I haven’t seen anything of note written about the probable effect of the implementation of the Affordable Care Act (ACA, or “Obamacare”) on Medical Care CPI. This is probably because the calculation of Medical Care inflation in the CPI is confusing to many and because the direct effects of the ACA are still speculative at this point. But this is a potentially dangerous oversight since Medical Care is 7.2% of the CPI, and is after all the part that has recently been dragging Core CPI and Core PCE lower because of its unusual weakness.
Even if one cannot fathom the details, we know that the ACA will add volatility to the measurement of medical care inflation, and with measured medical care inflation so low presently, relative to historical trends, this implies mostly upside risk to prices. The following chart (Source: Enduring Investments) shows the rolling annual increase in Medical Care CPI, along with core CPI.
The most generous interpretation of this chart is that the ACA was already having an impact on holding down medical care prices prior to its implementation, although this ignores the known effect of the sequester on medical care inflation outturns: the sequester slowed Medicare payments to providers, and this had the effect of lowering measured medical care inflation temporarily. Another cavalierly optimistic interpretation might be to suggest the possibility that the secular outperformance of medical care inflation relative to broad inflation is coming to an end.
While the actual economic effect of the ACA will only be determined over a long period of time as the actual rules and the free market response become more clear, I think that the effects of the ACA on the measurement of medical care inflation, at least for several years, will have the effect of pushing medical care inflation higher. The reasons for this are less about the question of whether disrupting the private insurance industry and price system is likely to create overall gains in efficiency in delivering health care, and hence lower prices (I doubt it), and more about the somewhat arcane way that medical care costs are accounted for in the Consumer Price Index.
Accounting for changes in the cost of medical care is a very challenging problem for a number of reasons. One of these reasons is that changes in medical care prices, like all price changes, reflect both inflation and the possible change in the quality of the delivered product. A mundane example of this problem outside of medical care is when the size of a candy bar increases 20% and the price of the bar rises 25%. Clearly, in such a case there isn’t 25% inflation in the cost of a candy bar, because the consumer is getting 20% more candy in the bargain. That is a simple quality adjustment, and the BLS regularly makes these changes (more often, of course, the candy bar shrinks so that the quality adjustment increases measured inflation rather than the other way around!). More problematic and controversial are when the quality change is more subjective, such as when a car adds chrome wheel rims or a disk drive doubles in size, or when the BLS makes changes for the aging of the housing stock. Nevertheless, the BLS has sophisticated models for making these adjustments with the least amount of subjective evaluation possible.
How, though, does one measure the improvement in the quality of medical care when the whole course of treatment for a given condition may change? The service being provided, after all, isn’t “one MRI image” but “improved leg function as the result of surgery done with the benefit of improved MRI imaging.” This is a continued challenge for the BLS and one that the Bureau has spent many resources researching over the last few years.
So one problem that the BLS faces is that the price index does not necessarily measure quality improvements well. Another problem is that the Consumer Price Index is supposed to measure costs to consumers, and few consumers pay directly for their medical care but rather for insurance; moreover, the government itself pays for much medical care through Medicare and other programs which have no direct cost (at least, in a direct financial sense as opposed to an economic sense) to the consumer of medical care. For many consumers, too, their employer picks up part of the cost of insurance.
The BLS therefore measures medical care not by looking at the cost of insurance but by looking at what insurance companies pay for the medical care on behalf of the consumers, and then separately accounting for the insurance company profit as a different consumer item. Government purchases of health care are entirely outside of the consumer price index since the government is not a “consumer!” The employer-paid portion of health care insurance is also excluded since a company is also not a consumer.
So what does this mean for the effects of the ACA on the cost of medical care? I can see several likely effects:
- Because the BLS measures the prices being paid by insurance companies to doctors, rather than insurance costs, the sharp increases in insurance costs due to the transition to the health care exchanges dictated by the ACA may not be immediately reflected in the price index for medical care. However, it is also possible that doctors and hospitals may take advantage of the confusion by changing their prices at this time and blaming the increase on the increased burdens of the ACA. Prescription drugs, too, may see price increases for this reason. The outcome of this part of the transition is probably indeterminate on medical care inflation in the short term, but it clearly increases the range of possible outcomes. If provider price increases happen quickly even though new insurance policies will only gradually be taken, then medical care inflation might increase quickly in the short run. But the opposite might also happen, so that consumers face higher insurance costs but medical care inflation does not reflect this.
- Much more problematic is a composition effect that will affect the relative health of the patients that doctors will be treating, almost immediately. Many Americans have just lost their private health insurance. Faced with this, consumers who are relatively healthy are likely to decrease their doctor visits relative to comparatively unhealthy patients because of the increased out-of-pocket cost of going to a doctor. Unhealthy patients have less of an option to decrease consumption of medical care in response to higher costs, and indeed some very unhealthy patients have seen their costs decline due to the ACA (which was, after all, the point: not affordable care for all, but affordable care for those who were finding health care very expensive partly because they needed a lot of it). Because the BLS measures health care costs at the provider level, this could increase measured health care inflation quickly because of increased utilization of more-expensive treatment options.
- The fact that the BLS only considers the employee-paid part of company health care plans also has very interesting implications under the chaotic transition to the ACA. When an employer pays less of the premium for a corporate plan, the employee pays a higher price (and feels inflation) even if the overall premium doesn’t change. But this increases the weight of Medical Care in the consumer’s consumption basket, so that the 7.2% weight in the CPI will increase, and probably substantially, over the next couple of years. Consider the previous chart, illustrating that medical care inflation has outstripped broader inflation indices for at least the last three or four decades. To the extent this continues, a higher weight of medical care implies a higher overall level of inflation.
- In general, the ACA creates uncertainty among service providers in the health care industry. A typical reaction of suppliers facing uncertainty in any industry is to raise prices in order to increase the margin for error (in much the same way that asset prices tend to be lower when investors feel less safe and thus must build a margin of safety into the bid price). While not strictly inflation since the cushion would not increase each year, it would tend to increase measured inflation over the medium term.
It is very difficult to evaluate the size and timing of each of these effects, but it is important to note that while some of the effects are indeterminate (such as #1 above), there are no effects I can discern that would tend to decrease measured inflation of medical care. Consequently, I expect that Medical Care inflation – which has been, I have previously mentioned, a key source of the weakness in core inflation compared to median inflation – is likely to rise appreciably over the next year. Note that this is likely to be the case even if the ACA actually succeeds in lowering the aggregate economic cost of healthcare (about which fact I are skeptical) because the way the BLS measures medical care inflation is likely to cause increases in this index.
The great news today is that mortgage delinquencies dropped to their lowest level in five years. Look at the chart (source: Bloomberg)! Doesn’t it look great?
This was actually a bit surprising to me. With the Unemployment Rate doing about what it usually does in recoveries, and the economy adding something a bit shy of 200,000 new jobs per month, and with interest rates low and housing prices rising, you would think that delinquencies would have improved much more than they have.
