Egypt and the growing problem of global inflation

February 1, 2011: 11:08 AM ET

When prices rise faster than economic growth, the outcome is damaging for any population, but especially for a young one like Egypt's. Unfortunately, there are worrying signs that stagflation is spreading around the world.

By Keith R. McCullough, Hedgeye

Suffocating your citizenry with stagflation is a problem, particularly when that citizenry is young, hungry, and unemployed. By definition this is the Egypt we're seeing today. While this may be a very old country (established in 3100 BC), this 21st century social revolution is being driven by the very young. Almost two-thirds of Egyptians are under the age of 30, and of the 79 million people who live in Egypt, approximately 40% of them live on less than $2 a day.

The Egyptian government has been telling its people that inflation is currently running around +12%. The people of Egypt obviously don't believe that -- and they shouldn't. However, they do believe that the country is running double-digit unemployment. They don't have jobs.

Captains of Keynesian economics don't use the word 'stagflation' very much for a reason. The last time these bubble-makers plugged the world with stagflation was in the mid-to-late 1970s. That's when US Federal Reserve Chairman Arthur Burns was attempting to monetize America's debt as President Jimmy Carter bet that it would not create any globally interconnected risk. Sound familiar?

We call it stagflation when real-world inflation readings are growing faster than economic growth. Even if we were lemmings enough to believe the Egyptian government on a +12% inflation number, that would be plenty enough to justify calling this situation for what it is. Egyptian GDP is only running +5% at this stage of what the thinkers in Davos, Switzerland last week would have you believe is an "emerging market boom." It's sad.

It's time to recognize what America's debauchery of the US Dollar is doing to global inflation. If US monetary policy makers are still in the camp of the willfully blind and want to believe there's no real-world inflation out there because Ben Bernanke's conflicted and compromised calculation of CPI says so, Godspeed having the world agree with them on that.

And for all of those who are still out there cheering this on because it's good for the inflation in our portfolios, here's some global starvation math we can't hide from – immediate-term inverse correlations between the US Dollar Index and three major global food prices:

  1. Corn = -0.91
  2. Rice = -0.90
  3. Wheat = -0.85

Those are extremely high (and alarming) correlations. So the next time someone tells you that the US Dollar and the policy that backs it doesn't matter to the price of the Number One food staple for 3 billion of the world's people (rice), forward them the math. Risk managers like me wouldn't be perpetuating higher food prices by trading them with a bullish bias if we didn't fully expect American policy makers to let its currency burn.

The US Dollar Index is down for 4 out of the last 5 weeks and down almost 4% since the first week of January. Chaos theorists don't have to look very far to find that incremental grain of sand that tipped the Egyptian pyramid of risk into turmoil. This is what you get when you debauch the world's reserve currency. Global Inflation is a policy – and it's priced in US Dollars.

Inflation kills emerging markets. Inflation kills bond markets. These are historical facts and they are also reflected in last week's bearish price action in emerging markets:

  1. Egypt = down 15.7%
  2. Chile = down 4.2%
  3. Turkey = down 4.1%
  4. Brazil = down 3.5%
  5. India = down 3.2%
  6. Thailand = down 2.5%

We've been writing about how Chinese growth is slowing as inflation accelerates for the last few months as well. Chinese equities, down 2% so far this year, are now outperforming 15 other country equity markets, including all of the ones on this list. Inflation's contagion is broadening its base.

Stagflation doesn't just stop when a politician tells it to. Stagflation is sticky. Since Bernanke opted for a second round of quantitative easing, the 19-commodity component CRB Commodities Index has inflated by +27%.

While that may be up less than what US stock market volatility (VIX) is up in the last 2 weeks (+29%), that's still up a lot – and we think that both globally interconnected markets and the people living in this world outside of Washington, DC have noticed.

Since the beginning of 2011, I have not been bullish on stocks or bonds in general, which is why I have such a large asset allocation to cash. Last week, I raised my cash position to 67% versus 61% at the end of the week prior. I've sold all of our oil and German equity exposures (and there are no rules against buying them back).

The updated Hedgeye Asset Allocation Model is as follows:

  1. Cash 67%
  2. International Currencies 21%
  3. US Equities 6%
  4. Bonds 6%
  5. Commodities 0%
  6. International Equities 0%

Again, this isn't an asset allocation model for a fund mandated to be fully invested. This is where I'd be positioned as an individual or family who has made positive absolute returns in all of the last three years. We'll have plenty of opportunities in the coming weeks and months to buy things on sale.

Inflation in emerging markets

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Hedgeye

Hedgeye, a real-time investment research firm founded in 2008 by former Carlyle-Blue Wave portfolio manager Keith McCullough, operates as a virtual hedge fund. Staffed by research analysts from across Wall Street, Hedgeye offers fundamental, macro and sector analysis, present picks in a transparent way to its clients. It has built a stable of subscribers, which includes hedge funds and mutual funds, and recently launched a retail investor product.

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