Tag Archives: inflation

The Signal and the Noise (Part 5)

So how do you decide?

Photo: Sebastian Lühnsdorf. Source: Morguefile

When a news event occurs, is it a new signal, or is it just noise? The European Central Bank is maintaining a negative inter-bank rate – is it signal or noise? The Consumer Price Index just came out flat from the month before – was that signal or noise?

It’s tempting to label all these interim economic reports financial static. And a lot of them are. So much data comes at us from so many directions that it’s hard to decide what we should care about. Consider inflation: two government agencies report three different indices, each of which has dozens of sub-groups. Or employment: it’s measured two different ways, and each indicator has both leading and lagging elements. If you look too closely, you get spots in front of your eyes!

If you’re involved in the markets, your attention should be determined by your perspective. If you have a long time-horizon – saving for retirement while in your ‘20s or ‘30s, or establishing a young child’s college fund – you should perhaps keep an eye on broad trends, but that’s all. Regular saving through all the ups and downs will probably be your best approach.

Similarly, if you’re drawing regularly from your nest-egg and most of your assets are committed to short-term bonds, the market’s squiggles and jiggles also shouldn’t affect you much. But when you’re in the middle – still saving, but getting closer to needing the funds – then the news will have more impact. A change in the economy’s direction might call for a change in your tactical allocation. Still, even then, looking at the trends and averages makes more sense than trying to follow every tick and tock.

In the end, whether a report is signal or noise depends on your perspective. One investor’s warning sign is another’s annoying distraction. But even the Federal Reserve – our most economically sensitive agency – only reviews policy every other month. That’s more than enough for most investors.

Douglas R. Tengdin, CFA

Alice and the White Queen

Is the market trying to believe impossible things?

Illustration: John Teniel. Source: Wikipedia

A classic “children’s” book – that isn’t really for children – is Lewis Carrol’s Through the Looking Glass, his sequel to Alice in Wonderland. In the book, Alice and the White Queen have this exchange:

“There’s no use trying,” Alice said. “One can’t believe impossible things.”

“I daresay you haven’t had much practice,” said the Queen. “When I was younger, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.”

Sometimes the market confronts us with what seems like impossible issues – things that appear to be part of the market’s calculation, but things that we know to be impossible. Here are a few:

The bond market is priced as if low inflation and negative real rates will be with us forever. Negative rates in Europe and Japan are the most egregious examples. In Germany, the 2-year Government bond yields minus 0.75%. In Switzerland it’s minus 1%, in Japan minus 0.1%. But even in emerging markets, stable, low inflation is expected. Colombian 10-year bonds yield 3.5%; Hungary yields 3%; South Korean (bordering a rogue nuclear power) yields 2.1%. The deep and liquid government bond market is assuming that inflation will never come back – even in emerging markets with a history of populism and hyperinflation. Hungary experienced the highest rate of inflation ever recorded in the 1940s: 200% per day.

Photo: Mizerák István. Source: National Museum, Budapest

Second, the Big Five tech stocks are priced as if they are unassailable. In the short run, this is clearly true. Facebook enjoys network effects: people join Facebook because other people are using it. Kids’ sports teams, local VFW Chapters, labor unions, and nonprofits all use Facebook to share information. Google uses information from billions of searches and clicks every day to improve its search algorithm – making it even more attractive as a search engine. Amazon does the same thing with purchase information – making online shopping ever-easier.

But size ultimately defeats itself. Large corporations become bureaucratic and layered. Rules that once made sense in a limited context become institutionalized and universal. And perhaps most importantly, the incentives to work for a large corporation are different than those presented by a small company. That’s why Steve Ballmer left a good job and P&G to be Microsoft’s 30th employee. It’s not about the pay, it’s about the autonomy – and doing something new that can change the world. And eventually big companies run into physical limits to growth. Mark Zuckerberg has said that projects aren’t really interesting unless they can impact at least billion users. But just there aren’t that many billion-consumer projects.

Finally, market participants seem to believe that cash is a source of stability – both in the economy, and within corporations. Certainly, in the short-run, this is true. Cash is a key element of credit risk. If you want a $1 million loan, it’s helpful to have $2 million in cash on hand. And cash is currently quite high, both as a percentage of our economy and total nonfinancial debt.

