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Make Hay While the Sun Doesn’t Shine

February 27, 2014 14 comments

Today new Fed Chairman Janet Yellen jumped on the bandwagon in blaming the recent growth slowdown on the weather.

Here’s what I have to say about the news and the weather.

First, although it’s becoming quite passé to point this out, the weather should account for a slowdown in economic activity – but, since economists were aware of the weather (presumably), it is less clear that it should account for a surprise in the amount of slowdown we are seeing. The chart below (source: Bloomberg) shows the Citibank economic surprise index, which measures how much recent data have exceeded (positive) or fallen short (negative) of expectations. It is not a measure of growth, per se, but merely of the direction in which economists are missing. I have plotted both the US index and the Eurozone index.

cesis

Obviously, economists were far too pessimistic about the numbers in December and January (reflecting data from October to December, and data kept exceeding their estimates. But now they are over-exuberant. So it isn’t that the numbers are falling short; it’s that they’re falling short of where economists (who can presumably recognize snow) thought they would be incorporating the known weather drags. That could simply mean the weather had a worse impact on real people than the bow-tied set thought it would. Or it could mean data is weaker than it ought to be.

Second point: just because the weather was bad should not be taken as carte blanche for the economy to collapse. If the economy was really as strong as equity investors seem to think, should weather be able to derail it so easily? Yes, weather makes it harder to detect the natural rhythm of what is going on, but it wasn’t as if that was easy to begin with. The danger is, as I suggested a week and a half ago, when all news can only be neutral or good. That’s a bad sign for once the weather normalizes again and it gets impossible to shrug off bad news as easily.

Third point: was the weather as bad in Europe? Because, as you can see from the chart above, economists have also been missing on the optimistic side for European figures. To be sure, they’ve been missing by less, and the numbers surprised less on the positive side over the last couple of months, but I don’t know that the Polar Vortex ought to be affecting Italy as seriously as it is affecting Chicago.

All of which is simply to say that the weather isn’t going to be bad forever, so … make hay while the sun doesn’t shine, I guess. Stocks are flat on the year, the hard way (but commodities are +6.5%, measured by the DJ-UBS index; according to our valuation estimates, that should be the normal case over the next few years rather than the rarity it has been over the last few).

It is interesting, too, that as bad as the weather effect has been on the construction industry and sales it hasn’t really impacted the price dynamics at all. The chart below (source: Bloomberg) shows Existing Home Sales in white, and the year/year change in median sales prices of existing single-family homes. Sales are 14% off their highs (seasonally-adjusted, which you should take with a grain of salt due to the unseasonal weather, but notice that the decline started in August when the snow was appreciably lighter), yet prices are still rising at nearly 11% year/year.

ehsl and prices

Now, a housing bull will say that these are the opposite faces of the same coin. They would say, “because there is so little inventory available – according to the NAR, only 1.9mm homes are for sale, which is higher than last winter but otherwise the lowest since 2002 – prices are rising and fewer are being sold because of the shortage of supply.” This is certainly possible, although I wonder at where all of the ‘shadow supply’ and bank REO property got off to so quickly, especially since the pace of existing home sales (and new home sales) remain at such low fractions of the pace prior to 2007 (existing home sales is currently 64% of the peak rate in 2005; new home sales are at 34% of the 2005 peak). How do you get rid of inventory without selling it?

The housing market continues to be a conundrum, but without a doubt prices are rising. And, also without a doubt, rising home prices are beginning to push rents higher. More economists are raising their forecasts for core inflation looking forward over the next year. Of course, readers of this column know that this is old news here. Speaking of which, Enduring Investments’ Quarterly Inflation Outlook for Q1 has been published. Institutional investors and others interested in our services can register for this private report on our website by filling out the contact form and requesting access to the blog.

Finally, I want to make one observation about the complete impotence of the Republicans to respond to the Democrats’ push for a higher minimum wage. It is terribly distressing to see such bad economics from one party (in this case, the Democrats) and such utter lack of common sense responses to bad economics from the other party (in this case, the Republicans). Here is the only question that needs to be answered: if raising the minimum wage has only salutatory effects on the economy and on the working class, then why not raise it to $1000/hour? Why not $10,000 per hour? Surely, if raising the minimum wage is good, then raising it more can’t be bad. Republicans should be amending the bill to make the minimum wage $10,000/hour.

The obvious answer is that if the minimum wage was $10,000/hour, no one would hire anybody – and we all know that, and even Democrats know that, and we all know why: because there is almost no one in the country who can produce enough goods or services to be worth $10,000/hour. If you are hiring people, you have to decide whether you will get enough out of them to afford their labor and still stay in business. The answer is obvious at $10,000. But it’s the same question at $10: can this group of workers produce enough so that I can afford to pay them all $10? If not, they will not be earning $10/hour but $0/hour (or at least some of them will be). We know exactly what would happen with a $10,000/hour minimum wage, and it’s easy to demonstrate it. But the Republicans are absolutely inarticulate on this point, and on most points, and that is why they keep losing arguments where they have the stronger position.

Housekeeping Note: earlier this week I published an article on the Mt. Gox/bitcoin fiasco. If you didn’t see the note (it didn’t get out on all of the syndication channels), you can find it here.

