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Equity Returns and Inflation
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,[1] 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:[2]
“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,[3] 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
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,[4] 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.
[1] “Does inflation matter for equity returns?”, Journal of Asset Management, vol 6, 4, pp. 259-273, 2005.
[2] “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
[3] “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
[4] “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.
Gold, and Dilemmas
At the start of another Employment week, the same refrain echoes: higher equity markets, soft commodities markets (because changes in China’s policies will hurt the demand for commodities…but I suppose that it will not hurt the profitability of U.S. shares?), and continued negative news from Europe that is mostly ignored during Employment week.
Actually, maybe the news from Italy is being mostly ignored here because it is hard for Americans to truly fathom what is going on. Remember that the basic issue is that a majority of Italians voted for one or another party that favored ending austerity measures and/or leaving the Euro, but left no single party controlling both houses of parliament. Until this morning, it appeared that no single party would be able to form a government, which meant that a new election would likely be called soon. But now it appears that the Five Star Movement (Beppe Grillo’s party) is offering to stage a walk-out from the senate. Now, that sounds negative, right? Well, actually it’s progress (and Grillo’s party would have to be given some policy concessions in exchange for walking out, which sounds like “lovely parting gifts” to me) since Five Star doesn’t have enough delegates to prevent a quorum from being established if they leave (with no quorum, the body cannot conduct business) but their absence would allow a majority to be established on a lower number.
In the U.S., the approach would be different: the Senators would reach a deal and then vote on the deal, with no one having to manipulate the process in an arcane Robert’s-Rules-of-Order fashion. On the other hand, they had a senate in Rome about 2,500 years before we had one, so who are we to question their parliamentary process?! And our institutions are no less clownish at times…such as right now, since despite so many dire threats the world apparently did not end over the weekend once the budgetary sequester went into effect.
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Since the markets were quiet today (and likely will remain relatively quiet until the Employment report on Friday, if recent patterns hold true), I thought I’d take up a topic I’ve been meaning to discuss for a while: a look at the relative value of gold and a link to an interesting new paper on gold.
First, let me say that our systematic metals and mining strategy is currently approximately neutral-weight on gold itself, overweight on industrial metals, and deeply underweight on mining stocks. But that strategy relies on metrics I am not discussing here; nothing, moreover, that I discuss here should be taken as an indication of whether Enduring Investments would suggest an investor should add or subtract to his or her particular exposure.
Disclaimer completed, let’s look at the yellow metal relative to other assets, as I first did in this space back in August of 2010 when I concluded that gold did not look particularly overvalued. Gold subsequently rallied another 60%, then slid (in case you haven’t heard!). It is currently still 30% above where it was in August of 2010. So is it overvalued?
Some observers have noted that the ‘real price of gold’ (that is, gold deflated by the current price level) has recently risen to levels not seen since the peak of the gold market in the early 1980s (see chart, source Bloomberg, which shows gold in constant December 2012 dollars).
This is true, of course, but measuring the ‘real’ price of gold is a funny concept. The gold price relative to the cost of the consumption basket is a metric that has meaning, because it tells you how much consumption you displace to buy an ounce of gold, but unless you’re evaluating the consumption of gold I am not sure that’s a relevant metric.
On the other hand, it makes more sense to me to look at investments relative to gold, since that’s what is likely to be displaced by a purchase of gold. Some of these relationships are not particularly useful analytically, though, or at least appear at first blush not to be. For example, looking at gold versus the stock market (see chart, source Bloomberg) you can’t tell very much except that gold was rich or stocks were cheap (or both) in 1980 and gold was cheap or stocks were rich (or both) in 2000. Or, so I wrote in 2010.
However, I subsequently noticed another chart that looked somewhat similar. Below (source: Enduring Investments) I have put the data from the chart above alongside a measure of the volatility of inflation expectations, as taken from the Michigan Sentiment Survey. (As I’ve written previously, surveys of sentiment are not satisfying ways to measure true inflation expectations, but they’re all we’ve got and they might nevertheless be valuable in measuring the volatility of inflation expectations, which is what we’re trying to do here).
The notion is this: when inflation expectations are becoming both lower and more stable, then stocks become more valuable and gold less so as an investment item. But, when inflation expectations are rising and/or becoming less-stable, then stocks become less valuable and gold more so as an investment item. I haven’t worked very carefully to refine this relationship, but the Michigan series begins in 1978 so that’s the main limitation. Yet, without any lags nor tweaking of period lengths, the R-squared here (on levels, not changes) is 0.745, which is firmly in the “interesting” category.
Having said that, unless we’re able to forecast the volatility of inflation this isn’t particularly helpful in assessing whether gold is rich or cheap relative to stocks (although on the regression, not shown, the ratio of gold/S&P is 1.04 but ought to be more like 1.07, so gold looks slightly cheap to stocks). The main thing we can do with this is explain why gold prices have risen relative to stock prices over the last decade, and it makes sense. In this context, the recent slide in gold/rally in stocks can be attributed to a soothing, perhaps temporary, in consumers’ concerns about inflation.
