inflation? maybe? …gold? no way!

I turned on CNBC in the middle of the day to look at the stock prices crawling across the screen below the talking heads.  I happened to hear the discussion, as well.

The topic was gold as an inflation hedge.  The back and forth sounded kind of like one of those Time Life infomercials selling the Greatest Hits of the (1960s, 1970s…) …or maybe the commercials that let you know you can get the same auto insurance as Snoop Dogg even if you have a bad driving record.

Even though the participants didn’t know much about gold (what a surprise), I find their unstated premise very interesting.  What do we do as investors if inflation comes back?

no sign of garden variety inflation 

The standard analysis of inflation is that it arises in an advanced economy during an employment boom when money/fiscal conditions are too loose.  Government policy stimulates firms to expand.  But there are no more unemployed workers.  So companies poach from each other, offering ever higher wages to lure workers from rivals.  Not the case, at least right now, in the US, where the administration’s white racism and anti-science stance have leading firms, if anything, figuring out how to leave.

developing world variety, though…

This is the situation where a corrupt or inept government favors politically powerful industries of the past, borrows heavily–especially from foreigners–and shows itself unwilling or unable to repay what it owes.  The local currency begins to slip as this picture becomes clearer–evidenced by government budget deficits–and foreign investors head start to pull their money out.  This raises the price of imported goods and starts an inflationary spiral.

Trump has recently invited this framing of the US situation by hinting that he will punish China by defaulting on a portion of the $1 trillion+ Beijing has lent to Washington.  He also seems to have suggested the possibility of a more general default  during his presidential campaign.

In the case of the US, past bouts of inflation have been fueled by domestic fixed income investors fleeing Treasuries much faster than foreigners.  My guess is that this would already be happening, except for two factors:

–the gigantic amount of debt the Fed is buying, and

–there’s no obvious other place to go.  Japan is a basket case, the EU isn’t much better, Brexit dysfunction rules the UK out and the renminbi isn’t a fully convertible currency.

guarding against inflation

For currency-induced inflation, the winning equity stance is to have revenues in the strong currencies and costs in the weak.  For wage-cost inflation, the economic remedy is to tighten government policy, that is, raise interest rates.  That hurts all financial instruments.  Least badly hurt would be traditional defensives.

 

 

 

 

 

 

 

 

Venezuela’s proposed “petro” cryptocurrency

the petro

Yesterday Venezuela began pre-sales of its petrocurrency, called the petro.  The idea is that each token the government creates will be freely exchangeable into Venezuelan bolivars at the previous day’s price of a barrel of a specified Venezuelan crude oil produced by the national oil company.  According to the Washington Post,  $735 million worth of the tokens were sold on the first day.

uses?

For people with money trapped inside Venezuela, the petro may have some utility, since it will be accepted by Caracas for any official payments.  For such potential users, the fact that the government determines the dollar/bolivar exchange rate and that a discount to the crude price will be applied are niggling worries.

perils

The wider issue, which remains unaddressed in this case, is that the spirit behind cryptocurrencies is a deep distrust of government, a strong belief that practically no ruling body will do the right thing to protect the fiscal well-being of users of its currency.

In Venezuela’s case, just look at the bolivar.  The official exchange rate says $US1 = B10.  But the actual rate, as far as I can tell, has fallen from that level over the past year or so to $US1 = B25000.

a little history

The more serious worry is that the history of commodity-backed currencies isn’t pretty.

Mexico

In the 1980s, for example a struggling Mexican government issued petrobonds.  The idea was that at maturity the holder could choose to receive either $1000 or the value of a specified number of barrels of Mexican state-produced crude.  Unfortunately for holders, Mexico reneged on the oil-price link.  My recollection (this happened pre-internet so I can’t find confirmation online) is the Mexico also declined to make the return of principal on time.

the US

The fate of gold-backed securities around the world during the 1930s isn’t so hot, either.  The US, for example, massively devalued (through depreciation of the gold exchange rate) the gold-backed currency it issued.  It also basically banned the private ownership of physical gold and forced holders to turn in the lion’s share of their holdings to Washington in return for paper currency.

