Inflation: The Elephant in the Room

It is no secret that at Treece Investment Advisory we are very bullish for the US economy and equities, more than we have been in the last decade. While signs of economic growth may not be noticeable just yet, they are all there. Residential real estate is beginning to sell and home builders are looking for new projects, corporations are beginning to hire, energy costs are slowly beginning to creep back down, and so on. It is our belief that two key factors are going to drive the US economy going forward.

First of all, businesses are looking for some certainty regarding Washington’s policies and how it will impact their respective industries. Second, once the US taps in to the oil and natural gas finds in the Dakotas, Midwest and New York the economy will take off. Cheap energy means that factories can operate at a lower cost, which will in turn lower the cost of goods to consumers, who will have more money for discretionary spending as their gas/electricity bills will drop along with prices at the pump. The increased demand for these goods will surely result in new job creation to meet consumer demand. History has seen this unfold before during the early 1980’s. Once energy was actively sought after domestically prices were nearly cut in half and US GDP was growing at nearly 10% year over year.

Once the economy hits this phase of substantial growth, inflation may be the truck that few investors see coming. Remember that since the credit crisis in 2008 the US has had two rounds of Quantitative Easing. Between the bank bailouts and QE2, several large lending institutions have cash and cash equivalents on hand that they have been hesitant to loan out. Due to a relatively low demand for loans from businesses and increased lending restrictions following the passing of Dodd-Frank, banks have been more than content to park their money at the Federal Reserve and take home a 1-3% return with no risk. However, when rates begin to rise and lending to the FED is no longer profitable, banks will begin to offer attractive loans to businesses and retail customers, and that is when inflation will rear its ugly head.

We have said before that in order to have inflation there must be two factors present; volume and velocity of money. The volume is most certainly there following QE2, but the velocity is not. Velocity has actually been on the decline since 2008, which explains why all of this newly printed currency has not found its way into the economy just yet. The price increases that we have seen in consumer goods, energy and agricultural products have been due to a high demand with a lower level of supply, not due to inflation.

Once this money makes it through the economy, it would not surprise us to see high single digit inflation for a period of time. The economy can handle this influx of cash, as long as growth exceeds inflation. Many investors hear inflation and think of it as a bad thing. We actually need money supply to grow at roughly the same rate as the economy expands. Without this positive correlation, we will either have too much money in the system which will raise the cost of goods, or we will not have enough money in the system and prices will be forced to drop substantially in order for consumers to be able to afford them. That sounds great from a consumer standpoint, but when manufacturers produce goods for more than they are able to sell them for, layoffs are sure to follow and the economy would likely retract.

There are places to be invested during inflationary times and places to avoid. Historically commodities hold their value very well during these times, which include gold, silver, copper, oil, natural gas, real estate, agricultural products, etc, but this is not the “Golden Rule.” If inflation outpaces economic growth, dollar denominated assets would not be a solid play as the value of the USD would likely slide. We will continue to watch both inflation and GDP and look for the sector that we feel will be most profitable, but even with inflation lingering, do not rule out US equities just yet.

Ben Treece is a partner with Treece Investment Advisory Corp (www.TreeceInvestments.com) and licensed with FINRA (www.Finra.org) through Treece Financial Services Corp. The above information is the opinion of Ben Treece and should not be construed as investment advice or used without outside verification.
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