Categories: Economy, Housing, Politics Tags:

Life is Like a Box of Bitcoin

February 25, 2014 7 comments

Whether the evaporation of popular Bitcoin marketplace Mt. Gox (which may have nothing to do with the Gox in Dr. Seuss’s beloved One Fish, Two Fish, Red Fish, Blue Fish[1]) is due to fraud, hacking, incompetence, or some combination of all three – it appears it may have been hacked three years ago, and have been insolvent since then before vanishing from the Internet last night – doesn’t really matter. Either way, investors/speculators with money at Mt. Gox got MFGlobaled. The money wasn’t segregated (if it was money at all, and if it can be segregated at all), there was no audit (if there can be an audit trail for something that doesn’t have a known origin or destination), and the firm was not overseen in any fashion (if it is even possible to oversee something that exists mainly because it is difficult to oversee).

Like Schrödinger’s cat, it was kinda there, until someone actually looked and discovered it was dead.

I have carefully eschewed writing about Bitcoin in the past, though people have asked me to do so. I chose not to write about it because I had no wish to be filleted by one side or the other in the argument. But what I would have said would have been a series of simple observations that have nothing to do with how Bitcoin is mined, managed, or mishandled:

  1. This is hardly the first currency that has been outside of government control. Currencies existed outside of government control before they existed under government fiat.
  2. Historically speaking, there is a reason that government-sponsored currencies won, and it wasn’t because they were backed with gold. It was because people trusted the government when it said the currency was backed with gold.
  3. Trusted banks were issuers of currency for a long time. The coin of the realm has always been trust – and even if a currency is limited, or backed by limited metal, or whatever, you still need trusted institutions through which the coin flows, or it doesn’t work. Where is the trusted institution in Bitcoin’s case?
  4. So what’s the big deal?

This isn’t schadenfreude. I don’t care if Bitcoin succeeds or not; I don’t think its success or failure has anything to do with whether fiat currencies succeed or blow up. I don’t think Bitcoin is a “safe haven” any more than gold is a safe haven.

But at least I can touch gold. At least I know that gold will have some value in exchange, whereas I don’t know that Bitcoin will, tomorrow. And now, indeed it may not. Surely no institutional investor can now invest in Bitcoin deposits without answering the following question to the satisfaction of its board: “How can we be sure that our money won’t go the way of Mt. Gox?” And institutional acceptance is a huge hurdle for the future success of this substitute currency. Ditto firms using Bitcoin for transactions – a daylight overdraft that can go to zero overnight is a big risk for a bank.

And so, what I think was always the not-so-subtle problem for Bitcoin or any crypto-currency remains: for it to succeed, a trusted institution needs to be involved. Trust can’t be distributed across a network. And if an institution is involved, then the idea of a “people’s currency” loses weight. Bitcoin wasn’t the first of these attempts, and it won’t be the last, but in my mind that is the challenge. You can’t make money that only is used by the credulous and the gullible. It must be used by the incredulous and the suspicious. It is adoption by those people which defines the success or failure of a currency.

(Unfortunately, this puts certain elements at my alma mater in the former category. In our January 2014 alumni magazine was an article on Bitcoin. In the information bar “Bitcoin Dos and Don’ts”, the first point was “Do your research first! More information is available on Bitcoin.it, a wiki maintained by the bitcoin community. For Americans, the most popular and trustworthy place to buy and sell Bitcoins has historically been mtgox.com.” Whoops! Do your research first – popular does not imply trustworthy unless the thing is popular with people whose trust is hard to win!)


[1] “I like to box. How I like to box! So, every day, I box a Gox. In yellow socks I box my Gox. I box in yellow Gox box socks.”

Summary of My Post-CPI Tweets

February 20, 2014 Leave a comment

Here is a summary of my post-CPI tweets. You can follow me @inflation_guy:

  • Well, that was boring. CPI exactly as expected. Although frankly, most big shops expected +0.2% on core (me too).
  • Weird month where higher fuel prices seem to have taken edge off Shelter, but lower gasoline prices pushed Transp down!
  • Apparel down, and New cars & trucks down despite rising in PPI. So much for new PPI. Medical care commodities up though…
  • Medical Care as a whole +0.3%. Only 7.6% of the whole CPI, but reverses a recent trend caused by last year’s sequester.
  • Core services remained at 2.3% y/y, core goods declined to -0.3%. My proxy, though, is rising so this latter won’t continue.
  • Striking – core less shelter now at +0.933% y/y, the lowest since the real deflation crisis in 2004.
  • accelerating CPI categories: Housing, Med Care, Other (52.4%), Decel: Apparel, Educ/Comm (10.5%). Unch: 37.1%
  • Primary rents +2.88% y/y, virtually unch from +2.87%. But Owners’ Equiv Rent +2.517% from +2.488%.
  • New & Used cars and trucks under tremendous pressure, +0.3% y/y, and that’s 7.5% of core CPI. And Apparel (another 4%) has flatlined.

The reason that most big shops – and me too – expected +0.2% or even +0.3% on core, as opposed to the +0.13% that we got, boils down to three things: second, the housing part of core CPI, which is huge, is clearly accelerating and continues to do so. Second, core goods, which represents most of the rest, has been flat or deflating for a while, and normally that part of inflation is more mean-reverting.