Pretty much all of the delinquency data looks the same way. Here is a chart of new foreclosure actions as a (seasonally-adjusted) percentage of total loans.
Is this a symptom of the “part-time America” phenomenon, in which all of these new jobs are being generated as part-time work, so that the improvement in the lot of the average worker is not paralleling the improvement in the jobs or unemployment rate numbers? (I’m not disputing that such a phenomenon exists; in fact I think it does. I am asking whether this is a symptom of that, or if there is another cause?) In any event, it isn’t a very good sign, and is one reason that even once QE ends, the Fed will endeavor to keep rates low for a very long time.
By the way, it also makes me wonder whether the celebrated move of institutional investors into the private residential real estate market is having a smaller effect than many people think it is. If there were big players looking to buy bank REO on the offered side, then wouldn’t you think banks would be accelerating foreclosures and that the delinquencies would be dropping faster (as homeowners either get into the foreclosure process, whereupon they aren’t in the delinquency stats, or get serious about becoming current)? I don’t know the answer.
Here is a technical point for institutional investors in inflation-indexed bonds and/or swaps – something worth watching for.
There has been much concern in some quarters recently about the coming increase in demand for high-quality collateral to back swaps under Dodd-Frank regulations. One way this could manifest in the inflation markets is to narrow the spread between inflation “breakevens” and inflation swaps. As the chart below (Source: Enduring Investments) illustrates, the inflation swaps curve is always above the “breakeven” curve. In theory, both curves should be measuring the same thing: aggregate inflation expectations over some period.And, in fact, they do. But while the inflation swaps market is a relatively-pure measure of inflation expectations, breakevens have some idiosyncrasies that make them less useful for this purpose. Predominant among these idiosyncrasies is the fact that nominal Treasury bonds act in the market as if they are very, very good collateral and so often trade at “special” financing rates. That is, when you buy a Treasury bond you not only buy a stream of cash flows, but you pay a little extra for it since you can borrow against it at attractive rates sometimes (if you are an investor who does not utilize the bonds for collateral, then you are paying for this value for no reason). However, TIPS are much more likely to be “general” collateral, and to offer no special financing advantage. There is no fundamental reason for this: TIPS are Treasuries, and are just as valuable as collateral to post as margin as are nominal Treasuries. There just isn’t a deep short base, and the main owners of TIPS are inflation-linked bond funds that actively repo them out so that they are rarely in short supply. It is unusual, although no longer unprecedented, to see a TIPS issue trade special.
The consequence of this is that Treasury yields are lower than they would otherwise be, by the amount of the “specialness option,” and TIPS yields are not affected by the same phenomenon. Therefore, breakevens are lower than they would otherwise be.
If, in fact, there becomes a shortage of “good” collateral to use to post as swaps margin, one place I would expect that to show up would be in the TIPS market. I would expect that TIPS issues would begin to go on special more-frequently, and to start to behave like the good collateral they are. The consequence of that would be to cause TIPS yields to decline relative to nominal yields as they gain the “specialness option,”, and for breakevens to rise towards inflation swap levels. (As an aside, that would also cause TIPS asset swaps to richen of course).
As I said, this is a technical point and not something the non-institutional investor needs to worry about.
 I am bound to include this notice with any online use of the article: “This article was originally published in The Euromoney Derivatives & Risk Management Handbook 2008/09. For further information, please visit www.euromoney-yearbooks.com/handbooks.”
 Frankly, I need to update this paper and get it published, but the last time I submitted it I had one referee tell me “this is wrong” and the second referee said “this is obvious” so I decided in frustration to let it drift.
There has been a lot written in the academic literature about why equity returns and inflation seem to be inversely related. What is amazing to me is that Wall Street seems to still try to propagate the myth that equities are a good hedge for inflation (sometimes “in the long run” is added without irony), when virtually all of the academic work since 1980 revolves around explaining the fact that equity returns are bad in inflationary times – especially early in inflationary times. There is almost no debate any longer about whether equity returns are bad in inflationary times. About the strongest statement that is ever made against this hypothesis is something like Ahmed and Cardinale made in a Journal of Asset Management article in 2005, that “For a long-term investor such as a pension fund, the key implication of these results is that short-term dynamics cannot be completely ignored in the belief that the stock market will turn out to be a perfect inflation hedge in the long run.” For someone looking for a refutation of the hypothesis, that is pretty small beer.
And yet, it is amazing how often I am called to defend this observation! So, since it seems I have never fully documented my view in one place, I want to refer to a handful of articles and concepts that have shaped my view about why you really don’t want to own equities when inflation is getting under way.
I will repeat a key point from above: this is not news. In the mid-1970s, several authors tackled the question about stocks and inflation, and all found essentially the same thing. My favorite summing up comes from the conclusion of an article by Zvi Bodie in the Journal of Finance:
“The regression results obtained in deriving the estimates seem to indicate that, contrary to a commonly held belief among economists, the real return on equity is negatively related to both anticipated and unanticipated inflation, at least in the short run. This negative correlation leads to the surprising and somewhat disturbing conclusion that to use common stocks as a hedge against inflation one must sell them short.”
By the early 1980s this concept was fairly well accepted (something about deeply negative real returns over the course of a decade-plus probably helped with the acceptance). In a seminal work in 1981, Eugene Fama suggested that the negative relationship between equity returns an inflation is actually proxying for a positive relationship between real activity and equity returns (which makes sense), but since real activity tends to be inversely related to inflation rates, this shows up as a coincidental relationship between bad equity returns and inflation. But I am not here to argue the nature of the causality. The point is that since about 1980, the main argument has been about why this happens, not whether it happens.
The reason it happens is this: while a business, in inflationary times, sees both revenues and expenses rise, and therefore reasonably expects that nominal profits should rise over time with the price level (and overall, it generally does), the indirect owner of shares in a business cares about how those earnings are discounted in the marketplace. And, over a very long history of data, we can see strong evidence that equity multiples tend to be highest when inflation is low and stable, and much lower when there is either inflation or deflation. The chart and table below represent an update I did for a presentation a couple of years ago (it doesn’t make much sense to update a table using 120 years of data, every year) illustrating this fact. The data is from Robert Shiller’s site at http://www.econ.yale.edu/~shiller/data/ie_data.xls but I first saw the associated chart (shown below it) in Ed Easterling’s excellent (and highly-recommended) book, Unexpected Returns: Understanding Secular Stock Market Cycles. The x-axis on the chart is the market P/E; the y-axis is annual inflation with each point representing one year.
Now, it should be noted Modigliani and Cohn in 1979 argued that equity investors are making a grievous error by discounting equities differently in high-inflation and low-inflation environments. They argue that since equities are real assets, investors should be reflecting higher future earnings when they are discounting by higher nominal rates, so that the multiple of nominal earnings should not change due to inflation except for various things like tax inefficiencies and the like whose net effect is not entirely clear. Be that as it may, it has been a very consistent error, and it seems best to assume the market will be consistent in its irrationality rather than inconsistent by suddenly becoming rational.
