We all have our hot button issues. It will not surprise you, probably, to learn that mine involves inflation. For the rant which follows, I apologize.
Reasonable people, smart people, learned people, can disagree on how precisely the Consumer Price Index captures the inflation in consumer prices. And indeed, over the one hundred years that the CPI has been published such disagreements have been played out among academics, politicians, labor leaders, and others. The debates have raged and many changes – some large, some small; some politically-driven, most not – have occurred in how prices have been collected and the index calculated. If you are interested, really interested, in the century-long history of the CPI, you can read a couple of histories here and here.
If someone is not interested in how CPI is calculated, in how and why changes were made in the methodological approach to calculating price change, then that’s fine. But if a person can’t spend the time to learn the very basics of this hundred-year debate, during which changes were made in the CPI with much public input, not in a smoky back room somewhere, then I wonder why such a person would spend time spewing conspiracy theories on the internet about how the CPI doesn’t include food and energy (um…it does), about how the CPI underestimates prices because it doesn’t account for changes in quality and quantity (um…it does), or about how sneaky methodological changes have caused the CPI to be understated by 7% per year for thirty years.
Recently, the CFA Institute’s monthly magazine for CFA Charterholders was duped into accepting an article that brings together some of the dumbest theories into one place. At some level, the article asks the “interesting” question about whether a consumer price index should include asset prices. Interesting, perhaps, but asked-and-answered: assets are not consumer goods but stores of value. If you are not consuming something, then why would you ever expect it to be included in a consumer price index? You might argue that we should include asset prices into some other sort of index that measures price increases. But we already do. They are called asset price indices, and you know them by names like the S&P 500, the NCREIF, and so on.
Worse, the magazine gives a great big stage to the person who has singlehandedly done more to confuse and anger people, to poison the well of knowledge about inflation, and to stir up the conspiracy theorists about inflation, than anyone else in the world – and all because he is selling an ‘analysis’ product to those people. I won’t mention his name here because I don’t want to advertise his product, but he claims that the CPI is understated by “about 7 percentage points each year.”
That this is being published in a magazine of the CFA Institute is almost enough for me to renounce my membership. It is offensively idiotic to claim that the CPI may be understated by 7% per year, and simple math (which CFA Charterholders were once required to be able to perform) can prove that. If inflation has risen at a pace of around 2.5% per year over the last 30 years, it implies the price level has risen about 110% (1.025^30-1). This seems more or less right. But if inflation had really been 9.5% per year, as claimed, then the cost of the average consumption basket would have risen about 1422% (1.095^30-1).
Can that be right? Well, Real Median Household Income, using the CPI to deflate nominal household income, has risen about 13% over the last 30 years. http://en.wikipedia.org/wiki/File:Median_US_household_income.png But if we use the 9.5%-per-year CPI number, then real median household income has actually fallen 84%. If this was true, we would be living in absolute Third-World squalor compared to how things were in the salad days of 1984. You don’t have to be an economist to know the difference between a slightly-better standard of living and one in which you can afford 1/6th of what you could previously afford. You just need a brain.
Any person who does even rudimentary research on the CPI – say, visiting http://www.inflationinfo.com and reading some of the hundreds of papers gathered there, or perusing the BLS website, or speaking with an actual inflation expert – cannot possibly think that this guy is anything other than a nut or a shill. It is a tragedy that the CFA Institute would publish such trash, and it tarnishes the CFA Institute brand. Let’s hope they publish an apologetic retraction in the next issue.
I also like to point out, when I am in rant mode over this (and, as an aside, let me thank the tolerant reader for allowing me to rant – this allows me to forever point people to this link when they bring up this guy), that if the CPI=9.5% number is right then you must also believe a bunch of other ridiculous things:
First: MIT is in on the conspiracy. The Billion Prices Project, which uses very different methodology from the BLS, figures inflation to be about the same as the BLS does. (Digressing for a bit, I think it’s also interesting that the BPP index has tracked Median CPI much better than headline CPI over the last year, when headline CPI has been dragged lower by one-off changes in medical care prices).
