Anyone who thinks inflation isn’t a problem isn’t looking at the numbers. It’s not a huge problem, it’s not a catastrophic problem. But it’s a problem, and it requires attention. Left untended, it’ll only get worse. And once the public thinks it’s destined to get worse, the Federal Reserve’s looking at a much bigger problem and one that could take a generation to reverse. The good news is that the problem is still manageable. Nonetheless, the clock is ticking.
Consumer prices rose 4.3% during the 12 months through last month, the Bureau of Labor Statistics reported this morning. As our chart below shows, that’s near the peak for the past 10 years. Core inflation (which excludes food and energy prices) is also pushing higher these days, running at a 2.5% annual pace, which is near its highest levels in recent years too.

Headline inflation is now far above the overall growth rate of the economy, which expanded by a paltry 0.6% in annualized real terms in last year’s fourth quarter. Even GDP’s 3.2% growth in nominal terms remains comfortably under CPI’s pace.
The inflationary pressure is all the more troubling with the Federal Reserve aggressively lowering interest rates of late, a course which increasingly looks like the monetary equivalent of throwing gasoline on a fire. Fed funds are currently 3.0%, down from 5.25% as recently as last September. As a result, Fed funds are now negative in inflation-adjusted terms. And more rate cuts may be coming. The April ’08 Fed funds futures contract is priced in anticipation of another 50 basis-point cut, which would bring rates down to 2.5%, or nearly 200 basis points below CPI’s pace.
Meanwhile, no one should mistake the inflationary momentum as a statistical artifact. The bubbling pricing pressure is evident in several crucial corners of goods and services. Food, energy, transportation and medical care prices are all advancing at annual rates above headline CPI’s pace, according to the government’s report today.
The Fed has been expecting that the slowing economy would take the edge off inflation. So far, however, nothing of the sort is happening. As GDP’s pace has slowed, inflationary pressure has only risen. So much for wishful thinking. That leaves the traditional solution, which is one of embracing a hawkish monetary policy, at least relative to what currently prevails. That’s an awkward prescription in an election year, especially one in which recession threatens. But no one ever said that running a central bank is a short cut to popularity. It remains to be seen just how much popularity Mr. Bernanke and company seek.

The future remains as murky as ever, but the questions are becoming increasingly obvious.
Let’s start with three. There are many more, of course, but these three seem particularly topical and so knowing the answers to the following questions—topics, really– would be immensely helpful for enhancing investment returns and all but eliminating risk. Unfortunately, that would require financial and economic clarity, both of which remain in short supply.
There’s always a delicate balance of risk and reward, of course, and it’s always laden with mystery as to what comes next. But the current outlook carries a bit more potential for each. So it goes in moments of distress and transition. In theory, asset allocation may warrant more extreme strategies when (and if) the valuations become immoderate. On the other hand, if valuations are generally middling, the case remains strong for broad diversification among the asset classes.

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Today’s update on weekly jobless claims is encouraging, but no one should confuse last week’s sizable decline in new filings for unemployment benefits with the all-clear signal for the economy. There are still too many risk factors bubbling to convince us that full-bore optimism is now the sentiment of choice.
The Labor Department reported that jobless claims fell to 348,000 for the week through February 9, down from a revised 357,000 the week before. That’s a handsome tumble, but as our chart below reminds the broader picture (as indicated by the black line, which graphs the linear trend) still doesn’t look encouraging.

Weekly jobless claims are, of course, a volatile series in the short run. Extreme weather conditions, for instance, can arbitrarily reverse long-run trends in any given week. But if we step back and consider the big picture, it’s hard to dismiss the rise in initial jobless claims as anomalous and unrelated to economic conditions of late. Indeed, it’s because we know of the pain unfolding in the wider economy that we see the growing jobless claims trend for what it is: a warning sign.

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Repricing of risk is, in theory, a fertile time for minting new opportunities for strategic-minded investors. But, of course, there’s a catch: the financial gods always forget to send instructions for making sense of the upheaval. That leaves mere mortals with the task of sifting through the data in the hope of finding order amid the chaos.
With that prelude, we present the widening spreads in two asset classes that have caught our eye in recent weeks: high yield bonds and REITs. Both have fallen on hard times of late, and so it comes as no shock to learn that their respective trailing yields over the 10-year Treasury’s counterpart looks compelling, relative to recent history.
Consider the chart below, which shows that spreads in junk bonds (represented here by monthly data for the Citigroup High Yield Index through the end of last month) have risen to the highest level since mid-2003. REIT spreads have improved too, but less so. Nontheless, FTSE NAREIT Equity REIT Index’s spread over the 10-year has climbed to its highest mark since the spring of 2004.

