Category Archives: inflation vs deflation

foreigners now own more Japanese government bonds than any time over the past thirty years…Why?

September 24, 2012 By in Bond Environment, Current Market Thoughts, inflation vs deflation, Investment firms, Japanese development, Strategy Tags: , , , , , , , Leave a comment

foreign JGB ownership continues to rise

The Bank of Japan announced last week that foreign ownership of its government bonds has now reached  the highest level since 1979.

The foreign investors piling in aren’t individuals like you and me.  They’re mostly professional bond investors who manage mutual funds and institutional pension accounts and, to a lesser extent, non-Japanese central banks.

What’s the attraction?

To the layman’s eye, there would seem to be none.  The Japanese economy hasn’t grown much for over two decades.  The Tokyo government continues to borrow heavily to run its operations, so the stock of JGBs continues to expand.  And interest rates are extremely low.

There are, however, two positives.

90% or more of Japan’s government bonds are held by Japanese citizens and institutions.  They regard JGBs as the ultimate safe investment.  They also see themselves as having little other choice (without taking unacceptably high amounts of risk) than to continue to hold.  They roll their money over into new bonds when their current bonds are redeemed, too.  So–unlike the case with, say, US Treasuries, where foreigners own about half the outstanding bonds–there’s little chance of the JGB market being roiled by panicky foreigners repatriating funds to the their home markets.

Also, the Japanese economic situation is well-known.  It has been for all practical purposes unchanged for over two decades.  Chances of any change appear to be slim.  To boot, in the deflation-prone Japanese economy, low yields look somewhat better in inflation-adjusted terms.

In other words, although you won’t make much money–other than a possible currency gain–the chances of a loss appear to be very small.  That’s what makes Japan so attractive to global bond professionals.

not so in the rest of the world

The sub-prime mortgage crisis in the US and the Greece/Italy/Spain government debt crisis in the EU have driven bond yields for Treasuries and for German governments to within striking distance of JGB yields.  In fact, short-term German government notes trade at negative yields.

Inflation-adjusted, Treasury yields are already negative, as well.  It’s possible that economic recovery now under way will eventually cause inflation to rise further, worsening this situation–and causing the Fed to raise rates.

In Germany’s case, if the Eurozone is to survive it looks like Germany will have to accept more inflation than it traditionally has been willing to do.  It will also bear a large amount of the cost of bailing out profligate Spain and Italy.  (Greece?  It’s too small to matter; my personal bet is that Athens will be eventually expelled from the EU.)

in short

Marketers of bond funds continue to tell us that bonds are a good place to have our money.  If we look at what those managers are doing with any funds we give them, however, we see the best low-risk option they’re able to find is Japan, whose virtue is that losses will probably be minimal.

Another case of:  watch what they do, not what they say.

the Fed’s QE3: a “reverse Volcker moment”?

September 21, 2012 By in inflation vs deflation, Strategy Tags: , , , , , , , , , , , Leave a comment

The most recent A-list editorial feature in the Financial Times, written by Pimco marketer Mohamed El-Erian, asks this question and answers it with a carefully hedged “Yes.”

Several aspects of the editorial are interesting:

–it’s not the usual El-Erian turgid statement of the obvious.  Instead, it’s concise, well-written and makes a point.  To me, this underscores the fact that Mr. El-Erian is writing, not as an individual, but as the voice of the collective wisdom of the largest and most successful bond investment management firm in the US.  As such, the opinion expressed should be taken seriously.

–the original “Volcker moment” was Paul Volcker’s decision as newly-appointed Fed chairman to deal with runaway inflation in the US by raising interest rates to extremely high levels for an extended period of time.

The editorial suggests Mr. Bernanke is currently in the process of deliberately trying to manufacture higher levels of inflation, thus reversing the major thrust of Fed policy over the past thirty years.  Calling the move a “reverse Volcker moment” implies that the decision may have equally momentous implications (more about this next week).

–although the editorial doesn’t say this (Pimco markets bond funds, after all), such a Fed policy reversal would likely have negative consequences for all securities markets, but especially unfavorable ones for bonds.

At present, long Treasuries yield about 3%, which we can break out into a 1% real yield and 2% as compensation for benign, stable annual inflation of around 2%.  If the world began to think that inflation in the US could be 3%–and rising–how would bonds be priced?  …at a 5% yield?  …higher?

That’s a big difference, one which would produce significant losses for current Treasury holders.

Wells Fargo: US economic recovery ISN’T sub-par

December 13, 2010 By in Current Market Thoughts, inflation vs deflation, Inventory Cycle, Recent Market Action, Shaping a portfolio for 2011, Strategy Tags: , , , , , , Leave a comment

a better than average recovery

A month or so ago, I wrote about the thesis of Jim Paulsen, the chief investment strategist for Wells Fargo, that the US is actually doing a bit better than average for economic recoveries over the past twenty-five years.  The perception that the economy is relatively weak comes, in his opinion, from comparing apples with oranges–from comparing this recovery with all post-WWII economic rebounds, not with those of the last quarter century.  This latter group, however, are the only ones that occurred with an economy like we have in the US today.

