inflation and stocks

wage inflation in the US?  …finally?

In my earlier post today, I didn’t mention that in the Employment Situation report from the Labor Department a week ago Friday, the annual rate of growth in wages rose from the 2.5% at which it had been stuck for a very long time, despite declining unemployment, to almost 3%.

an aside

Inflation in general is about prices in general increasing.  Deflation is when prices in general are actually falling.  Deflation is scarier than inflation both because it’s less common/harder to treat and because we have the object lesson of Japan, where a quarter-century of unchecked deflation has moved that country from penthouse to basement among world economic powers.

curing inflation

In developed countries, inflation is always about wages.

The garden variety, which seems to be what the Employment Situation may be signaling, is easy to cure.  …a little painful, but easy.

Raise interest rates.

The idea:  businesses want to expand.  To do that they need more workers.  But everyone is already employed somewhere.  So firms have to offer big wage boosts to poach workers from rivals.  Raising interest rates (eventually) stops that.  It increases the cost of expansion and also slows down demand.

Also nipping incipient inflation in the bud prevents consumer behavior from becoming all about defending oneself from it.

who wasn’t expecting this?

For years, economists have been anticipating a rise in inflation.  The first (false, then) alarms sounded maybe six years ago.

But, as they say, nothing is ever fully discounted until it happens.  In addition, Washington is arguably compounding the problem by enacting fiscal stimulus almost a decade too late–making it more likely that rates will go up sooner and more rapidly than if Washington had done nothing.  (Where did the deficit hawks disappear to?)

current Japanese inflation? ..there is none

Deflation means that prices in general are falling.  If this is the case, it’s better to put off buying new things for as long as possible, until they’re 100% absolutely needed.  That’s because anything you buy today will be cheaper tomorrow.

After a while, non-consumption becomes a habit, and an economy stagnates.

Conversely, in an inflationary environment, everything is more expensive tomorrow than it is today.  So consumers buy in advance.  In addition to things they need, they may also purchase items they have no intention of consuming.  They may think that keeping physical objects which they can later resell is a better way of preserving or enhancing purchasing power than keeping savings in the bank.

Japan has been in a deflationary economic funk for over a quarter century.   When Shinzo Abe became Prime Minister of Japan in late 2012, he decided to attack deflation as a way of boosting economic growth.  He had a plan that has become famous for its three “arrows”:  a massive depreciation of the yen, large-scale government deficit spending, and corporate/regulatory reform.  Each of the three should have been enough by itself to spark inflation.

The expense of the plan has been enormous, both in terms of the loss of international purchasing power of yen-denominated assets and in increased national debt.

The result after close to four years?   ….as the Tokyo government reported last week, no inflation at all.

How can this be?

From its outset, I’ve believed that Abenomics would be unsuccessful.  I thought the stumbling block would be corporate reform.  The earliest evidence that would indicate I would be wrong would, I thought/think, take the form of an effort to remove the legislative barriers to reform that the Liberal Democrats in the Diet had installed after the deflationary crisis had already begun.  So far, for all practical purposes there’s been nada.  So I continue to be convinced that corporate leaders will resist any changes to the status quo, aided as they are by the Diet’s removal of any levers to force reform from the outside.

Of course, any inflation-induced oomph to consumption won’t last forever.  People and institutions adjust. If nothing else, consumers run out of storage space for the extra stuff they’ve bought.  They then have to throttle back their spending   …or rent a storage unit  …or contemplate a McMansion.

What’s surprising to me, however, is that the same reluctance to spend–although perhaps not to the same degree–is evident in both the US and in Europe.  We might figure that the austerity approach of EU countries wouldn’t exactly spur consumers on.  But the lack of inflation and the paucity of mall-storming or website-crashing consumption in the US after eight years of extraordinary stimulus seem to argue that the overarching economic theories about how to induce inflation are incorrect.

Demographics as the cause?


Jim Paulsen on the US stock market

Yesterday’s Financial Times contains a guest column by Jim Paulsen, strategist for Wells Capital, a part of Wells Fargo.  I find Mr. Paulsen’s work to be orignal, thoughtful and, for me, thought-provoking.  On the other hand–a warning–he and I share the same generally optimistic view on markets and have tended to agree on most basics.

Here’s what he has to say:

–the current market swoon may have been triggered by worries about the Chinese economy, but its real cause is to be found in the dynamics of the US economy/stock market

–US stocks were, and still are, trading at an unsustainably high price-earnings multiple.  The final bottom for stocks in this correction will be around 1800 on the S&P 500, or about 3% below the low of a few days ago.  That’s where stocks will be on a more reasonable 15x PE

–full employment in the US, i.e., where we are now, creates a series of problems for the economy and stock market.  Employers wishing to expand are forced to find new workers by bidding them away from other firms.  Since inflation in advanced economies is all about wage increases, poaching creates inflation.  In the short term at least, a higher wage bill means lower margins–and therefore lower profit growth.  The Fed responds to the inflation threat by raising interest rates, which exerts downward pressure on PEs

–investors don’t get this yet.  They’re “more calm and confident than at any other time in this recovery.”

