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?

 

keeping nominal GDP growth above zero

A reader asked a question about this after my Stephen King post from last Friday.  I think the best place for an answer is here.

In most circumstances, what counts is real GDP, not nominal.  That latter is, after all, just real GDP + inflation.  However, what comes to mind when people start to look for instances where nominal GDP shrinks is the Great Depression   …or maybe Japan during the series of Lost Decades it has been experiencing since 1990.

A potentially huge economic problem during a period of declining nominal GDP is that virtually all borrowing contracts–bonds or bank debt–are written in nominal terms.    In many places, labor contracts are also framed the same way, with an x% increase in wages yearly over the term of the agreement.

The revenues that businesses generate to meet these obligations are a function of unit volumes and price changes.  If real GDP is falling by, say, 3% and prices rising by only 1%, overall revenues are contracting.  Given that operating costs are typically fixed over the short term, this means firms in the aggregate will have less income to meet debt repayments and salary obligations.  For highly operationally or financially leveraged companies, even small declines in revenues can be deadly.

If, on the other hand, volumes are down by 3% and prices are rising by 4%, then revenue growth will still be positive.  On the margin, at least, this means fewer layoffs and fewer insolvencies to act as an economic drag during a time  when governments are trying to stimulate demand.

 

The situation where nominal prices are actually falling–which we’re not talking about here– is far worse.  Consumer soon learn that waiting a month, or two or three, before buying will mean a lower price.  So they just stop buying.  Given that consumers make up the bulk of economic growth in developed economies, they can ill afford to get the idea in consumers’ heads that purchasing anything today is a bad idea.

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.

 

 

 

 

 

S&P downgrades Japan: a cautionary tale?

the S&P downgrade

Last week Standard & Poors downgraded the sovereign debt of Japan, reducing its rating on the Tokyo government’s bonds by one notch, to AA- from AA.  In doing so, S&P cited:

–high government debt ratios

–persistent deflation

–an aging population and shrinking workforce

–social security expenses at almost a third of the government budget, and rising

–the lack of a coherent plan to address the growing debt problem, and

–the global recession, which has worsened the situation.

With the possible exception of the last point, none of this is exactly news.  S&P could have cited all the other factors five years–or even ten years–ago.

What’s going on?

Two things, in my opinion:

1.  The Liberal Democratic Party, the dominant force in Japanese politics for the past fifty years, was tossed out of office in a landslide victory for the opposition Democratic Party of Japan in August 2009.  This happened once before, in the late 1980s, when the Socialist Party, from which the DPJ springs, did the same thing.  On both occasions, the transfer of power was followed by heavy-duty partisan infighting within the winning party, stunning ministerial ineptitude and legislative paralysis.  The past eighteen months have demonstrated that chances of another charismatic leader like Prime Minister Koizumi of the LDP emerging from the current fray are pretty remote.

2.  There’s a business cycle pattern to changes in the credit agencies’ ratings.  While the globe is expanding, the agencies’ ratings lag the economic reality.  They end up being too bullish for way too long.  In contrast, after having been castigated by the regulatory authorities and the markets for this behavior, the agencies become excessively cautious.  They downgrade aggressively and actively search for high-profile instances to do so, in order to tout their new-found conservatism.  Once the economic cycle turns up, of course, the rating agencies have tended to quickly forget this prudence and resume their former generosity to client bond issues.

no market reaction, but lots of expert commentary

Since the ratings downgrade contains no new insights into Japan’s malaise, the reaction from financial markets has been ho-hum.  But pundits have seized on this chance to air their views.  Internal commentators have been beating the drum again for economic reform.  External ones have reiterated their stance that Japan today is a look into the future for the US if we don’t mend our ways.

my thoughts, too

Since everyone else is doing it, I thought I’d also give my views about Japan (yet again), based on my twenty-five years of experience in the Japanese equity market.  Here goes:

1.  Reform just isn’t going to happen.  For decades, Japan has followed a policy of preserving the status quo, even at the cost of no economic growth.  The result has been that creative destruction, where a new generation of firms rises from the ashes of the old, isn’t allowed to happen.  Weak and inefficient entrants in an industry aren’t compelled either to change their ways or fail.  They receive explicit and implicit social protection instead.  So they drag down the strong.

2.  Perversely, the economic stagnation and mild deflation that result from this policy help perpetuate the system.  Lack of economic growth keeps interest rates low. Domestic investors have few viable investment alternatives, so they continue to put their savings into government bonds.    Therefore, Tokyo can fund continuing deficits easily and at low cost.  In a funny sense, the worst thing that could happen to Japan over the next several years would be for the economy to spontaneously (it would take a miracle, though) begin to grow.  Alternatives to government bonds would arise for investors.  And interest rates would likely go up, raising Tokyo’s financing costs.  Voilà, government debt crisis.

3.  There is a point of similarity, I think, between the Japanese situation and the American that is something to worry about.

It’s not in the industrial base, which is much more dynamic and much less hide-bound in the US than in Japan.

It’s not in the politics, either, though both the Capitol and Nagatacho are to my mind similarly dysfunctional.  But the Japanese electorate has put up with legislative failure for over twenty years.  I think, however, as Americans work out that Washington is not meeting its needs, change will come swiftly and dramatically.  We’ve already seen some of this twice within a little more than two years.

One of the most striking aspects of Japan to me as an investor is the strongly held belief in that country of its cultural and economic superiority over everyone else.  The fact of this belief isn’t so surprising.  Every major power seems to think more or less the same thing about itself.  Certainly, the US does, too. But in Japan, sort of like in France, its intensity stands out.  Neither seems to me to have a sense of perspective/humor about itself. (I’ve been told, for example, by a Japanese CEO in a face-to-face interview that he didn’t want foreigners like me holding stock in his company.  Why?  …we’re subhuman, that’s why.  Actually, he told my translator, who skipped over that part–both unaware that a “subhuman” might actually understand a little Japanese.)

If you think it’s a priori impossible for a foreigner to have anything to teach you, you can be blind to the objective situation–meaning that a sense of national pride that’s out of control will act as a barrier to beneficial change.

Although the US may have prominent individuals who believe as intensely as the Japanese/French that anything domestic is superior to anything foreign, I think most of us have a little more common sense.  Again, however, only time will tell.