So, if inflation picks up, then so do earnings – but only slowly. And in the meantime, a large change in the multiple attached to those (current) earnings implies that the current equity price should decline substantially when the adjustment is made to discount higher inflation. After that sharp adjustment, it may be that equity prices become decent hedges against inflation. And in fact, if multiples were particularly low now then I might argue that they had already discounted the potential inflation. But they are not – 10-year P/Es are very high right now.
In short, there is almost no evidence supporting the view that equities are a decent hedge for inflation in the short run, and some careful studies don’t even find an effect in the long run. In a thorough white paper produced by Wood Creek Capital Management, George Martin breaks down equity correlations by industry and time period, and only finds a small positive correlation between Energy-related equities and inflation – and that is likely due to the fact that energy provides most of the volatility of CPI in the short-run. Among many meaningful conclusions about different asset classes, Dr. Martin concludes that equities do not offer a good short-term inflation hedge, nor a good long-term inflation hedge.
In fact, I think (especially given the current pricing of equities) the case is worse than that: equities are, as Dr. Bodie originally said in 1976, likely to hedge inflation only if you short them.
 “Does inflation matter for equity returns?”, Journal of Asset Management, vol 6, 4, pp. 259-273, 2005.
 “Common Stocks as a Hedge Against Inflation”, The Journal of Finance, Vol. 31, No. 2, Papers and Proceedings of the Thirty-Fourth Annual Meeting of the American Finance Association Dallas, Texas December 28-30, 1975 (May, 1976), pp. 459-470, Wiley, Article Stable URL: http://www.jstor.org/stable/2326617
 “Stock Returns, Real Activity, Inflation, and Money”, The American Economic Review, Vol. 71, No. 4 (Sep., 1981), pp. 545-565, American Economic Association, Stable URL: http://www.jstor.org/stable/1806180
 “The Long Horizon Benefits of Traditional and New Real Assets in the Institutional Portfolio,” Wood Creek Capital Management, February 2010. Available at http://www.babsoncapital.com/BabsonCapital/http/bcstaticfiles/Invested/WCCM_Real_Assets_White_Paper_Final.pdf.
It has been a long time since we have had to worry about and think about the phenomenon of mortgage convexity and the effect that it can have on the bond market. But with 10-year interest rates up 50bps in less than 1 month, and some of the selloff recently being attributed to “convexity-related selling,” it is worth reminiscing.
We need to start with the concept of “negative convexity.” This is a fancy way of saying that a market position gets shorter (or less long) when the market is going up, and longer (or less short) when the market is going down. That’s obviously a bad thing: you would prefer to be longer when the market is going up and less long when the market is going down (and, not surprisingly, we call that positive convexity).
Now, a portfolio of current-coupon residential mortgages in the US exhibits the property of negative convexity because the homeowner has the right to pre-pay the mortgage at any time, and for any reason – for example, because the home is being sold, or because the homeowner wants to refinance at a lower rate. Indeed, holders of mortgage-backed securities expect that in any collection of mortgages, a certain number of them will pre-pay for non-economic reasons (such as the house being sold) and the rest will be pre-paid when economic circumstances permit. Suppose that in a pool of mortgages, the average mortgage is expected to be paid off in (just to make up a number, not intended to be an accurate or current figure) ten years. This means that the security backed by those mortgages (MBS for short) would have a duration of about ten years, so that a 1% decline in interest rates would, in the absence of convexity, cause prices to rise about 10%.
Now, that’s really just a guess based on where interest rates are currently. As interest rates change, so does the duration of the bond. If mortgage interest rates fall significantly, then most of the mortgages in that MBS would pre-pay and the duration of the security would fall sharply. Suppose that after a sufficient decline in interest rates, the same pool of mortgages in that MBS is expected to be pre-paid on average in only 3 years. Now a further 1% decline in interest rates will only cause the price of the MBS to rise about 3%. This is negative convexity, and what is significant here is how holders of MBS respond. In order to maintain a similar market exposure, the owner of the MBS needs to buy more bonds, swaps, or MBS to maintain his duration. That is, into a rally, the MBS owner needs to buy more. This is “buying high,” and it’s the manifestation of one side of that negative convexity.
Suppose that instead interest rates rise sharply. Now, instead of expecting those mortgages to economically pre-pay over the next 10 years, we realize that the opportunities for these homeowners to refinance just went away (at least for a while); consequently, we now expect the mortgages to pay off in 15 years on average, rather than 10. A further rise of 1% in interest rates will cause prices to fall 15% rather than 10%. Again, the MBS holders need to respond, and they do so by selling bonds, swaps, or MBS to maintain duration. That is, into a selloff, the MBS owner needs to sell more. This is “selling low,” and it’s the manifestation of the other side of that negative convexity.
Put together, a manager of a large MBS portfolio is earning a higher-than-average coupon, but is also systematically buying high and selling low on his hedges and losing a little money each time. More importantly for our case here is that if the market moves enough to trigger the hedging activity then we say that “the convexity trade” has caused a significant amount of selling into a selloff, or a significant amount of buying into a rally, and this essentially means fuel is being added to the fire and the move is worsened. The mortgage market is massive, and especially with dealers having less capacity for market-making risk-taking a big convexity trade could cause a huge move. In the 2000s, I recall two massive selloffs of at least 125bps over a period of just a few weeks, in which every 5bps seemed to bring out another huge seller and push the market another 5bps.
Figuring out exactly what the trigger level is at which the convexity trade kicks in is the domain of mortgage analysts, and there is a lot of brainpower and computing power put to this analysis. These folks can tell you that “a 10-year note rate of 2.25% will cause the market to get longer by 150bln 10-year note equivalents [just to be clear, this is a made up example],” which in turn implies that there will be substantially more selling when interest rates approach that level.
Now, I don’t know what the current trigger levels are, but I can tell you a few more things from years of experience.
First is that the market’s negative convexity is greatest when the market has rallied to a new level and stayed there for a long time, allowing most borrowers to refinance their mortgages to the current coupon. The chart of 10-year yields below (Source: Bloomberg) illustrates this point. In 2008, 10-year note yields fell below 2.5%, but did so very quickly and few people had a chance to refinance (plus, mortgage spreads were quite wide and credit was hard to get), so the mortgage market maintained something like its prior equilibrium.
However, over 2010 and especially after mid-2011, rates got substantially lower and stayed lower; mortgage credit also got somewhat easier than in early 2009 (although obviously underwater homeowners cannot refinance, and this limited the amount of refinancing activity so that MBS prepay speeds weren’t as rapid as the pre-2008 models had expected). We have now been at these levels for some time, so that I suspect the market’s average coupon is substantially lower today than it was two years ago. This means the bond market is very vulnerable to a convexity trade to higher yields, especially once the ball gets rolling. The recent move to new high yields for the last 12 months could trigger such a phenomenon. If it does, then we will see 10-year note rates above 3% in fairly short order.