Second: Consumers consistently underestimate inflation, or else are serially optimistic about how it is likely to decline from 9.5% to something much lower. The University of Michigan survey of year-ahead inflation expectations – and every other consumer survey of inflation expectations – is much closer to reported inflation than to the shill’s numbers (see chart below, source Bloomberg). I’ve written elsewhere about why consumers might perceive slightly higher inflation than really occurs, but I cannot come up with a theory that explains why consumers would always say it’s much lower than what they are in fact seeing. Maybe we’re all stupid except for this guy with the website.
Third, and related to the prior point: Investors who pour money into inflation-indexed bonds must be complete morons, because they are locking up money for ten years at what is “really” -9% real yields (meaning that they are surrendering 62% of the real purchasing power of their wealth, rather than spending it immediately). We don’t see this behavior in countries where it is known that the official index is manipulated. For example, we know that in Argentina the inflation data really is rigged, and in September of last year long-dated inflation-linked bonds in Argentina were showing real yields of more than 20%. In recent months, the government of Argentina has begun to release figures that are much more realistic and real yields have plunged to around 10% as investors are giving the data more credibility. The upshot is that we have bona fide evidence that investors will base their demanded real yields on the difference between the inflation index they are being paid on and the inflation they think they are actually seeing. The fact that we don’t see TIPS real yields around 6% or 7% is evidence that investors are either really stupid, or they believe the CPI is at least approximately right.
Fourth, and related to that point: if inflation has really being running at 9.5%, then every asset is a losing proposition. There is no way to protect yourself against inflation. You’re not really getting wealthy as you ride stocks higher; you’re only losing more slowly. Since there is no asset class that has returned 10% over a long period of time, we are all doomed. The money is all going away. Especially housing, and real goods like hard commodities – there is nothing you can do that is much worse than holding real stuff, which is only going up in price a couple of percent per year over time while inflation is (apparently) ravaging everything we know and love. There is no winning strategy. Of course, the good news is that it turns out that the U.S. government is being extremely fiscally responsible, with the real deficit falling by 5% or more every year. Right.
I really should not let this bother me. It is good for me, as an investor with a brain, when mindless zombie minions follow this guy and do dumb things in the market. But I can’t help it. The Internet could be a tool for great good, allowing people access to accurate, timely information and the opportunity to learn things that they couldn’t otherwise. It allows this author to come into your mailbox, or onto your screen, to try to educate or illuminate or amuse you. But there is also so much detritus, so much rubbish, so much terribly erroneous information out there that does real harm to those who consume it. And perhaps this is why I get so exercised about this issue: I absolutely believe that people have a right to say and to believe whatever they want, no matter how stupid or dangerous. I am simply aghast, and deeply saddened, that so many people are so credulous that they believe what they read, without critical thought of their own. Everyone has a right to his/her opinion, but they are not all equally valid. There is no FDA for the Internet, so snake-oil salesmen run rampant among their eager marks.
I want my readers to think. If you all agree with me, then I know you’re not all thinking! Look, it is perfectly reasonable to suggest that some minor improvements can be made to CPI. The number has been tweaked and improved for a hundred years, and it will be tweaked and improved some more in the future. It is in my opinion not reasonable to suppose that the number is completely made up and/or drastically incorrect. And that’s my opinion.
I haven’t written in a couple of weeks – a combination of quiet markets, and a lack of intersection between stuff that’s interesting to write about and my having time to write – but I thought I would “global cc” everyone on something I just wrote in a private email about some common misconceptions regarding the CPI:
A friend and longtime reader (name withheld) writes:
I thought you might find these interesting….
My response is below:
Thanks. Unfortunately Stockman doesn’t understand what he’s talking about. He understands better than most, but then he starts saying how the BLS asks homeowners what their homes would rent for…which they do, but only to determine weights, every couple of years, not to determine OER. It says this very clear in a paper on the BLS website called “Treatment of Owner-Occupied Housing in the CPI:“
“To obtain the expenditure weights for the market basket…Homeowners are asked the often-cited question:
If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?
This is the only place where the answers to this question is used; in determining the share of the market basket. We do not use this question in measuring the change in the price of shelter services.”
