On this site I almost never cross-reference posts that have been put up on the Enduring Investments blog, because access to that blog is only available to investors that we pre-screen while this blog is available to pretty much anyone. So, if I post something at the Enduring Investments site, it’s generally intended for a different audience than are the articles put here.
However, in this case I am making an exception because I think the article just posted on that blog, “Inflation and Insurers: How Inflation Resembles a Reinsurance Problem,” contains really important thoughts applicable to anyone in the insurance industry – and we’ve gotten feedback from a number of insurance companies that our presentation on this topic is timely and insightful. So, if you represent an insurance company or know of someone who ought to hear these thoughts, send them to the link above!
Since I wrote a blog post in early December on “The Effect of the Affordable Care Act on Medical Care Inflation,” in which I lamented that “I haven’t seen anything of note written about the probable effect of the implementation of the Affordable Care Act on Medical Care CPI,” several things have come to my attention. This is a great example of one reason that I write these articles: to scare up other viewpoints to compare and contrast with my own views.
In this case, the question is not a trivial one. Personally, I approach the issue from the perspective of an inflation wonk, but the ham-handed rollout of the ACA has recently spawned greater introspection on the question for purely political reasons. This is awkward territory, because articles like that by Administration hack Jason Furman in Monday’s Wall Street Journal do not further the search for actual truth about the topic. And this is a topic on which we should really care about a number of questions: how the ACA is affecting prices, how it is affecting health care utilization and availability, how it is affecting long-term economic growth, and so on. I will point out that none of these are questions that can be answered definitively today. My piece mentioned above speculated on possible effects, but we simply will not know for sure for a long time.
So, when Furman makes statements like “The 7.9 million private jobs added since the ACA became law are themselves enough to disprove claims that the ACA would cause the sky to fall,” we should immediately be skeptical. It should be considered laughably implausible to suggest that Obamacare had a huge and distinguishable effect before it was even implemented. Not to mention that it is very bad science to take a few near-term data points, stretching only for a couple of years in a huge and ponderous part of the economy, to extrapolate trends (this is the error that Greenspan made in the 1990s when he heralded the rise in productivity growth that was eventually all revised away when the real data was in). Furman also conflates declines in the rate of increase of spending with decelerating inflation – but changes in health care spending include price changes (inflation) as well as changes in utilization. I will talk more about that in a minute, but suffice to say that the Furman piece is pure politics. (A good analysis of similar logical fallacies made by a well-known health care economist that Furman cites is available here by Forbes.)
I want to point you to another piece (which also has flaws and biases but is much more subtle about it), but before I do let’s look at a long-term chart of medical care inflation and the spread of medical care inflation to headline inflation. One year is far too short a period to compare these two things, not least because one-time effects like pharmaceuticals losing patent protection or sequester-induced spending restraints can muddy the waters in the short run. The chart below (source: Enduring Investments) shows the rolling ten-year rise in medical care inflation and, in red, the difference between that and rolling ten-year headline inflation.
You can see from this picture that the decline in medical care inflation, and the tightening of the spread between medical care inflation and headline inflation, is nothing particularly new. Averaging through all of the year-to-year wiggles, the spread of medical care has been pretty stable since the turn of the century (which, since this is a 10-year average, means it has been pretty stable for a couple of decades). Maybe what we are seeing is actually the anticipation of HillaryCare? (Note: that is sarcasm.)
Now, the tightening relative to overall inflation is a little exaggerated in that picture, because for the last decade or so headline inflation has been somewhat above core inflation due to the persistent rise in energy prices throughout the ‘00s. So the chart below (source: Enduring Investments) shows the spread of medical care inflation over core inflation, which demonstrates even more stability and even less reason to think that something big and long-term has really changed. At least, not that we would already know about.
The other piece I mentioned, which is more worth reading (hat tip Dr. L) is “Health Care Spending – A Giant Slain or Sleeping?” in the New England Journal of Medicine. The authors here include David Cutler, whom Forbes suspected was tainting his views with politics (see link above), so we need to be somewhat cautious about the conclusions but in any event they are much more nuanced than in the Furman article and the article makes a number of good points. And, at the least, the authors distinguish between spending on health care and inflation in health care. A few snippets, and my remarks:
- “Estimates suggest that about half the annual increase in U.S. health care spending has resulted from new technology. The role of technology itself partly reflects other underlying forces, including income and insurance. Richer countries can afford to devote more money to expensive innovations.” This is an interesting observation that we ought to think carefully about when professing a desire to “bend the cost curve.” If we are reining in inflation, that’s a good thing. But is it a good thing to rein in innovation in health care? I don’t think so.
