Nolte Notes - Inflationary Growth

By: Paul_J_Nolte

Let's be perfectly honest – economists are a geeky bunch. In what may be their own super Friday, economic reports galore will assist them in determining the overall direction of the economy. Mind you, many of these reports are monthly, they get revised regularly and an economy as large as ours rarely is going to turn on a couple of reports. However, the financial markets are likely to get all worked up about inflation (which we will see with the employment report), consumer spending (in the income/spending report) and job creation (in the employment report).

The Fed, through various comments made over the past few weeks, has indicated they are more concerned with inflation still hovering above the 2% “comfort” level – which oil and food prices are doing little to reduce, than they are about the slowing economy. We try to look beyond a single report and proclaim anything with certainty (it is the nature of the business!), however we do look at the trends in the reports that are unfolding over months/years. Here is what we believe: headline inflation reports will be “uncomfortably” high, given the huge run-up in energy and food prices. The economy is slowing to roughly 1.5%-2% growth – well below the optimal 3% target and the consumer is beginning to save a bit – as spending patterns are slowing while income has at least remained stable. Friday should be fun – if only to watch the breathless reports on the economy!

Divining the future of the markets are nearly as geeky as determining the direction of the economy, however with real-time information 4-5 days a week, it is much more profitable. For the first time in two months all the major averages declined and our market internals continue to deteriorate, as they have been doing for the past three weeks. We have highlighted many of our indicators that are rolling over, along with the various industry groups that were once leads – now laggards. What did surprise us this week was China's decision to get into the hedge fund world with a huge investment in the Blackstone Group.

The grease that has made these markets go is now closing the circle. China too is trying to profit from the boom in private-equity funds that has been fueled by liquidity from China. Hence the markets swoon in February when China raised rates provided us with a glimpse into the demise of this bull market. Stoked by easy lending/money, the increases in rates around the world (our rates are up a quarter percent in 10 weeks) will eventually impact the equity markets. We stand by our view that an economic collapse is not in the cards; a financial one is much more likely.

The yield curve is slowly returning to a more normal curve, with short rates below long rates. However with the increase in rates at the long end, combined with a poor utilities market (down nearly 4%), our bond model has registered the first negative reading since the opening weeks of the year. Historically, a rising rate environment has been poor for stocks, with less than a 7% annualized return vs. over 11% when the model is positive. The results are from the inception of the model in mid 1989. Given the markets dependency upon low interest rates (and the anticipation of even lower) any backup toward the 5% level could create a problem for stocks.

By Paul J. Nolte CFA
http://www.hinsdaleassociates.com
mailto:pnolte@hinsdaleassociates.com

Copyright © 2007 Paul J. Nolte - All Rights Reserved.
Paul J Nolte is Director of Investments at Hinsdale Associates of Hinsdale. His qualifications include : Chartered Financial Analyst (CFA) , and a Member Investment Analyst Society of Chicago.

Disclaimer - The opinions expressed in the Investment Newsletter are those of the author and are based upon information that is believed to be accurate and reliable, but are opinions and do not constitute a guarantee of present or future financial market conditions.

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