For that purpose – calculating inflation itself – a survey of actual rents is used. I can understand how the casual observer doesn’t ‘get’ this, but there’s no excuse for Stockman not to know, especially if he is railing about the CPI…he should take some time to understand its main piece.
In short, Stockman writes a good populist screed, but he avoids the main questions:
1. Is headline inflation a better predictor of future inflation than core inflation? Answer: No, even if we can now realize that the rise in energy prices was a permanent feature of the decade ended in 2010, it tells us exactly nothing about whether those are likely to persist. The Fed uses core CPI not because they don’t think people use cars (whenever a columnist uses that silly argument, I know they’re just writing to please a certain audience), but because core CPI is persistent statistically in a way that headline is not. In fact, some Fed statisticians prefer median, or trimmed-mean, neither of which proscribes any particular category. So whining about how the Fed doesn’t include the particular brand of inflation that concerns you misunderstands how and why policymakers actually use measures of inflation in policymaking.
2. Suppose the CPI represents a miserable mis-estimation of actual inflation. Then, pray tell, why does a trillion-dollar market based on that index get priced as if it is accurate? In Argentina, where the inflation numbers are made up, the inflation-linked bonds trade very cheap because they will pay off in a number that is assumed to be too low. And the bond yields are too high by roughly the amount that inflation is assumed to be understated in the future. Markets are efficient, especially big markets. How did the Fed manage to convince at least $1T in private money to misprice the bond market?
3. If the CPI is so wrong, so manipulated, then why to measures of inflation that the government has nothing to do with, like the Billion Prices Project, come up with the same number?
It’s nice that Stockman has a following. And he’s gotten the following partly by ranting about a number people love to hate. That gets him read, but it doesn’t make him right.
Well, I guess it would be hard to have a clearer sign that investors are over their skis than to have the Fed drop the portion of their communique that was most-binding – in a move that was fully anticipated by almost everyone and telegraphed ahead of time by NY Fed President Dudley – and watch markets decline anyway.
To be sure, the stock market didn’t exactly plunge, but bonds took a serious hit and TIPS were smacked even worse. TIPS were mainly under pressure because there is an auction scheduled for tomorrow and it was dangerous to set up prior to the Fed meeting, not because there was something secretly hawkish about the Fed’s statement. Indeed, they took pains to say that “a highly accommodative stance of monetary policy remains appropriate,” and apparently they desire for policy to remain highly accommodative for longer relative to the unemployment threshold than they had previously expressed.
The next Fed tightening (let us pretend for a moment that the taper is not a tightening – it obviously is, but let’s pretend that we’re only talking about overnight interest rates) was never tied to a calendar, and it would be ridiculous to do so. But it seems that maybe some investors had fallen in love with the idea that the Fed would keep rates at zero throughout 2015 regardless of how strong or how weak the economy was at that time, so that when the Fed’s members projected that rates might reach 1% by the end of 2015 – be still, my heart! – these investors had a conniption.
Now, I fully expect the Fed to tighten too little, and too late. I also expect that economic growth will be sufficiently weak that we won’t see interest rates rise in 2015 despite inflation readings that will be borderline problematic at that time. But that view is predicated on my view of the economy and my assessment of the FOMC members’ spines, not on something they said. You should largely ignore any Fed communication unless it regards the very next meeting. They don’t know any better than you do what the economy is going to be doing by then. If they did, they would only need one meeting a year rather than eight. Focus on what the economy is likely to be doing, and you’ll probably be right more often than they are.
Arguably, this was not the right theory when the Fed was simply pinning rates far from the free-market level, but as the Fed’s boot comes off the market’s throat we can start acting like investors again rather than a blind, sycophantic robot army of CNBC-watching stock-buying machines.
Now, I said above that “the stock market didn’t exactly plunge,” and that is true. On the statement, it dropped a mere 0.3% or so. The market later set back as much as 1%, with bonds taking additional damage, when Chairman Yellen said that “considerable period” (as in “a considerable period between the end of QE and the first rate increase) might mean six months.
