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 -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.
Industrial Portfolio Strategy The Inflation Cycle of 2002 to 2015 ⎯ April 19, 2002 -25- Legg Mason Wood Walker, Inc. Exhibit 17 – Return and Growth Table for Commodities, Stocks and Inflation, 2002 to 2015E 2002 to 2002 to PPI All Commodities Expected Growth, 2002 to 2015E 2015E PPI 2015E PPI Com- Com- Prob- modities modities ability Growth Est. CAGR% Status Quo 15.0% x ( 1.1 )% = ( 0.2 )% Sharply Higher World GDP Growth, Some Warfare 60.0% x 6.1% = 3.6% Major Middle East Conflicts That Disrupt Oil Supply 25.0% x 10.7% = 2.7% Sum or Average 100.0% nmf 6.1% 2002 to 2002 to S&P 500 Expected Price Return, 2002 to 2015E 2015E S&P 2015E S&P Composite Composite Prob- Price Price ability Growth Est. CAGR% Status Quo 15.0% x 11.7% = 1.7% Sharply Higher World GDP Growth, Some Warfare 60.0% x 3.4% = 2.0% Major Middle East War 25.0% x 2.6% = 0.7% Sum or Average 100.0% nmf 4.4% 2002 to 2002 to U.S. Consumer Price Inflation, 2002 to 2015E 2015E CPI 2015E CPI Urban Urban Prob- Inflation Inflation ability Growth Est. CAGR% Status Quo 15.0% x 1.0% = 0.2% Sharply Higher World GDP Growth, Some Warfare 60.0% x 5.0% = 3.0% Major Middle East War 25.0% x 9.0% = 2.2% Sum or Average 100.0% nmf 5.4% Source: Legg Mason estimates and format
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The Inflation Cycle of 2002 to 2015 - Uhlmann Price Securities

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