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Archive for April, 2017

Tariffs are Good for Inflation

The news of the day today – at least, from the standpoint of someone interested in inflation and inflation markets – was President Trump’s announcement of a new tariff on Canadian lumber. The new tariff, which is a response to Canada’s “alleged” subsidization of sales of lumber to the US (“alleged,” even though it is common knowledge that this occurs and has occurred for many years), ran from 3% to 24% on specific companies where the US had information on the precise subsidy they were receiving, and 20% on other Canadian lumber companies.

In related news, lumber is an important input to homebuilding. Several home price indicators were out today: the FHA House Price Index for new purchases was up 6.43% y/y, the highest level in a while (see chart, source Bloomberg).

The Case-Shiller home price index, which is a better index than the FHA index, showed the same thing (see chart, source Bloomberg). The first bump in home price growth, in 2012 and 2013, was due to a rebound to the sharp drop in home prices during the credit crisis. But this latest turn higher cannot be due to the same factor, since home prices have nearly regained all the ground that they lost in 2007-2012.

Those price increases are in the prices of existing homes, of course, but I wanted to illustrate that, even without new increases in materials costs, housing costs were continuing to rise faster than incomes and faster than prices generally. But now, the price of new homes will also rise due to this tariff (unless the market is slack and so builders have to absorb the cost increase, which seems unlikely to happen). Thus, any ebbing in core inflation that we may have been expecting as home price inflation leveled off may be delayed somewhat longer.

But the tariff hike is symptomatic of a policy that provokes deeper concern among market participants. As I’ve pointed out previously, de-globalization (aka protectionism) is a significant threat to inflation not just in the United States, but around the world. While I am not worried that most of Trump’s proposals would result in a “reflationary trade” due to strong growth – I am not convinced we have solved the demographic and productivity challenges that keep growth from being strong by prior standards, and anyway growth doesn’t cause inflation – I am very concerned that arresting globalization will. This isn’t all Trump’s fault; he is also a symptom of a sense among workers around the world that globalization may have gone too far, and with no one around who can eloquently extol the virtues of free trade, tensions were likely to rise no matter who occupied the White House. But he is certainly accelerating the process.

Not only do inflation markets understand this, it is right now one of the most-significant things affecting levels in inflation markets. Consider the chart below, which compares 10-year breakeven inflation (the difference between 10-year Treasuries and 10-year TIPS) to the frequency of “Border Adjustment Tax” as a search term in news stories on Google.

The market clearly anticipated the Trumpflation issue, but as the concern about BAT declined so did breakevens. Until today, when 10-year breakevens jumped 5-6bps on the Canadian tariff story.

At roughly 2%, breakevens appear to be discounting an expectation that the Fed will fail to achieve its price inflation target of 2% on PCE (which would be about 2.25% on CPI), and also excluding the value of any “tail outcomes” from protectionist battles. When growth flags, I expect breakevens will as well – and they are of course not as cheap as they were last year (by some 60-70bps). But from a purely clinical perspective, it is still hard to see how TIPS can be perceived as terribly rich here, at least relative to nominal Treasury bonds.

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Book Review: The Mandibles (related to inflation)

April 7, 2017 1 comment

For something a little different, I wanted to write a book review today. But this is not as far removed as it seems, from my normal beat. In fact, this book could actually be a companion piece to my own book published last year, What’s Wrong with Money?: The Biggest Bubble of All. I really mean that.

The book is “The Mandibles: A Family, 2029-2047,” by Lionel Shriver. This is a terrific work of fiction, especially if you like futuristic dystopian novels. From the jacket:

In 2029, the United States is engaged in a bloodless world war that will wipe out the savings of millions of American families. Overnight, on the international currency exchange, the “almighty dollar” plummets in value, to be replaced by a new global currency, the “bancor.” In retaliation, the president declares that America will default on its loans. “Deadbeat Nation” being unable to borrow, the government prints money to cover its bills. What little remains to savers is rapidly eaten away by runaway inflation.

The Mandibles have been counting on a sizable fortune filtering down when their ninety-seven-year-old patriarch dies. Once the inheritance turns to ash, each family member must contend with disappointment, but also—as the U.S. economy spirals into dysfunction—the challenge of sheer survival.