The second point is somewhat more subtle. The nature of the negative convexity in the higher rate direction is different from the nature of the negative convexity in the lower rate direction. When rates fall, we are looking at borrowers refinancing, which means that we can stair-step lower: rates fall, borrowers refinance, rates fall further, borrowers refinance again, etcetera. But when rates rise, the duration increase is caused by a lack of activity. Borrowers eschew refinancing. And this, fundamentally, can only happen once no matter how far rates move. If it is not economical to refinance with rates 2% higher, then few borrowers will refinance. But at 5% higher rates, there is no additional effect: once your model expects essentially zero refinancing, the convexity trade is over until you get substantial new origination of mortgages, and this takes longer. Therefore, in a selloff the convexity trade is somewhat self-limiting. It sure doesn’t feel like it at the time, but it is.
This is a long article but it is worth reflecting on because of the conclusion, and that is this: if rates rise because the Fed begins to raise rates (or finds it doesn’t have enough will to keep them low, once the bond market expects much higher inflation), then there is no “cap” on how high they can go. But if rates rise in a sloppy fashion because of a convexity trade, there really is a cap. It would be ugly to see interest rates rise another 100bps (and really, really bad for stocks I think), but if they did so because of the convexity trade then we would probably get a bunch of that move reversed thereafter.
I don’t have a strong opinion about whether we are at that point yet, and I no longer have access to great mortgage analysts. But Fed speakers should tread very lightly, as I doubt the first trigger point is terribly far away and you surely don’t want to hit it.
There is one reason I don’t think that the bond market selloff we have seen to date is heavily driven by convexity-related flows, and that is that TIPS yields have risen faster than nominal bond yields. Over the period during which nominal 10-year yields have risen 50bps, 10-year TIPS yields have actually risen 58bps. If the trade was a convexity-driven trade, it would be primarily affecting nominal yields, which means that while TIPS would be suffering, they would be suffering less than nominal bonds, rather than more. (The flip side is that if you are bearish here because you think the convexity trade might kick in, you should also expect breakevens to widen substantially when that trade does kick in). Indeed, TIPS at -0.13% is the best bargain we have seen in quite some time (see chart, source Bloomberg).
Indeed, our multi-asset strategy has kicked the TIPS component all the way up to 11%, which is the highest it has been in a long while. TIPS are not cheap, but they are cheaper, and they are extremely cheap relative to nominal bonds. And they are not yet as cheap as i-Series savings bonds, although the yield advantage of those bonds has dropped from the 159bps it was when I wrote about it here to “only” 93bps. But that’s still a great arb, and so I continue to advocate i-bonds.
 I am abstracting from the niceties of Macaulay versus modified versus option-adjusted duration here for the purposes of exposition.
I just finished a paper called “Managing Laurels: Liability-Driven Investment for Professional Athletes,” and I thought that one or two of the charts might be interesting for readers in this space.
An athlete’s investing challenge is actually much more like that of a pension fund than it is of a typical retiree, because of the extremely long planning horizon he or she faces. While a typical retiree at the age of 65 faces the need to plan for two or three decades, an athlete who finishes a career at 30 or 35 years of age may have to harvest investments for fifty or sixty years! This is, in some ways, closer to the endowment’s model of a perpetual life than it is to a normal retiree’s challenge, and it follows that by making investing decisions in the same way that a pension fund or endowment makes them (optimally, anyway) an athlete may be better served than by following the routine “withdrawal rules” approach.
In the paper, I demonstrate that an athlete can have both good downside protection and preserve upside tail performance if he or she follows certain LDI (liability-driven investing) principles. This is true to some extent for every investor, but what I really want to do here is to look at those “withdrawal rules” and where they break down. A withdrawal policy describes how the investor will draw on the portfolio over time. It is usually phrased as a proportion of the original portfolio value, and may be considered either a level nominal dollar amount or adjusted for inflation (a real amount).
For many years, the “four percent rule” said that an investor can take 4% of his original portfolio value, adjusted for inflation every year, and almost surely not run out of money. This analysis, based on a study by Bengen (1994) and treated more thoroughly by Cooley, Hubbard, and Walz in the famous “Trinity Study” in 1998, was to use historical sampling methods to determine the range of outcomes that would historically have resulted from a particular combination of asset allocation and withdrawal policies. For example, Cooley et. al. established that given a portfolio mix of 75% stocks and 25% bonds and a withdrawal rate of 6% of the initial portfolio value, for a thirty-year holding period (over the historical interval covered by the study) the portfolio would have failed 32% of the time for, conversely, a 68% success rate.
The Trinity Study produced a nice chart that is replicated below, showing the success rates for various investment allocations for various investing periods and various withdrawal rates.
Now, the problem with this method is that the period studied by the authors ended in 1995, and started in 1926, meaning that it started from a period of low valuations and ended in a period of high valuations. The simple, uncompounded average nominal return to equities over that period was 12.5%, or roughly 9% over inflation for the same period. Guess what: that’s far above any sustainable return for a developed economy’s stock market, and is an artifact of the measurement period.
I replicated the Trinity Study’s success rates (roughly) using a Monte Carlo simulation, but then replaced the return estimates with something more rational: a 4.5% long-term real return for equities (but see yesterday’s article for whether the market is currently priced for that), and 2% real for nominal bonds (later I added 2% for inflation-indexed bonds…again, these are long-term, in equilibrium numbers, not what’s available now which is a different investing question). I re-ran the simulations, and took the horizons out to 50 years, and the chart below is the result.
Especially with respect to equity-heavy portfolios, the realistic portfolio success rates are dramatically lower than those based on the “historical record” (when that historical record happened to be during a very cheerful investing environment). It is all very well and good to be optimistic, but the consequences of assuming a 7.2% real return sustained over 50 years when only a 4.5% return is realistic may be incredibly damaging to our clients’ long-term well-being and increase the chances of financial ruin to an unacceptably-high figure.
Notice that a 4% (real) withdrawal rate produces only a 68% success rate at the 30 year horizon for the all-equity portfolio! But the reality is worse than that, because a “success rate” doesn’t distinguish between the portfolios that failed at 30 years and those that failed spectacularly early on. It turns out that fully 10% of the all-equity portfolios in this simulation have been exhausted by year 19. Conversely, 90% of the portfolios of 80% TIPS and 20% equities made it at least as far as year 30 (this isn’t shown on the chart above, which doesn’t include TIPS). True, those portfolios had only a fraction of the upside an equity-heavy portfolio would have in the “lucky” case, but two further observations can be made:
- Shuffling off the mortal coil thirty years from now with an extra million bucks in the bank isn’t nearly as rewarding as it sounds like, while running out of money when you have ten years left to lift truly sucks; and
- By applying LDI concepts, some investors (depending on initial endowment) can preserve many of the features of “safe” portfolios while capturing a significant part of the upside of “risky” portfolios.