Of course, higher spreads by themselves are no guarantee of easy profits from here on out. Indeed, Mr. Market never reveals his game in advance and so all the usual caveats apply when reading the past in the hope of divining the future. Nonetheless, we’re a believer in the proposition that lower prices equate with higher prospective returns. The trick is deciding when prices are at or near the end of their descent, at which point expected returns are at their highest. No one really knows, of course, at least not in real time, which suggests that diversifying one’s opportunistic buying efforts over time and over different asset classes is still the best game in town.

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The notion of pricing oil in something other than dollars has been around for some time. In fact, there’s been a bull market in predicting just that, motivated in recent years by the buck’s general descent in foreign exchange markets and the resulting financial pain the trend has imposed on foreign oil exporters. But rarely, if ever (as far as your editor can tell), has any high-ranking OPEC official discussed the idea in public in direct and transparent terms. Until now.
On Friday, OPEC Secretary-General Abdullah al-Badri told The
Middle East Economic Digest: “Maybe we can price the oil in the euro. It can be done, but it will take time,” according to AFP. He also observed via The Guardian: “In oil exchanges in New York, Singapore or Dubai, you can see the currency is the euro or the yen. But as long as we see the final sign in dollar, that means the pricing is in dollars. It took two world wars and more than 50 years for the dollar to become the dominant currency. Now we are seeing another strong currency coming into the [marketplace], which is the euro.”
Talking about pricing oil in something other than dollars is easy, of course. Doing it is something else entirely. The world’s oil market is still firmly tied into pricing crude in dollars, and changing the financial infrastructure will, as al-Badri said, take time–years, perhaps decades. At the same time, no one should dismiss the growing incentive to tackle this task, and where there’s a will there’s a way.

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The repricing of risk in the capital and commodity markets may be intimidating, but it’s a natural, recurring process, and one that often brings fresh opportunity (along with new and so perhaps unexpected risks) for strategic-minded investors.
Periodic rebalancing as a general rule is a good idea, perhaps more so than usual these days given the rise in volatility in some asset classes and the growing sense that more than the usual demons haunting the markets and the economy may be lurking in the shadows. All of which provides a timely excuse to update the correlation trends between stocks, bonds, REITs and commodities if only to see how the recent turmoil in markets has reshuffled the relationships between the asset classes.
To keep things manageable, we’ve crunched the correlations from a U.S. stock market perspective (see chart below by clicking for larger image). The decision doesn’t mean that looking at correlations from the vantage of bonds or REITs or commodities is unproductive. Indeed, a full and prudent study of correlations demands considering all the angles. But in the interest of brevity, today we look exclusively at how correlations have evolved vis a vis U.S. equities, as represented by the Russell 3000, which is a broad measure of the market.
click for larger image

Indices used in calculation: Russell 3000, Lehman Bros. Aggregate Bond, DJ Wilshire REIT, DJ-AIG Commodity, iBoxx High Yield, Citigroup
Non-$ World Govt (un Hdg, $), MSCI EAFE, MSCI EM
Before we start analyzing the trends, let’s first define some terms. The chart above profiles 36-month rolling correlations based on monthly total returns for the respective markets. For example, the correlation between U.S. stocks and commodities for January 2008 comes from a correlation derived on the previous 36-month total returns for each asset class. Correlation measures the relationship between two data series, in this case monthly total returns. A correlation of 1.0 equates with perfect positive correlation, meaning that the two markets are effectively one and the same, or at least highly similar. A correlation reading of 0.0 is no correlation, and a correlation of -1.0 is perfect negative correlation. And, of course, there’s a strong case for building portfolios by mixing asset classes with low and negative correlation. The devil’s in the details, but as a general rule this one carries a lot of weight in our book.

