Tag Archives: inflation

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.

 


liquidity trap: what is it? are we in one?

October 18, 2010 By in Current Market Thoughts, economics, liquidity trap, Recent Market Action, Strategy, Vocabulary Tags: , , , , , , Leave a comment

liquidity trap

Over the weekend, Charles Evans, president of the Federal Reserve Bank of Chicago, said at a Fed conference in Boston that he thought the US is in a “bona fide liquidity trap.”  His prescription to cue this situation:  a second round of quantitative easing (basically, the Fed trying directly to push down longer-term interest rates) plus inflation-level targeting (promising to continue loose money policy until inflation reaches 2%).  The purpose of the second is to try to assuage fears of deflation by money market participants.

What does all this mean?

what it is

When the Fed, or any central bank, lowers short-term interest rates, the move has a whole series of effects:

–the initial move signals that the short-term direction of policy is reversing;  the money authority wants to encourage faster economic growth, not slow down inflation

–lower returns on savings instruments tied to short-term rates encourages people to spend money rather than to leave it in the bank

–lower rates on lending money tend to encourage consumers to borrow to finance consumption;  to the extent that younger people tend to be borrowers and senior citizens savers, economic power undergoes a demographic shift that puts money in the hands of those more likely to consume

–arbitrage extends the lowering of rates to longer-maturity debt instruments; lower long-term rates make company investment projects more economically attractive and thus encourage spending on capacity expansion and new hiring.

You can, in theory–and, looking at Japan over the past twenty years, in practice–envision circumstances where this process of lowering interest rates to stimulate economic activity won’t work.  That’s a liquidity trap.  The money authority lowers rates but gets no economic response.

Economists have, not always clearly, distinguished between two types of liquidity trap:

1.  deflationary, sometimes called the “zero bound” case.  The goal of accommodative money policy is to lower nominal rates until they are negative in real terms.  The idea is that once the saver realizes he is no longer even preserving his purchasing power by holding short-term deposits, he will boost his consumption and look for (riskier) investments where he can earn a positive real return.

But nominal rates can in practice only be reduced to zero.  If prices are falling (which is what deflation is), real rates stay high despite the best efforts of the money authority.  If prices are dropping by 3% a year, for example, a zero nominal rate is a 3% real rate.  As a result, savers don’t budge.

There have been instances of negative nominal interest rates–like in Hong Kong in the late 1990s, when the government there announced plans to charge a recurring fee to foreigners for holding bank deposits.  But they’re a practical impossibility.

2.  a “true” liquidity trap, or “pushing on a string.”  The idea is that a point might be reached where central bank action in pumping ever larger amounts of money into the economy would have no further positive effect.  The economy would, in a sense, be saturated with money.  The original thought was that interest rates would remain above zero but would not decline further, despite the efforts of the central bank to push them down.  But the idea can easily be expanded to include other cases where money polity is ineffective:  the transmission mechanism may break down if economic entities are frightened and want to hold precautionary balances even though they earn no economic return; or there may be enough regulatory or government policy uncertainty that it’s hard to identify viable projects to invest in.

where we are now

In the US, inflation has been running at about 1% over the past year or so.  The sharp decline in the dollar over the past several months suggests that, if anything, inflation will rise a bit as we head into 2011.  So, although policy makers and economists may fear deflation, we’re not in that situation today.  That means type #1 above doesn’t apply to us.

There’s a lot of liquidity sloshing around in the US–in the whole world, for that matter.  Several private companies have been able to borrow money at a fixed rate for fifty years or more.  Mexico, despite its history of economic meltdowns and its internal political difficulties, has recently successfully issued a hundred year fixed-rate bond.

This leaves us with breakdown in the transmission mechanism as the reason why money policy has become ineffective.

Mr. Evans of the Chicago Fed seems to think that fear of deflation is the main problem, or at least that’s what his remedy of in effect having the Fed promise to create 2% inflation suggests.  Other economists lack of enthusiastic support suggests his is a lone voice.

This leaves the possibility that attractive investment projects are hard to find.  In a recent speech, the head of the Minnesota Fed, Narayana Kocherlakota, suggested that the gating factor may be lack of skilled workers.  The sound bite the press picked up was his observation that the Fed has no ability to turn construction workers into machinery workers.  He also pointed out that Bureau of Labor Statistics data indicate the economy has about 800,000 more unfilled jobs now than it did in March 2009.

It’s also at least a logical possibility that uncertainty about medical care costs or about future taxes is at the root of companies’ reluctance to invest domestically.  Given that the Fed members are political appointees, though, I think there’s a pragmatic limit to what they’re willing to say in print.  To me, however, it’s clear the Fed thinks a dysfunctional congress and an ineffective president are the reasons the current liquidity trap persists.

I think adjustment to the new economic circumstances is already taking place.  Lack of effective regulation and supportive legislation will just mean the transition process is a longer one.

the sharply rising yen

September 1, 2010 By in Current Market Thoughts, economics, Japanese development, Recent Market Action Tags: , , , , , , , Leave a comment

the rising yen

Since the beginning of April the Japanese yen has risen by about 11% against the dollar.  Over the same time period, the currencies of Europe have  either held even or fallen against the US currency.  So this is not primarily a dollar issue.

