Inflation fears may keep dogging markets, but gold’s drop is a ray of hope. Gordon Fowler Jr. is CIO of Glenmede Trust Company, an independent wealth advisory based in Philadelphia.

Summary The market suffered a terrible week as investors extrapolated their fears about higher inflation and interest rates into lower economic and earnings growth forecasts. Ben Bernanke, the new federalreserve.gov/ Federal Reserve chairman, seems to be an advocate of more lucid speaking and decision-making style than his predecessor. Adjusting to this new style may be contributing to the market’s angst. While resolving the inflation issue may take some time, the recent drop in gold prices by over 20% does seem to indicate that the Fed’s more hawkish tone is having an impact on investor’s inflation expectations. This may be the golden lining to the market’s recent volatility.

Review and outlook

We’re in the fifth month of Ben Bernanke’s term. The new Fed chairman has been hard at work telling the markets what he is thinking. Unfortunately, the more he tries to be clear and transparent, the more the market declines. In the process, he has managed to do what Alan Greenspan managed to avoid during his entire tenure – making himself the “issue” for the markets.

The “issue” though is really inflation. The market is obsessed with how big the current spurt of inflation is and how long it will last. It is quite possible that we won’t hear a lot of good news on the inflation front for some time. Inflationary pressures are already out, and it will take time to work them through the system. Inflation, however, is something that can be controlled by the Fed. As the market continues to be battered, there is at least one early indictor of the central bank’s success in controlling inflation – the price of gold has dropped by about 20% since its high on 12 May.

As measured by the S&P 500, the stock market dropped by 2.8% last week. No sector of the market was spared. Energy and materials posted the biggest declines, both falling by over 6%. Small-capitalization stocks, as measured by the Russell 2000, took even more of a hit, declining by 4.9%. International equities, thanks to a strengthening dollar, fell by 5.8%.

As the market has declined, much of the ire of traders has been focused on Bernanke. This is somewhat unfair. Greenspan’s retirement coincided with the end of a period of fairly predictable monetary policy. Not long after the beginning of Bernanke’s tenure, some of the most stable measures of inflation began to perk up. It is also true, however, that the new chairman’s communication style is different from his predecessor’s. That’s giving the markets some concern. Oddly, the market’s problem with Bernanke may be that he speaks too plainly.

End of a game show

If you’ve read surveys and books on what people want from their leaders, you know that clarity often comes at the top of the list. “Tell us what you are thinking and what you expect from us” is a common request. Interestingly, while clarity might work for football and basketball coaches, it may be a detriment to leaders in other professions.

Commentators rarely used the words “clear and concise” to describe Alan Greenspan’s testimonies. Opaque would probably be a better description. In fact, if you put the words “Greenspan” and “opaque” in a Google Search you will get over 50,000 hits. A combination of “Greenspan” and “clear and concise” gets only 774 hits. Chairman Greenspan’s speeches tended to wander in and around a wide range of subject matter. These rambling, intellectual journeys could be fascinating to listen to but, to the untrained ear, they could be incredibly murky. At one point, a game show sponsored by Motley Fool radio was entitled “What did the Fed Chief Say?” in which callers could win prizes by deciphering some of the Chairman’s public testimony.

An opaque speaking style may not be helpful, but by covering every dimension of an issue, it can subtly say to the audience, “I am listening to you.” At the end of the day, most of a leader’s audience may want to know that they are being heard more than, perhaps, what the leader really thinks. In the case of the financial markets, Greenspan was a master of incorporating every view of the economy into his perspective. This technique allowed different individuals -- investors, politicians, strategists and economists -- to feel comfortable that while there may be some uncertainties in the markets, the Chairman, at the very least, knew and understood their view of the state of affairs. Of course, a Chairman who understands “their view” implicitly will have the key to alleviating any problems.

Bernanke starts with a somewhat different premise. He seems to want you to know not only current policy but exactly what he and his fellow members of the Fed’s board of governors are thinking at any given point in time. There is an implication that he would like you to know not only the results of their deliberations but the thought process behind their decisions. In some ways this may be more unsettling to the market than the fog and mist that would surround a Greenspan-era pronouncement. Traders can now more easily decide whether the Fed is proceeding on the “right” course with the “right” logic. Since there is no real consensus on the “right” course or logic, this may leave the market more concerned and nervous than when the Fed was less definitive. (In an alternative viewpoint the markets reactions to missteps by the Fed provides valuable feedback to policy makers. For example, when Bernanke sounded too dovish on inflation in his April testimony, the bond market became skittish and sent him quick feedback that further tightening was needed to quell inflation expectations.)

Golden lining

There is very little fog and mist surrounding the Fed’s current view. They want you to know that they are worried about inflation and that they are on the case, even if that means raising interest rates to very painful levels.

In the short run, there isn’t much they can do about inflation. The statistics on inflation measure a countless number of individual decisions. Changing the direction of those decisions takes time. There is a place, however, where change can be more rapid: investor’s inflation expectations. Here gold serves are a marvelous barometer of sentiment about price and currency stability. And as it happens, this barometer seems to have some good news for us. Since 12 May, when the price of gold peaked at $715 an ounce, it has fallen by over 20%. This is approximately the date when the Government announced worse-than-expected core inflation numbers. Since then, the markets began to assume that the Fed would have to get tougher on inflation. Bernanke and his cohorts obliged by becoming increasingly hawkish about inflation in their speeches.

That said, many people view gold-price movements as a measure of worldwide political instability rather than a gauge of price and currency stability. The chart below is a nice example of why the movement in prices over the past few years has more to do with economics than politics. The recent change in direction coincides with a change in economic policy. To the best of my knowledge, the world has not become a much more stable and secure place over the last month.

|image1| It may take time for the markets to focus once again on earnings and the prospects for further economic growth. There is, though, the possibility that we may be able to see a glimmer – a flicker at least – of golden light at the end of the tunnel. –FWR

Review and outlook is intended to be an unconstrained review of issues, topics and considerations of possible interest to Glenmede's clients and is not intended to be applicable to any one particular client. Actual investment decisions for particular clients are made in light of applicable considerations and may be different from the views expressed here. Likewise, actual portfolio performance may differ from the results discussed.

.