The champion relationship, although less creative, is the ratio of gold to crude. Over a long period of time, an ounce of gold has bought between 15 and 20 barrels of crude oil (West Texas Intermediate), with occasional spikes wider and at least one lengthy period between 7 and 12. The chart below (source: Bloomberg) shows this classic relationship. It makes some sense that two hard commodities, both exchange traded and having no natural real return to them, ought to broadly parallel each other over time. Again, this isn’t a very good trading relationship but it is a decent sanity check.
By this measure, gold is approximately at fair value, although an argument could be made that WTI is no longer the fair price for crude. In terms of Brent Crude, Gold is only 14.3 barrels and so arguably slightly cheap.
None of this will delight the gold bulls, but it also won’t delight the gold bears. Gold, at least the way I look at it, seems to me to be somewhere between slightly cheap to roughly fair value versus a pair of comparables. Of course, it may be that stocks and crude oil are slightly expensive, on the other hand!
Gold bulls and bears also will both find things to like and things to dislike in a paper by Erb and Harvey called “The Golden Dilemma.” Given that gold bulls tend to be more, er, passionate about the subject, they will likely be more strident in their disagreements but it is a capable attempt to tackle many of the well-known arguments for owning gold and put them to logical and empirical test.
These gentlemen (who have some serious chops in commodities research) conclude that as an inflation hedge, gold is (1) not an effective short-term hedge, (2) not an effective long-term hedge, (3) might be effective over the very, very, very long-term, and (4) probably effective in a hyperinflationary situation. Although this depends somewhat on your meaning of “hedge,” I concur that gold is not a hedge. It can, with some work, be made into a smarter hedge, which works better (especially in conjunction with other metals, and mining stocks). But they make a fairly powerful argument that if there’s even a teensy chance that hyperinflation happens, a high gold price can be rational since the tail of an option contributes quite a bit to its value.
Incidentally, a slide-show version of the paper is here and is pretty good even if you didn’t read the paper.
It Pays To Be Contrary
At one time, I think most of us assumed that the stock market would have a hard time rallying without its largest component, Apple (AAPL).
Pretty soon, Apple will solve that problem, since it won’t be too long before it is smaller than Exxon-Mobil (XOM) again. It is actually fairly remarkable that the S&P has managed to rally 3.2% this year even though AAPL is -8.7%.
This phenomenon is amazingly timely, considering that in the November/December issue of the Journal of Indexes there was an article by Rob Arnott and Lillian Wu called “The Winner’s Curse” in which the authors noted that “For investors, top dog status – the No. 1 company, by market capitalization, in each sector or market – is dismayingly unattractive.” Later, they note that “the U.S. national top dog underperforms the average company in the U.S. stock market by an average of 5 percent per year, over the subsequent decade.”
Nice call.
That observation follows naturally from Arnott’s work that led to fundamental indexing – his observation, simply, is that by definition if you are capitalization weighting you will always have “too high” a weight in stocks that are overvalued relative to their true prospects and “too low” a weight in stocks that are undervalued relative to their true prospects. There is no way to know if Apple is one of those – it’s a great company, and there’s no reason that the top-capitalization company is necessarily overvalued – but the authors of that article note that when you’re the top dog, more people are taking potshots at you. It suggests an interesting strategy, of buying the market except for the top firm in each industry.
This is why contrarians tend to do well. If you buy what everyone else is selling, and sell what everyone else is buying, there’s no reason to think you’ll be right on any given trade but you are much more likely to be buying something that is being sold “stupidly” and to sell something that is being bought “stupidly.”
Which brings me back to commodities, which are unchanged over the last 9 years (DJUBS Index) while the basic price level has risen 24% and M2 is +72%. But I know you knew that’s where I was going.
Below is a picture of the worst two asset classes of the last nine years (I picked 9 years because that’s the period over which both of them are roughly unchanged). The white line is the S&P-Case Shiller index, while the yellow line is the DJ-UBS Commodity Index.
One of these two lines is currently generating much excitement among economists and investors, including institutional investors, who are pouring money into real estate. The other line is generating indifference at best, loathing at worst, and plenty of ink about how bad global growth is and how that means commodities can’t rally.
One of these lines is also associated with an asset class that has historically produced +0.5% real returns over long periods of time, and consequently isn’t an asset class that one would naturally expect to have great real returns. The other is associated with an asset class that has historically produced +5-6% real returns, comparable with equity returns, over long periods of time. Care to guess which is which?[1]
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Tomorrow, the BLS will release the Consumer Price Index for December. The consensus for core inflation is for a “soft” +0.2%, and a year-on-year core inflation increase for 2012 of +1.9%.
Now, last December’s core inflation number was +0.146%, and last month’s year-on-year core CPI was +1.94%. What that means is that it will be quite difficult to get both +0.2% on the monthly core figure and +1.9% on the y/y change. If get +0.17% on core, then we should round up to +2.0% unless something odd happens with the seasonal adjustments.
