A View from the Trenches

Martin Sibileau's market letter

A View from the Trenches, May 7th, 2012: "The path from asset inflation to generalized inflation"

M. Hollande has won the French presidency and fear is now widespread, that with the anti-bailout message sent by the Greek electorate, who voted this weekend too, the house of cards built by the European Central Bank may collapse. It is hard for us to see how this may take the markets by surprise, but….what do we know? We still remain long gold (although not so much as before, given the open and obscene manipulation this asset has been subject to) and bearish of stocks.

Over the past week, mainstream media sought to convince us that we, at least in North America, were enjoying a slow growth that would eventually take us out of recession, without inflation. No inflation was in sight, earnings had been showing recent strength and Europe…well, Europe was far, far away.

It all went well until U.S. jobs numbers on Thursday first and definitively on Friday, gave us an unpleasant indication of what really goes on. Of course, mainstream media, upon release of these numbers, sought to twist them in every positive way available…to no avail. Stock markets plunged at the end of the week, with Europenow in negative territory for the year…after a trillion or so of liquidity given by the European Central Bank between December 2011 and March 2012.

As is our usual approach, we won’t discuss statistics here. Readers count with an endless menu of other sources for that. But having heard the official explanation that the unemployment rate fell from 8.2% to 8.1% because the pool of people looking for employment had decreased, we were reminded of Argentina’s explanation for the increase in unemployment, leading to the financial collapse of 2001. In those years, the official story was that the rate of unemployment rose because things were looking so good that people could no longer afford to sit at home and had started looking for employment. In other words, the pool of people looking for jobs had grown because it was worthwhile, productive to work. Both explanations were ridiculous.

Now, let’s discuss the apparent perception that the world is not suffering from inflation. At least for now. We think it is valid to point out that so far, the substantial (let’s say above the explicit 2% target) increase in prices has been seen in assets, rather than in final good and services. This, for those of us within the Austrian School of  Economics, makes perfect sense, since it is precisely this school that maintains that the expansion of money supply is not neutral. It begins affecting one sector and then spills over to the next. As a matter of fact, we reproduce below the first graph ever published at “A View from the Trenches”, on April 14, 2009:

If we go by this graph, we must say that we have bad news. The situation we pictured three years ago foresaw an increase in the purchase of capital goods, which if it had materialized, would have meant strong investments and economic growth. But recent data shows, as we had warned since the beginning of 2012, that funds are not flowing to investments.

While companies carry high cash balances, given the manipulation by central banks and governments of interest rates, and commodities, as well as the uncertainty over taxes, labour regulations, etc., they have decided not to throw good money after bad. It’s common sense, because over the last decade, on average, equity prices have gone nowhere at best, and down at worst. Companies are therefore transferring those cash balances to “the people”. They are distributing dividends and buying back shares, in increasing amounts. If this trend holds, this will be the transmission mechanism that will link the inflation in asset prices with general inflation, in consumption goods.

 Another mechanism pointed to us by a friend and reader is vertical integration. An example of this is the recent purchase by Delta Air Lines Inc. of an oil refinery from ConocoPhillips, in a bid to save on fuel costs (announced on May 1st). Integrations like these go in opposite direction to economic growth. Economic growth is achieved with specialization, diversification that boosts productivity, complexity in the economic system and is based on ever growing economies of scale. This kind of vertical integration breaks with diversification and economies of scale. Fuel production will now not be guided by external demand but by transfer pricing. This is an isolated case, but if you generalize this example, you end up with a situation similar to that which transformed the economic system of  the Roman Empire into that of the Middle Ages. The complex and vast production network that had existed within the Roman Empire, thanks to socialist economic policies, gradually gave place to groups of mediocre, inefficient, isolated and self-sufficient populations scattered over Europe. This, we think, visualizes what we mean when we see vertical integration as a negative and unintended consequence.

In summary, so far, we are seeing three different channels that would eventually link the existing asset price inflation to a general increase in consumption goods prices: Dividend increases, share buybacks and vertical integration. The first two lead the cash currently held by companies to the pockets of people, which will later use it to purchase goods. If this takes place using leverage, we run the risk of seeing inflation with a future spike in corporate defaults. Another unintended consequence of this is that this transfer of purchasing power to shareholders is a transfer of wealth from the poor who could not save to those who could. In other words, it is a generational transfer of wealth from the young to the old.

The last channel (i.e. vertical integration) takes goods off the market and leaves less production available for people with higher nominal purchasing power.


Martin Sibileau

The comments expressed in this website and daily letters are my own personal opinions only and do not necessarily reflect the positions or opinions of my employer or its affiliates. All comments are based upon my current knowledge and my own personal experiences. You should conduct independent research to verify the validity of any statements made in this website before basing any decisions upon those statements. In addition, any views or opinions expressed by visitors to this website are theirs and do not necessarily reflect mine. My comments provide general information only. Neither the information nor any opinion expressed constitutes a solicitation, an offer or an invitation to make an offer, to buy or sell any securities or other financial instrument or any derivative related to such securities or instruments (e.g., options, futures, warrants, and contracts for differences). My comments are not intended to provide personal investment advice and they do not take into account the specific investment objectives, financial situation and the particular needs of any specific person.


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