There's no doubt in my mind that inflation is making a comeback in the latter half of the 2000s.
The accelerated disinflation of the last decade and all the benefits of high productivity growth are now behind us in 2007. And if I'm right about creeping inflation and major supply concerns developing for many commodities, then financial stocks, bonds and everything else that's interest rate sensitive is heading to the basement over the next 12-24 months.
I like high quality U.S. Treasury bonds for one reason: a hedge against a systemic financial crisis or meltdown. I don't like bonds for any other reason because over the next several years, the United States will have no choice but to hike interest rates to finance massive entitlement spending programs. Along with rising inflation caused by declining food harvests, soaring grain prices, a shrinking labor pool and a significant increase in global exchange-rate volatility, interest rates will rise.
All bonds, especially the riskiest segments, including emerging market debt and high-yield bonds, offer pitifully low spreads above risk-free T-bonds right now. In fact, spreads have remained near their lowest levels in history for all high-risk bonds since late 2005. I don't see any reason to own an emerging market bond when all you get is 1.6% more than a comparable ten-year T-bond. High-yield debt provides another 100 basis points in yield, but again, with default rates sitting at near record lows and spreads this tight, I don't want to own junk debt.
However, with every passing day this market rallies, the odds of a major sell-off or decline increases.
The mini-panics of February 27 and March 13, in retrospect, will look like a picnic compared to what lies ahead. U.S. economic growth is slowing, the labor market remains tight, wages are rising above the rate of inflation and productivity gains are disappearing. Plus, we've got a mania in private equity, fueling a major liquidity-driven market rally that will ultimately exhaust itself.
But the big threat lies in the banking sector.
Earnings for major U.S. banks are deteriorating as the sector continues to lag the broader market this year -- a bad omen for the primary trend. Indeed, banks will continue to struggle in the face of high short-term interest rates, a struggling yield-curve and deteriorating credit quality. I'm also not so sure the worst of the sub-prime mortgage fiasco is behind us. The government might yet have to bail-out this industry, similar to what occurred with the S&Ls in 1990-1991.
For now, markets are soaring. To be sure, overseas corporate earnings look better and a weaker dollar is a plus for international investors. But at some point, a colossal stock market correction lies ahead.
At 5% today, parking some money in cash is not a bad idea ahead of the best buying opportunity since late 2002.
