My musings on the economy, life, technology, business and things I find interesting.

Monday, June 2, 2008

Inflation: Is it Real and How Will They Fight It

Early last month the Globe and mail reported on Jeff Rubin's thoughts on inflation and interest rates. My comments in bold

Unrelenting upward pressure on food and energy prices will force the Bank of Canada to reverse course and start raising interest rates to combat inflation over the next year, a high-profile Bay Street economist says.

I think Jeff Rubin is underestimating the role of speculation in current commodity prices, the mitigating effect our dollar has with high commodity prices, the pressure prices will come under via credit destruction and the amount of margins that can still be destroyed given a dollar at par.

“While the Bank of Canada may still deliver another rate cut, reflation will compel it to raise interest rates by at least 100 [basis points] next year,” Jeff Rubin, chief economist and chief strategist at CIBC World Markets in Toronto said in a monthly report on portfolio strategy. The central bank has cut its key overnight lending rate to 3 per cent, down by 1.5 percentage points since last fall.

I think Jeff Rubin may be wrong here, but this is a tough call because Canada has certainly taken the higher road with setting it's rates closer to where they should be, but I'm not sure we'll go it alone with rate hikes and I don't think the Fed has the calzones to hike rates significantly, at least that's what the Futures are saying.

What is more, Mr. Rubin said he now expects U.S. federal Reserve Board chairman Ben Bernanke, to stop their rate-cutting drive when the key U.S. rate hits 1.5 per cent, rather than 1.25 per cent as CIBC previously forecast.

We'll see, Mr Bernake has some ammunition left and I think the US is willing to pursue whatever policies, regardless of how harmful, are necessary to re-inflate the markets.

The fed cut the benchmark federal funds rate by 25 basis points to 2 per cent last week, bringing to 325 basis points the cutting it has done since last summer in a bid to limit economic damage from the U.S. housing and credit crises. (A basis point is one one-hundredth of a percentage point.)

Actually what they're doing is loading up the Fed balance sheet with marked to fantasy assets and pretending its still the good old days, they avoided higher rate resets with these drops but, these are solvency issues, a few beeps won't save the Liar and NINJA loans, just look at the rising delinquency rates in the various pools, including impending muni failures and credit card debt. The failures are happening across prime and sub prime loans. Limit is the wrong word here, postpone and draw out are more accurate.

I'm not personally convinced the US won't simply socialize massive amounts of these debts, the numbers are very large and that would require significant action by Congress (aka printing - the economic stimulus package was effectively printing, but we'll need something bigger then that to counter out all the credit destruction going on)

As a result of the consumer price index inflation rate being set to “almost double next year,” Mr. Rubin said the firm is exiting its over-weight position in bonds and moving two percentage points of weighting to equities and the other two points to cash. This leaves it with 55 per cent in stocks, 38 per cent in bonds and seven per cent in cash, he said in the report. “Moreover, we anticipate that we will be moving further assets out of our fixed income portfolio, as well as shortening duration in that portfolio as our forecast of rising inflation pans out,” Mr. Rubin said, adding that markets will be “surprised at how rapidly” the central bank will be “compelled to take back” its rate cuts next year.

My portfolios are market neutral at the moment, about 40% long 40% short and 20% cash. Days like today are great, while the markets dumped over 1% I'm up 1%. I'm short the crap and long what's good. A two per cent adjustment to weighting seems ridiculous, the bond prices are adjusting at a pace that makes such an adjustment almost meaningless. Perhaps it looks bad to be sitting in cash, or more likely too difficult to be nimble with such large amounts under management.

Within equities, Mr. Rubin said the firm is adding an additional percentage point to its already over-weight position in the energy sector, taking the total to 37.1 per cent. It also is adding 0.5 percentage points to its weighting in the materials sector, taking the position to 20.4 per cent of the portfolio, with the additional weighting focused on agricultural chemicals. To compensate, the firm is trimming utilities by 1 percentage point to 2.5 per cent, while cutting back the consumer staples weighting by half a point to 2.2 per cent, “particularly in food retailers and processors, whose margins are getting decimated by soaring food costs,” Mr. Rubin said.

I like energy too, but it seems a bit toppy at this point, there are some good utilities that are down, I've moved some money in around the time this was written, a good utility with a solid return on equity is a good thing, people pay their hydro bills. Energy, especially the servicing companies and some select energy trusts look compelling, but I'm cheap so I wait for better NAVs, all my accumulation was done a while ago.

I think economist's have the job of setting up really good light and music shows so the brokers and salespeople have something to talk about when they go out selling, the court jesters if you will. I don't believe this because I dislike economists, one of my favorite professors who I still keep in touch with, Larry Smith is an economist. Its only because economists have a absolutely brutal record of calling markets, so empiracally they deserve my mistrust.

The fact is most of us have a brutal track record of timing the market and that doesn't seem to deter the Nostradamuses of the world. So be it I guess, all I can really have faith in is the simple fact that businesses that make money over a long period of time are worth buying at the right price and businesses that do the opposite are worth shorting at the right price, all so long as you have the calzones and money to see such trades through.

Two posts in a row!

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