Anyway, I’m suddenly on the mailing list for Dr. Paulsen’s monthly commentary (Thanks, Wells Fargo!).

a new angle

In his December comment, Dr Paulsen expands on his idea of a “back-loaded” economic recovery.  I don’t necessarily intend to talk about Dr. Paulsen every month, but I think he is making some interesting points.   They argue that we will be seeing accelerating economic performance out of the US economy in the months ahead.

women entering the workforce

In a nutshell, Dr. Paulsen’s November observation is that the US economy of the 1950s through the mid-1980s had a faster potential rate of growth than we have today because in the earlier period  the large-scale entrance of women into the workforce acted as a significant tailwind that we no longer have.

the effect of inflation

In his December commentary, Paulsen makes the additional observation that the switch from the inflationary mindset of the Seventies and early Eighties to a disinflationary one of the Nineties and beyond also has a significant effect on the behavior of corporations.  As he puts it, in the earlier period, “sales always rose and prices could always be increased.”  Therefore, it made no sense to worry about staffing levels or the size of inventories.  Price increases would always ensure that companies could report a satisfactory, and rising, level of profits.

The world has changed dramatically since the Sixties and the Seventies.  The Fed’s thirty year long fight against inflation has stamped out in customers’ minds the idea that prices inevitably rise.  In the new environment, a company has got to concentrate on keeping costs low and increasing productivity.  Hiring increases and capacity additions come only as a lost resort.

my thoughts

In my view, Dr. Paulsen’s observation about inflation is basically correct.   In fact, the old inflation-prone world of the Seventies is so foreign to today’s experience that it’s hard for people who didn’t experience it to comprehend how or why the economy ran the way it did back then.

But there are also a lot of other things different about the Sixties and Seventies:

–the industrial firms in Europe and Japan were still rebuilding after WWII

–trade barriers were much higher than today

–therefore, there were far fewer true multinationals, who aimed at selling large amounts of stuff at moderate prices all around the world

–electronic products, where performance always gets better while prices decline, were a much smaller percentage of industrial production

–the rate of technological change was much slower (so fewer worries that bloated inventories might become obsolete)

–there was no Internet and no online commerce

–there was no supply chain management software, so managements had little of today’s ability to analyze and control operations.

Yes, the Fed’s actions in the Eighties destroyed expectations of inexorably rising prices.  But the world is much more complex now.  Change is faster and competition is much more intense.  So cost control and productivity increases are essential for firms to remain competitive.  And today’s managements have powerful tools that allow them to dramatically curtail operations–as they did in late 2008 and early 2009–confident that this is the profit-maximizing thing to do.

good news

Today’s coin has another side, however.  Cost cutting and squeezing more output from a given amount of capital equipment can only go so far.  At some point, firms have to add people and plant in order to continue to grow.

Jim Paulsen thinks, and I agree, that we’re now at that point in the current recovery.  Productivity growth has been slowing for a while.  And there’s substantial evidence that companies are beginning to hire at a faster rate.  If so expect profits for publicly listed companies to accelerate in the months ahead.

Shaping a portfolio for 2011: investing in a world with inflation

November 7, 2010 By in Constructing a Portfolio, Current Market Thoughts, inflation vs deflation, Portfolio management, Shaping a portfolio for 2011, Strategy Tags: , , , , , , , , , , , Leave a comment

The way I’m reading the US stock market, investors are only now beginning to discount the possibility that the Fed will be successful in creating inflation through its QEII operations.

important stuff

The last time the US saw rising inflation was in the late 1970s and early 1980s—the pre-Volcker era.  This means that virtually no professionals active in the stock market today have actually worked in an inflation-conscious environment.  In other words, many people will talk in confident tones about the characteristics of inflation—just as they spoke about deflation—without having any knowledge other than wheat they obtained from books on the subject.  Some of these ideas may be really wacky—and translate themselves into actions in the market that, in the final analysis, will make no sense.  These oddities will, at some point, present opportunities for profit.  But it’s always dangerous to put yourself in front of a moving train—even if you know it shouldn’t be there or is moving in the wrong direction.

The key to enduring inflation or deflation is consumer expectations.  Changes in expectations translate into changes in purchasing patterns.  In a deflationary mindset, consumers purchase only at the last minute, since the trend of prices is down.  In inflationary times, in contrast, people purchase in advance of their needs, since they believe that prices will be higher if they wait.

For companies, this means, among other things, a change in behavior toward inventories.   In a deflationary environment, companies want to be as lean as possible.  During inflationary times, in contrast, companies try to achieve profits from holding inventories that rise in value before they’re used.

winners and losers

income statement

In a situation where costs are steadily increasing, the key question for profits is whether a firm is able to pass these extra expenses along to customers, and how quickly it is able to do so.  Companies that have  unusual, scarce, or sharply differentiated products will typically do well.  All other things being equal, the shorter the supply chain, the better.