The housing part of that view is working out. The Shelter subcomponent of Housing (which is ¾ of it, after extracting utilities and household furnishings and operations) is now rising at 2.58%, the fastest rate since 2008. Owners’ Equivalent Rent, the largest single component of the CPI, is at 2.52% y/y, and as I’ve illustrated often – here comes that chart again – there is every reason to expect this to continue. OER should be in the 3.3%-3.5% range by year-end.

morehousing

Core Goods, on the other hand, remains stuck in the mud. There was some reason to expect a rise in that index this month, as the Passenger Cars component of PPI rose +0.5% (but new vehicles in the CPI rose only 0.08% m/m), and the pharmaceuticals part of PPI was +2.7% (but only +0.9% in the CPI). In all likelihood, this suggests that core goods will move higher in the months ahead.

However, the weakness in Apparel and in vehicles has a commonality – those are sectors that are either sourced from non-US manufacturers or (in the case of vehicles) receive heavy competition from non-US manufacturers, and especially Japanese manufacturers in the case of autos. The recent strength of the USD with respect to the Yen and Yuan is not irrelevant here. Although early 2014 has seem some reversal in that trend with respect to the Yen, it’s not likely to have a serious reversal for a while – the Yen is going to keep getting weaker, and that will keep pressure on goods prices in the US.

Indeed, by one measure price dynamics in the US are closer to deflation than they have been since 2004. And it’s not a measure which should be taken lightly: core inflation, ex-shelter, is only 0.9% y/y, as the chart below (source: Enduring Investments) shows.

exhousing

In the mid-2000s, the Fed flirted much more with deflation than they thought they were, because the housing bubble hid the underlying dynamic. Conversely, in 2010 we weren’t really very close to deflation, but the fact that housing was collapsing made it appear that we were. You can see both of these episodes on the chart. It is possible that the 2004-type stealth deflation could be happening again, but I don’t think so for one big reason: in 2004, money growth was in the 4-5% range as the economy was recovering, which created disinflationary tendencies. But now, we’re coming off a period of 8-10% money growth, and it’s still at 6%. It’s much harder to get deflation in such a circumstance.

And, with rents rising smartly, there is almost no chance that core inflation ends 2014 lower than it currently is. I continued to expect core inflation to move towards 3% over the course of this year (and median CPI to reach that level).

Categories: CPI, Tweet Summary Tags: , ,

What Do You Care What Other People Think?

February 18, 2014 3 comments

In reflecting, over this weekend, about the markets of the last week, I wonder if we haven’t seen a subtle – and subtly disturbing – shift in the markets’ behavior.

Before the Fed began the taper, and even after the Fed began the taper but before we were really sure they intended to maintain it through at least mild economic wiggles, bad news was treated as good news in the markets (both stocks and bonds) because it implied more QE, or a longer QE, or a slower taper. This was lamentable because it suggested that the Fed was more important than global market fundamentals, but understandable at some level. All other forces summed to just about zero, so one big institution with a very big hammer was able to make the market vibrate the way policymakers wanted it to. So, while lamentable, this behavior was at least understandable.

But recently, as the Fed has started ever-so-slowly receding to the back pages, we have started to see behavior that is less unusual, but still not “normal.” Over the last couple of weeks, despite manifestly weak data – from the Employment report to Thursday’s surprisingly weak Retail Sales data and Friday’s weak Industrial Production data (which would have been even weaker if it hadn’t been for the utilities sector humming away) – the stock market has continued a marked rally. However, this is something we’ve seen before: a rally not because weak data would precipitate bullish policy, but because the weak data had a ready excuse in poor winter weather. In this sort of environment, good news is really good news, and bad news can be discounted (even if the cause to do so is sketchy).

There also is some “kitchen sinking” going on even among economists. “Kitchen sinking” refers to when a company takes advantage of a bad quarter to write off all sorts of expenses, all attributed to the “one time event” whether due to it in fact or not. This makes it far easier to score great earnings in the future. It’s understandable (if of questionable legality) in corporate accounting, but when economists do it then we should look askance. Without my naming names: on Friday one well-known macroeconomic advisor told clients that cold weather in November, December, and January will lower Q1 GDP by 0.4%. I am not sure how November’s weather would lower GDP in Q1…in fact, it seems to me that by lowering Q4 GDP, bad weather in December would tend to increase GDP in Q1 because it would be building from a lower base. Whatever the reason for the forecast, though, it certainly lowers the bar for the actual Q1 GDP report and increases the odds of a stock market-bullish surprise (although that’s way out in April).

Much more than the former mode of taking weak data as good because it implied more liquidity from the Fed, this sort of thing – kitchen sinking by economists, and markets taking all news as either neutral or good – is a signature of unhealthy bullishness. The concern is that when the reasons to ignore bad news have passed, the market will not be priced at a level that can sustain actual bad news. And, unlike the QE-baiting, it is something we have seen before. It is a weaker signature, and it’s entirely emotional rather than the twisted but at least debatable reasoning that investors employed when bad news was Fed-good.

It seems almost unfair to continue to list anecdotal signs of frothy behavior, because it’s so easy to do so these days. One that sprang into view last week was the incredibly vitriolic response to the chart that has been making the rounds showing the parallel in equity market action between 1928-29 and 2012-14. For example, here was one objection, which was perhaps a reasonable objection … but note the tone. And this was just one example among many.