Source: GMO, Federal Reserve

But in the long run, cash is a source of instability. Among governments, excess cash holdings inspire envy, leading to external threats and internal dissention. Income inequality doesn’t usually bother people when the income is earned. No one singles out entrepreneurs who work hard and create something new as plutocrats. They created something totally new.

Similarly, within corporations, big piles of cash on the balance sheet can lead otherwise sensible managers to do something stupid. They didn’t get to be managers through their timidity – they usually have a healthy combination of charm, ability, and animal spirits. If they’re successful in business, high returns on equity eventually lead to excess cash, posing a temptation to them – or outsiders, who want to “unlock” that value. Accumulated cash is like a dragon’s hoard, inspiring irrational conflict and delusional dreams.

Illustrator: Arthur Rackham. Source: Wikipedia.

In order to believe that the market is truly efficient, you have to believe these “impossible” things. Of course, they aren’t impossible. Just not very probable. Eventually, growth and inflation will come back – especially in the developing world. The temptations of populism and deficits are just too much. Eventually, large companies will yield to small companies as the engines of innovation. Eventually, cash hoards will be dispersed. We just don’t know how long it will take.

It’s not comfortable to consider multiple scenarios with uncertain outcomes in our investment portfolios, but as Voltaire once noted, “Doubt is not a pleasant condition. But certainty is absurd.”

Douglas R. Tengdin, CFA

War, Peace, Inflation, and Software

Is inflation dead?

Source: Morguefile

Growing up in the ‘70s, inflation was a fact of life. Sometimes we would see prices rise four or five percent in a single month. Persistent, high inflation was a problem, economically. The purchasing power of our savings was depleting at a rapid rate. Federal regulations kept interest rates low; banks couldn’t pay more than 4.25%, even while inflation was running at 10% per year. Gerald Ford declared a war on inflation.

Annual change in CPI. Source: St. Louis Federal Reserve

But those days seem as remote to us today as buggy whips and livery stables did to folks back then. What happened? The most important change happened in the early ‘80s, with monetary policy. The Fed reduced the growth of the aggregate money supply, and since the velocity of money in the economy was fairly steady, slowing money’s growth also slowed the rate of price increases.

But since 1990 – well after Paul Volker’s monetarism was implemented – inflation has fallen even more: from about 5% then to only 2% now. The most current measures indicate that it might run at only 1.5% going forward. And low inflation is a fact of life everywhere, not just in the United States. To answer this, we need to go a little further back.

Source: Ed Yardeni

The answer may have to do with war and peace. Dr. Ed Yardeni has written that during times of war, labor is in short supply, markets don’t work, commodities get requisitioned, and the Government prints money to finance the war effort. It’s inevitable that for prices to rise, often dramatically. During peace-time, the opposite happens: markets expand and trade flourishes, competition comes back, and prices fall. War is inflationary, peace is deflationary. Note that in the past this happened whether or not we had a gold standard. Congress determines the basis of all weights, measures, and standards, including our monetary base.

In 1989 the Cold War ended with the fall of the Berlin wall. The last 28 years has seen the greatest expansion of markets, trade, and capitalism that the world has ever known. The influx of supply has been met with an influx of demand as well, as billions of producers and consumers have entered the global marketplace. In addition, the nature of demand is changing: In the past, we needed raw commodities; as economies developed we needed finished goods. Increasingly, we need knowledge: knowledge about our work, our environment, our finances, even our own bodies. Increasingly, this knowledge is provided by software, readily available via computers we carry in our pockets. That’s why software is eating the world. And the marginal cost of software is virtually zero.

Software costs money to develop, but once it’s in place, it costs almost nothing to replicate. That’s one reason software companies that provide free products have done so well: Google provides free search, Facebook provides free networking, Amazon provides free streaming, storage, and shipping, if you’re a Prime member. Of course, nothing is truly free. These companies make money on your browsing and buying behavior. But the marginal cost of providing software is practically nothing, and they’re passing those savings on to consumers.

This is why inflation is dead. Peace killed it. And software.

Douglas R. Tengdin, CFA

Crisis Management

What’s the next crisis?

Photo Alvimann. Source: Morguefile

It’s usually not the last crisis. People are ready for that. We’ve seen the challenges and dealt with them. The Euro crisis of 2011 was brought on by the perception that leaders and voters weren’t sufficiently committed to the common currency. It was dispelled by Mario Draghi’s “Whatever It Takes” speech, as well as popular votes around the Euro-zone. The Financial Crisis of 2008 was brought on by excessive lending to US homeowners, coupled with implicit leverage in our banking and money-market sectors. These were addressed by the Dodd-Frank financial reforms.