On the other hand, companies in industries like utilities, where prices are highly regulated, may face strong resistance to raising prices at all, or at the very least a significant lag in their ability to do so.  Commodity-like products—ones where there are readily available close substitutes—like consumer staples, will also tend to suffer.

balance sheet

In an inflationary environment, prices rise.  The cost of money, that is, interest rates, is one of those prices.  So companies with fixed-rate debt, which usually means outstanding bonds rather than bank debt, benefit.  So do firms holding large amounts of real estate.  Capital-intensive firms that already have ample capacity, especially in industries where rivals are becoming capacity-constrained and must add plant and equipment at now-higher prices should also benefit.

my thoughts

It’s not clear how or if quantitative easing will work.  It’s also hard to predict exactly how Wall Street will respond, given that only professionals working thirty years ago have seen inflation at work while they’ve been on the job.

Having said that, one sea change already appears to be occurring.   Investors seem to me to be more conscious of the risk in holding longer-term fixed rate bonds—the clearest losers in an inflationary time.  That concern is starting to flow into the stock market, I think, where the closest analogues, that is, the most bond-like securities, are those whose dividend yields are their greatest (or only) attractions.  I think high-yielding cyclical companies will be ok, but utilities and consumer staples are at risk, because they will likely struggle to achieve inflation-matching earnings increases.  This means they must either up the proportion of income they pay out to shareholders, or let their dividend decline in real terms.  Income-oriented investors already seem to me to be shying away from situations where they must forgo dividend growth possibilities in return for high current yield.

Are individuals coming back to the US stock market?

November 2, 2010 By in Constructing a Portfolio, currency effects, Current Market Thoughts, inflation vs deflation, Portfolio management, Shaping a portfolio for 2011, Strategy Tags: , , , , , , , , Leave a comment

some preliminaries…

A little more than a week ago, I wrote a post I called “Thinking about 2011,” in which I discussed the economic and stock market forecast of Jim Paulsen of Wells Fargo.  My understanding of his position is that the US economy is much farther along the road to recovery than one would imagine from the doomsayers of the “new normal.”  In fact, judging by the experience of the past twenty-five years, this recovery is ahead of schedule, not behind.  More than that, things are about to pick up all by themselves.

If so, the soon-to-be-launched quantitative easing by the Fed is not only unnecessary, but it has the potential for creating a lot of inflation–fast.

I said I thought Mr. Paulsen’s analysis was far from consensus.  My friend Bart, a canny veteran still working on Wall Street, wrote a comment to my post saying that Paulsen is a lot closer to the thinking of institutional investors than I realize.  Although confident that Bert is correct, I replied that I didn’t see this consensus being acted on yet in stock or bond prices.

…bringing us to yesterday morning

Monday’s Financial Times contains an article with a London byline titled “Investors increase exposure to equities.”  The story references two data providers:  the Investment Company Institute, the trade association of the mutual fund industry in the US; and EPFR, a Cambridge, Massachusetts-based data aggregator that I’m not familiar with.

According to the FT, EPFR says funds that invest in US equities have had inflows of $13.3 billion since the beginning of September.  Funds focussed on Europe have taken in $1.2 billion over the same time span.  Last week alone, the inflows were $2.7 billion and $840 million, respectively.

The ICI maintains the official figures for mutual funds based in the US (which may be a slightly different universe than EPFR’s).  These data don’t clearly support the EPFR statements.  What they do show, however, is that in mid-October, redemptions of US-oriented equity funds suddenly slowed from a flood to a trickle.  At the same time, inflows to international funds began to accelerate.

I tried to contact EPFR this morning, without success.  By the way, I’ve been pleasantly surprised to find how uniformly cooperative the information sources I contact as an equity market blogger are.  I expect I’ll eventually hear from EPFR as well.  Whether I do or not, though, the point is still that we may have seen an inflection point in investor behavior.

What does this mean?

The change in money flow may mean nothing.  Or it could reverse itself in short order.  After all, at least according to the ICI data, bond fund inflows haven’t diminished a bit.

On the other hand, government bonds have been weak recently, as have bond-like domestic US stocks.

My hunch is that world stock markets may be in the process of changing their character in a meaningful way and that I don’t have the two months for leisurely thought that I thought I had, if I want to keep positioned in stocks with a good chance of outperforming.

The first thing to consider is what kinds of stocks might be vulnerable if:

–economic growth is picking up steam,

–interest rates are rising, and

–inflation may be a problem, meaning the Fed has got to see to it that rates rise some more.

At this point, I still need to be convinced that any of this stuff is really going to happen.  And I don’t want to launch into an overhaul of my positions without thinking about it carefully first.  All I want to do is to identify potential underperformers and figure what I would need to do to get from overweight to a more neutral position.

I’ve also been thinking that many of the same stocks that have done well over the past eighteen months also stand to be outperformers in a higher-growth, more inflationary world.  But I want to make sure of that, too.

More on this topic over the next few days.