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Inflation, Oil and Katrina
Investment Implications

Geneva, September 6, 2005: Inflation has been a major concern for the equity market in 2005. Until last week, the increasingly high price of oil has been the primary cause of this concern. The inflation picture has more recently become clouded by expected Katrina-related supply/demand shocks in certain important commodities. At Brady Investment Counsel LLC, we have long argued that secular inflation is the result of too many dollars chasing too few goods. This situation most typically is the result of an extended period of wages rising faster than productivity, which simply has not happened to date. Between September of 2000 and June of 2005, productivity increased at a 3.4% annual rate versus a 1.8% annual rate for wages. Inflation has remained very much in check over the same period with the PPI increasing at a 2.1% annual rate. More recently, wage increases have actually flattened while productivity has continued to rise. We therefore conclude that secular inflation is under good control and not a long-term concern brought about by the high price of oil or supply/demand shocks related to Hurricane Katrina. The Bond Market agrees. This is evident by the narrow, 25 basis point positive spread between the 2-year and 10-year yields.

However, it is possible to have short-term price level increases in certain commodities that are the result of supply/demand shocks. These imbalances are temporary as the market place will adjust. It is easy to see how the high price of oil can impact the price of an airline ticket. This situation can only be temporary as consumers will adjust their spending patterns. They have to because they don't have the money to pay for the ticket on a sustainable basis. This is because their wages haven't increased at a pace fast enough to support the higher priced ticket. In the short term, choices are made to support the nondiscretionary spending: No vacation, spending less on clothing, eating at home instead of going out. Long-term behavior will adjust as well but more slowly: To combat the high airline ticket cost, new technology can be embraced to reduce the need for travel.

Katrina will create the same kind of imbalance for building materials. The price of wood products will temporarily increase as New Orleans is rebuilt. Once the supply/demand balance has corrected, prices will adjust downward. You can clearly see the impact of supply shocks in the stock prices of certain companies. For example, XOM ($61) is near its all-time high. WY ($66) is up nearly 5% in the last week. This occurred in a market that up until Katrina, agreed that demand for building products would level off over the next year. On the other hand, WMT ($45), a business that is largely impacted by discretionary spending choices, is trading at a 4-year low.

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