what’s bad about inflation?

this is the first of several posts about inflation, which may turn into an important investment issue this year or next.

what it is

Inflation is a sustained rise in the level of prices in general.  An environment of modest inflation–the Fed’s target is an average 2% yearly increase–is the desired mode of operation for Western economies.  It’s what people are used to.  Government and university economists feel they understand how inflation operates and know what to do if it starts to get out of control.  They all agree, moreover, that inflation is a lot better than deflation, a sustained fall in the price level, whose effects have historically been devastating and for which there’s no tried-and-true cure.

what’s bad about inflation

Inflation has two bad characteristics, last seen in the US in the 1970s, that make it an object of concern:

inflationary psychology

If goods or services are in plentiful supply and if prices don’t change very much, buyers will purchase things when they need them.  If buyers think that prices are rising in a sustained and significant way, they’ll begin to buy ahead of time.  Some will buy more than they’ll ever need, either with the intention of selling later at a profit or simply viewing their purchases as a store of wealth.

Once ingrained in individuals and companies, as it became in the Seventies, this behavior is hard to change.  But it sends crazy signals to the providers of goods and services, who rev up production as fast as they can to meet this new demand.

Once convinced that inflation is here to stay, the economy begins to distort itself.  Interest swings toward the production/acquisition of items whose chief/only merit is that they are perceived as inflation hedges (think:  gold, diamonds, real estate,  oil and gas).  In the late Seventies, for example, industrial companies leveraged themselves to the sky to buy coal mines or hotels–things they knew nothing about, and whose purchase they would soon come to rue, but which they thought defended themselves against accelerating inflation.  If they could borrow from banks at fixed rates–which was the general practice back then–they figured that the real cost of their debt would soon turn negative, giving them further gains.  Once the Fed stepped in to halt the inflationary spiral, these firms (and their banks) were ruined.

In short, once inflationary psychology develops, an economy begins to go off the rails.

a tendency to “run away”

Three factors cause inflation to accelerate–and economic craziness to get out of control.  They are:

–Inflationary psychology tends to feed on itself.  Once you see the hundred pounds of pig iron you have in your basement has gone up 50% in price, you buy more   …as time goes on, a lot more.  As companies/individuals realize that “buy now” is a successful strategy, they expand the depth and scope of their activity.

–Some price rises are automatic, adding to the price rise momentum.  Labor contracts, for example, may have clauses that adjust wages for inflation.  Traditional pensions, too—and Social Security.  Utility companies typically are allowed to pass increased costs directly on to consumers.  In addition, these institutionalized price increases often use escalation formulas that overstate inflation (think:  Social Security).

–Some parties may systematically underestimate inflation and inadvertently throw gasoline on the fire.  For most of the 1970s, for example, the Fed set money policy that was much too loose, based on faulty inflation projections.  Banks typically didn’t protect themselves by lending at variable rates, either.  Potential borrowers soon learned that they could do a lucrative arbitrage by taking out a long-term loan at a rate that would soon turn negative and use the money to buy “hard” assets that would appreciate in value.  This became the focal point of many firms’ capital spending plans.

1970s vs. 2010s

A generation ago, the “runaway” factor was extremely powerful in the US.  That was partly because of bank activity and partly because a large portion of the labor force worked under multi-year collective bargaining agreements with inflation adjustment factors.  Much more so in Europe.

Today’s banks lend at variable ares and are no longer a pro-inflation force.  Labor arrangements have changed a lot in the US over the past forty years, though not in continental Europe.

As a result, my guess is that the tendency for inflation to accelerate is considerably lower in the US now than it was the last time we had an inflation problem.  One offset:  the early Volcker years, during which the Fed was successfully breaking an upward inflation spiral through super-high interest rates, were ones of severe economic hardship.  The memory of that pain was enough to engender a “never again” attitude toward too-loose money that lasted for almost twenty years–until the latter days of Alan Greenspan.  I think that mindset is gone now, not only from the Fed but from popular consciousness as well.

More tomorrow.





Revel bankruptcy, a sign of Atlantic City’s continuing gambling woes

Maybe this shows I’m just not so inspired this morning  …because it’s the last day of Spring?

As I was collecting data for this post, I noticed that the Revel casino in Atlantic City filed for Chapter 11 bankruptcy protection yesterday.  The pipe dream of Morgan Stanley master-of-the-universe wannabees, the Revel was supposed to be the upscale entry in a market that caters to little old ladies with buckets of quarters.  Not only was the concept suspect, but the timing was awful, coinciding as it did with the peaking of the seaside town’s gambling win in 2006.  Oddly, in my view, the state government pumped more than a quarter billion dollars into Revel in 2011 to help get it open.  That’s a half-decade after the numbers began to show that the last thing the existing gaming operations needed was more capacity.

Revel is actually the second AC casino bankruptcy in recent months.  Last November, the Atlantic Club (which was, once upon a time, the Golden Nugget) entered Chapter 11; in January it closed its doors.