This book was recommended to be by a friend who knows of my background in inflation – many years of study of the topic, and the fact that I founded and run a firm that’s dedicated to inflation hedging of various kinds (e.g., college tuition or healthcare, but also things like commodities and inflation-linked bond strategies). I took up the novel with some trepidation, since most treatments of inflation in fiction…heck, in non-fiction…are shallow and generally just plain obtuse. I’m including works by famous economists. So I didn’t have high hopes for this book.

I was completely wrong.

When I said that this book could be a companion book to my own (non-fiction) work, I wasn’t kidding. The author got virtually every detail right, about how the pieces fit together, about what causes inflation – including the question of how moderate and high inflation can turn into hyperinflation, a transition that has little to do with monetary policy actions and everything to do with confidence in the monetary unit. And that’s actually why my book is titled “What’s Wrong with Money…” the fact that confidence is the underlying unit (in a fiat currency) creates the potential for an outcome such as Ms. Shriver describes. It isn’t a likely outcome, but it is entirely plausible that it could work out in this way.

Ms. Shriver skillfully works current events of today into the novel, as characters occasionally recollect some old policy from the 2000s or 2010s and explain why that policy didn’t work. I was amazed at the competence with which she tackled all of these subjects.

All in all – if you like the things I write, and especially if you read my book and liked it (or even if you didn’t read it, and probably even if you didn’t like it), you will really like The Mandibles. I highly recommend it.

Categories: Book Review

Is This Bubble Smaller Than We Thought?

I haven’t written in a few weeks. It has been, generally, a fairly boring few weeks in terms of market action, with inflation breakevens oscillating in a narrow range and equities also fairly somnolent. But I can’t blame my lack of posts on a lack of interesting things to remark upon, nor on March Madness, nor on New Jersey Transit (although each of these is a very valid excuse for the general lackadaisical nature of trading in recent weeks). In my case, I plead business exigencies as we are working on a few very exciting projects, one of which I expect to be able to announce in the next week or two.

But writing a blog post/article is never far from my mind. I’ve been doing it for far too long – since the ‘90s if you count the daily letters I wrote for client distribution when I was on Wall Street – and when I haven’t written something in a while it is a bit like an itch on the sole of my foot: I am constantly being reminded about it and the only way to make it stop is to rip the shoe off and scratch. Which tickles. But I digress. What I mean to say is that I have a long list of things I’ve written down that I could write about “if I have time this afternoon,” and it’s only the lack of time that has stopped me. (Some of these are also turning into longer, white-paper type articles such as one I am writing right now estimating the cost of the “Greenspan Put.”)

Some of these ideas are good ideas, but I can’t figure out how to address my hypothesis. For example, I suspect that inflation swaps or breakevens, now that they are near fair value for this level of interest rates, have some component in them right now that could be interpreted as the probability that the Border Adjustment Tax (BAT) eventually becomes law. If the BAT is implemented, it implies higher prices, and potentially much higher depending on the competitive response of other countries. If the BAT fails, then breakevens may not set back very much, but they should decline some; if the BAT looks like it is fait accompli, then inflation quotes could move sharply higher (at least, they should). But prediction markets aren’t making book on the BAT, so I don’t have a way to test (or even illustrate) this hypothesis.

But enough about what I can’t do or won’t be doing; today I want to revisit something I wrote back in December about the stock market. In an article entitled “Add Another Uncomfortable First for Stocks,” I noted that the expected 10-year real return premium for equities over TIPS was about to go negative, something that hadn’t happened in about a decade. In fact, it did go slightly negative at the end of February, with TIPS guaranteed real return over ten years actually slightly above the expected (risky) real return of equities over that time period. At the end of March, that risk premium was back to +3bps, but it’s still roughly the same story: stocks are priced to do about as well as TIPS over the next decade, with the not-so-minor caveat that if inflation rises TIPS will do just fine but stocks will likely do quite poorly, as they historically have done when inflation has risen.

But I got to wondering whether we can say anything about the current market on the basis of how far stocks have outperformed the a priori expectations. That is, if we made a forecast and a decade goes by and stocks have shattered those expectations, does that mean that the forecast was bad or that stocks just became overvalued during that period so that some future period of underperformance of the forecast is to be expected? And, vice-versa, does an underperformance presage a future outperformance?

