Inflation & Some Emerging Markets

Have the recent run up in the emerging markets been on easy credit?

Vietnam has experienced a crack-up boom. They are under a grueling 25% inflation currently. The local currency, the dong, has lost 25% against consumer prices. Why? This is largely because of the run-up in food & energy commodity prices. High food prices will harm a people that spend a majority of their income on the basics. Even recently, Ho Chi Minh has banned the importation of gold. The government of Nguyen Tan Dung temporarily withdrew all licenses of gold importers, effectively banning the hedging against inflation with that yellow metal. The stock exchange is down roughly 60% this year.

Here's a brief run down of estimated inflation numbers in Asia. (thanks to Jim Juback at MSN Money)

Fun times?

But, why would this be? Let's think foundationally...what has happened to cause this?

Let's first start with the definition of inflation. Here would be the best source to show you the engagement even over the simple definition of inflation. There are two camps: one says that inflation is an "increase in the money supply" and the other says that inflation is an "increase in consumer prices".

By the way, folks, a consumer price is this: food, real estate, gasoline, natural gas. Basically it's the price of something a consumer uses (i.e. consumes). Make sense?

Back to the inflation definition. I would propose we use the former definition, not the latter. Why? Well, the former is more of a root definition. The latter is merely a product of the former. For instance, if I print more and more money then the price of an item will eventually go up. This is basically the law of supply & demand. If there's an increase in the amount of US Dollars in the market, then the value of that dollar is lessened. For instance, if coffee is selling for $1.00, and there's $1 Million dollars in circulation (yes, this is crazy simplistic) but then there is $2 Million dollars in circulation, then the price of coffee would double due to the devaluation that just happened....basically.

So, inflation is created from an increase in the money supply. Then, consumer prices rise.

Why are the emerging markets racked with inflationary pangs???

What happened in 2002 - 2007? Well, the Fed bottomed out the lending rates, credit became ridiculously easy because borrowers were paying their loans on time, and money gushed forth. The horse and rider were thrown into the sea of money supply. It was amazing! Lenders were accepting 1% payments on debts, and throwing the rest of the bill on top of the overall loan, ensuring certain borrowers would be underwater from the very first payment!! Low-hanging-fruit abounded, and the fruit was tasty. US Debt was bought up by foreign countries, starving for cheap US securities. It was the safest on record, and the cheapest. And did we feed them!

So, that defines the increase in the money supply. Here's a chart I got from the folks at GaveKal. These guys are genius, visit them here. Notice that in 2002 - 2006, the money supply in the US increased at a nice clip. As this cash was bought up by foreign countries, they then experienced incredible gains in their stock markets. (Just look at the ETF: ICHKX and it's gains over those years)

However, now with the money supply decreasing, and lenders fearful of lending, we're now starting to see the rise in consumer prices.

Remember, form 2002 - 2006, we saw the increase in the money supply. Now, we're seeing just the start of the rise in consumer prices...

What will happen as a result? Well, we'll definitely see!

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The Fed's next actions

The Fed has lowered rates again and again to induce consumer spending. Obama is saying that consumers need more "cash" in their pockets, and the "affect" of the stimulus checks is not very stimulating at all.

Granted, retail sales were up 1% this month, which is higher than economists expected. But, all that resulted in was an initial bullish push off stocks, with the bearish correction beginning at roughly noontime...during trader's lunchhour.

But is this a real solution? Put cash in consumer's pockets, and encourage them to make that downpayment with their stim-check...but don't worry about the payments! How is this not adding straws to the camel's back? Interestingly enough, most people are saving their stim-checks for a rainy day.

The summertime will show us an increasingly wan US economy...like a frail Victorian lady on a hot, muggy Southern day; the economy won't be able to stand up to much further beatings...and the beatings look like their coming.

We have not even fully dealt with the subprime problem. What about the Option Arm problem on the rise? And, then, what about the effect of potential class-action lawsuits against the banks that funded these loans? House prices haven't even reached their floor of support yet, which (I was told recently) was when the mortgage on a house (assuming 20% down) pays for the rents...in many areas that is a further decling of 10 - 25%.

Given that, will the Fed lower rates again???

Let's think of the rammifications. The Bank of England and the European Central Bank already said they made need to raise rates when they voted recently to keep the rates steady. Read it here. Indonesia may raise rates, read it here. China, India, Singapore are all experiencing inflation at rapid rates. Inflation is global, read it here, here, and here.

So, why does the Fed continue their inflationary policy?

Because consumer spending accounts for more tha 70% of the American Gross Domestic Product. So, why's the Fed lowering rates? To encourage spending!....err....I mean....borrowing! This is because we Americans don't pay cash for things, we charge it!

That mentality needs to change...

And it will; but it's going to be a painful, long, difficult road to hoe. It will mean high Volcker-like interest rates, hard-to-find credit, higher taxes, nasty state and federal budget cuts, Medicare & Social Security overhauls, and a cease to our nation-building policies. Basically, anything to save money.

It will be a good education for the American people. It will humble us, God knows we need it.

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I shorted Wachovia Bank 3 weeks ago, and am up approximately 23% thus far. They furthermore fired their top gun today, and I bought the October 2008 Put Option for Wachovia Bank. I would recommend this, but then I'd have to issue pages and pages of disclaimer saying that I can't be held accountable if you lose all your money...

Cheers!

PS, I was looking around for Irwin Financial Corporation put option chains, but couldn't find any...if you do find one, that might be a viable target.

The Unaccountability of modern Accounting Methods

A large portion of what's going wrong in the financial markets is due to the liberal accounting methods that are legal, but not at all sensical.

For instance, Bloomberg's headline article today, "Wall Street Says -2 + -2 = 4 as Liabilities Get New Bond Math" shows just one of the ways that modern accounting methods have, essentially, so diluted the truth in balance sheets that investors oftentimes don't even know what they're investing in (e.g. probably why Buffet and Munger like those investments you don't have three zeros after the decimal point). You can read the article here.

Another, for instance, is allowed by GAAP which pertains to those Pick-your-Payment mortgages. This allows for banks to claim, as profit, the negative amortization, which is only paper assets. The mortgage has a 1% payment interest rate, but the balance grows monthly because of the fully indexed rate, which is typically 6 - 8%. The difference between the payment rate (1%) and the fully indexed rate (6 - 8%) is then added on top of the balance monthly...and the lender claims this as profit.

So, how are you to invest your assets then? Whom can you trust? And, even if you can trust your broker, or the mutual fund/ hedge fund manager, do they even know what a tranche is??? Do they even know why mortgage-backed-securities are experiencing the highest defaults ever, and that for a AAA rated security? Why all this mess?

One answer...bad accounting.

I guess honesty is the best policy after all, eh?