 

In short, when the going gets tough, there’s a big risk that the terms of any government-backed financial instrument get drastically rewritten.  This recasting can come silently through inflation.  But, if history holds true, government backing of a commodity link to financial instruments gives more the illusion of protection than the reality–especially so in cases where the reality is needed.

 

 

 

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?)

calling for higher inflation

Last week a group of prominent economists wrote an open letter to the Federal Reserve arguing that the current Fed target of 2% annual inflation is too low.

Their basic view is:

–circumstances have changed a lot in the US since 2% became the economists’ consensus for the right level of inflation a quarter-century ago, so it isn’t necessarily the right number anymore, and

–the lack of oomph in the US economy is a result of maintaining an inflation target that’s too low.  So let’s try 3% instead.

Having a 3% inflation target instead of 2% isn’t a new idea.  I heard it for the first time about 20 years ago, from an economist at the then Swiss Bank Corp.  Her argument was that getting from 3% to 2% inflation would require an enormous amount of effort without any obvious payoff.  The whole idea of inflation targeting is to eliminate the possibility of the kind of runaway inflation–and associated crazy economic choices–of the kind the US had begun to experience in the late 1970s.  Whether actual inflation is 3% or 2% matters little, just as long as the current level is not the launching pad for a progression of 4%, 6% 9%…

Another way of looking at this would be to say that the nominal figures matter much more than academic economists realize, and that 4% nominal GDP growth (2% trend economic growth + 2% inflation) feels too much like stagnation.  Therefore, it undermines the entrepreneurial tendencies of ordinary people.

 

How to create 3% inflation?  …slower interest rate increases and/or increased government stimulus (meaning tax cuts and infrastructure spending).

 

The letter certainly won’t affect the Fed’s thinking about a rate rise in June.  But it seems to me that the debate on this issue can only intensify.

By the way, I think 3% inflation would be good for stocks, neutral/bad for fixed income.

 

the Fed’s inflation target: 2% or 3%?

There seems to me to be increasing questioning recently among professional economists about whether the Fed’s official inflation target of 2% is a good thing or whether the target should be changed to, say, 3%.

The 2% number has been a canon of academic thought in macroeconomics for a long time.  But the practical issue has become whether 2% inflation and zero are meaningfully different.  Critics of 2% point out that governments around the world haven’t been able to stabilize inflation at that level.  Rather, inflation seems to want to dive either to zero or into the minus column once it gets down that low, with all the macro problems that entails.  It’s also proving exceptionally hard to get the needle moving in the upward direction from t sub-2% starting point.  My sense is that the 3% view is gaining significant momentum because of current central bank struggles.

This is not the totally wonkish topic it sounds like at first.  A 2% inflation target or 3% actually makes a lot of difference for us as stock market investors:

–If the target is 3%, Fed interest rate hikes will happen more slowly than Wall Street is now expecting.

–At the same time, the end point for normalization of rates–having cash instruments provide at least protection from inflation–is 100 basis points higher, which would be another minus for bonds (other than inflation-adjusted ones) during the normalization process.

–Over long periods of time, stocks have tended to deliver annual returns of inflation + 6%.  If inflation is 2%, nominal returns are 8% yearly; at 3% inflation, returns are 9%.  In the first case, your money doubles in 9 years, in the second, 8 years.  This doesn’t sound like much, either, although over three decades the higher rate of compounding produces a third more nominal dollars.

Yes, the real returns are the same.

But the point is that the pain of holding fixed income instruments that have negative real yields is greater with even modestly higher inflation than with lower.  So in a 3% inflation world, investors will likely be more prone to favor equities over bonds than in a 2% one.

–Inflation is a rise in prices in general.  In a 3% world, there’s more room for differentiation between winners and losers.  That’s good for you and me as stock pickers.