Inflation Not The Problem

Investment Manager's Letter August 2008

Last month I, as investment manager, wrote about the possibility that we are facing a prolonged deep world wide recession. Since then I have run across the article "Inflation Not The Problem".

You can read the article at

During the last month several events have occurred that tend to support the argument put forward by Edwards and Montier (authors article "Inflation Not The Problem").

  • The oil price has broken (along with other commodities), an event that Mr. Market seems to think is good news, but if Edwards and Montier are correct should more properly be considered bad news.
  • The Dollar has rallied strongly though out the month. This will serve to slow Manufacturing activity in this country and liquidity around the World.
  • Estimates of total write-offs from credit crunch have gone up from $500 billion to between $1.0-$1.5 trillion (yes that’s with at). This is going to create a lot of rubble on the balance sheets of our largest financial institutions.

The strongest argument in support the view of Edwards and Montier is that the generals always fight the last war. Since the last big battle was inflation that is what most people are worried about, and this concern will make central banks slow to respond to the threat of deflation. Latest News flash from the WSJ is that Jeremy Grantham says emerging markets and commodities should be avoided for the next year or two:

"we have done an about-face and lowered our weightings in emerging equities to neutral or just below."

Mr. Grantham wrote that recent months have made him even more pessimistic than before about the challenges facing the global economy, which he says are dire. Mr. Grantham also said he was too quick to accept the premise that China will be able to manage its rapid growth without a stumble. All together, it is bad news for emerging markets.

"I now realize that in an unexpectedly bad global economy, the combination of rising inflation, commodity dependence, and particularly high export ratios leave them more vulnerable than I had thought," he said.

Western Refining

Western Refining returns have been crushed this year by record high crude oil prices and declining demand for gasoline. According to the EIA the refinery margin for gasoline in May 2008 was 10%. Compare that to 27.9% for May 2007 and 21.9% for May 2006. The price of oil rose more than 100% during the past year, but gasoline is up less than 50%, with refiners absorbing the difference in the form of lower margins. The addition of ethanol into the fuel supply has contributed to weak gasoline margins.

With the weak margins this summer, with summer driving season just about over: and with the $1.5 billion in debt from the Giant acquisition Western could be in for a rough winter, so we have exited the position.

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