Monday, February 18, 2008

Economic BiPolarity

Here's a theory that will confound traditional thinking.

I think we are headed into a period of inflation AND deflation. Call it economic bipolarity.

If you look at prices in bubble-inflated sectors of the North American economy, all of which have been supported by loose credit (housing and consumer spending top my list), we are well into a corrective phase which will include falling prices and the perception that if we wait before buying, things will get even cheaper. I can imagine this taking a couple of years or so to work itself out. On the far side of it we will find more prudent borrowing and lending practices, which would be a good thing.

Meanwhile, there is a prosperity-driven boom going on in the developing world as hundreds of millions of people in China, India and Southeast Asia start to move up the economic ladder. This will lead to a boom in commodities and food, as people want more infrastructure, more basic consumer goods and a more varied diet, commensurate with their sense of increasing prosperity. I see the price of commodities rising, and many analysts refer to historic 13-17 year upswing cycles in commodity prices, with 2008 being about year 7 of the current upswing.

And as a further "meanwhile", transportation and industrial infrastructure in the developed world is reaching a renewal point in its life cycle. Increasing frequencies of pipeline leaks, bridge collapses and major refinery revamp projects are indicators of a growing need to reinvest in what we already have. These corrective measures are far from glamorous, but they are necessary and society will support them.

So we should see a declining demand, and declining market valuations, in housing and consumer discretionary spending, at the same time as the price of energy, food and basic material commodities continues to rise.

This will reveal some weaknesses in the way that inflation is reported, since the average will consist of more disparate elements than before. The old analogy of the guy with his head in the oven and feet in the freezer comes to mind. On average, he's comfortable. But in reality he won't be comfortable at all, as the value of his house drops while his utility bills rise.

The prudent investor will have no consumer-related debt. She will invest in firms whose prospects relate to discretionary spending abroad and non-discretionary spending at home.

There is a lot of fear in the markets these days, and people underestimate the mass and inertia of the world economy, just as they overestimate the sensitivity of the global climate to rising CO2 levels (but I digress). People still eat, shave, get to work and enjoy the basic comforts of civilized life. These pleasant habits will go away only if western society is overthrown, not when the economy and the stock market go through their periodic spasms. Call me naive, but I don't see civilization as we know it ending any time soon.

This too shall pass...

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