The chart below shows two “cones” that correspond to two different strategies. For each cone, the upper line corresponds to the 90th percentile Monte Carlo outcome for that strategy and portfolio, at each point in time; the lower line corresponds to the 10th percentile outcome; the dashed line represents the median. Put another way, the cones represent a trimmed-range of outcomes for the two strategies, over a 50-year time period (the x-axis is time). The blue lines represent an investor who maintains 80% in TIPS, 20% in stocks, over the investing horizon with a withdrawal rate of 2.5%. The red lines represent the same investor, with the same withdrawal rates, using “LDI” concepts.
While this paper concerned investors such as athletes who have very long investing lives and don’t have ongoing wages that are large in proportion to their investment portfolios (most 35-year-old investors do, which tends to decrease their inflation risk), the basic concepts can be applied to many types of investors in many situations.
And it should be.
We have one month in the books in 2013 already; my, how time flies when you’re having fun! But the fun may not last much longer.
I have spent lots of time, over the last year, answering the question “why hasn’t inflation responded to QE?” My response has been that it has: core inflation rose from 0.6% to 2.3% from October 2010 to January 2012, rising for a record-tying fifteen consecutive months – a feat that last happened in 1973-74, as official prices adjusted to catch up for being frozen during wage and price controls. By a bunch of measures, that was an acceleration of core inflation that was unprecedented in modern U.S. economic history. As I wrote at the time (in “Inflation: As ‘Contained’ As An Arrow From A Bow“), the only reason to defer panic was that Housing inflation was overdue to level out and decelerate. Fortunately, it did.
But, as I’ve written extensively recently, that blessing has been rescinded and the question of “why hasn’t inflation responded to QE” will shortly be moot. In the next couple of months, core inflation will begin to re-accelerate, driven by the pass-through of rising home prices into rents. In our view, the best we can hope for is that core inflation only reaches 2.6% this year. Absent a change from the historical relationship between home prices and rents, some 40% of the core consumption basket is going to be rising at 3.5% or better by late this year.
So, when will markets get a whiff of this?
We are primarily motivated by valuations, and we are patient investors. Moreover, we think it makes more sense to focus effort on valuation work, because if your valuation work isn’t pretty good then timing isn’t going to matter much. But nevertheless, it is helpful to look for signs and signals that indicate time may be drawing short. So I’d like to go all ‘techie’ for a few minutes and show three charts that suggest markets are preparing for a new, higher-inflation reality.
The first one is the dollar index (see chart, source Bloomberg). This one is interesting, because I am not convinced that U.S. QE will cause a uniquely American inflation. After all, everybody’s doing it. This chart is technically of a head-and-shoulders pattern, but I’m just pointing to that trendline that keeps bringing in buyers.
A break below the current level (and as a trader, I’d be tentative until the September lows broke as well) projects to a test of the bottom end of a much bigger consolidation pattern that has been forming since the beginning of the crisis in 2008 (see next chart, source Bloomberg – the green oval is the area of detail in the prior chart). Below there be dragons.
Now, at the same time we have inflation breakevens (the compensation, in nominal bonds, for expected inflation – represented as the raw spread between the Treasury yield and the TIPS real yield). I’ve shown this uptrend in breakevens and/or inflation swaps in a number of ways recently, but the chart below (source: Bloomberg) shows a long-term view. In the last three months, the 5-year breakeven has risen about 35bps (and you get a similar picture from inflation swaps, but the data isn’t as clean that far back). Right now, bond investors are demanding a fairly high level of expected inflation compensation over TIPS and their guaranteed return of actual inflation. We’ve got a ways to go before we hit all-time highs on the 5y BEI, but the 10-year BEI is only about 22bps away from all-time highs.
Those prior charts haven’t yet broken out, and so while the timer is buzzing the alarm might ultimately not be set off. But in commodities, there are some interesting signs that the lows may be in even though sentiment remains very negative. The chart below (source: Bloomberg) illustrates that in January, the DJ-UBS commodity index gapped through trendline resistance not once, but twice.
In my experience, technical analysis of commodity indices is a fraught exercise, but commodities have quietly been doing quite well lately. Although the S&P rose 5% in January to only 2.4% for the DJ-UBS, that’s mostly due to the first trading day of the year. Since January 9th, the DJ-UBS is +3.7% while the total return of the S&P is only +2.6%. Surprised?
Now, the conventional wisdom is that stocks are a great place to hide if there is inflation. That conventional wisdom is wrong. Stocks may do okay if starting from modest valuations, but a rise of inflationary concerns (especially if accompanied by rising interest rates) while stocks are at high valuations would likely be less than generous to equity investors.
So, of course, retail investors have been breaking their piggy banks open to rush into stocks, in a rush not seen for many years. It is tragic, but it is the natural result of the Fed’s misguided crusade to stimulate the economy via the portfolio balance channel (see my discussion and illustration of this topic here). Where does the retail investor turn, when he sees rising gasoline prices, rising home prices, and a shrinking paycheck due to higher withholding rates? The television is telling him that it’s time to jump aboard the equity train. Although he has been prudently suspicious of equity markets for much of the last decade, he is also aware that the cash he has in the bank is evaporating in real value.
And perhaps that’s why total savings deposits at all depository institutions (the main component of non-M1 M2) has fallen more in the last two weeks than in any two-week period…ever. About $115bln has fled from savings accounts in the last fortnight. Now, that’s a volatile series, and it might mean nothing unless we happened to see it show up somewhere.
Like, perhaps, here?
The chart above (source: ICI, via Bloomberg) shows the net new cash flows into equity funds, which just happen to be at the highest level over the past three weeks (about $30bln) of any time during the period of data available on Bloomberg.
Again, it isn’t because the future suddenly looks bright. Initial Claims today was 368k, above expectations and unfortunately putting a big dent in the notion that the ‘Claims data over the last few weeks was signaling a meaningful shift in the rate of new claims. The number is probably still going to go lower, but it is likely to be a drift, not a break. And we will see a similar story tomorrow, probably, when the Payrolls figure (Consensus: 165k) and Unemployment Rate (Consensus: 7.8%, but I think it might tick up to 7.9%) will paint the same sort of picture. No, people are not reaching for their wallets to invest in stocks because they are suddenly flush. More likely, it’s because they’re frustrated and confused; they feel they’re being left behind. Perhaps there is a bit of desperation, if retirement is getting further away as the cost of retirement rises and take-home pay stagnates.
In any event, what you do not want to see, four years and 125% above the S&P lows, is people taking money out of savings to put into stocks. If you are not one of the people putting money in, then consider being one of the people taking your profits out – and looking to those markets that actually do tend to keep up or outperform inflation. I hasten to remind readers that they don’t ring a bell at the top of the market, and so one ought to be careful to rely too much on the “signs” and “timing signals” suggested above. But the sharp-pencil work suggests that core inflation is going to head back up in the next 2-3 months; in my opinion, you don’t necessarily need signs to position for that – you need excuses.