Come on, is it really so horrible, such a threat to civilization, to have someone trot out this chart? I will take either side of the argument with no acrimony. Personally, I don’t think it’s almost ever useful to think of the past as an exact roadmap (although if I ignored this chart, and the market did crash, I hate to think of how I would explain that insouciance to my clients after-the-fact), but I also don’t care if someone else does do so. Especially if it leads them to the right conclusion, and I happen to think that if investors start being cautious right now it is the right result, whether it happens because they were scared of a spooky chart or because they understand market valuation metrics.

But again: who cares? This is not a fact which is right or wrong – unlike, say, the claim that the government made a change to the CPI in the early 1980s which subtracts 5% from CPI every year. That is a verifiable statement, and it is demonstrably false. But saying “chart A looks like chart B” can’t possibly be wrong…it’s opinion! My concern isn’t about the chart; it is about the vehemence with which some people are attacking that opinion.

It is like I tell my daughter when someone calls her a dunderhead, or whatever the 7-year-old equivalent is these days. I ask “well, are you a dunderhead?” If the answer is yes, then you have bigger problems than what they’re calling you. If the answer is no, then as Feynman said what do you care what other people think? Similarly, if you’re bullish, what do you care if someone runs that chart? If it’s right, then you have bigger problems than the fact they’re running the chart. And if it’s wrong, then what do you care what they think?

Don’t Bank on it

February 17, 2014 7 comments

Here is a post from Sober Look that has some really good charts on the changing asset mix at US banks. I was a little surprised that they didn’t point out the obvious connection in the charts, although they do make some key points in a previous post.

To summarize: the charts show that the loan-to-deposit ratio in the banking system recently hit a 35-year low, and that the proportion of cash on the balance sheet of banks has gone from maybe 5% to around 20% (eyeballing it) in the last ten years.

Obviously, these two facts are not unconnected, since loans and cash are both assets to banks. The reason for the shift from loans to cash is very simple: QE. Banks don’t want to hold as much cash (reserves) as they are carrying, but the alternative is to lend it to people in sub-optimal loans – that is, where the interest rate charged does not compensate for the risk that the loan will not be paid back, so that the lending has a negative NPV. Moreover, the cash itself has a positive return because the Fed is paying interest on excess reserves, so that the lending has a higher hurdle to achieve than it would if this was just “normal” cash or reserves.

Understanding this dynamic is really important. So here’s how this works: if interest rates rise, but reserves have the same yield, then lending becomes more profitable and loans will increase – that is, the money multiplier will rise, with less money in the vault and more money in transactional accounts. If, on the other hand, the Fed raises the interest on excess reserves while lending rates stay unchanged, then even fewer loans will be made and banks will hold more cash relative to loans. This is one mechanism by which higher interest rates initially encourage higher inflation.

(And yes, while the total amount of reserves in the system is fixed, the total amount of loans is not, so while the Fed controls the former they do not control the latter except indirectly).

So, consider the “exit” strategy. As interest rates rise, the multiplier will increase unless the Fed hikes interest on excess reserves. But since interest rates move more flexibly, more rapidly, and often further than do policy rates, this probably means the multiplier will be determined mostly by the market (I wonder if the Fed declared the IOER to be “10-year yields minus 250bps” if that would change things?). The gap is the thing. And, if Yellen actually cuts the IOER to zero, as she has intimated is possible, then the multiplier would rise…and we don’t know by how much.

On the flip side, if the Fed tapers QE to zero, and lending rates fall, then the multiplier would tend to fall further because that gap narrows. In that case, you really could get a disinflationary scenario…though I am skeptical that long rates can fall very much when public debt is so high and the Fed is withdrawing its support for the bond market. Still, a crisis could do it. To be clear: you’d need the Fed to stop adding reserves, to neglect the IOER – or increase it – and long rates to decline substantially (at least 100bps, say). So if you are a deflationist, there are your signposts. I don’t anticipate that any of that happening, except that I imagine they will screw up the IOER strategy and they could screw that up in either direction.

And by the way, I don’t think any of that would affect inflation much in 2014, since higher housing prices are already going to be pressing core inflation higher. But it could affect 2015.

However, I digress from the other point I wanted to make that was suggested by the Sober Look article, and that is this: it continues to amaze me how well bank stocks are trading. I’ve been saying this for years – which helps to illustrate that I am a strategic investor, not a twitchy tactical guy. Return on equity equals gross margin (profit/revenue), times asset turnover (revenue/assets), times leverage (assets/equity), and for banks all three of these components are under pressure. Gross margin is under pressure from the movement of more products to electronic trading and from increasing legal bills at banks (the FX trading scandal is the latest threat of multibillion-dollar fines, adding to the LIBOR scandal and probes of the gold and silver price fixing system as sources of legal headaches for banks). Banks have been forced via the crisis to shed leverage, as a chart I recently ran illustrated. And low interest rates combined with large amounts of cash compared to loans on the balance sheet pressures the asset turnover statistic. So it isn’t surprising that bank ROEs are low (see chart of the NASDAQ bank index ROEs, source Bloomberg). roebanksWhat is surprising is that they even got this high, and market pricing seems to anticipate that they’ll keep rising. Bank stocks are actually outperforming the S&P since late 2011, and their P/E ratios are essentially where they have always been, excluding the spike when earnings collapsed in the crisis, causing P/Es to skyrocket (see chart, source Bloomberg).

bankpeMaybe all the bad news is already in the price of bank stocks, but it doesn’t look like it to me.

