My view has not changed that the risk this week for the market is to the downside. I wanted to take a step back and look at the bigger picture this morning.
The economy has a cyclical head of steam led by improved consumer confidence and strong cash flow by corporations. Generally, it would be too early to look for a turn less than two years into a cyclical recovery. However, many of the imbalances of the last recovery were swept under the rug instead of being dealt with during the last recession. As such there is a greater than average chance that one of these imbalances might come back to haunt us and derail the recovery.
I believe that inflation is the greatest threat to the recovery, as governments seem inclined to paper all of the other imbalances. Food prices are rising, oil prices are rising, prices of goods coming from China and other emerging market countries are rising and we are still early in the recovery. In a finance driven economy much higher interest rates would be a death knell.
While a lot of lip service is being paid to inflation, very little action is being taken as policy makers hope it just goes away. Emerging market countries are talking tough and making symbolic moves. However, they are insisting that their currency not appreciate against the dollar. They simply cannot have it both ways. They can either fight inflation or stay pegged to the dollar and the 0% interest rate it carries, but not both. Europe is talking tough against inflation but at the same time is conducting infinite bailouts of countries and banks. How can they tighten money and conduct bailouts at the same time?
Ben Bernanke is taking the most creative approach, the ostrich approach. He is denying that there is any inflation and still fighting deflation. My understanding of economics is that when interest rates are being held too low that inflation only worsens yet that is the approach being taken by most central banks around the world.
This does not mean that the bull market is over. This problem can stay under the rug or can come out at any time. The housing bubble persisted for years before becoming a problem yet still managed to surprise everybody. The key is to not be a die hard bull or bear but to realize this risk and be prepared for all outcomes.