–the combination of high PE, higher interest rates and slowing growth mean that equity investor focus will shift from the US to more fertile fields abroad.  These areas are more prospective because, unlike the US, they don’t face the need, caused by achieving full employment, to rein in the pace of domestic economic growth. I presume, although Mr. Paulson isn’t more specific, that this means the EU (it may also mean US stocks with high exposure to non-US economies).

my thoughts

Mr. Paulsen is in touch with institutional equity investors every day.  So he has a much better sense of the current thought processes of US professionals than I do.  He seems to feel his customers are only beginning to believe that the set of issues that come with full employment are at our doorstep–and are only now starting to discount them into stock prices.  Hence the correction.  While it’s risky to think you know more than the other guy–in this case, that the other guy slept through his elementary economics classes–I’m willing to go along and say it’s true.

Mr. Paulsen has previously made the point that interest rates are going to rise in an economy that doesn’t have much business cycle oomph left in it.  Therefore, he argues, past instances of cyclically rising rates, during which stocks generally were flat to up, may not be good guides to what will happen today.  I look at the situation in a different way.  If we ask where long Treasuries will be at the end of Fed tightening, the answer is that they’ll likely be yielding less than 4%.  If we think that the yield on Treasuries and the earnings yield (1/PE) on stocks should be roughly equivalent, then the implied PE on the S&P is 25x.

One might argue that the idea of the equivalence of earnings yield and interest yield arises from a long period in which Baby Boomers preferred stocks to bonds.  As Boomers have aged, that preference has reversed itself, meaning that yield equivalence between stocks and bonds may be too rosy a view for stocks.  If we assume that stocks trade at a 20% discount to this yield parity, however, the implied PE at the end of rate hikes is still 20.

Both results are a long way from the 15x that Mr. Paulsen proposes for the S&P.

It’s often the case that a significant drop in stocks often signals a leadership change.  I think it makes a lot of sense to reverse portfolio polarity away from an emphasis on earnings coming from the US to profits generated abroad.  How exactly to carry this idea out is the key, though.



inflationary and deflationary mindsets

It’s fascinating to see how glibly and assuredly financial commentators and their guests have been talking about both inflation/deflation since the onset of the Great Recession.  What I keep thinking when I hear them is that to have practical experience of either phenomenon someone must either have lived in Japan or an emerging economy, or been an adult during the 1970s.  So most of these “experts” are just rehashing what they learned in a textbook.

What I think is important to consider about either inflation or deflation:

–what makes either dangerous is not simply that occasional spells of price rise/fall can happen.  It’s the possibility that people will begin to believe that inflation/deflation has become a permanent fact of life and alter their economic behavior to take this into account.  A mindset change, in other words.  Once that happens–and inflation/deflation is entrenched–it becomes extremely difficult to eradicate.  (In the inflation case, companies/consumers tend to favor hard assets over bonds or bank accounts, to consumer heavily and to avoid saving.  In deflation, they tend to hoard, underconsume and–again–favor hard assets like gold.)

–inflation and deflation are not mirror images of one another.  Historically, inflation has tended to spiral upward at ever-increasing velocity but can be cured by the monetary authority in a country boosting interest rates high into positive real territory.  Deflation, on the other hand, has tended to be a continuous downward grind.  Positive interest rates make borrowing a crushing burden.  The cure requires slower-to-act, less-likely-to-be-done fiscal stimulation or structural economic reform.

–in advanced economies, inflation and deflation are all about changes in wages.

–Japan is the current deflation poster child.  Its economic experience over the past quarter-century is the main reason, I think, that the word “deflation” strikes so much fear into global investors’ hearts.  Japan has recently devalued its currency by almost half in a so far vain attempt to get wages to rise.  In fact, real incomes for ordinary citizens have declined, because the local currency price of imported commodities like food and fuel has risen while wages have been relatively flat.

Japan is unusual in two ways, however:

—-the population is significantly older than in the EU or the US.  The local workforce has been declining for many years because of retirements; the country is strongly opposed to immigration.

—-resistance to structural change of any sort, and particularly change led by foreigners, is extremely strong.  As far as I can see, Japanese industrial technology is stuck back in the 1980s, maybe for this cultural reason.