- The authors, though, clearly question the value of technological innovation. “The future of technological innovation is, of course, unknown. But most forecasts do not call for a large increase in the number of costly new treatments… some observers are concerned that a wave of costly new biologic agents (for which generic substitutes are scarce) will soon flood the market.” Heaven forbid that we get new treatments! “The use of cardiac procedures has slowed as well.” This is a good thing?
- “Health spending has clearly been associated with health improvements, but analysts differ on whether the benefits justify the cost.” Personally, it makes me uncomfortable to leave this question in the hands of the analysts. If the benefits don’t justify the cost, and the market was free, then no one will pay for those improvements. It’s only with a highly regulated market – replete with “analysts” doing their cost/benefit analysis on health care improvements – that this even comes up.
- Some of the statistical argument is a little weak. “The recent reduction in health care spending appears to have been correlated with slower employment growth in the health care field; this suggests that such changes may continue.” I’m not sure that the causality runs that way. Surely tighter limits on what health care workers can earn might cause slower employment growth? That’s at least as plausible as the direction they are arguing.
That sounds very critical, but I point these things out mainly to make them obvious. Overall, the paper does a very good job of discussing the possible causes of the recent slowdown in health care inflation (although they focus inordinately on “the first 9 months of 2013”, a period during which we know the sequester impacted health care prices), give plenty of credit to reforms instituted far before ACA implementation, correctly distinguish between utilization and prices, and highlight some of the promising trends in health care costs – and yes, there are some! The authors are clearly supportive of the ACA, which I am not, but by and large they raise the salient questions.
It matters less if we instantly agree on the solution than that we agree on the questions.
Note: The following blog post originally appeared on June 14, 2012 and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.
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.”
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. [Editor's Note: While core inflation in fact began to decelerate in the months after this post, median inflation has basically been flat from 2.2% to just above 2.0% since then. The reason for the stark difference, I have noted in more-recent commentaries, involves large changes in some fairly small segments of CPI, most notably Medical Care, and so the median is a better measure of the central tendency of price changes. Or, put another way, a bet in June 2012 that core inflation was about to decline from 2.3% to 1.6% only won because Medical Care inflation unexpectedly plunged, while broader inflation did not. So, while I was wrong in suggesting that core inflation would not begin to fall any time soon, I wasn't as wrong as it looks like if you focus only on core inflation!]
 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.
Trading, and to some extent investing, is all about knowing when markets are moving with the wisdom of the crowds and when they’re moving with the madness of the crowds. In recent years, there has seemed to be much more madness than wisdom (a statement which can probably be generalized beyond the financial markets themselves, come to think of it). Where do we stand now?
I think a recent letter by John Hussman of Hussman Strategic Advisors, entitled “An Open Letter to the FOMC: Recognizing the Valuation Bubble In Equities,” is worth reading. Hussman is far from the only person, nor even the most august or influential investor, questioning the valuation of equities at the moment. Our own valuation models have had the projected 10-year compounded real return of equities below 3% for several years, and below 2% since late April. For a time, that may have been sustainable because of the overall low level of real rates, but since the summertime rates selloff the expected equity premium has been below 1.5% per annum, compounded – and is now below 1% (see Chart, source Enduring Investments).
Hussman shows a number of other ways of looking at the data, all of which suggest that equity prices are unsustainable in the long run. But what really caught my eye was the section “Textbook speculative features”, where he cites none other than Didier Sornette. Sornette wrote a terrific book called Why Stock Markets Crash: Critical Events in Complex Financial Systems, in which he argues that markets at increased risk of failure demonstrate certain regular characteristics. There is now a considerable literature on non-linear dynamics in complex systems, including Ubiquity: Why Catastrophes Happen by Mark Buchanan and Paul Ormerod’s Why Most Things Fail: Evolution, Extinction and Economics . But Sornette’s book is one of the better balances between accessibility to the non-mathematician and utility to the financial practitioner. But Hussman is the first investor I’ve seen to publicly apply Sornette’s method to imply a point of singularity to markets in real time. While the time of ‘breakage’ of the markets cannot be assessed with any more, and probably less, confidence than one can predict a precise time that a certain material will break under load – and Hussman, it should be noted, “emphatically” does not lay out an explicit time path for prices – his assessment puts Sornette dates between mid-December and January.
Hussman, like me, is clearly of the belief that we are well beyond the wisdom of crowds, into the madness thereof.
