Entering New Phase of Sagflation

Based on recent news articles in Barron's and in the Journal, it appears as though monetary policy in both the US and Europe may be increasingly relied on to counter an economic slowdown. Around the world there has been a recent shift to expansionary monetary policies with loosening in Britain, Brazil, and possibly China. This shift in monetary policies was the main reason I recently sold my large position in 30-year treasuries since there is a greater risk of inflation, in my view.

However, fiscal policies have remained firmly focused on austerity, as shown by cuts in Greece, Portugal, Italy, and with some success in Britain. It would appear as though austerity remains the driving theme in the US with the deficit reduction super committee efforts. If the committee cannot reach a compromise then cuts are automatically enacted.

Under my Sagflation theme I argue that there are fundamental deflationary forces in the economy due to excessive debt and the deflating of previous asset bubbles. Expansionist monetary policies are acting against these fundamental forces. The result is slow to negative economic growth with larger price swings as monetary policies expand and then retreat.

I continue to believe economic growth likely remains slow to negative due to the austerity measures, stagnant house prices, declining income, high unemployment, burdensome consumer debt, and increasingly misallocated investments in an economy where money is cheap. The shift in monetary policies suggests that prices are likely to swing upward in the form of inflation over the next one to two years.

In the short-term, defined as the next 2-6 months, I believe the headline inflation of CPI may not show much increase, and may actually decline somewhat due to the recent slide in commodity prices trickling up to the consumer. Should the widely watched CPI remain tame over the next few months it is likely a positive for stocks as investors assume inflation is under control and stocks benefit from growing liquidity. As I reminder, I view the CPI as more of a 3-9 month lagging inflation gauge right now due to pricing pressure coming up through companies' cost structures from higher commodity prices. If the CPI was rising because demand was out-stripping supply, then I believe it would be a more current measurement. Other than stocks I believe rising bottom-up inflation pressures likely drives price movements in debt, commodity and currency markets.

While the European debt crisis is a black cloud over the markets, I believe the European leaders likely pursue financial appeasement, giving the financial markets just enough reform, bail-out, and stimulus to appease them in the short-term but not fix the longer-term problem. Political realities and economic challenges would tend to push the European leaders in this direction, in my view.

This short term outlook suggests over-weighting high beta stocks and precious metals, in my view. It also suggests the US dollar declines and yields on the 10 and 30 year treasury rise significantly, in my opinion.

Longer-term, however, these trends are setting us up for a period beginning at some point in 2012 that combines higher unemployment, slow growth, and high inflation, in my opinion. Emerging economies rich in natural resources that have historically tilted toward inflation, like Brazil, potentially move closer to the dangers of hyper-inflation. As we move through 2012 I believe rising commodity prices likely again force manufacturers and retailers to constrict labor in an effort to protect margins, eventually raising prices that pushes the CPI higher. US consumers are likely increasingly squeezed between falling income and rising prices. In addition, austerity plans implemented late in 2011 likely begin to have an effect in 2012. This is a potentially explosive combination both financially and socially, as explained in The Economist.

Once we move into 2012 I believe investors should become conservative as inflation worries mount, debt issues remain, and any short-term financial appeasements made in 2011 prove ineffective. At this point I believe we may reach the end game in which fiscal stimulus is neutered by high sovereign debt levels and monetary stimulus is neutered by high inflation. If volatility in 2011 was trying for investors, swings in 2012 may prove fatal.