The Marie Antoinette Rule

February 11, 2014 5 comments

The biggest surprise of the day on Tuesday did not come from new Fed Chairman Janet Yellen, nor from the fact that she didn’t offer dovish surprises. Many observers had expected that after a mildly weak recent equity market and slightly soft Employment data, Yellen (who has historically been, admittedly, quite a dove) would hold out the chance that the “taper” may be delayed. But actually, she seemed to suggest that nothing has changed about the plan to incrementally taper Fed purchases of Treasuries and mortgages. I had thought that would be the likely outcome, and said so yesterday when I supposed “she will be reluctant to be a dove right out of the gate.”

The surprise came in the market reaction. Since there had been no other major (equity) bullish influences over the last week, I assumed that the stock market rally had been predicated on the presumption that Yellen would give some solace to the bulls. When she did not, I thought stocks would have difficulty – and on that, I was utterly wrong. Now, whether that means the market thinks Yellen is lying, or whether there is some other reason stocks are rallying, or whether they are rallying for no reason whatsoever, I haven’t a clue.

I do know though that the DJ-UBS commodity index reached its highest closing level in five months, and that commodities are still comfortably ahead of stocks in 2014 even with this latest equity rally. This rally has been driven by energy and livestock, with some precious metals improvements thrown in. So, lest we be tempted to say that the rally in commodities is confirming some underlying economic strength, reflect that industrial metals remain near 5-year lows (see chart, source Bloomberg, of the DJUBS Industrial Metals Subindex).

indmet

One of the reasons I write these articles is to get feedback from readers, who forward me all sorts of articles and observations related to inflation. Even though I have access to many of these same sources, I don’t always see every article, so it’s helpful to get a heads up this way. A case in point is the article that was on Business Insider yesterday, detailing another quirky inflation-related report from Goldman Sachs.http://www.businessinsider.com/goldman-fed-should-target-wage-growth-2014-2

Now, I really like much of what Jan Hatzius does, but on inflation the economics team at Goldman is basically adrift. It may be that the author of this article doesn’t have the correct story, but if he does then here is the basic argument from Goldman: the Fed shouldn’t target inflation or employment, but rather on wage growth, because wage growth is a better measure of the “employment gap” and will tie unemployment and inflation together better.

The reason the economists need to make this argument is because “price inflation is not very responsive to the employment gap at low levels of inflation,” which is a point I have made often and most recently in my December “re-blog” series.

But, as has happened so often with Goldman’s economists when it comes to inflation, they take a perfectly reasonable observation and draw a nonsensical conclusion from it. The obvious conclusion, given the absolute failure of the “employment gap” to forecast core price inflation over the last five years, is that the employment gap and price inflation are not particularly related. The experimental evidence of that period makes the argument that they are – which is a perversion of Phillips’ original argument, which related wages and unemployment – extremely difficult to support. Hatzius et. al. clearly now recognize this, but they draw the wrong conclusion.

There is no need to tie unemployment and inflation together …unless you are a member of the bow-tied set, and really need to calibrate parameters for the Taylor Rule. So it isn’t at all a concern that they aren’t, unless you really want your employment gap models to spit out useful forecasts. Okay, so if you can’t forecast prices, then use the same models and call it a wage forecast!

But the absurdity goes a bit farther. By suggesting that the Fed set policy on the basis of wage inflation, these economists are proposing a truly abhorrent policy of raising interest rates simply because people are making more money. Wage inflation is a good thing; end product price inflation is a bad thing. Under the Goldman rule, if wages were rising smartly but price inflation was subdued, then the Fed should tighten. But why tighten just because real wages are increasing at a solid pace? That is, after all, one of society’s goals! If the real wage increase came about because of an increase in productivity, or because of a decrease in labor supply, then it does not call for a tightening of monetary policy. In such cases, it is eminently reasonable that laborers take home a larger share of the real gains from manufacture and trade.

On the other hand, if low nominal wage growth was coupled with high price inflation, the Goldman rule would call for an easing of monetary policy…even though that would tend to increase price inflation while doing nothing for wages. In short, the Goldman rule should probably be called the Marie Antoinette rule. It will tend to beat down wage earners.

Whether or not the Goldman rule is an improvement over the Taylor Rule is not necessarily the right question either, because the Taylor Rule is not the right policy rule to begin with. Returning to the prior point: the employment gap has not demonstrated any useful predictive ability regarding inflation. Moreover, monetary policy has demonstrated almost no ability to make any impact on the unemployment rate. The correct conclusion here is a policy rule should not have an employment gap term. The Federal Reserve should be driven by prospective changes in the aggregate price level, which are in turn driven in the long run almost entirely by changes in the supply of money. So it isn’t surprising that the Goldman rule can improve on the Taylor rule – there are a huge number of rules that would do so.

Two Types of People?