 One is tempted to say ‘evil,’ but I don’t believe the Fed actually is anticipating the pain they are likely to cause to the little guy. Indeed, they may believe that the impact of their actions may fall disproportionally on the rich: an economist at the Federal Reserve Bank of St. Louis recently co-published a paper entitled “Understanding the Distributional Impact of Long-Run Inflation,” which concludes in part that “When money is the only asset, a faster rate of monetary expansion acts as a progressive tax that lowers wealth inequality; when bonds can be traded, wealth inequality is less affected by inflation because the rich hold more illiquid portfolios than the poor.” [emphasis added]
Whether it’s with a bang or with a whimper, the year is drawing to a close. So too is this author’s year; I expect that this will be my last post for 2012. Let me take a quick moment to thank all of you who have taken the time to read my articles, recommend them, and re-tweet them. Thanks, too, for your generous and insightful comments and reactions to my writing. One of the key reasons for writing this column (other than for the greater glory of Enduring Investments and to evangelize for the thoughtful use of inflation products by individual and institutional investors alike) is to force me to crystallize my thinking, and to test that thinking in the marketplace of ideas to find obvious flaws and blind spots. Those weaknesses are legion, and it’s only by knowing where they are that I can avoid being hurt by them.
In my writing, I try to propose the ‘right questions,’ and I don’t claim to have all the right answers. I am especially flattered by those readers who frequently disagree with my conclusions, but keep reading anyway – that suggests to me that I am at least asking good questions.
So thank you all, and I hope you have a blessed holiday season and a happy new year. And now, back to our regularly-scheduled article.
It seems likely, although not a sure thing, that 2013 will be a better year in terms of economic growth. Certainly, we are ending 2012 in better shape than we entered it. One way or the other, the budget deficit will come down – at least partly because the prospective rise in tax rates has moved forward some realization of taxable gains – and, although that is a negative from a classical C+I+G+(X-M) perspective, I believe a smaller deficit will help assuage some business and consumer fears and be no worse than neutral … if, in fact, we get a smaller deficit! A bigger point is that while Europe is far from out of the woods, a near-term exit of Greece from the Euro finally seems unlikely. Stay tuned for Italian and Spanish dramas in 2013, and plenty of other pressures on the continent, but the worst case that we feared a year ago has been at least kicked down the road a piece.
Domestic growth to end 2012 is looking better, too. Today the Philly Fed index showed its highest print since March (8.1 versus -10.7 last month and expectations for -3.0). Existing Home Sales came in at 5.04mm, the first time above 5mm (without a government program, such as got Existing Home Sales up there briefly at the end of 2009) since 2007. The inventory of existing homes fell to the lowest level since 2002 (see chart, source Bloomberg).
Yes, there is additional “shadow inventory,” and so this isn’t the “true” inventory once you include bank REO property and other wannabe sellers who are waiting for the market to pick up, but that shadow inventory will clear a lot faster now that prices are rising. The monthly Home Price Index from the FHFA was released today, showing that nominal home prices in October rose 5.5% over last October (see chart, source Bloomberg).
Even in real terms, home prices are rising. Over time, residential real estate has roughly appreciated at the rate of inflation plus 0.5% (so that in real terms, home prices tend to just tread water). Between 1997 and 2007, however, real home prices rose some 50% before collapsing 28% between 2007 and 2011. But this latest bounce is real (see chart, source Bloomberg; I’ve merely divided the HPI by the NSA CPI price level and multiplied by 100), and it comes thanks to profligate monetary policy. To the extent that tax rates rise but the mortgage deduction persists, fiscal policy too will probably support home prices going forward. It isn’t a sustainable rise in real prices, but if it is merely sustainable in nominal prices it will heal a lot of upside-down borrowers.
On the topic of profligate monetary policy, I ought to note that M2 growth has been reaccelerating, and has grown at a 9.8% pace over the last 13 weeks. Over the last 52 weeks, M2 is +7.6%. Assuredly, it isn’t the sustained 10% pace we saw at the beginning of 2012, but it is still far more than is needed to keep prices stable with a 2-3% real growth rate…as long as velocity stabilizes or heads higher. So, while the unemployment part of the “misery index” has been improving, the inflation part of the index is likely to continue to worsen. That will be the story in 2013, I suspect, as quantitative easing continues by central banks around the globe (and continues to accelerate in places: the Bank of Japan last night increased its purchasing program by another ¥10trln) and prices or real assets are not only no longer falling, but rather starting to rise.
Where to invest in this environment? Nominal bonds are the worst of all worlds; Treasuries are priced for a -1% real return over the next 10 years, and corporate bonds are even worse with a -2.1% expected real return. (Incidentally, you can compare these estimates to those I produced in 2010 and 2011 via these links. They’re mostly worse, following a better year from asset markets than we had a right to expect!) TIPS produce a -0.74% real return for the next 10 years. Stocks are at +2.44%, which looks good by comparison but is only fair given the risk, and low compared to historical norms – and also more expensive than they were at the end of 2011 (2.57% expected 10 year real return) and 2010 (2.58%). Commodities are cheaper: by my metric, diversified commodity indices are now expected to return 5.43% per year, after inflation, over the next decade (2010: 4.30%, 2011: 4.78%, so you can see this is not an exercise in forecasting the next year’s returns!). Residential real estate has richened slightly but is priced roughly at the long-run average, so I expect returns to be around 0.2% per year for the next decade. The chart below summarizes these estimates (source: Enduring Investments).
Our Fisher model is flat inflation expectations and short real rates; our four-asset model remains heavily weighted towards commodity indices; and our new metals and miners model is skewed heavily towards industrial metals (53%, e.g. DBB) and precious metals (43%, e.g. GLD) with negligible weights in gold miners (2%, e.g. GDX) and industrial miners (2%, e.g. PICK). (Disclosure: We have long positions in each of the ETFs mentioned.)
Feel free to send me a message (best through the Enduring website) or tweet (@inflation_guy) to ask about any of these models and strategies. And otherwise, have a happy holiday season and a merry new year! I look forward to a great 2013, a robust inflation market that continues to grow (the CME is likely to list both TIPS and CPI futures in the coming year), and no small amount of volatility to navigate. This column will return circa January 3rd or 4th.
Housekeeping note: if you missed my comment on CPI from Friday, you can find it here. And if you missed my Bloomberg Radio interview with Carol Massar on Monday, don’t worry! I will post it when Bloomberg makes it available on their site.
One of the busier sessions in recent memory (although still well short of 1bln shares traded on the NYSE, which was the standard not that long ago) resulted in a sharp rally in the equity market with the S&P +1.2% on the day.
