The Inflation Cycle of 2002 to 2015 - Uhlmann Price Securities

Industrial Portfolio Strategy
The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -24- Legg Mason Wood Walker, Inc.
The Structure of This Report
This report is constructed as a probability array of expected values, based on what we believe are the
three most plausible 2002 to 2015 outcomes; we use historical precedent as the “effect,” and our objective
assessment of the facts presented in the remainder of this report as the “cause.” For a long period
such as 2002 to 2015, we would expect some combination of the often mutually exclusive events we
cite, so a probability-weighted analysis seems the best approach, in our view. The scenarios we describe are
as follows.
Scenario (1) Continued deflation and a continuation of the western-dominated status quo, to include
the (technology) capital spending boom and sustained, double-digit U.S. equity bull market returns in
the 2002 to 2015 period. (Probability 15%)
Scenario (2) Rapid developing country modernization, combined with synchronous G-7 economic recovery,
leading to a sustained boom in commodity demand relative to more inelastic supply. There is
the potential for Persian Gulf conflict that may periodically constrict supply, further tilting the supply/
demand equation in favor of commodity inflation in the 2002 to 2015 period. (Probability 60%)
Scenario (3) Middle East war(s) that result in large oil supply disruptions. Because major wars produce
high inflation and low real stock price gains, and even minor wars can interrupt trade, we devote a
section of this report to analyzing the potential for conflict in the Persian Gulf. (Probability 25%)
As a result of this probability matrix, for the period 2002 to 2015, we see the PPI All Commodities as
outpacing the price return of the broad U.S. stock market (S&P 500) index, and we expect gradually
rising CPI inflation. As Exhibit 17 shows, we expect the following:
• 6.1% CAGR for the PPI commodities (back-half higher),
• 4.4% price only CAGR for the U.S. stock market (front-half higher),
• 5.4% CAGR for consumer price inflation (back-half higher), and
• CPI-urban inflation cresting at a rate of almost 8% late in the 2002 to 2015 period.
This is not a forecast for specific years, in which leadership may alternate from one year to the next, but
rather, it is a full-cycle view meant to position long-term investors, as well as guide short-term investors
who may employ a trading discipline. History and probability assessments based on current events are imperfect
as forecasting tools, but using the tools to the best of our ability is our purpose as an analyst. Our
report concludes that Caterpillar, Deere, and Joy Global would be beneficiaries of the environment
we foresee to 2015, which is a marked change from the environment of the last two decades.