This is why lightning doesn’t strike twice: we see the problems and adapt our institutions to prevent their recurrence. That’s why generals are often accused of fighting the last war: they’re ready for the threats they’re aware of. Indeed, it would be foolish to ignore issues that you know about.

So what is the issue that no one thinks about, that no one is prepared for? It seems to me that the unrecognized threat is inflation. The last time we had an inflation crisis was in the early 1980’s, over 35 years ago. There are lots of reasons why inflation isn’t an issued now: automation and trade make labor inputs to inflation less important; financial innovations have disrupted monetary velocity; search technology makes it easier than ever for consumers to comparison shop. And all the folks who thought that the global monetary expansion implemented over the last ten years would lead to hyperinflation have been proven wrong — or at least, extremely early.

In addition, the current top policy-makers came of age during the inflationary ‘70s and ‘80s. They repeatedly say we “know how to deal with inflation”: strangle it with higher interest rates – and in the case of Zimbabwe or Venezuela-like hyper-inflation, turn off the government’s printing press. (Of course, these solutions may be technically effective but politically impossible.)

Dow Jones Industrial Average, log scale. Source: Bloomberg

But what if the next round of inflation isn’t caused by labor costs or monetary mischief? Economists and politicos will have to figure it out all over again. The solution to the next crisis won’t be found in file 265.83(a) in Ben Strong’s old office at the New York Fed. Solving the next crisis will require intellectual honesty, strategic ingenuity, and political courage to act when most people would rather hunker down. It will require leadership.

The time to buy straw hats is in February, and the time to get ready for a crisis is during the preceding boom. It may be many years before inflation shows up again, so you don’t want to over-insure. But economies always come unglued, eventually. “Man is born to trouble as the sparks fly upward.” (Job 5:7, and Peanuts)

Douglas R. Tengdin, CFA

Inflation Nation (Part 1)

Why isn’t inflation coming back?

Year-over-year CPI change. Source: Bloomberg

In the ‘60s and ‘70s inflation grew out of control. Nixon’s price controls didn’t stop it. But it settled down after Paul Volker’s restrictive monetary policy and Alan Greenspan’s careful management of the Fed. Economist Milton Friedman famously claimed that inflation is “always and everywhere a monetary phenomenon.” But after the financial crisis, inflation dipped below zero and the Fed flooded the economy with money. Many feared that inflation would come roaring back.

But this didn’t happen. Prices have been pretty stable. In fact, inflation still seems to be on a downward trend that began around 1990. Why?

A lot of theories have been proposed—the Fed’s money just “sat in the banks,” the rate that money circulated through the economy fell, that assets have inflated via bubbles while consumer goods have stagnated. But these seem to miss the point, or to be tautologies. The economy’s money supply has expanded dramatically, but consumer prices have grown at a snail’s pace.

M2 growth and Core CPI growth, year-over-year. Source: FRED

It’s not enough to say that monetary policy acts with long and variable lags. M2 is the most common measure of transactional money—what we use to purchase goods and services. It’s been growing faster than 5% for over six years. Both core and headline inflation, however, remains extremely low.

The problem must lie in the theory—the theory that dictates that inflation is exclusively a monetary issue. There must be elements of the real economy keeping inflation in check. I see three large-scale, long-term issues. First, the US economy is far more integrated with the rest of the world than ever before. And we do not have good data on global money supply. Second, global demographics limit demand. Populations around the world are aging—in some cases, quite dramatically. This is because life-expectancy is rising while fertility rates are falling. This is happening in almost every country around the world, but especially in high-demand countries like Europe and Japan. Since 1980, the share of the world’s population over 60 has grown from 8.5% to 12.3%, and older folks don’t consume as much as younger people.

Source: UN

Finally, technological innovation continues to challenge traditional economic equations. The cost of distributing a movie to a billion wired households is only marginally greater than streaming it to a million homes. Information is not conserved, the way that material and energy are. Digital information can be copied and multiplied for almost nothing. This radical change in the economy continues to disrupt business models, from record stores to hotels and restaurants to airlines. There’s a lot less need to travel when videoconferencing is almost like being there in person.

