The Inflation Cycle of 2002 to 2015 - Uhlmann Price Securities

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Industrial Portfolio Strategy The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -20- Legg Mason Wood Walker, Inc. We believe inflation cycles are more regular and pronounced when viewed through the lens of longterm history. In Exhibit 14, we show the 10-year moving average of consumer price inflation, with our forecast for the 2002 to 2015 period. The trough years for the inflation index cycles were 1901, 1933, 1963 and, we believe, 2001. Bonds are usually the first to react to those inflation concerns, and thus far we note that there is little reason for alarm. For example, Treasury Inflation-Protected Securities (TIPS) spreads have widened, but no differently than they did in the Spring of 2001 when there was also economic recovery optimism. The fact that so little inflation risk is embedded in market expectations only raises the risk to investors if we are correct about the direction change. Exhibit 14 – U.S. CPI Inflation Cycles, 1880 to 2001, With Our 2002 to 2015 Estimates CPI - Urban Inflation Rate, 10-Yr. Moving Average 10% 8% 6% 4% 2% 0% -2% -4% Periods of commodity inflation have similar implications for consumer inflation, as well as the stock market via compression of valuation and profit margins. 1901 1933 CPI Inflation Cycles 1880 1885 1890 1895 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005E 2010E 2015E 1963 CPI Urban Inflation Rate, 10-Yr. Moving Average 2001 2002 to 2015 LMWW Ests. Repeat of the Cycle? Source: U.S. Department of Commerce, U.S. Bureau of the Census, Standard and Poor’s Corp., Legg Mason estimates for 2002 to For investors with a long-term horizon, acknowledging the inflation cycle enables them to position portfolios by better understanding the real return cycles of the inflating and deflating assets. In Exhibit 15, we show the 10-year moving average of the real (after consumer inflation) price return of the U.S. stock market composite for the 1880 to 2015E period. We note the way in which the real price return of stocks fluctuates around 0% plus-or-minus 10%. After a fairly normal retrace from negative-to-positive returns in the 1982 to 2000 period, we believe the recent market break foreshadows a period of declining real returns, with the greatest adversity felt later in the 2002 to 2015 period.
Industrial Portfolio Strategy The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -21- Legg Mason Wood Walker, Inc. Exhibit 15 – Stock Returns Minus Inflation, 1880 to 2001, with our 2002 to 2015 Estimates Stock Price Return Minus CPI Inflation, 10-Year M.A. 15% 10% 5% 0% -5% -10% -15% CPI inflation cycles shown in boxes. Note that stocks follow a +/- 10% real return track. 1880 1885 1890 1895 1900 1905 1910 1915 1920 1925 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005E 2010E 2015E S&P Stock Composite Return Minus Consumer Inflation 10-yr. Moving Average 2002 to 2015 LMWW Ests. Source: U.S. Department of Commerce, U.S. Bureau of the Census, Standard & Poor’s Corp., Legg Mason estimates for 2002 to 2015 Although we have stated that war and inflation are linked, we observe that rapid money supply growth typically has begun several years before wars. In Exhibit 16, we walk through the quantitative side of the macro-history of U.S. inflation and stock market cycles, and demonstrate the effect each has on the stock market. The chart pairs are displayed as follows: Each of the chart pairs in Exhibit 16 is centered on the trough year for the inflation cycle previously identified as 1901, 1933, 1963 and, we believe, 2001. For each of those years, we show the inflation-adjusted U.S. stock market index versus M2 money supply growth (left chart) and versus the U.S. consumer price inflation index (right chart), in the 12 years before and after the inflation cycle trough year. Each point is a 12-month average. The charts show the way in which, approximately every one-third of a century, (1) M2 rises, (2) stocks rise, (3) inflation rises, (4) stocks go flat in real terms, and (5) war in one form or another ensues. Not shown in the charts, but discussed later in this report, is the fact that there often has been a deterioration of the velocity of M2 (rearranged as M2 divided by real GDP or GNP in our analysis). Regardless of the “New Era” thinking of the time, or the transitory effects of liquidity preferences, we believe that money supply growth is at the core of inflation cycles. Later in this report we discuss recent trends in M2, real U.S. GDP and CPI inflation growth.
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The Inflation Cycle of 2002 to 2015 - Uhlmann Price Securities

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