At first glance, there doesn’t seem to be much reason for the move.  The domestic Japanese economy is weak.  Export champions continue along their well-worn track of loss of market share to nimbler Korean or Chinese rivals.  Last year’s reform promises from the Democratic Party seem to have had no more permanence than the cherry blossoms of the spring (see my post on the resignation of prime minister Hatoyama for more details).  In fact, with Ozawa loyalist Naoto Kan as the new PM, the sitting government, to my eyes anyway, is looking more and more like a rerun of 1980s-style Liberal Democratic Party administration.

Tokyo is even talking about intervening in the currency markets to stop the yen’s rise.  The just released results of a poll by the BIS illustrates just how futile a notion this is.  The survey reveals that the world currency markets have growth by about a third over the past three years and amounts to $4 trillion worth of trades each day. The ten largest bank participants account for three-quarters of the business.  How can any government compete with this size–much less one so heavily in debt as Tokyo.

So the economy’s dysfunctional–with even modest deflation for the past twenty years.  Interest rates are as close to zero as you can get.  Ordinary citizens are nostalgic for the “golden” days of the early nineteenth century, when Japan was isolated from the rest of the world.  How is this a recipe for a rising currency?  After all, it wasn’t that long ago that these attributes were ones that motivated international speculators to short the yen, not buy it.

As the endaka economy began to crumble as the Bank of Japan raised rates to cool speculative fever, the country chose, for good or for ill, to maintain its traditional way of life rather than to face its economic problems and restructure.  Periodic political attempts to revisit that decision have all failed, the latest being the election of the Democrats last year.  If this analysis is correct, the outstanding characteristic of the Japanese economy is that things just aren’t going to get better any time soon.

Odd as it may seem, I think this is what is attracting currency investors to the yen.

Real short rates in the US are negative; real short rates in Japan, even at zero nominally, are positive because of the country’s chronic deflation.  The only way this difference can express itself is through mild appreciation of the yen against the dollar.

Also, economically the worst is past for the US.  At some point, the domestic economy will become strong enough that the Fed will change its current extraordinarily loose money stance.   Then bond prices will fall.  We don’t have that worry in Japan.

Why now?

What made the currency markets decide to play this idea starting in April?  Maybe it was political developments in Japan.  It certainly shouldn’t have been signs of a slowing economy in the US, since that diminishes the chances of rising rates.

Twenty-five years of watching currency markets as an international equity investor have taught me that the currency markets march to their own drummer and are almost always way ahead of everyone else.  This is a short way of saying I don’t know.

But the political events in Japan were highly predictable.  So I don’t think they can be the reason.  Arguably, then, currency traders may be saying that the recovery in the US may be stronger than domestic markets expect and that rising rates are a more serious concern than we now realize.  That would fly in the face of the consensus, however.  We’ll see.

The Fed’s Narayana Kocherlakota: FRB can’t change construction workers into manufacturing workers

August 30, 2010 By in Academic Theories, Current Market Thoughts, discount rate; Fed Funds rate, economics, Recent Market Action, Strategy Tags: , , , , , , , Leave a comment

When I updated Current Market Tactics yesterday, I mentioned the August 17th speech of the President of the Federal Reserve Bank of Minneapolis, Narayana Kocherlakota.  I thought I’d elaborate on it a bit today.

First, Mr. Kocherlakota.  He went to Princeton (1983) as an undergraduate, and got a PhD in economics at U Chicago (1987).  He taught at a number of places, the  last being Stanford and U Minnesota, before being appointed President of the Minneapolis Fed last year.

Mr. Kocherlakota says the speech contains his own views, and not necessarily those of the rest of the Fed.  But the Fed routinely uses occasions like this to provide background about its actions or to air its thoughts in a way that can’t draw Congressional ire in the way an “official” position might.

As I read it, the speech has several main points:

1.  An economic rebound is under way, although the recovery is unusually slow and accompanied by an unusually low amount of inflation.

2.  The labor market is responding only sluggishly to very stimulative money policy. How so?

The Bureau of Labor Statistics has been keeping a tally of job vacancies since December 2000.  Older, but less detailed data, are available from the Conference Board for the years 1951 onward.  Robert Shimer, an MIT-educated economist teaching at UChicago, has studied the relationship between the vacancy rate and the unemployment rate, publishing the results in an article frequently discussed by the Fed and cited in the printed version of  Mr. Kocherlakota’s speech.

Anyway, there’s a stable, inverse relationship between the unemployment rate and the vacancy rate–the higher the unemployment  rate the smaller the number or unfilled jobs and vice versa–until mid 2008.  Then the relationship breaks down.  Over the past year, for example, the number of unfilled jobs the economy has created has risen from 2.34 million (the low point, last July) to 2.94 million this June.  But the unemployment rate went up during this time, despite the extra 600 thousand extra open jobs.

