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Long-Term Investors, Beware This Market

By Hans Parisis
Thursday, 30 Apr 2009 02:47 PM More Posts by Hans Parisis

In a recent statement, the Fed said that the economy continues to contract, although more slowly, and that its rate-setting committee expects low inflation will continue for an extended period of time, longer than is good for the economy.

To me, the Fed doesn’t have that same, optimistic view the markets seem to herald at this moment. The markets seem to tell us better days are here again.

Unfortunately, that’s not so for the longer term equity investor. Japan’s road of misery of the 1990s could easily be in the offing.

About this recession, the only thing we all know for sure now is the shape of the “left down side” of the V. When one reads the statement carefully, one learns that that the right side of the V will not be the best friend of the longer term equity investor.

The “end up side” of the V will need several years, in my view, and will more probably end up looking like an L instead, which is, of course, the worst-case scenario as experienced in Japan, or an elongated U or a series of W’s.

No doubt, that outcome will be close to misery for the long-term equity investor, but, on the contrary, it will be trader’s paradise. I’m sorry, but I’m not a trader.

All that said, the bigger problem can be found in the details, where the FOMC states very prudently: “The committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.”

Indeed, one could call that a very prudent warning of a very serious risk factor.

After global inflation (of course, this includes the United States) set a decade high in the middle of 2008, inflation dynamics abruptly changed. The two critical and related developments were the collapse in global commodity prices and the onset of the worldwide economic recession.

Now, because movements in oil and agricultural commodity prices pass through quickly to consumer energy and food products, the collapse in commodity prices had an immediate and profound effect on consumer inflation.

In contrast, the inflation effects of the severe recession and the resulting plunge in resource utilization rates will take longer to develop, and will ultimately prove to be more important and longer-lasting.

While energy and food prices are responsible for much of the monthly volatility in the CPI, consumer prices excluding food and energy, what is called the true core, drive the underlying trend of inflation. Globally, true core inflation has been remarkably stable in recent years.

The plunge in commodity prices also dampened core inflation in late 2008 via pass-through to other prices. However, this pass-through effect apparently diminished in the past few months.

Over the next year, as I have explained before, we should have a global resource utilization contraction that go down to its lowest level in decades, exerting intense downward pressure on the already low level of core inflation. It’s certainly not an overstatement to say one can expect core inflation to fall to near zero in the developed world, and that includes the United States, by the end of 2010.

The real risk is of tilting into outright deflation, and that’s what the Fed remains worrying about, and what the markets seem to overlook, at least for now.

Time will tell if the Fed’s worries were justified. At this moment, literally nobody knows.

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HansParisis
In a recent statement, the Fed said that the economy continues to contract, although more slowly, and that its rate-setting committee expects low inflation will continue for an extended period of time, longer than is good for the economy.To me, the Fed doesn’t have that...
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