Does that tell you anything about the staying power of equity investors, that a nuance of six months rather than, say, nine or twelve months of low rates, causes the market to spill 1%? There are a lot of people in the market today who don’t look to own companies, but rather look to rent them. And a short-term rental, at that, and even then only because they are renting them with money borrowed cheaply. For the market’s exquisite rally to unravel, we don’t need the Fed to actually raise rates; we need markets to begin to discount higher rates. And this, they seem to be doing. Watch carefully if 10-year TIPS rates get back above 0.80% – the December peak – and look for higher ground if those real yields exceed 1%. We’re at 0.60% right now.
Stocks will probably bounce over the next few days as Fed speakers try and downplay the importance of the statement and of Yellen’s press conference remarks (rhetorical question: how effective is a communication strategy if you have to re-explain what you were communicating)? If they do not bounce, that ought also to be taken as a bad sign. Of course, I continue to believe that there are many more paths leading to bad outcomes for equities (and bonds!) than there are paths leading to good outcomes. Meanwhile, commodity markets were roughly unchanged in aggregate today…
Note: The following blog post originally appeared on March 28th, 2010 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.
Some bond bears were probably also scared by the fact that CNBC asked the question on Friday, “Time To Sell Bonds To Buy Stocks?” (Remind me when they last asked whether it was time to sell stocks to buy…anything?) They’re half right this time, I think, but I don’t like having them as company either. Balancing the Groucho effect (“I don’t want to belong to any club that would accept people like me as a member”) is the Holiday Inn Express effect (in which people develop amazing abilities unrelated to their backgrounds: “Are you a doctor?” “No, but I stayed at a Holiday Inn Express last night”). Barron’s, specifically Michael Santoli, who writes the “Streetwise” column, sought to explain why rising yields are good for stocks. When equity guys are busy telling the bond vigilantes why they’re not scared of them…they’re scared of them.
During a day in which there was little in the way of economic data, several Fed speakers were on the tape. While it is ordinarily very important to listen attentively to comments from Fed officials, these days it isn’t so crucial because we know what conditions will lead to meaningful tightening and they (much lower unemployment rate, some sign of broad core inflation including housing) aren’t going to happen any time soon. Why? Dr. Bernanke is fighting a desperate rear guard action against those people who reasonably question whether the Fed has been all it’s cracked up to be. The threat is real; Fed Governor Kevin Warsh on Friday stated that Fed credibility would suffer if independence was lost. Although this statement raises other questions (namely, “what credibility??), it is indicative of the FOMC’s mood. If you think Bernanke is going to tighten rates meaningfully when Unemployment is near 10%…or 9%…or 8%…and risk having the Fed’s independence stripped, I think you ought to think again. Of course, this means that the de facto independence of the Fed is questionable, but anyone who thinks that this is a fight the Fed should pick shortly after the bottom of the worst recession in at least 30 and maybe 80 years, please raise your hand. I didn’t think so.
A Word About Current Value In Long TIPS
When investors are thinking about what assets to include in their portfolios, they obviously care about both risk and return. Of course, the problem is that they care about a priori risk and return, which are unknowable, and so tend to populate portfolio allocation simulations with estimates of long-run returns that are no better than guesses (we tend to have a better sense of long-run variances, although what causes problems there is that the distribution is not normal). This is why equities are so dominant in many portfolios, despite their evident short-term risk: generally, investors make one of three key errors in looking at long-run equity returns:
- They use long-run historical nominal returns to form the estimate. Investors shouldn’t care about nominal returns at all, so this is clearly incorrect.
- They use long-run historical real returns. This is better, but it neglects the fact that most historical periods which terminate in the last decade-plus will also reflect multiple expansion as a source of return. There is no good reason to expect that the multiple expansion of the last eighty years will repeat over the next eighty.
- They use a tortured interpretation of the Capital Asset Pricing Model to back out high expected returns for equities. “Stocks are riskier; therefore, they should have a higher return.” The CAPM isn’t meant to be a causal model but rather an observation about how capital assets should be priced. If riskiness implies more return, then lottery tickets should be the best investment.