February 10, 2014 2 comments

Investors have learned the same wrong lessons over the last couple of years that they learned in the run-up to 2000, evidently. I remember that in the latter part of 1999, every mild equity market setback was met immediately with buying – the thought was that you had to jump quickly on the train before it left the station again. There was no thought about whether the bounce was real, or whether it “made sense”; for quite a number of them in a row, the bounce was absolutely real and the train really did leave the station.

Then, the train reached the end of the line and rolled backwards down the mountain, gathering speed and making it very difficult to jump off. I remember getting a call from my broker at the time, recommending Lucent at around $45 – quite the discount from the $64 high. I noted that I was a value investor and I didn’t see value in that stock, and to not call me again until he had a decent value idea. He next called with a recommendation later that year, with a stock that had just hit $30…a real bargain! And, as it turned out, that stock was also Lucent. The lesson he had learned was that any stock at a discount from the highs was a “value” stock. (Lucent ended up bottoming at about $0.55 in late 2002 and was eventually acquired by Alcatel in 2006).

This lesson appears to have been learned as well. On Thursday and Friday a furious rally took stocks up, erasing a week and a half of decline. This happened despite the fact that Friday’s Employment number was just about the worst possible number for equities: weak enough to indicate that the December figure was not just about seasonal adjustment, but represented real weakness, but nowhere near weak enough to influence the Federal Reserve to consider pausing the recent taper. We will confirm this fact tomorrow, before the market open, when new Fed Chairman Janet Yellen delivers the Monetary Policy Report (neé Humphrey-Hawkins) testimony to the House Financial Services Committee (her comments to be released at 8:30ET). While I believe that Yellen will be very reluctant to raise rates any time soon, and likely will seize on signs of recession to stop the taper in its tracks, she will be reluctant to be a dove right out of the gate.

And that might upset the apple cart tomorrow, if I’m right.

I have been fairly clear recently that I see a fairly significant risk of market volatility to come, both on the fixed-income side but especially on the equity side. I think stocks are substantially overvalued and could fall markedly even without any important change in the underlying economic dynamics. But there is actually good news which should be considered along with that fact: when markets were last egregiously overpriced, financial institutions were also substantially more-levered than they are today. The chart below (source: Federal Reserve) shows that as a percentage of GDP, domestic financial institutions are about one third less levered than they were at the 2008 peak.

debtdelevNow, this exaggerates the deleveraging to some extent – households, for example, appear to have deleveraged by about 20% on this chart, but the actual nominal amount of debt outstanding has only declined from about $14 trillion to about $13.1 trillion. Corporate entities have actually put on more debt (which made sense for a while but probably doesn’t now that equity is so highly valued relative to earnings), but in terms of a percentage of GDP they are at least not any more levered than they were in 2008.

The implication of this fact is some rare good news: since the banking system has led the deleveraging, the systemic risk that could follow on the heels of a significant market decline is likely to be much less, at least among U.S. domestic financial institutions. So, in principal, while it was clear that a decline in equity and real estate prices in 2007-2008 would eventually cause damage to the real economy as the financial damage was amplified through the financial system, this is less true today. We can, in other words, have some reasonable market movements without having that automatically lead to recession. The direct wealth effect of equity price movements is very small, on the order of a couple of percent. It’s the indirect effects that we have to worry about, and the good news is that those indirect effects are smaller now – although I wouldn’t say those risks are absent.

Now for the bad news. The bad news is that significant market volatility – say, a 50% decline in stock prices – would likely be met with “help” from the federal government and monetary authorities. It is that help which likely would hurt the economy by increasing business uncertainty further. It is probably not a coincidence that the last couple of months, which correspond to the implementation of the Affordable Care Act, have led to some weaker growth figures. Whether change is perceived as positive or negative, it’s the constant changing of the rules – and especially now that these rules are increasingly changed by executive fiat without the moderating influence of Congress (I never thought I would write that) – that damages business confidence.

In other words, I wouldn’t be concerned about the direct economic effect of a 50% decline in equity prices; but I would be concerned if such a decline led to meddling from the Fed, the Congress, or the White House.

While investors learned the hard lessons after 2000 and 2008 about the wisdom of automatically buying dips, they eventually forgot those lessons. But that makes them almost infinitely smarter than policymakers, who have refused to learn the obvious lesson of the last few years: your ministrations do little to help, and most likely hurt. So, maybe it really is true that there are two types of people: those who listen to everybody, and those who listen to nobody. The former become investors, and the latter enter government service!

Inflation and Insurance Companies

February 5, 2014 Leave a comment

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!

Do Data Matter Again?

February 3, 2014 Leave a comment

In normal times, by which I mean before actions of the Federal Reserve became the only data point that mattered, the monthly ISM report was important because it was the first broad-based look at the most-recent month’s data.

Now that the Fed’s taper has begun – right about the time that the uncertainty of the impact of Obamacare implementation was at its peak, curiously enough – the ISM data seems to have taken on importance once again. I must say that I did not see that coming, but since guessing at the Fed’s actions every six weeks and ignoring all intervening data was so all-fired boring, I suppose I am glad for it. Looking at economic data and trying to figure out what is happening in the economy is more like analysis and less like being on The People’s Court trying to rule on a he-said, she-said case where the hes and shes are Federal Reserve officials. And that is welcome.