In other words, I think it’s very likely that core inflation will pop back up to 2.0%. As a reminder, the Cleveland Fed’s Median CPI is still higher, at 2.2%, so it should not be surprising at all that core inflation has a better chance of going up than going down from here.
The two major subindices to look for are Owner’s Equivalent Rent, which last month was at 2.14% y/y, and Rent of Primary Residence, which was 2.73% y/y. Those two, combined, represent 30% of the consumption basket, and it was the flattening out of those series that caused core CPI to flatten around 2.0%. (Six months ago, the trailing y/y change in OER was 2.1%; the y/y change was 2.7%). Accordingly, watch closely for an uptick in those indicators. We believe that they are going to accelerate further, likely sometime in the next 3 months.
[1] Hint: the one that has historically provided great returns is one that few investors have very much of. The one that has historically provided bad returns is the one that represents most of a typical investor’s wealth.
Fama on the Fed and Inflation
I don’t agree with Eugene Fama on everything, but I’d be a fool if I didn’t agree with him on quite a bit. Fama wrote the paper which, back in the early 1980s, pointed out that if you modeled inflation as a result of monetary factors and Keynesian factors (unemployment, e.g.), the Keynesian factors didn’t add anything. Since then, economists have pretty much forgotten that lesson, so that we have to continually battle the Keynesian “let’s just expand government spending” crowd.
Many of his views about efficient markets are pretty extreme, and that’s where I can’t agree wholeheartedly. However, I read with interest the discussion between Fama and Bob Litterman in this month’s issue of the Financial Analysts Journal. The full interview, called “An Experienced View on Markets and Investing,” is located here, and since the FAJ has made the entire interview available for free I am going to quote liberally from the last page. Indeed, I am going to print three of the last four questions, because they correlate exactly to things I have written in this space, and echo almost exactly the views I have expressed. Considering Fama is one of the godfathers of modern finance, I take this as indication I am on the right track, at least sometimes.
In the passages below, I have added all the emphasis marks.
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Litterman: What impact will the big expansion in the Federal Reserve’s balance sheet have on the markets?
Fama: It has basically rendered the Fed powerless to control inflation. In 2008, when Lehman Brothers collapsed, the Fed wanted to get the markets moving and made massive purchases of securities. The corollary to that activity, however, is that reserves issued by the Fed and held by banks exploded. An explosion in reserves causes an explosion in the price level unless interest is paid on the reserves. So, the Fed started to pay interest on its reserves, which means that the central bank issued bonds to buy bonds. I think it’s a largely neutral activity.
Before 2008, controlling inflation was a matter of controlling the monetary base (currency plus reserves). But when the central bank pays interest on its reserves, it is the currency supply that determines inflation. But banks can exchange currency for reserves on demand, which means the Fed cannot control the currency supply and inflation, or the price level, is out of its control. The Fed had the power to control inflation, but I don’t think it does under the current scenario.
[Ashton's note: Fama identifies why the monetary base is no longer tied to inflation - the link to transactional money has been severed thanks to IOER. See some of my remarks on this here.]
Litterman: But isn’t one way out of our debt problem to inflate it away?
Fama: Yes, that’s one way to handle it, but it’s far from a great solution. If the Fed were to stop paying interest on its reserves, we’d probably have a big inflation problem. The monetary base was about $150 billion before the Fed stepped in in 2008. Currency plus required reserves are still in that neighborhood, but the Fed is holding $2.5 trillion—trillion!—worth of debt financed almost entirely by excess reserves. The price level could expand by the ratio of those two numbers, and that translates into hyperinflation. Economies typically do not function well in hyperinflation. The real value of the government debt might disappear, but the economy is likely to disappear with it.
Litterman: What would your suggestion be for monetary or fiscal policy at this point?
Fama: Simple. Balance the budget. I heard a very prominent person say in private that we could balance the budget by going back to the level of government expenditures in 2007. The economy is currently about the size it was then. If you just rolled expenditures back to that point, I think it would come close to balancing the budget.
[Ashton's note - just this month, I commented that all you have to do to get the budget back into a semblance of balance was to reverse most of the things that were done over the last decade.]
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The whole FAJ article is pretty good, but I wanted to make sure that everyone caught this part of it!
Shifting Regimes And Those at Risk of Toppling
Equities weakened today, while commodities strengthened (and especially energy commodities). Although it is only one day’s trading, this messes around a little bit with the popular themes at the moment regarding why stocks are so high despite widespread expectations for a lackluster Q3 earnings season.
One theme has it that the stock market is doing well because the economy had been looking pretty good, especially with Friday’s positive (although not terrific) Employment Report, even if Q3 turns out to be disappointing. After all, stocks are supposed to discount the future, not the past, right? In line with that theme, today’s pullback might represent a weakening of sentiment about global growth. The IMF revised downward its forecast for global growth to 3.3% this year (and advanced economies only 1.3%). However, if that’s the reason then surely commodities ought to have suffered as well, especially gasoline. On the contrary, gasoline rose 2.6%, with November RBOB coming within $0.60 of a contract high set in March.
