You can slice it, you can dice it. You can even massage it and look on the bright side. But you still can’t get blood out of a stone or, it seems, inflation-adjusted increases in consumer spending.
Real personal consumption expenditures were flat in April, down from a slight 0.1% increase in March, the government reported today. Meanwhile, as our chart below shows, the longer-term trend isn’t inspiring.

Looking at the three major components of consumer spending–durable goods, nondurable goods and services–doesn’t inspire either. As the second chart below reminds, inflation-adjusted spending looks tired by several measures.

At least there’s no mystery as to what ails Joe Sixpack’s spending habits. Higher energy and food costs, a general if still modest rise in overall inflation, and housing and job stress are collectively taking their toll.
That leads to the question of whether the stress testing has legs? By this editor’s reckoning, there’s good news and bad news. The good news: the economic slump may not deteriorate into a full-blown recession. Yesterday’s modest upgrade of Q1 GDP’s growth is one clue. The bad news: the “recovery,” when it comes, won’t seem much like a recovery.
Why? We’ll discuss this in more detail in future posts. For now, we’ll simply say that the economic chickens are returning home and they’re of a mind to roost.

Reports of rising inflation are everywhere, and the bond market is paying attention.
As evidence, we turn to Exhibit A–the 10-year Treasury yield, which closed above 4% for the first time since December 31, 2007. Rising yields are present in other maturities, too, including the 2-year Note, which yesterday settled at 2.62%, the highest since this past January.
It’s not hard to guess what’s behind the pop in yields: inflation fears, the bond market’s worst enemy. Securities with fixed coupon payments are the first to suffer in a world of higher inflation.
As The Economist points out this week, inflation is bubbling around the world, particularly in the emerging market countries. What does that mean for U.S., Europe and the rest of the developed world? Food, energy and raw materials prices will “remain high,” the magazine predicts: “In other words this is a permanent relative-price shock, not a temporary one. Yet this does not mean that commodity prices will keep rising at their current pace. Higher prices will encourage increased supply. And even if prices remain at today’s levels, the 12-month rate of increase will decline, helping to ease global inflation.”

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Commodities may or may not be in a bubble, which leaves strategic-minded investors grasping (and gasping) for context.
The media is flush these days with the “B” word, including today’s Wall Street Journal, which advises: High Oil Prices Spur Thoughts About Bubbles, But This Might Be Misguided Meanwhile, earlier this month, Lehman Brothers energy analyst Edward Morse wrote in a report that commodities were, in fact, in a bubble and that it would burst by the end of the year, via Bloomberg News.
Many others preach the opposite, arguing that the run-up in commodities prices are a reflection of supply and demand trends rather than a speculative frenzy. True or not, the idea that speculators have gone wild is catching on and some in Congress are considering new laws aimed at curtailing commodity trading by institutional investors.
So, what’s a prudent investor to do? There are no easy answers, although we can start with the facts. Fact number one: pricing commodities is inherently speculative. That’s independent of whether commodities are in a bubble or not. In contrast, stocks, bonds and real estate (save for raw land) enjoy the attribute of generating measurable cash flows, which can be analyzed in the cause of putting a valuation on said assets. Commodities, by contrast, generate no income directly. Instead, one can only sell a barrel of oil or an ounce of gold to produce cash flow. The problem is that it’s forever unclear how much cash the commodity will generate until the day of the transaction arrives.

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There are no easy answers to America’s energy challenges, but if there’s any hope of finding anything resembling a solution, it surely begins with an honest assessment and discussion of the facts. And therein lies the problem: coming to terms with reality.
It’s a simple task, really, although in a business as politically charged as energy nothing is as easy as it seems. Yesterday’s affair in the U.S. Senate offered no evidence to the contrary. Consider a few quotes from Wednesday’s Judiciary Committee hearing that heard testimony from executives of the country’s largest oil companies:
“Is there anybody here that has any concerns about what you are doing to this country, with the prices that you are charging and the profits that you are taking?”
–Sen. Dick Durbin
“Yet you rack up record profits, record profits, quarter after quarter after quarter, and apparently have no ethical compass about the price of gasoline.”
–Sen. Diane Feinstein
“Consumers are angry, and they have every right to be. You’re making more money than ever. It doesn’t seem fair, guys. It just doesn’t seem fair.”
–Sen Herb Kohl
There’s also this intriguing colloquy yesterday between Sen. Patrick Leahy and two oil executives about their salaries. The Senator’s point, as far as we can tell, is to alert the American public that high-level oil executives make a lot of money. That’s not unusual, compared with many other industries. But oil, of course, is different.
And, this is a political year and politics is in high gear in Washington, perhaps more so than usual. The problem is that political grandstanding is as irrelevant as ever when it comes to intelligently discussing, much less solving America’s energy problem.

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It’s not just about food and energy, and that makes it all the more worrisome.
Core wholesale prices, which is to say ignoring food and energy prices, are now running at their highest annual pace since the early 1990s, as our chart below shows. Through April 2008, core producer prices rose by 3.0% for the year, the highest since December 1991.