But we can look at long-term data in a more thoughtful way and get a better sense for what a fair return to equities is, in the long run. Brad Cornell and Rob Arnott wrote a short article (“The ‘Basic Speed Law’ for Capital Markets Returns“) that pointed out three important long-term truisms. First, the long-run growth rate of per-capita GDP in the U.S., a measure closely related to productivity growth, has been around 2% for the last 100 years. Second, if the real economy is growing around 2% per capita in the long run, then earnings in the corporate sector must also be limited to roughly that growth (since otherwise it would soon become larger than the economy itself). And third, if the growth of earnings is limited similarly, then stock price index growth must be limited to something similar as well, net of valuation changes.
The version of the chart which appears below is sourced from Census, BEA, and Robert J Shiller data, and updated through the end of 2009. Over the last 80 years, the compounded growth rate of real per capita GDP has been 2.1%; for real earnings it is 2.6%; and for stock prices it is 1.8%. However, those rates are computed using arbitrary end points – December 1929 and December 2009. A better way is to run an exponential regression, and on the chart the straight lines are the results of that regression (the line appears straight because the axes are loglinear, so the regression line is linear in log space). The growth rates then are 2.25% for real per capita GDP, 1.74% for real earnings (n.b., if you take out 2008Q4-2009Q3, the coefficient is 1.95%), and 2.87% for the real stock price growth rate.
Now, 2.87% as a long-run real growth rate for equities doesn’t sound great, but it’s actually even exaggerated because over that period, equity multiples expanded from 13.3x earnings to 21.6x earnings, so a bunch of that return is coming from multiple expansion that may not repeat. If the current multiple is fair (I think it’s high, but let’s be generous), then the long-run expected return to equities ought to be similar to the long-run expected growth in earnings, which is limited to the long-run growth in GDP per capita. Or, roughly, 2-2.25% (There really isn’t a lot of difference here, actually; real GDP uses the GDP deflator to measure price inflation, while real earnings uses CPI; the latter is generally about 0.25% or so higher, so these are essentially both 2%, if you use CPI, or 2.25%, if you want to use the deflator.)
That’s what you can expect to get from equities in the truly long-run, plus dividends – of 1.8% on the S&P right now. With that long-run growth, of course, comes a ton of volatility. Meanwhile, you can get a 30-year real yield of 2.17% from TIPS, with much less volatility (and no volatility at a horizon equal to the duration of the bond). Moreover, remember TIPS pay based on CPI, which is the “faster” of the two inflation measures used above.
So, unless you are into market timing, TIPS are currently priced to produce a long-run real return equal to stocks, with less volatility. That’s a decent deal! If we get a big rate sell-off, that deal may get better still, but while the short end of the TIPS curve doesn’t look terribly attractive the long end remains reasonable.
You can follow me @inflation_guy, or subscribe to receive these articles by email here.
This will be my last “live” post of 2013. As such, I want to thank all of you who have taken the time to read my articles, recommend them, re-tweet them, and re-blog them. Thanks, too, for your generous and insightful comments and reactions to my writing. One of the key reasons for writing this column (other than for the greater glory of Enduring Investments and to evangelize for the thoughtful use of inflation products by individual and institutional investors alike) is to force me to crystallize my thinking, and to test that thinking in the marketplace of ideas to find obvious flaws and blind spots. Those weaknesses are legion, and it’s only by knowing where they are that I can avoid being hurt by them.
In my writing, I try to propose the ‘right questions,’ and I don’t claim to have all the right answers. I am especially flattered by those readers who frequently disagree with my conclusions, but keep reading anyway – that suggests to me that I am at least asking good questions.
So thank you all. May you have a blessed holiday season and a happy new year. And, if you find yourself with time to spare over the next few weeks, stop by this blog or check your email (if you have signed up) as I will be re-blogging some of my (subjectively considered) “best” articles from the last four years. 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 post, or follow me @inflation_guy on Twitter.
And now, on to my portfolio projections as of December 13th, 2013.