The trigger for this holiday treat was the “progress” in the budget talks and what investors see as the increasing likelihood that the ‘fiscal cliff’ is averted. Be careful, however; whatever progress there was is fairly speculative, and I suspect we will see a bad news wiggle before all is resolved.
It is ironic, perhaps, that what is moving the process closer to resolution is the Republicans’ sudden refusal to be steamrolled, and to instead try and play the game rather than try to negotiate as if both parties were trying to reach a fair resolution. I refer to the fact that Speaker Boehner has begun plans to start a separate legislative track in the House of Representatives by passing a bill that would keep the Bush tax cuts in place for most Americans; the bill would not avert the spending cuts that would take effect as part of the “fiscal cliff,” but would keep the government from reaching more deeply into citizens’ pockets on January 1st. It is, therefore, just exactly what the Republicans would want in these circumstances: spending cuts without tax increases (although fewer spending cuts than they would like).
The fact that this is a good play from the standpoint of the Republicans was immediately apparent from the fact that Democrats wasted no time in accusing Boehner of not negotiating in good faith with the President, and the President himself abruptly began to try and compromise slightly from his heretofore rigid position.
Of course, the Boener plan won’t pass the Senate because it will produce exactly zero Democrat votes, and if it somehow passed by luck it would be vetoed by the President, so it has no chance to become law. However, by putting the Democrats in the position of having to vote against tax cuts, it greatly increases the chances that both parties might negotiate to something that all parties hate, and therefore passes with flying colors.
In the US system, by Constitutional writ all revenue bills have to start in the House of Representatives, so by the very nature of this process the Republicans, who dominate the House, hold the serve in this negotiation. Incredibly, this is the first time they’ve shown any desire to use that advantage to produce a bill that represents something closer to their views.
As noted above, equities reacted very well to the Republicans’ show of spine. I’d noted several weeks back that I thought the Republicans had little incentive to negotiate, since going over the fiscal cliff represents smaller government and this may be the only opportunity that party has to get smaller government in the next few years. If this move persuades the Democrats of this fact, and the President moves to address the spending problem rather than just trying to soak the rich, then the fiscal cliff may be averted. It’s really important in a negotiation, especially if a true compromise is to be reached, that your counterparty knows that you may walk away.
Personally, I think the odds are still against this happening before year-end, but some resolution fairly early in the new year is probably odds-on. However, with the debt ceiling also approaching, 2013 may well see more of these cliffhanger negotiations.
Bonds, interestingly, sold off. You would think that the prospect for a smaller deficit, even marginally, would help the Treasury market but in this case I think investors are reacting to the fact that if the fiscal cliff is averted, it lessens the chance of near-term recession and brings forward the day of reckoning for the Fed. Today, 10-year Treasury yields rose to 1.82%, which is near the highest level since early May, and 10-year real yields rose to -0.73%. Over the last five days, nominal yields have risen 16bps, and all of that has come from real yields. That is, inflation expectations have barely moved and 10-year breakevens remain at 2.50%. Ten-year inflation swaps are at 2.77%, and the important 1-year inflation, 1 year forward has risen to 2.23%.
So, whether the ‘day of reckoning’ for the Fed is near, or far…what do they do, when they’ve hit that point? And, more importantly, what does it do to the market?
Let’s assume that we are at some point in the future and either the Unemployment Rate has dipped below 6.5%, the forward PCE inflation rate has risen above 2.5%, or inflation expectations have become “unanchored.” The first thing that the Fed will do is to stop unlimited QE: the statement does not imply that they will immediately start trying to get out of the hole they are in, only that they will stop digging the hole. But suppose that inflation continues to tick up – since the evidence is that inflation is a process with momentum. What does the Fed do next? This is the real question. How quickly can the Fed react to adverse inflation outcomes?
The traditional option is that the Fed raises the overnight rate. The Fed announces this move, but the important part is what happens next: the Open Market Desk (aka ‘the Desk’) conducts reverse repos to decrease the supply of reserves, or sells securities outright if it wishes to make a more-permanent adjustment. This causes the price of reserves (also known as the overnight rate) to rise, and the Desk adjusts its activity so that the overnight rate floats near the target rate.
The problem is that this won’t work right now. There are far too many reserves in circulation for the overnight interest rate to be increased by reverse repos or small securities sales. In fact, if it wasn’t for the interest being paid on excess reserves, the overnight rate would certainly be zero, and might even be negative because the supply of reserves greatly outweighs the demand for reserves. They are called “excess” reserves for a reason – the bank doesn’t need them, and will lend them overnight for pretty much any available rate.
So in order for the Fed to push the overnight rate higher, it must first soak up all of the excess reserves in the system – about $1.5 trillion at the moment – by selling bonds. Obviously, this is not something that can be done in the short-term.
But this misses the point a little bit anyway, because it isn’t the rate that matters to monetary policy but the amount of transactional money (such as M2). The Fed can set the overnight rate at 1% by simply agreeing to pay 1% as interest on excess reserves (IOER). But that won’t do anything at all to M2, because it won’t change the amount of reserves in the system and doesn’t change the money multiplier that relates the quantity of those reserves to M2.
So the short rate is dead. It isn’t going to move for a very long time, unless the FOMC decides to help the banks out by paying a higher IOER. And if they do that, it’s not going to affect inflation so it would just be a sweet present to the banks.
Okay, so perhaps the Fed can sell those long-dated securities and push long-term interest rates higher, slowing the housing market and the economy and squelching inflation, right? That’s partly right: the Fed can sell those securities, and it can push long rates higher (although the Fed has oddly claimed that if it sold those bonds, interest rates wouldn’t rise very much, which makes one wonder why they did it in the first place since presumably the opposite would also be true and buying them wouldn’t push rates down), and that would slow growth. However, it wouldn’t affect inflation, because inflation is not meaningfully affected by growth (I’ve discussed this ad nauseum in these articles; see partial arguments here, here, here, and here). But you don’t have to believe all of the evidence on that point; just play it in reverse: if driving long rates down didn’t cause a sudden jump in inflation, why would driving long rates up cause a sudden dampening in inflation?
Fama, in that article I quoted last week, had a very good point which I thought it was worth developing in more detail. The Fed has its hands off the wheel with respect to inflation…which isn’t a problem, except that they’re sitting in the back seat. The back seat of a very, very long bus.
In any event the issue isn’t when the Fed starts its tightening, but when inflation stops going up. These are not the same things. If core inflation were to start ticking higher today, at a mere 1% per year, I think it would take 6-9 months for the Fed to stop QE (core PCE is at 1.6%), probably another 3 months at a minimum before they started to tighten, and then at least 1-2 years before they could have any meaningful impact on the money supply and cause inflation to slow. Maybe I’m being pessimistic, or maybe I’m being a bit generous by assuming that after a year the FOMC would start doing something very dramatic to sop up reserves, like issuing a trillion dollars in Fed Bills, but even assuming that everything works out just about as well as it conceivably can, if inflation started heading higher in that way then you’re looking at a core CPI figure of 4-5% before it stops rising. Like I said, it’s quite a long bus, and that translates to long “tails” of inflation outcomes.
