Inflation Worries

Disinflation - a moderating of the rate of increase in prices has characterized the U.S. for much of the last two decades and contributed to attractive stock and bond market returns. Lately, investors have worried about a return of inflation with the Consumer Price Index and the core Personal Consumption Expenditure deflator rising at levels above what Bernanke has stated to be price stability.

According to Van Hoisington and Dr. Lacy Hunt of Hoisington Investment Management Company, "a further pass-through of energy costs is likely to push the year over year rise upward over the next several months, such a development should not be taken as a sign that inflation is moving higher. Multi-year inflations take the character of what may be termed a money/price/wage spiral."

"To have a money/price/wage spiral develop and become entrenched in the economy, money growth must accelerate, be sustained, and lead to a speed-up of price increases across the board. Then the widespread rise in inflation must lead to faster wage increases that are validated by a further acceleration in money growth and inflation. This happened in the 1960s and 1970s when M2 growth was the highest for any two consecutive decades. M2 growth averaged 7% in the 1960s, and then accelerated to almost 10% in the 1970s. This was the fastest acceleration for any decade other than those containing World Wars I and II. In the 1970s the core PCE deflator increased by as much as 8% per annum, more than triple the average 135 year inflation rate. Wage costs accelerated steadily in those years. The Employment Cost Index registered its all time high of nearly 11% in 1980."

"The current situation is extremely different. In the past two years, M2 growth has averaged just 4.2% per annum, a far cry from the pattern in the 1960s and 1970s, and well below the 6.6% average increase in M2 since 1900. The Employment Cost Index was up just 2.6% in the latest four quarters, a record low increase. Hence, money growth is decelerating and so are wage costs. This is more likely to lead eventually to a downward money/price/wage spiral rather than to an upward one. "

This is further evidence of our belief that interest rates will decline in the second have of 2006.

Leading Economic Index

We think the recent drop below zero of the Leading Economic Index (LEI) supports our view of lower interest rates on the near horizon. The thirteen times since the Korean War that the LEI has dropped below zero has a perfect record of declines in long and short term rates. In addition, recessions occurred in 9 of the cases and significant economic slowdowns in the other 4 periods.

If the Fed raises rates at the August Meeting it likely marks the last time this cycle they raise rates. On average, the Fed has started easing five months after the end of the prior tightening cycles. This ranges from one month in mid-1984 to eight months after the end of tightening in mid-2000. This suggests easing by late 2006 or the first few months of 2007.

Strategy Update: Our projection of lower interest rates over the balance of the year has us long maturity in most fixed income Strategies.

Slowing

Several recent economic reports have confirmed the widespread slowdown currently unfolding. Last week saw declines in total retail sales and consumer confidence and a much bigger than expected rise in inventories. The inventories, in the face slowing sales, should continue to impact overall growth in coming months as end product users order less and attempt to work off backlog.

Existing home sales volumes dropped 1.3% in June versus May. Prices continued their steep momentum descent - slowing to just 0.9% year-over-year in June. It has only been eight months since the momentum peak of 16.8% y/y, quite a dramatic change. It seems likely that with existing higher interest rates and changes in federal mandated mortgage lending practices coming (tighter underwriting standards, improved portfolio management policy, and fuller consumer disclosure of risks) that y/y prices will go negative in the near term.

Strategy Update: Our strategy manager eliminated the long exposure to the US Dollar in the Dynamic Fx Strategy after a favorable two-month move. The strategy is now flat the dollar and invested primarly in intermediate-term bonds. We also booked profits (over 10% since mid-June) in gold and commodities in the Dynamic Commodity Strategy leaving it invested in short/intermediate treasuries. This makes sense in the context of a slowing economy. We continue to favor gold and commodities longer-term yet believe a better entry point will be evident in the next several months. (see BCA's comments on the long-term picture at http://www.bcaresearch.com/public/story.asp?pre=PRE-20060721.GIF