Last year, I said “it seems likely…that 2013 will be a better year in terms of economic growth.” It seems that will probably end up being the case, marginally, but it is less likely that 2014 improves measurably in terms of most economic variables on 2013 and there is probably a better chance that it falls short. This expansion is at least four years old. Initial Claims have fallen from 650k per week in early 2009 to a pace of just barely more than half that (335k) in the most-recent 26 weeks. About the best that we can hope for, plausibly, is for the current pace of improvement to continue. The table below illustrates the regularity of this improvement over the last four years, using the widely-followed metric of the Unemployment Rate:
Sure, I know that there are arguments to be made about whether the Unemployment Rate captures the actual degree of pain in the jobs market. It plainly does not. But you can pick any one of a dozen other indicators and they all will show roughly the same pattern – slow, steady improvement. There is no doubt that things are better now than they were four years ago, and no doubt that they are still worse than four years before that. My point is simply that we have been on the mend for four years.
Now, perhaps this expansion will last much longer than the typical expansion. But I don’t find terribly compelling the notion that the expansion will last longer because the recession was deeper. Was this recession deeper because the previous expansion was longer? If so, then the argument is circular. If not, then why would that connection only work in one direction? What I know is that the Treasury has spent the last four years running up large deficits to support the economy, and the Fed has nailed interest rates at zero and flooded the economy with liquidity. Those two things will at best be repeated in 2014, not increased; and there is a decent chance that one or the other is reversed. Another 0.8% improvement in the Unemployment Rate would put it at 6.2%, and I expect inflation to head higher as well. A taper will be called for; indeed, it should never have been necessary because policy is far too loose as it is. Whether or not an extremely dovish Fed Chairman will actually acquiesce to taper is an open question, but economically speaking it is already overdue and certainly will appear that way by the middle of the year, absent a crack-up somewhere.
Global threats to growth do abound. European growth is sluggish because of the condition of the financial system and the pressures on the Euro (but they think growth is sluggish because money isn’t free enough). UK growth has been improving, but much of that – as in the U.S. – has been on the back of housing markets that are improving too quickly to make me comfortable. Chinese growth has recently been downshifting. Japanese growth has been irregularly improving but enormous challenges persist there. Globally, the bright spot is a modest retreat in Brent Crude prices and lower prices of refined products (although Natural Gas prices seem to be on the rise again despite what was supposed to be a domestic glut). Some observers think that a lessening of tensions with Iran and recovery of capacity in Libya, along with increasing US production of crude, could push these prices lower and provide a following wind to global growth, but I am less sanguine that geopolitical tensions will remain relaxed for long and, in any event, depending on a calm Iran as the linchpin of 2014 optimism seems pretty cavalier to me.
Note that the muddled growth picture contains some elements of risk to price inflation. The ECB has been kicking around the idea of doing true QE or experimenting with negative deposit rates. The UK housing boom, like ours, keeps the upward pressure on measures of core inflation. There is no sign of an end to Japanese QE, and the PBOC seems willing to let the renmimbi rise more rapidly than it has in the past. And all of these global risks to domestic price inflation are in addition to the internally-generated pressures from rapid housing price growth in the United States.
The good news on inflation domestically is that M2 money growth has slackened from the 8%-10% pace of last year to more like 6%-8% (see chart, source Bloomberg). This is still too fast unless money velocity continues to slide, but it is certainly an improvement. But the bad news is that money growth remains rapid in the UK and is accelerating in Japan. The only place it is flagging, in Europe, has a central bank that is anxious not to be last place on the global inflation scale. I expect core inflation (and median inflation) in the U.S. to rise throughout 2014 and for core inflation to end up above 3% for the year.
Now, I have just made a number of near-term forecasts but I need to change gears when looking at the long-term projections. In what follows, I make no effort to predict the 3-month, 6-month, or 12-month returns of any market. Indeed, although I will present long-term risk and return outlooks, and they are presented as point estimates, I want to make it very clear that these are not predictions but rather statements of relative risk and return possibilities. For many types of instruments, the error bars around the average annual performance are so large as to make point estimates (in my view) nearly useless. The numbers come from models of how markets behave when they are priced “like they are now” in terms of several important metrics. They are not prescient. However, that is what investing is really all about: not making the “right” bet in terms of whether you can call the next card off the deck, but making the “right” bet with respect to the odds offered by the game, and betting the right amount given the odds and the edge.