How would markets react to this? Obviously, bond rates would be much higher, but would this be good or bad for equities? The conventional wisdom holds that equities are good hedges for inflation, because over a long period of time corporate earnings should broadly keep pace with inflation. While that is true, it is also the case that earnings tend to be translated into prices at lower multiples when inflation is high (a fact that has been known for a long time; in 1979 Franco Modigliani and Richard Cohn described this as an error but there isn’t consensus on that issue) so that stocks tend to do relatively poorly when inflation is rising and better when inflation is falling from a high level. Moreover, stocks do especially poorly in the early stages of inflation when short-term inflation is surprising to the upside, as the chart below (Source: Enduring Investments) illustrates.
This chart highlights headline inflation, rather than core, but the point should be clear: nominal bonds and equities produce good real returns when inflation is surprising to the low side (even if that means that inflation is just going up slower than expected), and very poorly when inflation surprises to the high side (even when the overall level is low).
In my mind, this means that every investor needs to have some inflation protection, but especially now when the chances for an ugly inflation surprise are significant. For the record, the best asset class when inflation is surprising to the high side as measured here? Even inflation-linked bonds have produced negative real returns in such circumstances, because the real yield increase outweighs the higher inflation accruals in the short run. But commodities indices historically produced a 4% real return over that time period when inflation surprised at least 2.5% to the upside.
 It isn’t clear to me why you would want to wait until they were unanchored, if anchoring matters, since presumably it isn’t easy to anchor them again. After all, the whole reason the Fed wants anchored inflation expectations is because a regime change is thought to be hard – so if they are unanchored, you’ve just made it really hard to get inflation back down. In any event there’s not much evidence that “anchored” inflation expectations matter to actual inflation outcomes, but it’s just weird to me that the Fed would imply that they’d wait until expectations get loose from the anchor.
Markets continue to gyrate in what seems like wider and wider arcs as volumes gradually decline but the density of news headlines does not. Today, at least one meaningful piece of news that pressured stocks early was that hedge fund (and market-maker) SAC Capital told its investors that it has received a Wells notice from the SEC (indicating that the SEC has determined it may bring legal action against the firm), alleging insider trading. An allegation against the firm, as opposed to individuals within the firm, is a much bigger deal and the concern is that if SAC is impacted or distracted by the charges that liquidity in certain parts of the market may suffer.
This concern didn’t linger very long, though, as stocks were back in the black by lunchtime.
New Home Sales were reported significantly weaker-than-expected, with a downward revision to the prior month’s reported sales. While sales of existing homes have been on a steadily improving pace for a while, New Home Sales have been stuck around 365k since January. Economists had expected a number more like 390k, which sounds aggressive when you look at the chart (source: Bloomberg) below but recall that last month’s figure had been previously announced at 389k and the economists’ estimates don’t seem so outlandish.
This figure doesn’t appreciably change my positive view of the housing market (and more important for me, price change in the housing market) going forward, for two reasons. First is that sales of new homes are dwarfed by sales of existing homes, so that the latter is simply lots more important and the data more statistically useful (e.g., the year-on-year change in the median price follows the same path, but as you can see below in the Bloomberg chart, the new home sales number is dramatically more volatile).
The second reason is that I suspect one reason for the failure of New Home Sales to rise more aggressively is that the gross inventory of new homes has recently been at the lowest level on record (dating to at least 1963). This is a better number to look at, incidentally, than the “months of inventory,” which still shows slower inventory turns than was normal back prior to the bubble. But that’s because of the denominator (monthly sales), not the numerator (houses for sale). And at some level, there are just not enough of the right kind of homes where they are needed. With just 147,000 new homes available for sale, there is only 1 new home for every 2,200 Americans. And they’re mostly bunched together. I suspect this dampens new home sales, and so I am looking much more closely at existing home sales for both activity indications and for price indications.
I had the honor of speaking today at the Euromoney Forex Forum 2012 in New York, on a panel concerning the future of the Euro and how much that future depended on individuals as opposed to bigger historical/economic forces. Readers will be unsurprised to hear that I was fairly firmly on the side of “in the long run, economics wins.”
But as often happens when I am running my mouth, I hit on what I think is an interesting analogy for the Euro and the Euro crisis, and for why “kicking the can” makes at least a certain kind of sense.
The analogy is astronomical in nature, and concerns the process of accretion as it applies to planets. The way that planets are thought to form is by the gradual accretion of small bits of matter – asteroids, rocks, dust into larger and larger bodies until the resulting body is able to sweep its orbit clean of anything which might otherwise accrete. But in the process of that accretion, there are two main determinants of how quickly the accretion occurs (actually, there are probably hundreds, but an analogy is supposed to be a simplification, right?). One is the speed of rotation of the body. A body that is spinning rapidly has a greater tendency to fling stuff outward, while a body that is spinning slowly allows more stuff to clump together. The second is the radius of the body: the larger the body, the greater the angular momentum of the outlying bits for a given rotational speed.
Now, the unification of the Euro was like the creation of a planetoid from seventeen different asteroids, each of which was originally moving with a different vector. As you may recall, the Maastricht Treaty described convergence criteria that required all of the member states to essentially match their inflation rates, their debts, deficits, and interest rates, because the treaty signers wisely realized that if the countries were all moving at different speeds when they joined, there was no chance that they would accrete into a single, unified entity (a planet in my analogy).
But the planet never entirely formed, and some pieces of it on the outer fringe are in danger of being ejected by inertia. The crisis is effectively spinning the planetoid faster and faster, making it harder and harder for the pieces on the outside to avoid flying off into new orbits of their own. In this context, it makes sense to try and slow the rotation, on the theory that if everything just stops spinning long enough, the natural gravity will take over and the pieces will fall back in towards the center and everything will be okay. So policymakers kick the can down the road, assuming that if they can just keep everything together for long enough, it will get easier and easier to do so.
The problem, though, is that this body isn’t acting in isolation. There are tidal forces acting to rip the body apart, in the same way that the comet Shoemaker-Levy 9 was ripped to pieces as it approached Jupiter – the difference in the the pull of Jupiter’s gravity from one side of the comet to the other was so significant that there was no way that the object’s gravity could hold it together .
In the same way, in my view, the many significant differences between the periphery and the core of Europe, combined with the effects of over-indebtedness and a debt market no longer willing to ignore the question of a state’s ability to repay the debt, are tidal forces that are destined to rip the periphery from the core, eventually. I recognize that Europeans will tell me that the gravity of the Euro itself is far greater than I think it is, and if they’re right then the Euro will not splinter and the policymakers are correct to kick the can. But I don’t think they’re right.
 These two forces work against one another, for when the radius of the body decreases because stuff falls towards the center, the speed of rotation accelerates because of the conservation of angular momentum, but that little detail doesn’t enter into the analogy.