Aggregate casino revenue for Atlantic City has been dropping steadily since the legalization of casino gambling in nearby Pennsylvania (casinos have since opened in Maryland, Delaware and New York.  More are on the drawing board for NY and Massachusetts).  The current run rate is slightly above half of the peak.

As I wrote about at the time, last year Trenton tried to breathe some new life into Atlantic City, which even in its weakened condition will chip in $150 million – $200 million in tax revenue to the state, by allowing online gambling.

Early predictions by the politicians were that online gamblers would boost aggregate casino win (the amount lost by gamblers) by $1 billion.  Microeconomically minded might observe that some of this new-found money might come from gamblers betting online instead of in the physical casinos–so it might not be a pure gain.  In addition, any redistribution might deepen the plight of any casino that didn’t offer an online option.

But, since the state tax on online gambling revenue is almost double that for onsite betting (15% vs. 8%), Trenton would likely come out a winner no matter what collateral damage might occur.

results so far

Through May, online gambling has generated $53.5 million in casino win, or about $10 million a month.  On the same measure, physical casinos are down by 6.5% year-on-year, or about $74.0 million.   …Ouch.


While it’s still early days, online gambling in New Jersey so far seems to be a bust for everyone except the tax collector.  So Las Vegas may have little to worry about.

Also, in the Northeast US at least, there appears to be a relatively fixed amount of money that people are willing to spend on gambling in the local area.  New casino openings–of which there are plenty in the pipeline–don’t appear to add much to aggregate demand, but rather mostly shift money from one pocket to another–and add to overall industry costs.  This implies continuing trouble for overbuilt areas like Atlantic City, or, eventually, any of the other states that are adding capacity.




the June Fed meeting and “normal” interest rates

The other day, I wrote that the SEC is considering allowing mutual fund companies to place (presumably, large) exit fees on corporate bond funds, in hopes of stemming redemptions when interest rates begin to rise.

the Fed’s plans

This raises anew the issue of when the Fed will start to move the price of overnight money above the current zero, how fast will it move, and what level of rates it perceives its endpoint will be.

Wall Street perception…

What makes this important is that financial markets have come full circle over the past half-decade.  Initially, they didn’t understand the severity of the economic damage that occurred in 2008-09 and lambasted the Fed for lowering rates in a way they asserted would quickly lead to runaway inflation.  Hard to believe   …but that’s what pundits, especially hedge fund managers, were bellowing back then.

…has turned 180º

Today, however, the markets are clearly, though more quietly, expressing their disbelief in the economic and interest rate projections that the Fed had been publishing before yesterday.

before yesterday’s announcements

Before the just-completed Fed meeting and announcements, the agency’s official stance was that the normal or neutral rate for Fed Funds was 4.0%.  It also had been saying it thought the central tendency for US annual growth in real GDP to be close to 2.5%.  And it expected trend inflation to be 2%.  Add another 100bp in yield to overnight money to get the 10-year yield, and that comes in at 5%, or about double the current level.

Why the skepticism?  The main reason is that so far the US has struggled to produce a strong economic pulse, even after five years in intensive care.  Part of this is the extent of the damage done in the financial meltdown, but part is also demographics and past is that there’s little chance that Washington will make things any easier.  So, Wall Street argues, there’s no reason for interest rates to be so high.

There’s more.  Bond yields in the EU are much lower, for comparable quality, than in the US, because of the miserable shape Europe is in.  No relief in sight, as well.   As a result, European investors will find “high” US yields attractive.  This buying should temper the domestic urge to have yields rise.

In addition, China continues to generate trade surpluses with the rest of the world.  Those funds ultimately find their way into US or EU bond markets, keeping yields lower than they otherwise would be.

…and after

The Fed issues new projections yesterday.  The changes that caught my eye are:

–neutral Fed Funds rate at 3.75%, and

–trend growth in the US closer to 2.0% than 2.5%.

The Fed is edging closer to the view being expressed by the markets.  One exception:  the Fed is now signalling that the initial move up in the Fed Funds rate next year could be a bit more rapid than it had previously been planning.


Historically, the Fed’s post-emergency moves to raise rates back to normal have been bad for bonds and neutral for stocks (yes, higher rates are a negative for stocks, ass well as bonds, but rising corporate profits act as an offset).  The biggest worry about the current situation is that the required rate rise may be much larger than normal.  I suspect this may not be the Fed’s final ratcheting down of the size of its projected upward rate move.  If so, I think we can be more confident that past experience is applicable.

A lower trend growth rate for the US economy implies that growth will be harder to come by.  If so, companies that can grow their earnings quickly should acquire a scarcity premium; their stocks may well trade at higher than normal multiples.  I see strong growth coming in four areas:

–emerging markets

–companies with unique products/services

–firms serving needs of Millennials, and

–firms in mature fields building market share through acquisition.




US 401ks may be facing negative cash flows in two years

That’s the conclusion of a study by consultant Cerulli Associates reported earlier this month in the Financial Times.    