I also will not make portfolio allocation recommendations here. The optimal portfolio allocation for you depends on more variables than I have at my disposal: your age, your career opportunities, your lifestyle, your goals, any insurance portfolio and your risk tolerance, to name just a few.
What I will do here, though, is to give top-down estimates of the long-run returns and risks of some broad asset classes, and make some general observations. I don’t analyze every possible asset class. For this exercise, I limit the universe to stocks, TIPS, nominal bonds (both long Treasury and corporate bonds), commodity indices and (since many of us already own it) residential real estate. My estimates and some notations about the calculations are in the table below.
|Inflation||2.50%||Current 10y CPI Swaps|
|TIPS||0.68%||Current 10y TIPS. This is not at equilibrium, but it is what we can lock in today. It is the highest rate available at year-end since 2010.|
|Treasuries||0.37%||Nominal bonds and inflation-linked bonds ought to have the same a priori expectation, but Treasuries trade rich to TIPS because of their value as repo collateral. Current 10y nominal rate is 2.87%, implying 0.37% real.|
|T-Bills||-0.50%||Is less than for longer Treasuries because of liquidity preference.|
|Corp Bonds||-0.69%||Corporate bonds earn a spread that should compensate for expected credit losses. A simple regression of Moody’s “A”-Rated Corporate yields versus Treasury yields suggests the former are about 45bps rich to what they should be for this level of Treasury yields.|
|Stocks||1.54%||2.25% long-term real growth + 1.83% dividend yield – 2.54% per annum valuation convergence 2/3 of the way from current 24.3 Shiller P/E to the long-run mean. Note that I am using long-run growth at equilibrium, not what TIPS are implying. This is the worst prospective 10 year real return we have seen in stocks since December 2007. Now, to be fair in 1999 we did get to almost -2%, which would imply up to another 35-40% upside to stocks before we reached an equivalent height of bubbliness. That is a 35-40% that I am happy to miss.|
|Commodity Index||6.26%||Various researchers have found that commodity futures indices have a long-run diversification return of about 3.5%. To this we add 1-month LIBOR to represent the return on the collateral behind the futures, and a ‘relative value’ factor to reflect the performance (relative to the expected model) of hard assets relative to currency.|
|Real Estate (Residential)||-0.19%||The long-run real return of residential real estate is around +0.50%. Current metrics have Existing Home Sales median prices at 3.79x median income, versus a long-term average of 3.55x. Converging to the mean over 10 years would imply an 0.69% per annum drag to the real return. This is the first time since 2008 that housing prices have offered a negative real return on a forward-looking basis.|
The results, using historical volatilities calculated over the last 10 years (and put in terms of ‘real annuitized income,’ a term that means essentially the variance compared to a fixed 10-year real annuity, which in this analysis would be the risk-free instrument), are plotted below. (Source: Enduring Investments).
Return as a function of risk is, as one would expect, positive. For each 0.33% additional real return expectation, an investor must accept a 1% higher standard deviation of annuitized real income. However, note that this is only such a positive trade-off because of the effect of commodities and TIPS. If you remove those two asset classes, which are the cheap high-risk and the cheap low-risk asset classes, respectively, then the tradeoff is worse. The other assets lie much more closely to the resulting line, which is flatter: you only gain 0.19% in additional real return for each 1% increment of real risk. Accordingly, I think that the best overall investment portfolio using public securities – which has inflation protection as an added benefit – is a barbell of broad-based commodity indices and TIPS.
TIPS by themselves are not particularly cheap; it is only in the context of other low-risk asset classes that they appear so. Our Fisher model is long inflation expectations and flat real rates, which merely says that TIPS are strongly preferable to nominal rates but not a fabulous investment in themselves (although 10-year TIPS yields are better now than they have been for a couple of years). Our four-asset model remains heavily weighted towards commodity indices; and our metals and miners model is skewed heavily towards industrial metals (50%, e.g. DBB) with a neutral weight in precious metals (24%, e.g. GLD) and underweight positions in gold miners (8%, e.g. GDX) and industrial miners (17%, e.g. PICK). (Disclosure: We have long positions in each of the ETFs mentioned.)