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The theory of peak oil remains as contentious as ever and by definition unresolved. The supporting evidence starts with the bull market in crude prices in recent years, inspiring some to proclaim that global production is about as high as it ever will be.
The optimists counter that technology will save the day, through new discoveries that offset declining production from aging fields and recovering more oil from older wells that would otherwise run dry.
The jury is still out on the big picture, and it may remain so for years. In the meantime, there is no shortage of data to review. Case in point: the reported peak (so far) in global crude oil production came in May 2005 at 74.3 million barrels per day (bpd), as our chart below shows, according to numbers from the U.S. Energy Information Administration. In fact, there’s been only three months when global production crossed above 74 million bpd, the latest one coming last October at 74.1 million bpd, or just below the May 2005 summit.

It’s any one’s guess if the old high will stand or not. And, of course, there are questions about the accuracy of EIA’s numbers. In fact, there’s skepticism regarding any database attempting to consolidate such an unwieldy beast as the world’s oil production into one number. Nonetheless, everyone will be watching the updates, eager to declare victory for their side. All the more so considering how close last October’s total was to the May 2005 apex. As we write, EIA’s monthly production figures run through October 2007; the November report is coming soon.
Meantime, as the world ponders the supply side of the oil market, there’s far less mystery on the demand side. In fact, it’s the same old story: up, up and away.

There’s been a lot of talk of bubbles lately, including speculation on where the next one lies. Some say it’s in the energy sector; others claim that gold’s a bubble. Here’s our nomination: bonds.
Our proxy for fixed-income is the ever-popular 10-year Treasury, the benchmark for U.S. debt markets and in some cases foreign markets too. Exhibit A in our bubble thesis is the chart below, which shows the daily closing yield of the 10 year for 40 years-plus through last night’s close. Restating the graphically obvious: the great decline in yield for the past 26 years. Since the peak of 15.84%, set on September 30, 1981, the 10-year Treasury’s yield has, with fits and starts, become a shadow of its former self.

As of yesterday’s close, the 10 year trades at 3.61%–a tidy 1200 basis points below the 1981 summit. In fact, that’s not the lowest yield in recent memory. In June 2003, the 10-year yield briefly dipped to 3.20% (measured by daily closes) and 3.09% on an intraday basis. As we write, those troughs are theoretically just a few trading sessions away–if the bond market is willing.
So far, the fixed-income set has seen fit to follow the Federal Reserve down the slippery slope of fading rates. That’s unsurprising, given that falling rates are the fuel that’s lifted bonds to the upper levels of the performance horse race among the major asset classes. No wonder, then, that bonds generally have been faring well recently in relative and absolute performance terms. The iShares Lehman Aggregate Bond ETF (AGG), for example, boasts a 2.5% total return so far this year through yesterday and 8.9% for the past 12 months. Inflation-indexed Treasuries and foreign bonds in developed markets, along with the broad commodity indices, have done even better over those time frames. Otherwise, lesser performance and red ink prevail among the major asset classes.

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Taxes are forever topical, especially in an election year, particularly one in which big ideas about government programs, old and new, are increasingly front and center. Government action, of course, means government spending, which in turn leads to the inevitable question: Who’s going to pay for it?
With that backdrop we offer a bit of perspective about where we’ve been. The future of tax policy is, as always, unclear. The past, by contrast, is eternally crystal. In the February issue of Wealth Manager, your editor took a look backward, if only as an antidote to the bull market in political-speak. By this reporter’s reckoning, a dose of context is always useful and sometimes it’s even refreshing.

After 52 straight months of gains, job growth finally gave way in January.
The Labor Department reported that non-farm payrolls dipped by 17,000 last month, the first case of red ink since August 2003. Granted, a loss of 17,000 in a labor pool of nearly 159 million is insignificant. In fact, we wouldn’t rule out a revision to positive territory next month. Indeed, the first report of December’s paltry 18,000 rise in nonfarm payrolls was revised up today to a more respectable 82,000 gain.
But revisions can’t reverse the downturn now gathering momentum throughout the economy. The all-important trend in job creation is clearly downshifting. It’s obvious in one-month and 12-month comparisons. And as today’s numbers suggest, the warning signs are no longer confined to manufacturing.
The service sector, which accounts for more than 80% of U.S. employment, eked out a tiny gain last month, creating just 34,000 new jobs. That’s a rounding error in the context of 116 million people working in the service sector. It’s also the first time since October 2005 that the service sector employment growth was effectively flat.

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