This has profound investment implications—from Fed policy and bond yields to business models, profit margins, and stock prices. Although difficult for monetarists to confront, the data from the last 20 years seem conclusive: inflation is—at least partially—real.

Douglas R. Tengdin, CFA

Chief Investment Officer

Inflation Ahead?

Is inflation finally headed higher?

Core Personal Consumption Inflation. Source: Bureau of Economic Analysis

It sure doesn’t look that way. The broadest measure of consumer prices, the deflator for personal consumption expenditures, was flat November. That’s because incomes were flat, and consumption was flat. Most economists believe that a reacceleration in consumption will be the overarching economic theme for 2017. But this isn’t set in stone. If employment growth slows and wages stall, then we’ll still be stuck in the rut we’ve been in for a while.

Over the past 12 months core inflation has growth about 1.7%–up slightly from a year ago, when prices were growing only 1.4% per year. There’s a slight upward trend, but only very slight. And the latest dip in the rate will put downward pressure on the trend. This is a far cry from the fears of accelerating inflation that accompanied the Fed’s unconventional policy initiatives five or so years ago.

Inflation is important. If prices rise too fast, purchasing power erodes and people can’t make ends meet. In the ‘70s and ‘80s, when prices were spiraling out of control, it was hard for businesses to plan for the future, and investment spending a productivity lagged. But if prices decline – deflation – firms have difficulty financing their debt. Business leaders become cautious about expanding, because the price of what they sell may fall. That’s why many folks think productivity is lagging today.

Source: Bureau of Labor Statistics, Bloomberg

The post-election rally has been based on the expectation that tax reform and regulatory relief could boost the economy and get us out of the slow-growth low-inflation rut we’ve been in for the past six years – ever since the Financial Crisis and Great Recession. But we’ve been in a disinflationary trend for the past 30 years. If inflation stays low or moves even lower, we may not see the faster growth everyone is hoping for.

Douglas R. Tengdin, CFA

Chief Investment Officer

Mixed Money Messages

Where does money come from?

Source: Morguefile

Money is a funny thing. Most people around the world look at yen and euros and dollars and say that that’s money. But banknotes are only a small fraction of the money in the world. Most money exists in the form of bank deposits. When we buy a house or a car or pay our credit card bill, we just instruct our banks to make ledger entries transferring some of our account to someone else. When a bank issues a loan, it creates money.

But it wasn’t always this way. “Moneta” was another name for the goddess Juno, or Hera. She was the protectress of wealth. Her temple in Rome is where Roman coins were minted. Coins were a great facilitator of trade: they had uniform weights and materials, they could be used to pay taxes or debts, and they were highly portable. But they have one major drawback: often, there just aren’t enough of them around.

Some years ago I was travelling in a developing country. It was a hot day, and I was thirsty. When I went into a local store to buy a cold soda, the merchant told me that he didn’t have any change – that he could only take whole bills, roughly equivalent to a dollar. That was a lot for a soda there, which normally cost about 20 cents. Most folks would have turned away. The lack of coinage would have impeded commerce. But I was really, really thirsty, so I paid the larger amount anyway.

The first expansion of monetary powers beyond the central government came in England in the late 17th century. William III of England needed money to fight wars on the Continent, but there simply wasn’t enough coinage in the country to pay the army and to keep the economy going. So he allowed banks to issue claims on their deposits – banknotes – and also let people pay their taxes with these notes. The modern, mixed economy started out in England because of a fiscal crisis brought on by a foreign war.

CSA Banknote with Juno Moneta. Source: Wikipedia

Ever since then, the economy has been a partnership, with both the State and the banks sharing the authority and responsibility for creating money – a delicate balancing act. England got that balance largely right, avoiding both massive inflation and crippling deflation, although there were a few speculative bubbles along the way.

When we think about the origins of money, though, It’s useful to remember: money started out in the temples of the gods. And sometimes, the gods seem a little crazy.

Douglas R. Tengdin, CFA

Chief Investment Officer

[catgegory Global Market Update]

Revising the Limits

Are we seeing the limits to demand?

Copyright: Dennis Meadows. Source: Amazon

Back in the early 1970s, a think-tank called the “Club of Rome” published a little book called the “Limits to Growth.” It used a fairly simple computer model to predict that unless people radically changed the way they lived, we would run out of some of the key resources necessary for modern life. They described our expected population growth-path as “overshoot and collapse.” The book predicted that because we were continually increasing our standard of living and human populations keep growing, we would overshoot the earth’s sustainable carrying capacity—like white-tailed deer on the Kaibab Peninsula.

