outlook of increased regulatory activity and austerity, a product of the high debt levels today, promised benefits levels, and high deficits projected near-term.

Not surprising then that the Federal Reserve continues to threaten more monetization measures as it throws trillions of dollars into the market to stimulate economic growth. For this reason I believe after 1-3 months of muddled signals the first swing in prices is likely upward, in the form of unexpected inflation acceleration. How this acceleration is perceived in the market will be interesting. At first it may appear as though the economy is improving, boosting equity prices and relaxing the Fed's aggressive actions. Despite these apparent improvements, businesses likely continue to feel pressure from weak competitors remaining in the marketplace due to lower capital costs and from rising costs associated with higher commodity costs. Thus hiring may remain weak, unemployment high, certain industries ballooning, M&A active, all while the real economy struggles.

A key question is how much inflation how quickly? If the Fed dances through this minefield without blowing us up, then maybe inflation of 3-4% before settling back. If China's policies exasperate the pent-up inflation potential in the system and the Fed remains aggressive, then inflation could spike higher. It is a spike that I most fear because of its impact on treasuries, the dollar, business uncertainty, and the Fed's future actions.

I remain cautious on U.S. equities in the near-term but would like to establish positions on an opportunistic basis. Pricing power is a key characteristic of any attractive companies, in my view, both to pass-on inflationary costs and as an indicator of a favorable competitive landscape. Again, I also remain focused on companies with higher foreign non-dollar exposure. As a retail investor I likely have to play a few international ETFs and mutual funds in order to gain exposure on a cost effective basis.