Oh, How Jaded We Have Become: In their latest commentary on the state of the economy, the U.S. FOMC finally raised the alarm regarding the threat of rising inflation. The concerns were expressed in a few carefully worded sentences. They wrote, “Output evidently continues to grow at a solid pace” rather than “a moderate pace” in their last commentary. And they added, “pressures on inflation have picked up in recent months and pricing power is more evident.”

For the past several quarters, we have voiced concerns with respect to rising inflation in our quarterly letters. We knew we were premature but we suggested it was only a matter of time. Now that inflation has moved center stage in investor’s minds, we suspect that the threat is close to a peak and will now recede away over the next few quarters.

Despite higher prices for most commodities and oil, we think that the peak in core inflation will be felt over the next three to four months. It is important to realize that core inflation “is the most lagging of all lagging indicators – it generally peaks well after the economy has begun its slowing and on average, peaks six months after bond yields have seen their highs.” (David Rosenberg, Economist, Merrill Lynch). Mr. Rosenberg goes on to list ten points that argue inflation concerns are overblown from here including:

1. The U.S. dollar is in the process of stabilizing
2. Wage pressures remain benign
3. Money supply growth is slowing
4. There is lingering excess capacity in manufacturing
5. Global companies pressures remain intense
6. Service sector inflation is just rolling over and keep in mind that 72% of the Core CPI is in services, not goods.
   So while we now feel that core inflation is near it peak, the risk is that the FOMC overreacts and tightens monetary policy excessively. We need to be vigilante in the months ahead and watch for any signs that this may be the case. As for the U.S. economy, it appears to remain on reasonably solid footing. A very recent chart from the Bank Credit Analyst sums it up, “U.S. companies are optimistic and we expect further solid investment growth ahead”.

Despite this outlook, analysts’ current long-term EPS growth assumptions are at their lowest point in 15 years reflecting a shift from excessive confidence to a more historically conservative outlook. With all that has happened in the past four years postbursting of the technology bubble, investors and analysts have become leery of optimistic earnings forecasts and have turned quite defensive in nature. We do not share the view that recent stock market weakness is indicative of an earnings problem a few quarters away.

Nevertheless on a valuation basis, the U.S. market appears to us as fairly valued. In addition, the housing sector has played a large role in sustaining U.S. economic expansion. While we hesitate to call it a bubble, housing prices have moved up dramatically since 2000 in many parts of the country on the back of low mortgage rates. That may be coming to an end as the FOMC shifts to a tighter stance. While it might persist for a while yet, the housing market appears poised to slow and with it, the general sense of well-being. This does not bode well for higher equity valuations overall going forward.

Growth in the Chinese economy remains paramount in our opinion with respect to the direction of commodity prices and selected equities. While efforts that began in early 2004 to slow the Chinese economy down have been successful, growth appears to remain quite robust. From a peak of 11-12% growth in GDP in 2003, growth slowed to 9-10% last year. For the current year, growth appears to be solid at 8-9% with annual growth in the 7-9% range thereafter until 2010. In the words of Andy Rothman of CLSA Securities, “This mild slowdown is due primarily to physical constraints to growth (limited availability of imported raw materials, power shortages, transportation bottlenecks), not because the PRC government is trying to slow growth or substantially limit new investment.” The point simply is that while the Chinese growth rate may have peaked, growth and demand for commodities will stay strong for the remainder of the decade. In fact, annual double-digit growth in demand for energy, iron ore and base metals is anticipated.

Chart Six shows China’s increasing dependency on basic commodity imports. The shifts are simply staggering and have massive implications for commodities markets globally in our opinion.

Again, in the words of Andy Rothman, “China is now a continental economy, with growth driven primarily by domestic factors; the view that China is dependent on trade and foreign direct investment is outdated…it is clear that its economic expansion is not a zero-sum game for the rest of the world”.

In our opinion, the Chinese dragon will stay hungry for some time to come. And relations with resource-rich Russia will only broaden significantly over time. Oil markets and equities remain a conundrum. The price of oil, having tested its 200 day moving average twice then soared to new highs only to exhibit even greater volatility at quarter’s end. Short term, bullishness on the commodity had become overdone and a correction overdue and necessary. A pullback in energy prices is positive longer term as it reduces the threat of a slowdown in the global economy and with it, lower oil demand.

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