Feel free to send me a message (best through the Enduring website http://www.enduringinvestments.com ) or tweet (@inflation_guy) to ask about any of these models and strategies. In the new year, I plan to offer an email “course”, tentatively entitled “Characteristics of Inflation-Protecting Asset Classes,” that will discuss how these different assets behave with respect to inflation and give some thoughts on how to put an arm’s-length valuation on them. Keep an eye out for the announcement of that course. And in the meantime, have a happy holiday season and a merry new year!
In one of those “what could possibly go wrong with that plan” moments – which are becoming all too frequent these days – the New York Times this weekend reported that there is “growing concern inside and outside the Fed that inflation is not rising fast enough.”
At some level, this is not exactly new thinking. For decades, economists have argued that “price stability” really means inflation of something just slightly over 0%, because it is assumed to be quite hard to get out of a deflationary spiral. in my view, that’s silly, because simply adding a zero to the currency in everyone’s pocket is a guaranteed way to get out of deflation. It may be that since nudging inflation higher is harder than kicking it higher, the costs of mild deflation are higher than the costs of mild inflation, but I think the jury is out on that question since it isn’t something we have ever experienced. But in any event, this is the reason that inflation in the neighborhood of 2%, rather than 0%, has been the Fed’s implicit or explicit target for a long time.
To the extent that discussion stays academic, it’s not worrisome. Navel-gazing is an occupational hazard of being a professional economist, after all. But now, there are louder and more frequent voices arguing that 2% is too low a target. To see how urgent a problem this is, I submit the following chart, which shows median CPI, along with a horizontal line at 2.25% (roughly equivalent to a 2% target on PCE). Wow, I can see the reason for panic. We are nearly 0.2% below that! And we got within 0.6% of deflation in 2010, in the aftermath of the worst credit crisis in almost 100 years.
I am all for the idea that mild inflation serves to lubricate the gears of commerce, but we should remember that when the CFO of Costco says he likes rising inflation because in that circumstance “the retailer is generally able to expand its profit margins,” that’s good for the equity market perhaps but not as good for the consumer!
It always amazes me how sketchy is the understanding of inflation in a capital markets context by members of the Fed. In the aforementioned article, Chicago Fed President Evans is quoted saying “If inflation is lower than expected, then debt financing is more burdensome than borrowers expected. Problems of debt overhang become that much worse for the economy.” This is absolutely true, but almost completely irrelevant in the current context. Inflation has been lower than a priori expectations since about 1980, which is why a long-nominal-bond position has routinely outperformed inflation. But currently, as the chart below illustrates, 10-year inflation breakevens are at 2.19%. Fully 72% of all 10-year periods since 1914 have seen compounded inflation above that level.
Ten-year inflation swaps, a better measure of inflation expectations, are at 2.52%, which still doesn’t sound like a horrible bet for borrowers. If inflation comes in above 2.52%, the borrower of 10-year fixed-rate money wins; if it comes in below 2.52%, the borrower loses. This is one reason that it is so rare to see corporations issue inflation-indexed debt…they like that bet.
Finally, the article explains that higher inflation allows workers to get higher wages, and gives the example of teachers in Anchorage, Alaska, who just agreed to a contract giving them 1% pay increases for each of the next three years. Since inflation is likely to be above that, the article says, they will be probably receiving a pay cut in real terms. This is absolutely true. (It is also the exact opposite position of the debtor, in that the teachers will do better in real terms if deflation actually happened. Sometimes I just wish the authors of these articles would be consistent.) But this circumstance certainly isn’t helped by inflation; since wage increases tend to trail inflation, real wages tend to lag in inflationary upticks.
None of this represents deep insight from this author. It merely represents that I have at least a rudimentary understanding of how inflation works, and a respect for the damage which inflation can cause to economies, workers, and savers. The fact that this is increasingly rare these days is probably cyclical, and unfortunately is probably a minimum condition for setting up this next inflation debacle. In that context, and with more Federal Reserve economists openly musing about needing to target higher inflation, does 2.19% breakeven sound like a bad deal?