Another theme is that quantitative easing has been levitating stocks, despite weak fundamentals. But that doesn’t hold water either, since quantitative easing ought to be pushing commodities higher at least as much as it is pushing equities (which, after all, tend to trade with weak multiples in high-inflation regimes). The chart below (source: Bloomberg) shows the last year’s trading in the S&P, gold, and the DJ-UBS generally, normalized to October 10th = 100. While all three of these markets have rallied since the first implementation of the “soft” Evans rule back in June, stocks have clearly outpaced the markets that traditionally respond best to monetary largesse. So stocks are not likely up here because of QE, although that excuse probably helped over the last month.
It could, of course, be an equity-specific reason…like high valuations and probably unsustainable gross margins…but that doesn’t play well in Peoria so even though it is the simplest answer, it probably isn’t one the majority of analysts will put forth. It would be bad for business!
More subtle is the possibility that the inflation regime is moving from one that is accommodative to equity valuations (low, stable inflation) to one that is less accommodative. A ‘regime shift’ in inflation expectations is consistent with the way that inflation markets are trading – although breakeven inflation weakened very slightly today, 10-year BEI have rallied back to near all-time highs after the set back in the second half of September. It isn’t that the regime shift has happened today, and I’m not claiming that, but that it may be in the process of happening as the stock market is looking and acting toppy while inflation markets are showing some vibrancy.
It is hard to say why regime shifts happen, and the econometrics doesn’t tell you why – it just gives you ways to measure it and model it after the fact. It may be something incalculably complex, or something as easy as a news story that causes investors to reassess the context of the risks they are taking. A story, for example, about the rapidly rising prices in Iran and the collapsing rial.
It is hard to measure just exactly what inflation is in Iran. The latest figures from the central bank are from April, and show that inflation in the first four months of the year was running at a 44% annualized rate. But from all accounts, this has accelerated recently, and the behavior of consumers in the article linked to above smacks not of 3% monthly inflation, but of a much higher rate.
The reason that some people are calling this ‘hyperinflation’ is because the black market exchange rate for Iranian rials has apparently collapsed (I personally am not in touch with the black market so I have to take that on faith). The official rate, shocker of shockers, hasn’t changed much; since February you’ve been able to get about 12,350 rials for the dollar (see chart, source Bloomberg).
Now, whether or not the exchange rate is 12,000 IRR/$ or 40,000 IRR/$ isn’t as important to the average Iranian as the exchange rate of IRR for stuff – that is, the price level. This fact has led to some analysts making the rather wacky claim that inflation isn’t really that bad since the exchange rate doesn’t really matter to most Iranians. According to the story linked to here,
The politically-important lower-classes…are shielded from devaluation of the dollar because their day to day lives don’t even involve dollars. Salehi-Isfahani told Business Insider, “The Iranian currency is very worthwhile for poor people. They go to work, they get their daily wage, they go buy their chicken and bread, and they get the same that they got the day before.”
That’s crazy. If prices are changing for the upper class, I can’t think of how the lower class could possibly be insulated from those price changes. Economies just don’t work that way. If there is one exchange rate for one set of goods and another exchange rate for a different set of goods, it implies a changing exchange rate between those goods, unless there is to be arbitrage. So, to make up an example: perhaps the price of an egg is table in rials, except that a few months ago it was enough to buy bus fare and now you can trade it for a car, because both can be exchanged for enough rials to equal $1. See anything absurd about that? The relative prices matter, and you can’t stop barter, and therefore you can’t have different exchange rates in different parts of the economy without completely screwing up the economic system – probably worse than if you just let the inflation do its thing, which would at least not destroy the relative prices of goods to each other.
Moreover, the anecdotal stories don’t point to a low level of inflation, whether it’s called “hyperinflation” or not. Any way you slice it, when inflation is 40%+ whatever wealth you have saved up for a rainy day is vanishing quickly, and in Iran this is undermining an already unpopular regime (although probably not quickly enough for Israel!).
The simple realization is: when inflation starts getting out of control (and wonder of wonders, M1 money supply in Iran has risen at roughly a 34% per annum pace since 2007), all your stored-up wealth had better be in real things, or you won’t have any stored-up wealth. This is more true at 60% inflation than at 6% inflation, but even 6% inflation will halve the real value of your wealth in less than a decade. In that context, in context of the mere risk of such an outcome, I’ve wondered for a long time why more investors don’t look to protect a bigger portion of their portfolios with inflation-linked solutions. Maybe that regime is finally shifting (the inflation expectations regime, that is, not the Iranian regime) as we have an example that we can see today, rather than harkening back to the 1970s.
