Energy & Inflation Analysis — March 13, 2008
I recently listened to a Wall Street analyst on MSNBC discussing how he did not understand why the price of oil was at $100. According to him, the supply demand fundamentals did not justify such a high price. I simply do not agree with his assessment since the cost of my fuel has not significantly increased here in Ontario. Aside from a spike to $1.25 during the fire at a Sarnia refinery in September of 2005, the cost to fuel my car has only increased by $0.20 during the last three years. It amazes me that these so called “experts” on Wall Street do not see the reality of the situation. At a news conference after the latest OPEC meetings, OPEC's President Dr. Chakib Khelil said the Federal Reserve, not OPEC, is to blame for high oil prices: “What’s happening in the oil market is due to the mismanagement of the US economy, which is affecting the rest of the world.” This also explains why OPEC refuses to change its production targets.
In my opinion the Wall Street analyst would have been correct if on a real basis the price of oil had actually increased. What he failed to notice was that the majority of the increase in the price of oil, and most commodities, has been due to the decline of the US dollar, which is the currency in which these commodities are traded. This makes these commodities more expensive on a relative basis for Americans. This is inflation. The devaluation is the net result of the Federal Reserve having to bail out the banking sector due to the unwinding of the Credit Bubble. The US Federal Reserve has to inflate or the banking sector will fail, and this inflation will continue to devalue the US dollar. These so called “experts” must have failed in math if they can't calculate the rate of loss of purchasing power of the US dollar. US Headline Inflation is tracking 4.1%, yet two year treasuries are at 1.5%, meaning that we have a loss of purchasing power of 2.6%. Add energy and food (not currently accounted for in Consumer Price Index (CPI)) and CPI increases from 4.1% to 7.5% for a real loss of purchasing power of 6%. Once we understand this we can try to answer the real question of the day: how low will the US$ go?
US Dollar Index
Source: Stockcharts.com
When the subprime problems first came to light, most analysts expected that the cost would be around $100 billion. In its latest report, UBS estimates that taxpayers have subsidized the banking sector to the tune of $600 billion and we are only 2/5 of the way through this financial storm. Mr. Bernanke (Chairman of the US Fed) said last week that they were ready to pump another $300 billion into the system, and on Monday March 10th they announced another $400 billion. From this we can reasonably expect two outcomes: 1. Since we still have 3/5 of the way to go through this storm, the Fed will continue to inflate and the dollar will go lower. 2. As a consequence of the first outcome, by default, all assets that are priced in US$ will continue to appreciate in price. Knowing this, leaves the rational investor with a great opportunity to benefit if properly invested.
I do not have a crystal ball to tell me how low the US dollar will go; however, since I am a true believer in the concept that "history does not repeat itself but it rhymes,” I can surmise that if the inflationary period of ‘70s is any indication, the US dollar should still fall by a fair amount. So far the US dollar has lost 30% of its value versus a 70% decline in the ‘70s, and the situation then was not as bad. In the ‘70s, the US was the world's largest lender, many younger Americans were net savers, and the US banking system was in good shape. Today the US is world's largest debtor, Americans are indebted at unprecedented levels at the same time that Baby Boomers are facing retirement, and the banking system is very weak. The then Chairman of the US Fed, Mr. Volker, understood that the solution to reverse the inflationary storm was to increase interest rates and force people to start saving — a solution that is sadly inconceivable today due to the economy's dependence on consumerism. Historically, the end of credit cycles is always followed by much greater interest rates and a reduction of the consumption to encourage savings and productivity. It is my opinion that we are seeing the beginning of the end of the age of consumerism, and this natural economic change will require Americans to enter into a period of economic pain.
By understanding the reason for this increase in the value of commodities we can see that their increase in price will continue. The US Fed has to inflate in order to keep the US economy from imploding; however, this inflationary storm is just the beginning, because the prices do not yet reflect the low level of supplies.
My informed observations have led me to conclude that the true inflationary storm that is taking shape beyond the horizon lies in is the fact that the system is not currently pricing the supply and demand imbalance of commodities. There are 300 million Americans versus a global population of five billion, with many of these members entering the global middle class and demanding a better quality of life. This further weakens the US as it is the populace of these nations that will dictate the future price of things and the interest rate levels, for today they are the world’s biggest lenders. Changes are afoot that will require a forward looking perspective for the rational investor to profit. We are entering a new era that will lead to the end of consumerism and a return to savings and productivity as the world competes for limited resources.
Do you know how to profit in this new reality? It would be my pleasure to sit down with you and review my strategies for benefiting from an inflationary environment.
Jaime E. Carrasco, BA, CFP
Investment Advisor
T: 416-864-3623
C: 416-271-6630
E: jcarrasco@blackmont.com
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