Needless to say, their predictions didn’t pan out as expected. Technology made it not only cheaper but also easier to produce more goods and services using fewer resources, and population growth slowed dramatically in country after country once industrialization arrived and child mortality fell. People aren’t ungulates overgrazing their feeding grounds. The ultimate natural resource is human creativity—especially when it‘s brought to bear on problems critial to our survival.

Photo: Sgarton. Source: Morguefile

But the predictions seemed to make sense when everything was getting more and more expensive: gas went from 7 cents a gallon to 25 cents, then to $1.50. Houses that cost $5000 to build went to $25,000, then $100,000. Inflation was running in the double digits, and we could see starving masses in China and Biafra on television every night. What we couldn’t see was technology-driven green-revolution crops and integrated microprocessors that would make life radically better for billions of people. Who thought computers would both predict and solve the problems of scarcity?

Now we’re facing new limits: limits to demand. The problem isn’t inflation, it’s deflation. We don’t have too many dollars chasing too few goods, we have too few dollars and too many goods. We don’t have too little computing power, now we all have an Apollo 11 computer in our back pockets, tied to a networked database with the world’s knowledge available with one spoken search string. And lots of cat videos.

CRB Commodity Index. Source: Bloomberg

In the ‘70s Keynesian economists tried to fine-tune demand when demand was rising and supply was stagnant. The result was too much demand and too little supply—a recipe for accelerating inflation. Since then a global supply-side revolution has created an age of over-abundance where resource deflation threatens the financial economy that made all this production possible in the first place. The result is falling demand and increasing supply.

35 years ago I actually worked and studied with two of the authors of “Limits to Growth,” Dana and Dennis Meadows. But today we’re not seeing limits to growth. Rather, it’s the limits of growth.

Douglas R. Tengdin, CFA

Chief Investment Officer

Jobs, Jobs, Jobs

How tight is the labor market?

Photo: Douglas Tengdin

After hitting 10% in October of 2009, unemployment has fallen to 5.3%. That’s pretty good. But there are still areas where the job market feels week—especially in long-term unemployment. Folks unemployed 6 months or more currently make up a quarter of the unemployed. That ratio has come down from almost 50% in 2010, but it’s still pretty high. That’s one reason why this recovery doesn’t feel very strong.

Another reason is the participation rate—the percent of the US population either working or looking for work. That number peaked in 2000 at just above 67%. It had risen pretty steadily until then. But it started falling after the dot-com bust, and continued to fall after the last recession. It’s currently down almost 5% from its peak to 62.6%, a level not seen since the late ‘70s.

Source: Alan Krueger and Princeton University

Still, 5.3% unemployment is pretty low. Conventional wisdom says that as the economy strengthens, people not in the labor force will start looking for work and push the unemployment rate higher, but there’s little evidence that this is happening. The rate at which people move from outside to inside the labor force has been pretty stable, between 7 and 8%. In fact, it recently slowed to just below 7%.

The best measure for tightness in the job market is compensation. When workers are scarce, employers have to pay up—both to attract new workers, and to hold onto the staff they have. And by this measure, things are getting better. During the ‘90s, real wages and salaries—after inflation—gradually increased. That’s part of the reason stocks got so bubbly at that time. We had a sense that things were getting better and better. But pay raises were harder to come by after the dot-come bust, and real wages and salaries actually fell in the shadow of the financial crisis. Gloom in the stock market was matched by gloom in the labor market.

Source: Alan Krueger and Princeton University

But lately, pay raises have perked up. Real salaries and wages rose 1½% last quarter, the biggest increase in over a decade. Indeed, with unemployment so low and real compensation rising so much, there’s some risk that wages will rise fast enough to squeeze profits. Among other issues, this has the market worried.

How tight is the labor market? If pay is any indication, it’s getting tighter.

Douglas R. Tengdin, CFA

Chief Investment Officer

Inflating the Future?

Is deflation over?

Source: BGAEconomic.com

Around the world markets have been worried about deflation. And the latest CPI release seems to validate these worries. Year-over-year, inflation is flat. And it was flat last month as well. Are we about to turn Japanese, struggling with deflation, where folks stop buying because things just get cheaper every month?

Continue reading Inflating the Future?