"From Our President.... The Economy, Deflation or Inflation?"

On July 8th, the Federal Reserve reported that the level of seasonally adjusted outstanding U.S. Consumer Credit decreased during May by $9.1 billion, representing a rate of credit contraction of 4.5%. Although even this change is above the average for the preceding 12 months, it is much smaller than a quiet revision to the previously published April U.S. Consumer Credit figure -$14.9 Billion (a 7.3% contraction rate.)

Consumer credit has now contracted in 15 of the past 16 reported months, and is down a record total $148 billion over that time span. The $14.9 billion in credit "lost" during just April is the second highest amount in history, second only to the $34.4 billion "lost" during November, 2009.

On July 12th, Federal Reserve Chairman Bernard Bernanke noted "that small businesses were not getting the loans they need to create new jobs." You would think he just woke up from a "Rip van Winkle" sleep.

The New York Times reported Mr. Bernanke wondered: "How much of this reduction has been driven by weaker demand for loans from small businesses, how much by a deterioration in the financial condition of small businesses during the economic downturn, and how much by restricted credit availability?" Maybe Mr. Bernanke should also ask how much the small businesses have been hurt by the bureaucratic policies coming from Congress and the White House.

The Senate passed the new Financial Regulatory Reform Bill, which if it does nothing else, will create new rules for Registered Investment Advisors and Broker-Dealers to follow. This will increase the cost of compliance forcing many small broker-dealers out of business. The bill did not address any of the problems with Fannie Mae and Freddie Mac (two of the companies who caused the problem in the first place). We have now added more regulations and no one to enforce them. Regulations do no good if the people doing the regulating are (a) improperly trained, (b) overburdened and (c) unknowledgeable in the workings of Wall Street. The problems with Wall Street are not with the regulations, but with the regulators.

In addition, the bill is expected to make credit harder to obtain. Congress has put a terrible burden on the small entrepreneur. Small business accounts for more than 60% of the new jobs and this bill will make it more difficult for small businesses to obtain funding to hire employees.

It appears that deflation is winning over inflation. The economy is slowing and the stock market is showing concerns with its increase in volatility and a large second quarter correction. For the quarter ending 6/30/2010, the S&P was down -11.9% and -7.6% for the year. The Dow was down -10% for the quarter and -6.3% for the year. The problem is that governments have few options left to deal with deflation.

Markets do not like uncertainty. The environment is filled with uncertainty; uncertainty with employment, the economy, two wars, massive debt, health care, cap and trade and more. All of these things are weighing on employers and employees and are causing indecision.

Commodity prices are falling. The U.S. Dollar has strengthened as the European credit crisis continues hurting U.S. exports. We would not be surprised to see yields in the long bond to fall in the short term.

David Rosenberg has provided a long term history of deflation vs. inflation. It seems that "looking over the past three centuries we have 92 years of war and prices rose at an average annual rate of 6%. When we are not at war, prices typically decline at a 1.2% pace." I have no idea why we are now getting deflation when we are fighting two wars, except for the contraction in global credit.

According to Rosenberg, the world is "awash with $222.5 trillion of total liabilities spread across public and private sector claims, or the equivalent of 362% of global GDP. Extinguishing this debt will be deflationary. We are still in the early stages of the deleveraging cycle. The governments of the world have succeeded in switching private sector debt to public sector debt. The amount of debt however is still excessive.

At the Commonwealth Group, we are always conservative in our approach to investing. There are opportunities to take advantage of inefficiencies in various markets at this time. Safety of your portfolio assets and income at a reasonable price works because yield works in a deflationary cycle. We encourage clients to rebalance portfolios to take advantage of this opportunity.

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