And yet the Labor Department yesterday reported that producer prices overall advanced by a relatively mild 0.2% in April, down considerably from March’s soaring 1.1% rise. On first glance, that looks encouraging. So, what’s the problem?
The short answer is that inflation at the wholesale level is spreading into the broader economy. Indeed, although top-line wholesale prices rose just 0.2% last month, core wholesale prices jumped at twice that pace, or 0.4%.
This should come as no surprise to those who’ve been following wholesale prices in recent months. Back in February, your editor noted that the trend in core PPI looked threatening, and the threat has only grown since then.

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Studying history promises no short cut to easy profits, but it does provide some intriguing perspective at times. The last six months or so is one of those times. We’re speaking here of the real or inflation-adjusted rate on the 10-year Treasury yield. By our somewhat subjective calculation (more about that below), this real yield has gone negative in recent months, which is to say that owning a 10-year Treasury bond leaves owners with less than nothing after deducting inflation.

The negative real yield in the 10 year isn’t unprecedented, although as the chart above reminds it’s a fairly rare occurrence. Back in 2005, the real yield went negative in September, but that was a one-time flirtation with life below zero. The last sustained dive into negative territory came during a two-year stretch in 1978-1980. Of course, that was a time when inflation was taking a toll on fixed-rate investments and the country was grappling with high energy prices. (Sound familiar?)

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At long last, some good news from a pair of front-line economic reports.
Housing starts and new housing permits popped higher last month, the Census Bureau advises. After more than two years of nearly nonstop declines, robust increases in April in these two critical housing surveys lend fresh reason to think that the housing crisis, if not over, may at least be stabilizing.
Certainly the numbers look good for April, relative to the past. Housing starts jumped more than 8% last month, the strongest since last October. Meanwhile, new permits issued for building houses advanced nearly 5% last month–the highest since December 2006. In both cases, the actual numbers exceeded the consensus forecast by a healthy margin, according to Briefing.com.
April’s rebound in these numbers is all the more encouraging since both data series are considered leading indicators. Economists consider housing starts and new housing permits a sign of what may be coming rather than what’s passed.
Adding to the statistical cheer is yesterday’s better-than-expected update on inflation for April, the Bureau of Labor Statistics reports.
But there’s still plenty to worry about. The notion that the economy may be at or near a bottom is one thing. Expecting a strong rebound is something else. Indeed, yesterday’s report showing a sharp loss for industrial production last month reminds that not all the news for April is encouraging.

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The investment universe is filled with surprises, and perhaps the biggest shocker of all is the idea that the value strategies of Ben Graham and his disciples are in general agreement with modern portfolio theory (MPT).
Granted, it sounds absurd. MPT, after all, is the suite of financial theories that spawned index funds and the view that market prices are the best estimate of intrinsic value. Meanwhile, Graham’s value strategy asserts the opposite, advising that savvy investors on the hunt for bargains can do a better job of calculating fundamental value, a strategy that boosts the odds of generating market-beating returns.
MPT and value investing, it would seem, are natural adversaries. That was true, but the two ideas have become similar thanks to the evolution of MPT. But while the academic interpretation of MPT has changed, the popular perception remains stuck in the 1960s and 1970s, when two of its major components–the efficient market hypothesis (EMH) and indexing–first arrived on the financial scene. Recognized or not, there’s been a slow but steady accumulation of empirical research since the 1980s that’s altered financial economists’ view of capital markets. As a result, there’s a new MPT in town and it’s a lot closer in spirit to a Graham-inspired view of investing.
Ok, but why should investors care? Because if the classic strategies of active and passive investing are more closely aligned around value investing principles, the union lends more authority to value strategies generally. Indeed, if two formerly competing notions of money management–each commanding huge amounts of money under management–are now in basic agreement, it probably reflects a fundamental truth about how the capital markets function and how investors should build and manage portfolios.

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Retail sales last month slipped a bit, the Census Bureau reports. But much of the decline came from the auto and related industries. Given the soft economic backdrop of late, it’s no wonder that consumers are reluctant to buy cars, which for most folks are the largest purchase after a house. Otherwise, this was a surprisingly good report, given the dominance of plus signs elsewhere in the column of monthly changes among the broad categories of retail sales. Excluding motor vehicles and parts, retail sales overall rose 0.5% last month.
Joe Sixpack seems to be holding up quite nicely in the face of recessionary fear, or so this data series is telling us. So, what’s the problem? For some thoughts on that, we turn to import prices, which surged by 1.8% last month, the Bureau of Labor Statistics reports. Sure, that’s lower than the nosebleed 2.9% for March. But no one should be celebrating. The United States is importing inflation, and the problem may get worse.

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Exports account for about 13% of the U.S. economy these days. That’s a small piece of the GDP pie, but it’s an important piece, thanks to the strong growth in exports.
Exports have been one of the rare consistently bright spots in the U.S. economy. For each and every quarter since Q4 2005, exports have grown at a higher pace–quite often a significantly higher pace than overall GDP, according to the U.S. Bureau of Economic Analysis. In this year’s Q1, for instance, exports jumped by 5.5%–a world above the meager 0.6% rise in overall GDP (both are quoted in seasonally adjusted real annual rates).
In fact, the strong performance in exports in Q1 is typical of the trend for the last several years. Exports, in short, have become a critical factor in keeping the recessionary forces at bay. Exports climbed 5.2% through this year’s Q1 over the year-ago quarter. Overall GDP is up only 2.5% over the same period (seasonally adjusted real annual rates).

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