Monday, November 5, 2007
The Threat Of Inflation
JEDDAH, 16 August 2004 — The term used in financial markets: "Super Money" is a measure of global money supply. It's the sum of the US monetary base plus dollars held by foreign central banks. It is a good measure of the world's supply of dollars.It's important to measure foreign dollar holdings as well as the US monetary base because many of those foreign dollars are invested in the US bond and stock markets.Specifically, foreigners now own 40 percent of all US Treasury debt. Over the last 12 months, foreign central banks bought $198 billion of US Treasury securities, financing 49 percent of the US deficit last year (the largest annual deficit on record).Federal credit creation (deficit spending) and foreign investment increases the money supply in the United States, which leads to faster rates of economic growth and inflation.It is worthy to note that the "Super Money" is now growing at a faster rate than at anytime in the last 30 years.Foreign central banks will not be able to continue to be such large holders of US currency, especially considering that China is now the world's largest buyer of US government paper (debts).China buys tons of US paper in order to maintain its currency peg to the dollar. Eventually, the Chinese government will have to stop buying so many dollars and let the yuan rise in value in order to afford the raw materials China needs — oil in particular. When this happens, foreign central banks could begin selling their Treasuries. The result would be a financial catastrophe for the United States — a run on the dollar. That would cause drastically higher interest rates for US consumers and businesses.The most likely trigger for a reversal in foreign investment is the falling purchasing power of the dollar, especially in the market for oil.These facts, combined with the skyrocketing, over 20 percent annual growth in "Super Money," mean investors must be on the lookout for rising commodity prices and higher interest rates. We've already seen examples of both. Oil soared to over $46 a barrel last week. And US Treasury bonds have just experienced their worst quarterly performance since 1980.The US Federal Reserve's measures of inflation (primarily CPI) ignore many of inflation's most important effects — such as asset price inflation.The Fed took its overnight borrowing rate to a level unseen in the last 40 years (1 percent). And, thanks to the war on terrorism, deficit spending has soared. Meanwhile, Greenspan continues to insist that there's little to no inflation in the US economy.Apparently, he doesn't consider soaring housing prices, a wildly expensive stock market and rocketing raw materials prices to represent inflation. Worse yet, in the Fed's opinion the supply of money isn't even a factor in the rise of inflation.Inflation, even measured by the Fed's CPI measure, is running at about 3.5 percent right now. The Fed's overnight interest rate is 1.25 percent annualized — nowhere near the rate of inflation. How can Greenspan ignore such data?Inflation is moving higher. But interest rates are still at near record lows. Prices for financial assets, real estate, stocks, and now commodities are at record levels. Returns on fixed income investments are not attractive, given the rate of inflation and the likelihood of it increasing. There's almost nothing safe to do with your money... or anything to buy that's likely to give a good return.Warren Buffett is now holding $34 billion in cash — with most of it in foreign currencies. In his previous 50 years as an investor, he'd never bought foreign stocks or currencies. Now he owns billions of both.Other notable money managers — the best in the business —have allocated heavily into cash and foreign securities too. Mason Hawkins of Longleaf Partners is the best mutual fund manager in the United States. He's holding 25 percent of his fund's assets in cash now, and his largest equity holding is Vivendi, a French media conglomerate.Bill Gross, the "bond king," who manages $400 billion in bonds for PIMCO, says he'd own more foreign bonds if he could, but his funds' charter prevents him. Meanwhile, he personally sold his own flagship bond fund and is buying commodities and, more recently, tax-free municipal bonds, another way of holding a cash-like asset.Ironically, as the world's best investors get out of stocks, move out of US bonds, and move heavily into cash and foreign securities, Mr. and Mrs. Mutual Fund are still piling in. But that's par for the course. Mutual fund buyers tend to have all their money in stocks and bonds at the market top and all their money in cash at the market bottom. They're right on track once again.In 1981, after a 15-year grinding bear market, Mr. and Mrs. Mutual Fund held 77.1 percent of their investable assets in money market funds (cash). Said another way, at the bottom of the market, Mr. and Mrs. Mutual Fund only held 22.9 percent of their investable assets in stocks and bonds.Today the average mutual fund buyer holds 72.3 percent of his investable assets in stocks and bonds. Only 27.7 percent of his mutual fund assets are in cash.This bullish level of asset allocation was only slightly exceeded at the last market top, in 1999, when money market fund assets, as a percentage of all mutual fund holdings, hit a cycle low of 23.7 percent (76.3 percent in stocks and bonds).In their own ways, the world's best investors (in cash) and the world's patsies (in stocks & bonds) are telling us it's time to be cautious in stocks and bonds.Expensive stocks and inflation don't mix.