It’s possible, therefore, that Japan’s current woes are more a function of an aging, hidebound population than anything else.  If so, then generic treatment of deflation–monetary and fiscal expansion–isn’t going to have much of an effect.  Unfortunately for the EU, “aging, hidebound” also sounds an awful lot like Europe.  So the EU may be next in line for the lost-decade syndrome.

Two other caveats:

–historical instances of inflation and deflation in the US have come during times when fixed-interest-rate bank lending was the norm for raising debt finance.  A changing price level could alter the real cost of that debt significantly.  This is no longer the case.

–indexing of wages and prices was common in the US during the 1970s and could easily have acted as a transmission mechanism for inflation.  Again, this is no longer the case.

my bottom line

I think the current economic situation is a lot more complex than pundits are making it out to be.  I also think they’re making a fundamental mistake by failing to distinguish between transitory inflationary/deflationary influences, like commodity price changes, and more fundamental, mindset-changing ones.  My guess is that this is because they’ve only read about the phenomena in books.






average wages in the US are back to pre-recession levels …the point is?

Good news, but not great.

How so?

80% of the wage gains since 2008 have gone to the top 20% of wage earners, meaning those earning $190,000 a year or more (this is despite recent government allegations that top tech firms in Silicon Valley have conspired to hold down their employee wages).

In other words, the vast bulk of the workforce still isn’t as well off as six years ago.

In addition, the unemployment situation remains stubbornly high.

My conclusion is that what we have now is about as good as it gets in the domestic economy, without policy action from Washington.

Two data points suggest that structural changes in the world economy are at the root of a lot of this:

–the decline in the fortunes of the middle class in the US coincides with an improvement in the lot of the middle class in emerging markets, and

–anecdotal accounts are circulating of firms filling their vacancies by poaching from rivals, which would suggest we’re close to full employment.  I heard economist Paul Krugman the other day saying that the basic problem in the US is that there are too few jobs.  He means that necessity isn’t forcing employers to hire unskilled workers and train them.  In a sense, that may be right.  On the other hand, how long will it take and how much will it cost to train an average high school graduate to become a statistician or a web designer?   Why not relocate to a place where skilled workers are more plentiful and corporate taxes are lower (the latter meaning just about anyplace else)?

investment implications

The current domestic economic situation says, I think, that we should continue to focus on companies with worldwide, rather than simply US, businesses.  We should also avoid firms that cater to domestic customers with average or below-average incomes.  These will only be able to grow revenues by “stealing” them from competitors–persistent price wars will break out, in other words.

At the same time, this state of affairs has been around long enough that we should also be scanning the horizon for evidence of change.  I suspect that changes in education/training will come informally–not through intelligent government action–and will sort of sneak up on us.  On the other hand, reduction of the Federal corporate tax rate to a level more in line with the rest of the world would probably give a surprisingly large spur to job formation (more about this tomorrow).

pining for inflation to return


Every macroeconomics student quickly learns the lesson of the Great Depression–that deflation (an environment where prices in general are falling) is the gravest ill that can befall a country.  Why?   …for companies, deflation means continuously declining revenues.  At some point, the firm can no longer meet its payroll.  Eventually, it can no longer service, much less repay, any borrowings it may have.  As the 1930s showed, deflation breeds widespread unemployment and corporate bankruptcies.

Second place on the list of bad things that can happen goes to runaway inflation (accelerating rises in prices in general), a malady common in emerging economies–and one the US experienced in the 1970s.  The issue here is that no one knows what interest rates in the future will be–only that they’ll be crazy high.  So no one, neither individuals nor companies, invests in long-term projects–because they can’t figure out whether they’re money-makers or not.  Instead, everyone starts to shun financial assets in favor of buying and hoarding tangibles like gold or real estate, sometimes in a completely loony way, on the idea that they will rise at lest in line with the soaring price level.

When the US began to fight its incipient runaway inflation under Paul Volcker in the early 1980s, the question arose among  academic economists as to what was the “right” level of inflation.  The consensus answer:  2%.  Not so close to zero as to say “deflation,” but low enough not to suggest “runaway.”

So 2% inflation became the holy grail of US, and global, monetary policy.  It took the US twenty years to hit this target.

the present

Over the past several months, I’ve been reading and nearing comments from lots of different sources that suggest that 2% may be the wrong answer.   Not the academic world, of course.  Two reasons:

1.  The Fed has been perplexed at its inability to keep inflation at 2%. The number seems to want to gravitate toward zero, instead.  This raises the specter of deflation, the sure-fire investment killer.  So this tendency is bad.