Incidentally, if you’re thinking about inflation investing, you may be interested in the following item. In the August “Beyond the Numbers,” a publication put out by the Bureau of Labor Statistics, there was an article entitled “Consumer Price Index data quality: how accurate is the U.S. CPI?” If you know any of those people who grouse and grumble about hedonic adjustment (the net effect is almost zero) and about the substitution of chicken for steak (the BLS makes no such adjustment, which is an ‘upper level’ substitution; the BLS only suggests that if the price of Purdue chicken goes up you might buy a different brand of chicken), then suggest this piece to them. It describes and addresses some of the biases in the CPI and how the BLS deals with them. Those that take the time to read this (relatively brief) piece will understand a lot more about how the number is actually computed, as opposed to how some hacks claim it is computed, and hopefully such an understanding will open up a wider universe of potential investments in the ‘inflation control’ toolbox.
Side Bet With Ben?
The markets are saying pretty clearly that there will be no more business done until the results of the Greek elections are known. For the last six trading sessions, the S&P has traded mostly in a range between 1310 and 1329, having made roughly seven round-trips of that range since last Wednesday’s updraft. Ten-year nominal yields have been between 1.56% and 1.70% for the most part. Ten-year real yields have oscillated between -0.60% and -0.50%. That’s despite disappointing Retail Sales on Wednesday, disappointing Initial Claims (386k, with an upward revision to last week), and a CPI release that bond and equity bulls certainly wanted to seize hold of. Late in the day, Egan Jones downgraded France to BBB+ with a negative outlook, but this news – not really news, in a way – was overshadowed by the rumor which circulated (sourced to Reuters) that said the G20 central banks had prepared coordinated “action” in the event that the Greek election this weekend rattled markets. The S&P spiked 15 points on that story, but then came back to the high end of the range.
Headline consumer prices fell -0.3% on the month, dropping the year-on-year rate of increase to +1.7%. As I predicted, the airwaves were replete with talk about the Fed’s response to an indicator that they largely ignore. According to Bloomberg, the renewed “stimulus speculation” was responsible for the decline in Treasury prices, the rise in oil prices (“The cost of living in the U.S. fell in May by the most in more than three years, Labor Department data showed today, giving Fed policy makers more flexibility to take further action to bolster U.S. economic growth”), and the fall in the dollar, and NASDAQ chimed in suggesting that stocks were rallying on Fed stimulus hopes. So many “hopes” on such a slim reed! To be sure, these articles all mentioned the weak ‘Claims figure, but it wasn’t that far out of line. It has been running around 380k, and 386k appeared on the tape. If that’s good enough for QE, then we should be on about QE14 by now.
Outside of the decline in headline inflation, core inflation didn’t show any signs of rolling over. As I suggested yesterday, economists were looking for a “soft” 0.2% on core inflation, causing the year-on-year rate to drop to 2.2% on a rounded basis. The BLS actually reported something just barely above 0.2%, which caused y/y CPI to stay at 2.3%. Keep in mind that the only reason that a downtick was even threatened was because last May showed a +0.3% and that is now rolling out of the data. Today’s figure, annualized, would produce 2.45%. Over the next few months, the hurdle for core CPI to move higher – or at least to avoid declining – grows easier. We’re unlikely to see core CPI dipping any time soon, so if the Fed wants to do QE, they’ll need to suddenly grow interested in headline inflation. (But if they do, they run the risk of getting caught sounding stupid if there’s a Middle East flare-up, or if Natural Gas follows up on the 14% rally it had today after a very weak inventory build).
That said, there could be some signs that core CPI is flattening out. Of the eight ‘major-groups’, only Medical Care, Education & Communication, and Other saw their rates of rise accelerate (and those groups only total 18.9% of the consumption basket) while Food & Beverages, Housing, Apparel, Transportation, and Recreation (81.1%) all accelerated. However, the deceleration in Housing was entirely due to “Fuels and Utilities,” which is energy again. The Shelter subcategory accelerated a bit, and if you put that to the “accelerating” side of the ledger we end up with a 50-50 split. So perhaps this is encouraging?
The problem is that there is, as yet, no sign of deceleration in core prices overall, while money growth continues to grow apace. I spend a lot of time in this space writing about how important money growth is, and how growth doesn’t drive inflation. I recently found a simple and elegant illustration of the point, in a 1999 article from the Federal Reserve Board of Atlanta’s Economic Review entitled “Are Money Growth and Inflation Still Related?” Their conclusion is pretty straightforward:
“…substantial changes in inflation in a country are associated with changes in the growth of money relative to real income…the evidence in the charts is inconsistent with any suggestion that inflation is unrelated to the growth of money relative to real income. On the contrary, there appears to be substantial support for a positive, proportional relationship between the price level and money relative to income.”[1]
But the power of the argument was in the charts. Out of curiosity, I updated their chart of U.S. prices (the GDP deflator) versus M2 relative to income to include the last 14 years (see Chart, sources: for M2 Friedman & Schwartz, Rasche, and St. Louis Fed, and Measuring Worth for the GDP and price series). Note the chart is logarithmic on the y-axis, and the series are scaled in such a way that you can see how they parallel each other.