The first thing that we have to confess is that the way we project expected real returns will not produce something that we expect to hit the target every decade. Indeed, the misses can be huge in real dollar terms – so this is not a short-term or even a medium-term trading system. Consider the following chart (Source: Enduring Investments), which shows the difference of the actual 10-year return compared with the a priori forecast return from 10 years prior. A positive number means that stocks over the period ending on that date outperformed the a priori forecast; a negative number means they underperformed the forecast. In context: a 5% per year miss in the real return means a 63% miss on the 10-year real return. That’s huge.

What you can really see here is that stocks have – no surprise – very long ‘seasons’ of bear and bull markets where investors en masse are disappointed with their returns, or excited about their returns. But let me update this chart with an additional observation about real yields. During the period covered by this chart, there have been three distinct real yield regimes. In the 1960s and 1970s, real yields generally rose. In the late 1970s, 10-year real yields rose to around 4.25%-4.50%, and they didn’t begin falling again in earnest until the late 1980s. (This is in contrast to nominal yields, which started to fall in the early 1980s, but that was almost entirely because the premium for expected inflation was eroding). Between the late 1970s and the late 1980s, real yields were more or less stable at a high level; since the late 1980s they have been declining. In the following chart (Source: Enduring Investments), I’ve annotated these periods and you may reasonably draw the conclusion that in periods of rising interest rates, stocks underperform a priori expectations in real terms while in periods of falling real interest rates, stocks outperform those expectations.

These rolling 10-year rate-of-change figures are interesting but it is hard to see whether periods of outperformance are followed by underperformance etc. It doesn’t look like it, except in the really big macro picture where a decade of outperformance might set the stage for a decade of underperformance. I like the following look at the same data. I took the a priori 10-year real return forecast and applied it to the then-current real price level of the S&P 500 (deflated by the CPI). That produces the red line in the chart below (Source: Enduring Investments). The real price level of the S&P is in black. So the red line is the price level forecast and the black line shows where it ended up.

As I said, this is not a short-term trading model! It is interesting to me how the forecast real level of equities didn’t change much for a couple of decades – essentially, the declining market (and rising price level) saw the underperformance impounded in a higher forecast of future returns. So the “negative bubble” of the 1970s is readily visible, and the incredible cheapness of stocks in 1981 is completely apparent. But stocks were also cheap in real terms in 1976…it was a long wait if you were buying then because they were cheap. Value investing requires a lot of patience. Epic patience.

However, once equity returns finally started to outpace the a priori forecast, and the actual line caught up with the forecast line, the market leapt higher and the twin bubbles of 1999 and 2006 are also apparent here (as well as, dare I say it, the current bubble). But since the forecast line is climbing too, how bad is the current bubble? By some measures, it’s as large or nearly as large as the 1999 bubble. But if we take the difference between the black line and the red line from the prior chart, then we find that it’s possible to argue that stocks are only, perhaps, 30% overvalued and not as mispriced even as they were in 2006.

This may sound like slim solace, but if the worst we have to expect is a 30% retracement, that’s not really so terrible – especially when you realize that that’s in real terms, so if inflation is 3% per year then you’re looking at a loss of 10-15% per year for two years. That’s almost a yawner.

On the other hand, if we are entering an up cycle for real interest rates, then the downside is harder to figure. In the last bear market for real yields, stocks got 60% cheap to fair!

None of this is meant to indicate that you should make major changes in your portfolio now. If all of the evidence that stocks are rich hasn’t caused you to make alterations before now, then I wouldn’t expect this argument to do it! Rather, this is just a different rationality-check on the idea that stocks are overvalued, and my words could actually be taken as soothing by bulls. The chart shows that stocks can be overvalued, and outperform a priori expectations that incorporate valuation measures, for years, even decades. Maybe we’re back in one of those periods?

But we have to go back to the very first point I made, and that’s that if you don’t feel like betting the 30% overvaluation is going to get worse, you can lock in current real return expectations with zero risk and give up nothing but the tails – in both direction – of the equity bet. The equity premium, that is, is currently zero and stocks are additionally exposed to rising inflation. I see nothing tantalizing about stocks, other than the possibility that the downside is perhaps not as bad as I have been fearing.


Administrative Note: Our website at EnduringInvestments.com is about five years overdue for a facelift. We are currently considering how we want to change it, the look & feel we want, and the functionality we desire and require. If you have a suggestion for something you think would be helpful for us to include, please let me know. (Note that this is not a solicitation for web design services so please do not ask! We have picked a firm to do that. I’m just curious what customers and potential customers might want.)

Categories: Investing, Stock Market
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