The stock market continued to climb this quarter without any significant pullbacks, the Dow moving from 11,891 to 12,810 over the past three months, which is a three-year high. Corporate earnings have fueled the market, with over 80% of reporting companies exceeding analyst expectations. The Dow has moved up 3.6% since earnings season started last month. Most of the major news items this quarter did not have any effect on stock prices; the earthquake in Japan only affected the market for about three days, and the effect of the death of Osama Bin Laden was minimal on markets, although great news in the fight against terrorism. However, the balance between improving economic conditions and the coming inflationary environment was the main catalyst for market behavior, with investors giving more weight to the improving conditions and for now ignoring the inflationary clouds on the horizon. The market usually climbs a wall of worry – smooth upwards momentum is definitely the exception, not the rule, and things have been exceptionally calm over the past several months. Moving into the summer quarter, I would expect a more volatile market as this tussle between a recovering world economy and impending global inflation plays out.

Much of the record profit levels of U.S. corporations can be attributed to the lag between the extreme cost cutting that went on during the recession and the current need to hire more workers – a sweet spot for corporations that is not sustainable but allows them to shine at the present time. While unemployment rates have been dropping, full employment is still not predicted until late 2013 at the earliest. In spite of this, consumer confidence (and spending) are back to pre-recession levels, although real estate is still slumping and not really expected to heat up until we do get to the full employment level in late 2013. So, while many components of the economy are on a fairly defined path of recovery or anticipated recovery, the longer-term issues of debt and inflation are less well-defined in terms of when and how bad they will affect economic conditions.

Inflation has been a tame beast for many years, mostly because for the last twenty years there was a huge increase in cheap global labor supply (China). However, with the higher output, rising living standards and investment in modern infrastructure in Asian labor markets, Asia has pulled closer to developed economy levels and the free ride that first world economies have enjoyed with low inflation is rapidly becoming a thing of the past. Prices for everything coming out of Asia are going to rise as China now has the economic size and clout to raise prices more in line with first world labor. Think about how Japan used to be known for plentiful, inexpensive products. Now think of a country ten times the size of Japan in the same situation Japan was in thirty years ago. China is expected to be the world`s biggest economy by 2020, and when you combine their rising price pressures with the incredible stimulus that all first world countries injected into their economies to keep the world from a global depression – you have a double dose of inflationary pressure that world governments will very soon need to address.

Many economists predict that Europe, led by England, will start to fight inflation first in the form of higher interest rates and tighter credit as early as late this year, and that the U.S. will follow suit early in 2012. Gas costs are up 36% over the past year, food prices and commodities are on the rise, and at this point it really is not a question of whether we will have some inflation, but how much and will it be serious enough to derail economic recovery. The issue is much more prevalent in Europe, their debt issues are much worse, their economies more fragile. England in particular is the canary in the coal mine – so it will be interesting to watch how their central government handles the issue of curbing inflation without snuffing out their delicate economy. Here in the U.S. the Fed`s monetary injection program (QE2) will end next month, creating a temporary lull in the economy – but will be the final step in completely removing all stimulus from the economy. From there the next actions will be tapping the brakes rather than the gas – but at least we will be able to see the cars (Europe, China) in front of us tapping their brakes first (to continue the analogy).

Debt is a longer-term, more insidious problem that cannot really be addressed by monetary policy. Governments really have only two choices when it comes to reducing debt – raise taxes or cut entitlements. In the U.S., Republicans don`t want to see higher taxes, and Democrats don`t want to see any entitlements cut. And so the stalemate continues even while the debt load piles higher and higher. In late April, Standard and Poor`s credit rating agency put a “negative credit watch” on U.S. government debt – meaning that they were reviewing whether U.S. debt still warranted the world`s only AAA rating for government debt. While this is likely only an attempt to put some much needed attention on the entire world`s growing debt problem, it is an issue that will not go away without politicians making some hard choices – something they aren`t exactly well known for doing. Obviously, European debt load is far worse than the U.S., mostly because of higher levels of entitlements to its citizens. Even raising the topic of reducing entitlements in Europe has been enough to cause riots. It is speculated that Greece may be forced into restructuring its sovereign debt as early as next month, which could easily destabilize other European debt in countries in similar dire straits – namely Ireland, Portugal, and Spain. Once a sovereign nation`s ability to repay its debts is in question, the trust of the credit system breaks down – and, as we have seen in recent history, the results are not pretty. But while the U.S. is far removed from the problems that Greece faces today, there is no question that, without significant change, we are headed down the same path. We may get lucky and defer resolving the issue to the next generation – but our unavoidable issue over the next ten years is investing in an inflationary environment and ceding economic power to China.

As I`ve said before, the way to prepare for an inflationary environment is to avoid fixed income investments and invest in hard assets – namely real estate, stocks that deal with commodities and energy, stocks tied to demographics rather than economics (like healthcare and utilities) and stocks in businesses with low debt and fixed costs that can raise prices to fight inflationary pressures. This means over the next several years we will be concentrating on REITs, mining and energy companies, agricultural and utilities, and technology and healthcare related companies. All of these areas should perform better than average in an inflationary environment.