That’s a pretty impressive correlation over a long period of time starting from the year the Federal Reserve was founded. When the authors produced their version of this chart, they were addressing the question of why inflation had stayed above zero even though M2/GDP had flattened out, and they noted that after a brief transition of a couple of years the latter line had resumed growing at the same pace (because it’s a logarithmic chart, the slope tells you the percentage rate of change). Obviously, this is a question of why changes in velocity happen, since any difference in slopes implies that the assumption of unchanged velocity must not hold. We’ve talked about how leverage and velocity are related before, but an important point is that the wiggles in velocity only matter if the level of inflation is pretty low.
A related point I have made is that at low levels of inflation, it is hard to disentangle growth and money effects on inflation – an observation that Fama made about thirty years ago. But at high levels of inflation, there’s no confusion. Clearly, money is far and away the most important driver of inflation at the levels of inflation we actually care about (say, above 4%!). The article contained this chart, showing the same relationship for Brazil and Chile as in the chart updated above:
That was pretty instructive, but the authors also looked across countries to see whether 5-year changes in M2/GDP was correlated with 5-year changes in inflation (GDP deflator) for two windows. In the chart below, the cluster of points around a 45-degree line indicates that if X is the rate of increase in M2/GDP for a given 5-year period, then X is also the best guess of the rate of inflation over the same 5-year period. Moreover, the further out on the line you go, the better the fit is (they left off one point on each chart which was so far out it would have made the rest of the chart a smudge – but which in each case was right on the 45-degree line).
That’s pretty powerful evidence, apparently forgotten by the current Federal Reserve. But what does it mean for us? The chart below shows non-overlapping 5-year periods since 1951 in the U.S., ending with 2011. The arrow points to where we would be for the 5-year period ending 2012, assuming M2 continues to grow for the rest of this year at 9% and the economy is able to achieve a 2% growth rate for the year.
So the Fed, in short, has gotten very lucky to date that velocity really did respond as they expected – plunging in 2008-09. Had that not happened, then instead of prices rising about 10% over the last five years, they would have risen about 37%.
Are we willing to bet that this time is not only different, but permanently different, from all of the previous experience, across dozens of countries for decades, in all sorts of monetary regimes? Like it or not, that is the bet we currently have on. To be bullish on bonds over a medium-term horizon, to be bullish on equity valuations over a medium-term horizon, to be bearish on commodities over a medium-term horizon, you have to recognize that you are stacking your chips alongside Chairman Bernanke’s chips, and making a big side bet with long odds against you.
I do not expect core inflation to begin to fall any time soon.
[1] The reference of “money relative to income” comes from manipulation of the monetary identity, MV≡PQ. If V is constant, then P≡M/Q, which is money relative to real output, and real output equals income.
Monetary Sedition
Is it really necessary to have a canary in the coal mine when the mine is belching clouds of noxious smoke? Today’s Empire Manufacturing Report surprised on the weak side by printing only 6.56 for April, the weakest number of the year so far although still well ahead of the lows from last year (see Chart, source Bloomberg).
With most recent data being acceptable, albeit not robust, this early current-month data will worry some observers. It doesn’t worry me very much, partly because the series clearly has some choppiness to it but more because I’m already fairly worried about how rapidly the European situation is unraveling again. I am generally towards the more-skeptical end of the spectrum, which tells me that it’s probably true that most observers thought that surviving the cliffhanger over the Greek funding package bought us 3-6 months, if not a year, of relative calm. That includes both the Pollyannas who really thought the worst was over, and those of us who were confident that the last chapter had not been written by a bailout that added to the debt burden of Greece.
The first hint was that the new Greek bonds immediately started trading with yields to maturity of 18-20%, but it is still striking that the dogs were only put at bay for one solitary month.
Because now that Spanish yields are officially back above 6% in the 10-year sector and Spanish economic ministers are publicly pleading with the ECB to buy bonds to support the market, the blood is back in the water. On Friday (but not getting much play until the weekend) there was also a report that net borrowings by Spanish banks from the ECB rose 49% in March, and that Spanish banks represent about 29% of the long-term borrowings from the ECB to Euro-area banks. The “net” number, which recognizes that some of the money that banks borrowed in LTRO was immediately re-deposited with the ECB, indicates that Spanish banks account for 60% of that “net” lending.
Curiously, equity markets took only executive notice of the rising temperature in Spanish debt markets, with the US bourse closing unchanged measured by the S&P. Indices with more Apple exposure closed weaker, and indices with less Apple closed stronger, as the Nifty One stock continued the now-stomach-wrenching decline started last week (see Chart, Source: Bloomberg).