One might reasonably ask “what could cause such a crash to happen?” My pat response is that I don’t know what will trigger such a crash, but the cause would be the extremely high valuations. The trigger and the cause are separate discussions. I can imagine a number of possibilities, including something as innocuous as a bad “catch-up” CPI print or two that produces a resurgence of taper talk or an ill-considered remark from Janet Yellen. But speculating on a specific trigger event is madness in itself. Again, the cause is valuations that imply poor equity returns over the long term; of the many paths that lead to poor long-term returns, some include really bad short-term returns and then moderate or even good returns thereafter.
I find this thought process of Hussman’s interesting because it seems consonant with another notion: that the effectiveness of QE might be approaching zero asymptotically as well. That is, if each increment of QE is producing smaller and smaller improvements in the variables of interest (depending who you are, that might mean equity prices, long-term interest rates, bank lending, unemployment, etc), then at some point the ability of QE to sustain highly speculative valuations goes away and we’re left with the coyote-running-over-the-cliff scenario. Some Fed officials have been expressing opinions about the declining efficacy of QE, and Janet Yellen comes to office on February 2nd. I suspect the market is likely to test her very early.
None of this means that stocks cannot go straight up from here for much longer. There’s absolutely nothing to keep stock prices from doubling or tripling from here, except the rationality of investors. And as Mackay said, “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.” Guessing at the date on which the crowd will toggle back from “madness” to “wisdom” is inherently difficult. What is interesting about the Sornette work, via Hussman, is that it circles a high-risk period on the calendar.
For two days in a row now, I’ve discussed other people’s views. On Wednesday or Thursday, I’ll share my own thoughts – about the possible effects of Obamacare on measured Medical Care inflation.
Before getting into today’s column, let me first describe my plan of attack for the month of December. I plan to have several comments this week and next week, culminating in my annual “Portfolio Projections” piece at the end of next week. Then, for the last two weeks of the month, I plan to ‘re-blog’ some of my best articles from the last four years (editing out the current events, which will no longer be topical of course). Included in that list is an article on long-run returns to equities, one on Yellen’s defense of large-scale asset purchases, an article on the Phillips Curve, one on why CPI isn’t a bogus construct of a vast governmental conspiracy, and so on. Because I don’t expect some of the places where this column is ‘syndicated’ to post the re-blogs, you should consider going to the source site to sign up for these posts.
With that housekeeping complete, I want to turn today to a scholarly article I recently stumbled on which is worth a read even once you have read my synopsis and comments. The article, written one year ago by Samuel Reynard of the Swiss National Bank, is entitled “Assessing Potential Inflation Consequences of QE after Financial Crises.” It appears to be unpublished except as a working paper, which perhaps shouldn’t be surprising since it is so decidedly clear-eyed and takes the consensus view of QE to task.
What I love about this article is that Reynard’s view is remarkably consonant with my own – the only example I can come up with of a reasonably-placed central banker espousing such commonsensical views (Daniel Thornton at the St. Louis Fed gets an honorable mention though), backed with quantitative data and clear reasoning. Here is the paper’s abstract:
“Financial crises have been followed by different inflation paths which are related to monetary policy and money creation by the banking sector during those crises. Accounting for equilibrium changes and non-linearity issues, the empirical relationship between money and subsequent inflation developments has remained stable and similar in crisis and normal times. This analysis can explain why the financial crisis in Argentina in the early 2000s was followed by increasing inflation, whereas Japan experienced deflation in the 1990s and 2000s despite quantitative easing. Current quantitative easing policies should lead to increasing and persistent inflation over the next years.”
In the introduction, the author directly tackles current central bank orthodoxy: “It is usually argued that it is sufficient to monitor inflation expectations, and that central banks can avoid accelerating inflation by quickly withdrawing reserves (or by increasing the interest rate payed on reserves) once inflation expectations start rising. The monetary analysis of this paper however shows that there has never been a situation of excess broad money (created by the banking system) which has not been followed by increasing inflation, and that the increase in inflation occurs after several years lags.”
Reynard starts with the quantity theory of money (MV≡PQ), which I have discussed at length in this column. Regular readers will know that I am careful to distinguish transactional money from base money – as does Reynard – and that the sole reason inflation has not accelerated is that money velocity has declined. This decline is not due to the financial crisis directly, but as I have shown before it is due to the decline in interest rates. This makes monetary policy problematic, since an increase in interest rates which in ordinary times (that is, when there isn’t a couple trillion of excess reserves) would cause M2 to decelerate and dampen inflation will also cause money velocity to rise – offsetting to some extent the effects of the rising interest rates on the money supply. (Among other things, this effect tends to help cause monetary policy to overshoot on both sides). Reynard’s insightful way around this problem is to “model equilibrium velocity as a function of interest rate to reflect changes in inflation environments.” That is, the monetary equation substitutes an interest rate variable, based on a long-run equilibrium relationship with velocity, for velocity itself. In Reynard’s words,
“Thus the observed money level is adjusted…by the interest rate times the estimated semi-elasticity of money demand to account for the fact that, for example in a long-lasting disinflationary environment when inflation and interest rate decrease, the corresponding increase in money demand reflecting the decline in opportunity cost is not inflationary: the price level does not increase with the money level given that equilibrium velocity decreases.”
