While You Watch the Goldman Show, Don't Lose Sight of Inflation

ATMs Inflation higher pricesAs public outrage at Goldman Sachs mounts, Warren Buffett's full-throated support of the investment bank at Berkshire Hathaway's annual shareholder meeting grabbed the headlines. But investors would be wise to look even more closely at another of the Oracle of Omaha's against-the-grain proclamations that got less attention.

As an economic recovery gains steam, "the prospects for significant inflation have increased," Buffet warned. "Not only here, but around the world." And the warning is meaningful beyond Buffett's guru status. With stakes in a broad variety of businesses, Buffett's Berkshire (BRK.A) has greater insight into changing business conditions than most investors could ever hope for.

Buffett is among a minority in voicing concerns about inflation. More than a few money managers, after all, are now envisioning a "Goldilocks" scenario for the economy where profits climb sharply but inflation remains at bay. And most measures of inflation remain tame for the time being, with the Federal Reserve adding last week that inflation expectations weren't a cause of concern and interest rates would remain at rock-bottom levels partially as a result.

"The Magnitude and the Variety of Inflation"

Still, a handful of investors who have been dead on so far about the economic recovery taking shape can't help but grow concerned at the mounting anecdotal evidence of prices spiraling upwards. Jeff Mathews of hedge fund RAM Partners recently pointed to an earnings call by Leggett & Platt (LEG), an engineered component maker with a "uniquely broad view into end-market demand among businesses ranging from bedding to automobiles." Given its perch, "the company has virtual real-time insight into the supply-and-demand characteristics of many industrial commodities," Mathews wrote.

"If there is a difference today, it is the magnitude and the variety of inflation," a Legget & Platt executive said when asked about the changing business landscape. "From our finished bedding and furniture customers' standpoint not only are they getting it from steel but they are seeing it in everything petrochemical-based."

That view is corroborated by steel giant ArcelorMittal, which took to meeting with customers last week to inform them that substantial increases in the price of steel were on the way. Rapidly rising costs in raw materials like iron ore and coal meant the company had to pass the costs on to customers, executives at Arcelor Mittal said.

Raymond James Strategist Jeff Saut painted a similarly compelling picture of a manufacturer passing on rapidly rising input costs to customers weeks ago in a warning about inflation threats.

Less Damaging to Stocks Now?

Mathews and Saut are worth listening to because of their impressive track records. Both were bullish on stocks when most investors had dismissed the prospects of an economic rebound. Another high-profile investor that got the recovery right and is now watching inflation closely is James Paulson of Wells Capital Management.

But while Paulson is confident that higher interest rates are on the way, he's less certain about what the impact will be on stocks. "The bad news for stocks? Interest rates are headed higher," Paulson recently wrote. "The good news for stocks? Rising rates no longer are as damaging to the stock market as they once were."

Paulson points out that much of the impact of rising rates tend to depend on the broader backdrop. At times when interest rates are already high and investors are paranoid about inflationary concerns like during the 1970s, rising rates can clobber stocks. But since 1998, when rates have been low and deflation has been the primary concern during downturns, rising rates have had a more benign impact. As a result "rising yields, especially from such low current levels, may prove less troublesome for stock investors," Paulson wrote.

"Back to What Makes Markets Move"

The magnitude of any inflation will also play a key role in its impact on stocks, among other assets. But the proclamations by Buffett serve as a reminder that investors need to keep an eye on such seemingly mundane developments even as a much more riveting drama unfolds at Goldman Sachs.

"Fun as it has been to weigh in on the Goldman situation," Matthews wrote about the bank's recent exchange with a Senate committee (which he scored in favor of Goldman), "it seems time to get back to what makes markets move."
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