Pimco:

In the short term, the U.S. and the rest of the developed world do not have to be overly concerned about rising prices as those economies are slowing down. But economic forces are gathering over a larger, secular timeframe to generate “–flation” in the U.S. and around the world. Government response to the current financial crisis will actually add to longer-term –flationary forces. This could take the form of re-flation, in-flation, stag-flation or a combination of the three over time. (It’s unlikely to be de-flation or dis-inflation over a secular timeframe.) While these –flationary scenarios may not be desirable economic conditions, they need not be detrimental to portfolio returns. To the extent investors recognize this regime shift, they can reorient their portfolios away from asset classes that perform well in disinflation, which defined the last quarter century, and into those that are well-suited for the era of –flation going forward.

The current dip in commodity prices, however, has created uncertainty about the stable high prices needed for long-term investment. (It should be noted that the price declines resulted not from increased supply, but from reduced demand expectations due to the slowing economy.) Meanwhile, demand for energy in the short run is fairly inelastic, and demand for food is inelastic in both the short and long run. There is no action that central banks can take to provide the world any more oil, wheat or coffee. And the traditional solution to inflation, which entails slowing the U.S. economy, does little to reduce demand for energy and food, especially since these prices are driven by global, not local, supply and demand. Fed policy, at least, can reduce demand for “infrastructure” commodities such as industrial metals. But these infrastructure commodities are less important in most measures of consumer inflation. Fed policy may also reduce demand at the margin for other commodities should it sufficiently slow the world’s largest economy, but that is akin to using a very blunt tool to address a delicate, specific problem.

Economies, at varying speeds, will be moving from an era of disinflation to a –flation regime. And that –flation regime will not be static. An awareness of the investment implications of changing states of –flation can help investors to control their portfolio risks and achieve desired returns.

My comment: This is a well argued article and is pretty close to the thesis I have adopted. Obviously I did not see the big deleveraging that caused the dollar spike and commodity collapse. Even if I did I proba bly would have not been able to trade it effectively. I did have a nice holding in the Prudent Bear Fund that acted as a nice hedge. However with just about every Central Bank around the world inflating it is a matter of time before the liquidity makes its way into the economy. Of course this liquidity will not cause real growth but it will cause prices for food and energy to increase. That has been the investment thesis from day one. I suspect we are getting close to a bottom as everybody and his brother is screaming great depression and deflation right now. Its that old to many people on one side of the canoe idea again. The contrarian in me is saying look out for a rally when everybody is looking for a continued down market.

John Polomny
The Real Deal