This is exactly right, and it is exceedingly rare that a central banker has that sort of insight – which is one of the reasons we are in this mess with no obvious way out. Reynard then uses his model to examine several historical cases of post-crisis monetary and inflationary history: Switzerland, Japan, Argentina and the 1930s U.S. He finds that there are downward rigidities to the price level that cause inflation to resist turning negative (or to fall below about 1.5% in the U.S.), but that when there is excess liquidity the link between liquidity and inflation is very tight with a lag of a couple of years. Reynard’s opinion is that it is this non-linearity around price stability that has caused prior studies to conclude there is no important link between money and inflation. As Fama observed back in the early 1980s, and I observe pretty much daily to the point that it is now a prohibited topic at the dinner table, when inflation is very low there is a lot of noise in the money-inflation relationship that makes it difficult to find the signal. But the money-inflation connection at higher levels of inflation and money, and over longer periods of time, is irrefutable.
In the last section of the paper, the author assesses the effects of current QE (through November 2012) on future inflation in the U.S. His conclusion is that “Excess liquidity has always been followed by persistent increases in inflation. Current quantitative easing policies should lead to increasing and persistent inflation over the next years.” The chart accompanying this statement is reproduced below.
As you can see, the model suggests inflation of 3-4% in 2013 and 5% in late 2014. While clearly inflation in 2013 has been lower than suggested by the chart, this isn’t supposed to be a trading model. I suspect that if get 3-4% in 2014 and 5%+ in 2015 (our forecast is for 3.0%-3.6% on core inflation in 2014 and 3.3%-4.8% in 2015), the issue of whether Reynard was essentially correct will not be in question!
There is a blog post on the site of the New York Fed might be significant. The title of the post is “Has the Fed Stabilized the Price Level?” In the post, the authors take up the question of price level targeting. This, in itself, is worth noting because the debate about whether the Fed should target the inflation rate (trying to hit 2% on the PCE deflator every year) or the price level (trying to average 2% over the next 10 years, say) has been ebbing and flowing for the last few years but during and after the crisis has generally taken a back seat to more pressing issues like “how can we buy a couple trillion dollars’ worth of Treasury and mortgage-backed securities without impairing market function?” Back at the end of 2010, I wrote a blog post about the fact that price-level targeting is gaining currency (no pun intended) at the Fed.
The authors start by noting that the Fed has been incredibly successful, as it turns out, at hitting the 2% target on inflation. Like most authors who address this subject, they choose a historical period where that happens to be the case and draw a nice exponential curve that happens to fit nicely since, after all, they chose a period during which low and stable inflation was the norm. They then proceed, as most establishment economists do, to give the Fed most if not all of the credit for maintaining inflation low and stable even though any fair real-time analysis of the history – see, for example, my book which, incidentally, makes a fine Christmas gift – must conclude that this was partly a lucky break.
What is interesting and potentially significant, though, is where the authors focus on the deviation from that trend. Although drawing the line the way they originally drew it suggests that the Fed has successfully targeted long-term price-level growth almost exactly, they then re-draw the line based on an arbitrary start date of January 2006 (this happens to be the beginning of Bernanke’s tenure, but since the price level in 2006 has nothing to do with actions he took in 2006, that date is purely arbitrary). The significance is that when drawn from that date, the price level appears too low:
“While the price level has remained remarkably close to its 2 percent trend line since the early 1990s, the total PCE deflator has been below this trend line since 2009 with a 1.4 percent gap in July 2013; the core index displays an even larger gap.”
Hmmm. At this point, one suspects that the authors may be adjusting the lens to reach the conclusion they want. They proceed to ask whether the Fed is, or should be, aiming to stabilize inflation (at 2% on PCE, about 2.25% on CPI) or the price level, and suggest (remember, the authors are at the Fed) that quantitatively speaking the Fed’s policy has worked out to be essentially price-level targeting whatever they called it. The big moment comes:
“Moreover, while the FOMC has stated its policy strategy in terms of an inflation rate and not the price level, it is interesting to note that there is a technical equivalence between the Fed’s “longer-run inflation goal” of 2 percent and price-level targeting. As such, if the FOMC’s past behavior continues, it is reasonable to expect inflation temporarily higher than 2 percent so that the price level will return to its long-run trend line.”