2.  For small businesses, which have been the biggest engine of economic growth in the US in recent decades, a 2% rise in prices + at best 2% real growth = a 4% increase in annual revenues.  The first objective for most family-owned firms is to make sure that this year’s profits won’t fall short of last year’s.  That’s because any shortfall is money out of their pockets, not simply a theoretical loss.  Apparently, +4% in revenues isn’t far enough away from zero to create enthusiasm for taking the risk of investing to expand the business.  Therefore, no capital projects, no new hires.


Two reasons are most often cited for the current slow growth in the US:  hangover from the Great Recession and dysfunction in Washington that prevents growth-promoting fiscal policy from being enacted.

I think a consensus is beginning to form that there may be a third culprit–an inflation target that has been set too low and which has inadvertently mired us in a kind of Bermuda Triangle monetary situation that  the Fed can’t extract us from by itself.

This implies fiscal policy may be the only cure for sub-par growth.  Therefore, ineptitude in Washington, even if that has been the norm forever, is no loner as tolerable as it has been in the past.

If this is so, growth stocks will continue to outperform value names in a slow-growth economy–unless/until fiscal policy gives a helping hand.

the late 1970s: the last real inflationary period in the US

inflation in the 1970s

The most recent US experience with a real inflationary spiral came in the late 1970s.  In early 1977, prices were rising at a 5% annual rate.  A year later, inflation was running at 7%.  A year after that, the number was 9%, with 14% posted in early 1980.  Then Paul Volcker was appointed as Fed chairman.  He pushed the Fed Funds rate from 11% to 20%, creating a deep recession but breaking the back of the inflationary psychology that was feeding the accelerating rate of price rises.

There’s an academic debate, itself with political dimensions, as to what caused the spiral in the first place.  One side says it was a series of mistakes by the Fed, whose inflation forecasts were systematically too low–that therefore its setting of short-term interest rates(the main tool it used to regulate the economy) was, too.  The other side says it was Washington’s political meddling.

who lived through it?

If you were in your mid-twenties in 1975, when the world was just emerging from a horrible recession (the UK had to call in the IMF to rescue its economy), and the subsequent inflation problem was just being ignited, you’d be in your sixties now.

In other words, virtually all commentators about the perils of inflation today have no practical experience with the phenomenon.  Most of them are clueless.

two parts to runaway inflation

In my view, for what it’s worth, runaway inflation has two characteristics:

1.  money policy that’s too accommodative (read:  interest rates are too low), and that stays that way in the face of rising inflation, and

2.  a resulting mindset change that accepts rising inflation as a fact of life and seeks to benefit from it.

how people deal with rising inflation

I’ve seen this behavior in the US in the late 1970s, and also in high-inflation emerging economies around the world since then:

1.  The price of everything is going to be higher tomorrow than it is today. So you should buy now, rather than wait.  That’s true of everything …houses, cars, clothes, appliances.  If you have to borrow, do it!  In fact, if you can borrow at a fixed rate, inflation will probably soon make the loan look like a gift from the lender and you’ll profit from that, too.

Companies will load up on extra raw materials inventories, expecting to profit from holding them while prices rise.

2.  Workers will look for protection from inflation through contracts where wages are indexed for inflation (wages will rise in lockstep with the general price level). Companies will look for the same in multi-year sales agreements. Many contracts signed in the 1970s had prices indexed to the CPI or other indices that overstate inflation.  Good for the seller, but this also added to the inflation problem.

3.  Economists talk a lot about “money illusion,” the idea that most people can’t figure out how fast prices are rising.  So they’re satisfied with, say, a 5% raise when prices are going up by 8%.  In reality, that’s a 3% wage cut, after inflation.  Of course, once you’re aware of this possibility, you’ll ask for a 10% pay increase–fueling the inflationary fires.

4.  Investors of all stripes will look for assets that will protect them from rising prices.  Typically, these would be physical things, like property, oil and gas or metals.  At the same time, they’ll shun financial assets.  Investors may even short financial assets by borrowing heavily, at fixed rates when possible.

In fact, in the late 1970s many companies made what turned out to be disastrous acquisitions as they tried to work the inflation game, with, say, an industrial parts maker borrowing heavily to buy a coal mine or a chain of hotels.  These turned into almost certain recipes for Chapter 11 after inflation was tamed.

At one time in Brazil, investors bought used cars and stacked them up in their back yards as inflation hedges.  Sounded good at the time, but…

5.  Stock market investors will look for hard-asset companies or firms that can grow their profits at a faster rate than nominal GDP.  This excludes most defensive industries, like telecom or gas/electric utilities, where rates of return on investment are regulated, or like staples, where large price increases cause consumers to look for cheaper substitutes.

an alternate reality

Sounds like an alternate reality?  I think so.

But that’s the point.  It shows how far away from an inflationary environment we are today.