Inflationary Expectations

Shelter from the Rain

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Inflationary Expectations

While inflationary expectations pervade, deflationary forces are still at work in the United States. The housing bubble, particularly evident in the "Sand States" of California, Nevada, Arizona, and Florida, has driven housing price decline of as much as 50%. In some areas, home values have declined to below replacement cost. Foreclosures have soared, and families as well as businesses have been disrupted and dislocated due the resulting huge loss of capital.

The housing correction has had consequences beyond just home values. As the values for homes have declined, many related factors have been affected. Insurance companies have lowered premiums for Homeowner and Landlord Policy Coverage due to lower labor and materials costs, as well as valuation changes of as much as 50%. As valuation has deteriorated, County Tax Assessors have reassessed properties, and cash starved governments are receiving lower tax revenues, exacerbating the local recession effects; conversely, individuals will benefit from lower real estate taxes. As the economy has cooled and the Federal Reserve aggressively lowered short-term rates to almost zero, intermediate-term rates collapsed, and long-term rates have dropped to historically low levels.

Fixed income investors experienced much lower income, yet consequently, any adjustable rate mortgage that has recently re-set has adjusted downward, resulting in lower monthly mortgage payments; any fixed rate re-finance has also benefited. The long-term rates for 30-year fixed rate mortgages have dropped from 6.5% to mid 5% or upper 4%, and with the base indexes of 1-Year Treasury, MTA, CofF, and LIBOR all under 1%, the typical margin is 2.75%. The new rate for adjusted and re-set loans will be the typical limit down of 2% below last adjustment rates. This brings a huge savings for the consumer and adds to the availability of spendable income.

Along with these savings, the actual cost of home ownership has dropped dramatically. As an example, a home purchased for $400,000 in 2006 can often be found today for $225,000. The monthly loan obligation has dropped from approximately $2800 to an unbelievable $1350; that's over 50% savings! This reduction has also impacted residential rentals, as rental housing prices have followed the correction down. Rental rates never exploded with the bubble excesses of 30-60% price gains, but did enjoy consistent annual increases of 3-5%, loosely tracking the price of housing but lagging by 12-18 months. The recent developments have resulted in a decline in rent revenues, but the decline has been partially offset by the decline in taxes, interest rates, insurances, and material and labor costs. The economy is adjusting.

The deflation of oil prices and the adjustment of housing is a huge stimulus for the economy. The deleveraging of lenders has been underway for 18 months, and the loss of capital has been staggering. The Treasury and the Federal Reserve, along with most of the world's central banks, have committed to a policy of replacing this lost capital and have increased the supply of money. The economy is adjusting; it is recovering! The new cycle is starting from a much lower and much better basis. Many of the excesses have been wrung out of the system.

"The economy is correcting... the economy is adjusting... it is healing..."

Unemployment is a lagging indicator and typically is an issue for 12-18 months after the economy has bottomed and started to recover. Many economists believe that point was reached in the May/June time frame of 2009. Although housing foreclosures will be an issue for the next 12 months and beyond, the brutal correction is working. I fully expect home price stabilization and population growth will bring the "Housing Crisis" to an end by the 4th quarter of 2010. The economy is correcting... the economy is adjusting... it is healing...

A new business cycle, although in its infancy, has begun, and by many accounts, less than 20% of the $13.6 trillion dollars of stimulant is in the system. The surprise to the economy should be the strength of the recovery, as banking system reserves are filled and lenders look for places to lend the extra trillions of dollars earmarked for the system. The new cycle will change concerns from deflation to fears of not 2% or 3%, or even 5% inflation, but pervasive double-digit inflation that will require investments that are different from today.

Just as rain is welcome to a parched and drought stricken region, capital and money supply is welcome and necessary for any economy to function. First the rain is first absorbed by the dusty earth, and then the deep aquifers begin to be replenished. As the rain continues to fall, the shallower wells begin to fill; trees sprout buds; and "green shoots" appear. The rain continues, and the "drought" is termed officially broken. Farmers rejoice and fields are sown with crops. The aquifers are full; the wells are full; the large reservoirs are full. The drought has broken, much as deflation will give way to inflation. The forecast is for more and more rain... Commodities, tangibles, and real estate will give shelter from the "RAIN".


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