In 2016, Cerulli estimates inflows from plan participants will be $364 billion; withdrawals by retiring workers will amount to $366 billion.  And the negative cash flow gap widens from there.  This doesn’t mean that aggregate 401k assets will decline precipitously, or even decline at all for a while.  Presumably appreciation of assets in the system, now at about $3.5 trillion, will more than offset net withdrawals for a long while. Still, this marks another milestone in the waning of the wealth and influence of the Baby Boom.

Most often, 401k withdrawals find themselves rolled over into IRAs, which now amount in total to about $5.4 trillion, according tothe FT.  Despite the inflow of refugee 401k money, however, the IRA market isn’t a picture of health, either.  It’s possible that the overall defined contribution market (401ks + IRAs) will turn cash flow negative by the end of this decade.

Although some retirees may be permitted to remain in the company 401k plan, most opt for the greater flexibility, arguably more favorable tax treatment and wider universe of choice afforded by IRAs.  When they do so, they apparently go from reasonable asset allocations of 45% -60% stocks, with the rest in fixed income, into a conservative shell, with 65% – 80% in bonds. It’s not clear whether this has always been the case, or whether current behavior is a PTS reaction to the financial collapse of 2008-09.  It may also be that IRA holders need that large an allocation to bonds just to generate a reasonable amount of income.

The net result of all of this is that pension saving is gradually turning from being a mild net positive for stocks into a mild net negative.

My take from this is that it’s one more reason for turning one’s attention away from the Baby Boom and toward Millennials in trying to figure out retail investors’ influence on the stock market.

exit fees for junk bond funds?

contingency planning

The SEC is doing contingency planning for the time when the Fed will declare the current five-year+ economic emergency over and begin to raise interest rates back to normal.  What “normal” is in today’s world is itself a subject of debate .  The official Fed view is that overnight money should carry an annual interest charge of 4% vs. the current zero.  Even if the right number is actually 3%, that’s still a huge jump (more on this topic in a couple of days).

According to the Financial Times, the SEC is worried about what will happen to junk bond funds/ETFs when rates begin to rise.

the problem

The issue is this:

–investors wary of the stock market but searching for yield have put $1 trillion into corporate bond funds since the financial crisis.  Such funds now have about $10 trillion in assets under management.

–the charm of mutual funds is that the holder is entitled to cash in any/all of his shares at any time before the market close on a given day, and cash out at that day’s net asset value.

–junk bonds are relatively sensitive to changes in interest rates and go down when rates go up, and

–many junk bonds trade “by appointment only,” meaning they’re very illiquid and basically don’t trade.

So, the question arises, what happens if/when holders see their net asset value eroding and decide to all withdraw at once?  Arguably buyers will disappear when they see an avalanche of selling coming toward them.  The initial selling itself will tend to put downward pressure on bond prices.  A falling NAV can conceivably generate even more, panicky, selling.

If a big no-load junk bond fund is hit with redemptions equal to, say, 25% of its assets over a period of several months, will it be able to sell enough of its portfolio to meet shareholders demands for their cash back?  Maybe   …maybe not.

operates like a bank…

Put a different way, a junk bond fund is a lot like a bank.  It takes in money from depositors and lends to corporations.  In the pre=-junk bond days, a bank would lend at, say, 10%, pay depositors 2% and keep the rest for itself.  That opened the door to junk bond funds, which reverse the revenue split, keeping a little for themselves and paying the lion’s share of the interest income to shareholders.

…but no FDIC or Fed

If there’s a run on a bank, the government steps in and stands behind deposits.  If there’s a run on a mutual fund, there’s only the fund management company.

a real problem?

How likely is any of this to happen?  I have no idea.  Neither does the SEC   …but it’s apparently thinking it doesn’t want to find out.

Allowing/requiring junk bonds to charge exit fees would do two things:  it would decrease the flow of new money into the funds from the instant the fees were announced–and maybe trigger redemptions in advance of the imposition date; and it would make holders think twice before taking their money out.

footnote-ish stuff

Historically, there’s a sharp difference between the behavior of holder of load and no-load funds.  In experience, load funds that I’ve run have experienced redemptions of maybe 5% of assets in bad times.  Similar no-load funds might lose a third of their assets.

Mutual funds typically have tools they can use to deal with high redemptions.  They can usually buy derivatives that will hedge their portfolio exposure; they have credit lines they can use to get cash for redemptions immediately; in dire circumstances, they can suspend redemptions or meet redemptions in kind (meaning you get a junk bond instead of your money ( ugh!)).

Junk bond ETFs are a tiny portion of the whole.  They’re a special type of mutual fund.   Holders of ETF shares don’t deal directly with the management company.  They buy and sell through designated market makers, who have no obligation to transact at or near NAV.  Therefore, they can staunch selling simply by swinging the market down far enough.  At the bottom of the stock market in March 2009, for example, I can recall specialized stock ETFs trading at over 10% below NAV!

This issue is part of a larger government debate about whether large investment management companies are systematically important to the financial system and, as such, should be more highly regulated.