That being said, the January ISM report isn’t one I would necessarily place at the head of the class of importance, mainly because it is January. Still, it was an interesting one with the Manufacturing PMI dropping 5.2 points, matching the steepest decline since October 2008. The New Orders subindex plunged to 51.2 versus 64.4 last month, and Employment and Production indices also declined significantly. It’s clearly bad news, but I would be careful ascribing too much value to any January number – especially one based on a survey.

Also standing out in the report was the increase in the (non-seasonally adjusted) “Prices Paid” subcomponent, to 60.5. the jump was initially somewhat surprising to me because as the chart below – which I tweeted shortly after the number – seems to show, we have had a jump in Prices Paid that is not being driven by a concomitant jump in gasoline prices – and Prices Paid is predominantly driven by gasoline prices.

ismpric and gasoline

However, as I noted in that tweet, the Prices Paid index is measuring the rate of change of prices (the question posed to purchasing managers is whether prices are increasing faster, slower, or about the same as the month before), so just eyeballing it may not be enough. The chart below plots the 3-month change in gasoline prices versus the ISM Prices Paid subindex. What you can see is that the first chart is slightly deceiving. The change in gasoline prices has accelerated – back to zero after having been declining since February of 2013. And “unchanged” gasoline prices is roughly consistent with about 60 on the Prices Paid indicator. So, this isn’t as much of a surprise as it looked like, initially.

ismvsgas

Still, whether it was the data or because of continued concern about emerging markets (though the S&P fell nearly as far in percentage terms as did the EEM today, leaving open the question of which is following which), stocks didn’t enter February with much cheer. But never fear, I am sure there is “cash on the sidelines” that will come charging to the rescue soon.

The past week has given a great illustration of one important difference between the price behavior of equities and commodities. That is that stocks are negatively skewed and positively kurtotic, while commodities are positively skewed and negatively kurtotic. That is to say, in layman’s terms, that stocks tend to crash downward, while commodities more frequently crash upwards. This happens because what tends to drive severe movements in commodities is shortages, where the short-term supply curve becomes basically vertical so that any increase in demand pushes up prices sharply. Exhibit one is Natural Gas (see chart, source Bloomberg), where inventories were above normal as recently as October and now are the lowest in a decade.

natty

Exhibit two is Coffee (see chart, source Bloomberg), where drought in Brazil has lifted coffee prices 8-9% today and 35% from the five-year lows set in November. There’s an awful lot of coffee in Brazil, I understand, but there may be less this year.

coffee

In my view, stocks remain very expensive even after this quick 5.75% loss (-2.3% today). Obviously, less so! Commodities have outperformed stocks by basically remaining unchanged, but remain very cheap. Bonds have rallied, as money has shifted from stocks to bonds. This is fine, except that 10-year notes at 2.57% with median inflation at 2.1% and rising is not a position to own, only to rent. The question is, when investors decide that it’s time to take their profits in bonds, do they go to cash, back to equities, or to commodities? If you are one of the people mulling this very question, I have another chart to show you. It is the simple ratio of the S&P to the DJ-UBS (source: Bloomberg).

stockscomm

I think that makes where I stand fairly clear. If both stocks and commodities represent ownership in real property, and both have roughly the same long-term historical returns (according to Gorton & Rouwenhorst), then the ratio of current prices should be a coarse (and I stress coarse) relative-value indicator, right?

But let’s shift from the long-view lens back to the short view, now that a retreating Fed makes this more worthwhile. I am not sanguine about the outlook for stocks, obviously (and here’s one for the technicians: for the first time in years, exchange volume in January was higher than last year’s January volume). However, bulls may get a brief reprieve later this week when the Employment Report is released. Yes, it’s another January data point that ought to be ignored or at least averaged with December’s figure. And that’s the point here. Last month’s Employment Report showed only a 74k rise in Nonfarm Payrolls. That weakness was likely due to the fact that the seasonal adjustments (which dwarf the net number of jobs, in December and January) assumed more year-end and holiday hiring than actually occurred. But the flip side of that is that if fewer were hired in December, it probably means fewer were fired in January. Thus, I expect that the 185k consensus guess for new jobs is likely to be too low and we will have a bullish surprise on Friday. That might help the bulls get a foothold…but it is a long three trading days away.

Do Floating-Rate Notes (FRNs) Protect Against Inflation?

February 1, 2014 2 comments

Since the Treasury this week auctioned floating-rate notes (FRNs) for the first time, it seems that it is probably the right time for a brief discussion of whether FRNs protect against inflation.

The short answer is that FRNs protect against inflation slightly more than fixed-rate bonds, but not nearly as well as true TIPS-style bonds. This also goes, incidentally, for CPI-linked floaters that pay back par at maturity.

However, there are a number of advisors who advocate FRNs as an inflation hedge; my purpose here is to illustrate why this is not correct.

There are reasonable-sounding arguments to be made about the utility of FRNs as an inflation hedge. Where central bankers employ a Taylor-Rule-based approach, it is plausible to argue that short rates ought to be made to track inflation fairly explicitly, and even to outperform when inflation is rising as policymakers seek to establish positive real rates. And indeed, history shows this to be the case as LIBOR tracks CPI with some reasonable fidelity (the correlation between month-end 3m Libor and contemporaneous Y/Y CPI is 0.59 since 1985, see chart below, data sourced from Bloomberg).

liborcpi

It bears noting that the correlation of Libor with forward-looking inflation is not as strong, but these are still reasonable correlations for financial markets.

