Redefining Masochism

January 1, 2004

Dear Investor:

The most massive fiscal and monetary stimulus in history has revived the economy. The new risk is inflation.

The current state of affairs is the opposite of the stagflation of the 1970’s: enormous global growth paired with moderate inflation—a cure that has bailed out the world from the worst market collapse since the Great Depression. This period is most reminiscent of the period from 1951-1965 when inflation ran at 1.6% and equities returned 16.5% annualized. Fear of inflation will start to simmer, however, as liquidity overshoots and the money supply grows disproportionately.

The number one question for inflation over the next ten years will be China. Until recently, China had acted as a deflationary force, pumping cheap goods onto every consumer market. But as internal growth has fueled China’s own consumption, demand for oil and imported goods is quickly changing the equation. Now China hungers for a Western standard of living. A billion people here and a half billion there, and pretty soon you’re talking real population.

Since China’s deflationary exports and inflationary imports have the potential to net out the real price level, the balance will hinge on productivity. The good news is that productivity growth is enormous right now. It will slow as hiring resumes, but gains in productivity have a long way to run. In our own business, it’s obvious how technology and internet platforms have driven enormous productivity: our prime money management software, Centerpiece, does the same workload that would have required several people years ago. The new “paperless” office is reducing labor requirements in every workplace. Technology is finally being applied in ways that promote unbelievable efficiency. As long as the U.S. and China continue to invest in technology, this miracle will continue. If not, well, that’s another story.

The two greatest economic risks to the world, aside from terrorism, are protectionism and inflation. Fortunately, Bush withdrew his misguided steel tariffs, but the protectionist rhetoric continues on both sides of the aisle. The restriction of trade in any form would be an unmitigated disaster.

The implication for investors is clear: Bond duration must be kept extremely short until 10-year rates climb another 100-200 basis points. Equities don’t look nearly as attractive as they did a year ago, although they still look relatively compelling. And anyone in an adjustable rate mortgage is looking to redefine masochism.