It should be noted that 26% of Apple’s 2011 revenues, and about 21% of its growth in revenues from 2010 to 2011, came from Europe. I make no predictions about Apple’s future trajectory, but I will note that I was stunned to find that revenue for Apple’s hugely popular iPod line actually declined last year to a level last seen in 2005, when it was 40% of the company’s revenues as opposed to 7% now (as the iPhone is 44% of revenues in 2011). I wonder aloud (without stating a conclusion) whether a high-teens multiple ought to be attributed to a company that needs to reinvent whole product lines every six years. I guess the market is asking the same question, as the P/E is now down to 16.5. (By contrast, Microsoft has an 11.5 multiple, and its revenues have been roughly 30% “Business Division,” 30% “Windows Division,” and 20-25% “Server and Tools” for quite a long time. And MSFT pays a higher dividend. Disclosure: I have no position in either stock).
The other topic that was distracting from Spain discussions was the sharp decline in gasoline futures. Front gasoline futures fell to $3.267/gallon. Retail gas is up around $3.91, but this is almost the lowest that gasoline futures have been since early April. Brent Crude dropped to the lowest level since February, although NYMEX Crude didn’t decline very much. Some observers attributed these declines to agreement among the UN Security Council members (plus Germany) to go meet Iranian delegates in late May to talk about Iran’s nuclear program, but the fact that Brent and Gasoline fell further than NYMEX Crude suggests the real reason is more likely the growth fears emanating from Europe.
Interestingly, inflation markets mostly ignored the decline in energy markets. I wonder if the relative buoyancy of TIPS lately has anything to do with the persistent elevation of money supply growth. I have been harping on the steady rise in the broad transactional aggregate for a while – for at least 36 weeks, in fact. That’s how long that year-on-year M2 has been above 9.2%. To find a longer streak of such rapid money growth, you have to look back to 1983-84, when M2 rose at a 9.2%-or-faster pace for 56 consecutive weeks (see Chart, Source Federal Reserve).
There is some sign, at least, that there is starting to be some introspection around the Federal Reserve system about this money growth; perhaps rebellion is more like it. I pointed out on February 29th the article by St. Louis Fed economist Daniel L Thornton in which he said “While discussions of the money supply are nearly nonexistent in modern monetary theory and policy, both economic theory and historical experience suggest that a significant and persistent expansion in the money supply will be associated with a significant increase in the longer-run inflation rate.” Today, on the Federal Reserve Bank of Atlanta’s “macroblog,” senior economist Mike Bryan introduced a new animated video the Fed has created (the ostensible reason for the blog entry) by citing Fisher’s explanation of the difference between two types of inflation – one of which is purely monetary:
“If it can be shown, for instance, that today the good things of this world are becoming scarce on the one hand while money and its substitutes are not becoming plentiful it would be reasonable to conclude that the fault lies with goods and not with money. If, on the contrary, it can be shown that money and its substitutes are becoming plentiful and that goods are not becoming scarce, it is reasonable to conclude that the fault lies chiefly on the monetary side.”
Clearly, in the current instance the latter definition is the dominant force. It is interesting, isn’t it, that as far back as 1913 economists recognized that money could cause inflation even without growth-driven demand pushing on prices? And yet, today, this point is difficult for some economists to accept.
By the way, the video explaining the difference between increases in the cost of living (real prices) and inflation is very good (except that it makes you wonder why the Fed is letting the money supply grow so rapidly), and worth the four-minute investment.
I don’t necessarily think that the cheeky blog entries by the Atlanta Fed and the “Economic Synopsis” articles by St. Louis Fed economists indicate that the Board is about to rein in money growth, but it is heartening that the “nearly non-existent” minority opinion that money matters is starting to become at least a little more vocal. There is no rebellion, but there is sedition in the ranks.
Odds In The Skeptic’s Favor
Friday’s shocking news was that new home sales are weak!
I would say that sometimes I don’t understand market reactions, but the fact is that I fully understand them much of the time; I just can’t understand how investors can be so myopic. New Home Sales came in at 313k, below the 325k that had been expected. The stock market initially didn’t take the news well, and bonds rallied. But look at the chart below – what number, short of 500k, would have been great news?
And in fact, there was some good news in both the New Home Sales data and the Existing Home Sales data from Wednesday, and that is that the inventory of homes continues to decline. While it’s certainly true that there could well be “shadow inventory” of existing homes to come on the market, the actual inventory that is out there now is near the lowest level it has seen since 2005, and in somewhat of a ‘normal’ range (see Chart). The inventory of new homes, already at multi-generational lows, fell further. Both of these facts speak to the likelihood that we are not likely to see a new leg lower in home prices soon, although the fact that there probably is some shadow inventory means home prices might continue to lag inflation a bit on the upside (thereby falling in real price terms).
Friday trading volumes were light, and stocks rebounded to close with small gains with the S&P just shy of 1400 again. Treasury bond yields fell again, by a smidge. But gasoline prices, now at a $3.89/gallon nationwide average price at the pump, continue to roll higher as the front Gasoline contract rose to a new record for March ($3.3852). Support for energy prices was partly due to a report that Iranian crude exports declined this month – again, in a shocking surprise since Iran has been saying they are cutting exports.