The correlation between inflation and T-Bills has a much longer history, and a higher correlation (0.69) as a result of tracking well through the ‘80s inflation (see chart below, source Bloomberg and Economagic.com).

tbillscpi

And, of course, the contemporaneous correlation of CPI to itself, if we are thinking about CPI-linked bonds, is 1.0 although the more-relevant correlation, given the lags involved with the way CPI floaters are structured, of last year’s CPI to next year’s CPI is only 0.63.

Still, these are good correlations, and might lead you to argue that FRNs are likely good hedges for inflation. Simulations of LIBOR-based bonds compared to inflation outcomes also appear to support the conclusion that these bonds are suitable alternatives to inflation-linked bonds (ILBs) like TIPS. I simulated the performance of two 10-year bonds:

Bond 1: Pays 1y Libor+100, 10y swaps at 2.5%.

Bond 2: Pays an annual TIPS-style coupon of 1.5%, with expected inflation at 2.0%.

Note that both bonds have an a priori expected nominal return of 3.5%, and an a priori expected real return of 1.5%.

I generated 250 random paths for inflation and correlated LIBOR outcomes. I took normalized inflation volatility to be 1.0%, in line with current markets for 10-year caps, and normalized LIBOR volatility to be 1.0% (about 6.25bp/day but it doesn’t make sense to be less than inflation, if LIBOR isn’t pegged anyway) with a correlation of 0.7, with means of 2% for expected inflation and 2.5% for expected LIBOR and no memory. For each path, I calculated the IRR of both bonds, and the results of this simulation are shown in the chart below.

nominalcorrs

You can see that the simulation produced a chart that seems to suggest that the nominal internal rates of return of nominal bonds and of inflation-linked bonds (like TIPS) are highly correlated, with a mean of about 3.5% in each case and a correlation of about 0.7 (which is the same as an r-squared, indicated on the chart, of 0.49).

Plugged into a mean-variance optimization routine, the allocation to one or the other will be largely influenced by the correlation of the particular bond returns with other parts of the investor’s portfolio. It should also be noted that the LIBOR-based bond may be more liquid in some cases than the TIPS-style bond, and that there may be opportunities for credit alpha if the analyst can select issuers that are trading at spreads which more than compensate for expected default losses.

The analysis so far certainly appears to validate the hypothesis that LIBOR bonds are nearly-equivalent inflation hedges, and perhaps even superior in certain ways, to explicitly indexed bonds. The simulation seems to suggest that LIBOR bonds should behave quite similarly to inflation-linked bonds. Since we know that inflation-linked bonds are good inflation hedges, it follows (or does it?) that FRNs are good inflation hedges, and so they are a reasonable substitute for TIPS. Right?

However, we are missing a crucial part of the story. Investors do not, in fact, seek to maximize nominal returns subject to limiting nominal risks, but rather seek to maximize real return subject to limiting real risks.[1]

If we run the same simulation, but this time calculate the Real IRRs, rather than the nominal IRRs, a very different picture emerges. It is summarized in the chart below.

realirrs

The simulation produced the assumed equivalent average real returns of 1.5% for both the LIBOR bond and the TIPS-style bond. But the real story here is the relative variance. The TIPS-style bond had zero variance around the expected return, while the LIBOR bond had a non-zero variance. When these characteristics are fed into a mean-variance optimizer, the TIPS-style bond is likely to completely dominate the LIBOR bond as long as the investor isn’t risk-seeking. This significantly raises the hurdle for the expected return required if an investor is going to include LIBOR-based bonds in an inflation-aware portfolio.

So what is happening here? The problem is that while the coupons in this case are both roughly inflation-protected, since LIBOR (it is assumed) is highly correlated to inflation, there is a serious difference in the value of the capital returned at the maturity of the bond. In one case, the principal is fully inflation-protected: if there has been 25% inflation, then the inflation-linked bond will return $125 on an initial $100 investment. But the LIBOR-based bond in this case, and in all other cases, returns only $100. That $100 is worth, in real terms, a widely varying amount (I should note that the only reason the real IRR of the LIBOR-based bond is as constrained as it appears to be in this simulation is because I gave the process no memory – that is, I can’t get a 5% compounded inflation rate, but will usually get something close to the 2% assumed figure. So, in reality, the performance in real terms of a LIBOR bond is going to be even more variable than this simulation suggests.

The resolution of the conundrum is, therefore, this: if you have a floating rate annuity, with no terminal value, then that is passably decent protection for an inflation-linked annuity. But as soon as you add the principal paid at maturity, the TIPS-style bond dominates a similar LIBOR bond. “Hooray! I got a 15% coupon! Boo! That means my principal is worth 15% less!”

The moral of the story is that if your advisor doesn’t understand this nuance, they don’t understand how inflation operates on nominal values in an investor’s portfolio. I am sorry if that sounds harsh, but what is even worse than the fact that so many advisors don’t know this is that many of those advisors don’t know that they don’t know it!


[1] N.b. Of course, they seek to maximize after-tax real returns and risks, but since the tax treatments of ILBs and Libor floaters are essentially identical we can abstract from this detail.

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