Wave at SunsetAs I reflect on a year dominated by travel designed to unveil whether or not our strategies were properly thought out, I am struck by an overwhelming feeling of thankfulness for the continued opportunity to serve my family, our clients, and community. Nearly a year ago (click for article) I stated that the period that we are moving through may give the appearance that any strategy may be unsound. Fortunately, our attention to historical precedent has kept us well positioned for the reality of these days. Thanks to each of you for your continued willingness to adhere to the course that we have charted and confidence in our navigation of it. Based on historical evidence, we are certain that your confidence is well placed.

The price of a complete Thanksgiving Turkey dinner this year was approximately 13% more than last year. Inflation is rising, and most of us see it in many places regardless of what official measures report. The following chart is courtesy of via the folks at American Business Analytics & Research LLC. The data compares inflation measures of the historical (blue) method versus the newer (red) ‘adjusted’ methods that began in 1980.

Annual Consumer Inflation CPI vs SGS Alternate

In short, using the same methods that detailed heavy inflation from 1977 through 1981 where USA residents saw purchasing power decline cumulatively in excess of 50%, the chart above indicates the return of similar inflation rates.

Other than investments in gold and silver bullion, the markets have not yet rewarded those who have prepared for this sort of an environment. Historically speaking, segments in mining, energy production, farming and other commodity related areas tend to perform well. This can be attributed to the intrinsic value creation met through these segments by providing for the core needs of humanity – people require food and energy just to live and are willing to pay for it regardless of inflating costs. Thus the value inherent in companies within these segments generally appreciates along with, or above, the rate of inflation.

Currently, economic difficulties – punctuated by inflation – are generally ignored and companies representing the abovementioned segments have meandered, and even declined, in market value for the past few years. Notable examples are gold and silver mining companies. They are available at remarkably inexpensive cash flow multiples that were only last seen during the beginning of the great depression as well as in the early 1970s. If prices of these companies remain muted, mergers and/or stock repurchases should not be far behind. This is because the cash piling up within companies will be put to productive work rather than left exposed to the ravages of inflation. Whatever the eventual result it is clear that at this time people have expectations different from what is actually happening. Many that I have spoken to in various industries will not fully acknowledge the current difficult state of affairs. As I wrote in June, “People desire normalcy so intensely that they frequently attempt to disregard knowledge that is disruptive to their expectations of reality”.

This brings us to another major trend tracked by our firm: Regionalization. According to Chinese monetary authorities, about 0.7% of China’s total trade was conducted and settled in Yuan during 2010. This year it is already in excess of 9%. This is an incredible change – one completely unexpected by the ‘experts’. It shows that the Chinese are completely capable of transacting more than 50% of their trade via Yuan by 2014 or 2015. Additionally, China is overtly working with the ASEAN (Association of Southeast Asian Nations [click for an article with additional background]) to more rapidly pursue this effort. Early indications, such as regional unemployment rates in the 3% to 5% range – less than half that of westernized countries – indicate early success in differentiating their experience from the rest of the planet. Further, this week Hang Seng Bank Executive Director Andrew Fung said;

“It is good to enhance the size of the currency swap to facilitate more cross-border trade settlement though local authorized financial institutions will be less prone to use the currency swap line unless liquidity dries up suddenly due to some economic crisis.”

What this complex sentence translates to is that China is not only enabling broader use of the Yuan in trade, but that they are now publically preparing for another round of the global solvency crisis by making liquidity available to help the orderly processing of Yuan settled business in their region. They previously relied on the Federal Reserve with its dollars to assist in this area – no longer. Having less dependence on the US Dollar to transact business and US monetary policy for managing inflation, unemployment and crises will be detrimental to the future importance of the dollar as a reserve currency. This is a distinguishing characteristic. While Asia is looking to insulate itself, much of the rest of the world is speaking about how there should be even more economic connectedness.

This is in spite of the growing stress fractures in our current form of pseudo-capitalism. According to Federal Reserve Board Chairman Bernanke in December 2010, inflation is 100% controllable. It has not been (see chart above). According to Treasury Secretary Geithner in August, USA debt would never lose its AAA rating. The USA average rating is no longer AAA. The so-called congressional super committee was supposed to agree to tangible (as opposed to accounting gimmickry) cuts in return for yet another increase in the debt ceiling. Well, the debt ceiling was raised yet again back in August but no tangible budget cuts resulted from the super committee. And just as Lehman Brothers was not ‘supposed’ to fail, derivatives broker-dealer MF Global imploded a few weeks back leaving individuals with at least $1,200,000,000 in missing funds. The CME, an exchange that is supposed to ensure that companies such as MF Global play by the rules – such as not absconding with client monies – has promised a paltry $300,000,000 to backstop the shortfall. This from a company who’s Executive Chairman, Terence Duffy stated last year,

“Since we are the guarantor of every transaction that happens in our markets, we have to guarantee the performance of each and every one of these contract [etc. . . .] To do this, we hold more than $100 billion of collateral to support the transactions that are being done on our markets.”

Apparently when losses are actually incurred, this stated ’guarantee’ no longer applies. All of these stresses are summing to a fracture in confidence across the breadth of the westernized economic system.

Finally, we note that our European brethren are not fairing much better. They too are experiencing high unemployment rates, maximized debt burdens, inflation in food and energy, and an inability to affect change through monetary intervention. Some observe that they are actually worse off. Many countries have seen their credit downgraded. Just this past week, Germany – the strongest rated country of the bunch – was unable to complete a bond financing to its satisfaction. What does it say when the standard bearer for a region cannot raise capital at will? To add insult to injury this week also saw the European Financial Stability Facility fall below the important AAA rating level. Yes, the region seems to be in full blown disarray. For awhile these past few weeks, the Euro increased in value against even the US Dollar. While this did happen, it was not a positive sign. The strength is at least partially explained by the wholesale liquidation of European owned assets. As those assets are sold to raise capital and increase perceived strength in banks, companies, and individual balance sheets, the proceeds generally flow into Euro denominated deposits – which puts a temporary upward pressure on the currency. Once the liquidations ebb, then the Euro is likely to resume its decline. This process is also likely in store for the US Dollar when the USA hits its limits – which will one day happen.

Our previous hope that the USA and Europe could muddle through the current environment is now but a distant recollection. Inflation measures are traditional leading indicators of difficult times. Thus our investment perspective now requires, rather than merely supports, exposure to the segments mentioned near the beginning of this article. Their value will eventually show through as people’s expectations of reality come to change to the current set of circumstances. Unusually, if Asian entities such as China and ASEAN are able to withstand the economic contagion enveloping the West, these segments may do even better as real incremental demand adds to inflationary pressures.