But for myopia, it’s hard to beat economists. The Atlanta Fed macroblog on Friday had an article by research director Dave Altig that is worth reading even though I am about to focus on something about it that annoyed me. Most of the posts on the macroblog are fairly interesting, but in some cases they are interesting in the same way it is interesting to look at tree sloths at the zoo. You can gaze at economists behind the glass and muse “they really aren’t like us, are they?”
In this case, Dr. Altig shows a number of intriguing charts showing the weak pace of job growth in this recovery, before raising the good question about “whether historical standards represent the appropriate yardstick today.”[1] Then he goes off the rails a little bit:
“In other words, is the correct reference point the level of employment or the pace of improvement in the labor market from a permanently lower level? For the proponents of the latter view, the bubble chart might very well look like a return to normal, despite the fact that employment has not returned to prerecession levels.
“One way to adjudicate the debate, in theory, is to rely on the trajectory of inflation. If there remains a significant amount of slack in labor markets, as the conventional interpretation of things suggest, there ought to be consistent downward pressure on prices. The case for consistent downward pressure on prices is not so obvious…
“There may not be much evidence of building disinflationary pressure, but neither is there building evidence of an inflationary push that you would expect to see if the economy were bumping up against capacity constraints. Obviously, the story isn’t over yet.”
Readers of this column know that I’ve pointed out a number of times that the failure of the growth-causes-inflation theory in this recession – the worst recession in eighty years didn’t cause prices to fall on a year-on-year basis even a little, or to even get very close; moreover, if you exclude the imploding cost of housing, inflation didn’t even slow very much at all – ought to more or less end the debate over whether growth (or recession) causes inflation (or deflation). It takes a Herculean feat of open-mindedness to say “the case for consistent downward pressure on prices is not so obvious” when core prices have accelerated for 15 of the last 16 months.
But Altig actually it trying to resuscitate the moribund theory by suggesting that perhaps what is wrong isn’t the theory, but rather the estimate of how much slack there is in labor markets. In other words, the theory is still good, but they were just completely wrong about what the limits of productive capacity were. My question is, if the theory’s parameters can be so wrong, is it useful as a theory? And the Occam’s Razor explanation is that…the theory is wrong.
I find the continued resistance to that possibility, despite the accumulating evidence that it is the case, almost incredible. I think it is probably a consequence of the way we try in college to teach the current state of knowledge as the ‘right answer’ instead of ‘our best guess right now.’ Students think they are learning the answers, and therefore they don’t need to question the answers. This is a sad state of affairs. We should be always looking for ways the prevailing theory is wrong, rather than just assuming it is right, because we find over and over and over again, in almost every category of knowledge from physics to astronomy to economics, that the prevailing theory is, in fact, wrong. The odds are in the skeptic’s favor!
And that is one reason that true contrarians (as opposed to those people who want to be just like the other contrarians) tend to do well in markets.
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I will be in San Diego for the next few days, where I am speaking at the IMN Public Funds Summit on the topic of innovations in inflation hedging and trying to make contact with potential clients in the public funds space. Accordingly, there will be no commentary produced until Thursday evening (and an article at that time will depend on work load!).
[1] Note that this isn’t the place to argue the demographic (baby boomers retiring) angle because the Unemployment Rate, which is based on a survey which incorporates job seekers’ intentions, still shows a very high rate. This debate is on the jobs-creation side: have jobs been permanently destroyed here, so that we are rebuilding the economy from a lower plateau rather than restoring lost jobs? I think that’s fairly likely, given the depth and length of the recession.
Liability-Driven Investment for Individuals
I will have another comment out over this long weekend, and it may well mention the S&P ratings downgrades of most of Europe, which just hit the tape. However, I just learned that the Society of Actuaries finally published a paper of mine in their “Retirement Mongraph,” available here, and I figured I would mention it to followers of this blog.
Here’s my abstract:
To date, the financial literature has focused on very simple algorithms designed to improve the solution to the two-part challenge of determining the optimal portfolio asset-allocation strategy and determining the maximum sustainable withdrawal rate for retirees. Most research, for example the well-known “Trinity Study” of Cooley, Hubbard, and Walz, pursues the asset-allocation problem by maximizing long-run asset growth subject to a withdrawal rule and a given acceptable probability of remorse (a.k.a. shortfall). However, the Liability-Driven Investing (LDI) thought process improves the approach by seeking instead to maximize return for a given level of volatility of the portfolio surplus, rather than optimizing on the basis of the volatility of the assets themselves; by more closely matching assets and liabilities, the sensitivity of the strategy to unexpected returns, risks, and correlations is greatly decreased. I updated the Trinity Study to incorporate inflation-indexed bonds and then illustrate how the LDI thought process may be applied to individual investors.
Please let me know if you have any questions or comments!