Whether or not the Fed actually chooses, or should choose, price-level targeting or rate targeting is a debate for a future day although the link to my blog post above shows it is also a debate for a past day! The interesting thing about the NY Fed blog post, though, is that the price-level argument is being used to support the notion that inflation somewhat above the target is not only acceptable but actually desirable. This may be merely an academic discussion, but take note of it just in case.
In our business, one must be very careful of confirmation bias of course (as well as all of the other assorted biases that can adversely affect one’s decision-making processes). And so I want to be very careful about reading too much into today’s CPI report. That being said, there were some hints and glimmers that the main components of inflation are starting to look more perky.
Headline (“all items”) inflation rose in June to 1.75% y/y, with core inflation 1.64%. About 20% of the weights in the major groups accelerated on a year-on-year basis; about 20% declined, and 60% were roughly flat. However, two thirds of the “unchanged” weight was in Housing, which moved from 2.219% to 2.249% y/y…but the devil is in the details. Owner’s Equivalent Rent, which is fully 24% of the overall CPI and about one-third of core CPI, rose from 2.13% to 2.21%, reaching its highest rate of change since November 2008. Primary Rents (that is, if you are a renter rather than a homeowner) rose from 2.83% to 2.89%, which is also a post-crisis high. Since much of my near-term expectations for an acceleration in inflation in the 2nd half of the year relies on the pass-through of home price dynamics into rentals, this is something I am paying attention to.
This is what I expected. But can I reject a null hypothesis that core inflation is, in fact, in an extended downtrend – that perhaps housing prices are artificially inflated by investor demand and will not pass through to rents, and the deflation in core goods (led by Medicare-induced declines in Medical Care) will continue? I cannot reject that null hypothesis, despite the fact that the NAHB index today surprised with a leap to 57, its highest since 2006 (see chart, source Bloomberg, below). It may be, although I don’t think it is, that the demand is for houses, rather than housing and thus the price spike might not pass into rents. So, while my thesis remains consistent with the data, the real test will be over the next several months. The disinflationists fear a further deceleration in year-on-year inflation, while I maintain that it will begin to rise from here. I still think core inflation will be 2.5%-2.8% by year-end 2013.
In fact, I think there is roughly an even chance that core inflation will round to 1.8% next month (versus 1.6% this month), although the 0.2% jump will be more dramatic than the underlying unrounded figures. The following month, it will hit 1.9%. That is still not the “danger zone” for the Fed, but it will quiet the doves somewhat.
Meanwhile, the Cleveland Fed’s Median CPI remained at 2.1%, the lowest level since 2011. The Median CPI continues to raise its hand and say “hello? Don’t forget about me!” If anyone is terribly concerned about imminent deflation, they should reflect on the fact that the Median CPI is telling us the low core readings are happening because a few categories have been very weak, but that there is no general weakness in prices.
Although I maintain that the process of inflation will not be particular impacted by what the Fed does from here – and, if what they do causes interest rates to rise, then they could unintentionally accelerate the process – the direction of the markets will be. And not, I think, in a good way. We saw today what happens when an inflation number came in fairly close to expectations: stocks down, bonds flat, inflation-linked bonds up, and commodities up. Now, imagine that CPI surprises on the high side next month?
Speaking of the fact that commodities have had (so far at least) their best month in a while, there was a very interesting blog entry posted today at the “macroblog” of the Atlanta Fed. The authors of the post examined whether commodity price increases and decreases affect core inflation in a meaningful way. Of course, the simple answer is that it’s not supposed to, because after all that’s what the BLS is trying to do by extracting food and energy (and doing that across all categories where explicit or implicit food and energy costs are found, such as in things like primary rents). But, of course, it’s not that simple, and what these authors found is that when commodity prices are increasing, then businesses tend to try and pass on these cost increases – and they respond positively to a survey question asking them about that – and it tends to show up in core inflation. But, if commodity prices are decreasing, then businesses tend to try and hold the line on prices, and take bigger profit margins. And that, also, shows up in the data.
To the extent this is true, it means that commodity volatility itself has inflationary implications even if there is no net movement in commodity prices over some period. That is because it acts like a ratchet: when commodity prices go up, core inflation tends to edge up, but when commodity prices go down, core inflation tends not to edge down. Higher volatility, by itself, implies higher inflation (as well, as I have pointed out, as increasing the perception of higher volatility: see my article in Business Economics here and my quick explanation of the main points here). It’s a very interesting observation these authors make, and one I have not heard before.
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.
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.
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.
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.”
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?
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.
 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.