The unemployment rate should have fallen to 6.3% over the past twelve months as these new jobs were filled.  Why not?  Mismatch.  “Firms have jobs, but can’t find appropriate workers,” as Mr. Kocherlakota put it.  Mismatch can come in different forms:  a worker can live in Nevada but the job can be in Florida and the worker may be unable/unwilling to sell his house or otherwise reluctant to move; the worker may be only comfortable with pencil and paper, but the job may require computer literacy; or the worker may hope against hope that his old job will magically reappear rather than starting to retrain himself.

The headline grabber of the speech is the statement that “the Fed does not have a means to transform construction workers into manufacturing workers.”  I interpret this as being a strong statement about what it thinks is the problem.  But it could equally well be that the Fed just doesn’t want to make specific policy recommendations about, say, housing.

3.  The recent Fed decision to reinvest proceeds from mortgage-backed securities into Treasuries accidentally scared the securities markets. The reason the Fed is buying Treasuries is not that the economy is in worse shape than commonly thought, but that mortgage prepayments have been larger than anticipated (because low interest rates have prompted lots of refinancing).  Because of this the Fed’s holdings of government securities have dropped below the intended level.

4.  The Fed will likely begin to raise rates before the consensus thinks it’s appropriate. Standard economic theory says that money policy actions can have short-term real effects on an economy but that over time the economy adjusts to restore the pervious real status quo.  The way this is usually expressed is that an inappropriate drop in interest rates can temporarily boost economic activity in a country but that growth soon moderates and the country is in the same place as before, but with higher inflation.

Mr. Kocherlakota’s point is that the long-term real rate of return on cash-like securities is around 1% annually.  If the Fed holds the policy rate at effectively zero after the economy is restored to health, the economy will adjust to restore the real rate to 1%.  It can only do this through deflation–by making real prices decline by around 1% a year.  Sounds kind of wacky, until you think that this is a good description of what Japan has been doing for the past twenty years.

It seems to me the speech does several things:

–it provides an answer to critics who say that money policy is still too tight, by pointing to the large number of unfilled jobs available.  The passage of time will eventually cure the mismatch.  Government programs may speed the process up, but looser money policy will just create more unfilled vacancies.

–it implicitly criticizes the notion that more “shovel ready” projects will do any good.  Again, Japan’s experience over the past twenty years is a cautionary tale.  in 1990, a startlingly high 10% of Japan’s work force was employed in construction.  Rather than allow/force a transition to other occupations, Tokyo launched wave after wave of make-work pork barrel public construction projects.  The government also used formal and informal means to preserve the status quo in other sectors, in order to keep the unemployment rate low.  What did all this get Japan–twenty years (so far) of economic stagnation, chronic deflation, a crippling amount of government debt and a tendency to rue the day that the black ships arrived at its shores.

–it signals to academic critics that it understands the negative implications of keeping the fed funds rate at zero too long.

All in all, the speech is a lot more interesting, and revealing, than the single sound byte.

prospects for deflation: Andre Meier and Gavyn Davies

August 24, 2010 By in Current Market Thoughts, economics, emerging markets, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , , , , , , , Leave a comment

Gavyn Davies as blogger

Gavyn Davies, formerly chief economist for Goldman Sachs, then head of the BBC, is now among other things a blogger for The Financial Times.

My experience as a portfolio manager has been that Goldman’s economic commentary has always been truly excellent, and the high spot of the firm’s research offerings. As to Mr. Davies in particular, I read and admired his work for years.  (Equity strategy and individual stock research at Goldman is another story—lots of facts, no useful opinions would be my call.)

A recent post on his FT blog talks about deflation.

The  deflation problem, in a nutshell,  is this:  the main tool governments use to treat a sick economy is to lower interest rates to the point where the real (that is, after adjusting for changes in the price level) cost of funds is less than zero.  But an agency like the Fed can only lower rates to zero, where they are now.  It draws the line at actually paying us for the privilege of lending us money.

Because of this, a deflationary economy, i.e., one with a falling price level, is like having a patient with an antibiotic-resistant virus.  You can’t make real rates negative.  So tried and true treatment methods for curing a slumping economy are ineffective.  The monetary authority can either try unconventional methods, which have no track record, or stand on the sidelines with fingers crossed, hoping the patient recovers on his own.

It doesn’t help matters that the word deflation conjures up images of the worldwide depression of the 1930s or the decades-long stagnation of Japan.

Andre Meier on deflation threats

In his post, Mr. Davies cites work by Andre Meier of the IMF in cataloging and analyzing all the instances of recessions in the developed world over the past forty years that have been serious enough to pose a deflation threat.

Mr. Meier’s conclusion:  while inflation does rapidly approach the zero level in the twenty-five instances he looks at, it doesn’t seem to want to cross over into negative (deflationary) territory.  The higher the previous inflation, the faster the plunge downward, but in all cases save two the rate of descent slows and the inflation rate stabilizes as the zero line is reached.

In pre-1990 instances, which tend to originate at higher inflation levels, the march to zero is relatively steady.  Post 1990, the initial fall is sharp, but disinflation then tends to decelerate in later periods.  In the two exceptional cases from the past paragraph, which start from very low initial levels of inflation, Sweden in 1992-94 and Japan 2001-2003, the price level actually starts to rise as the recession deepens (presumably because of currency weakness and imported commodity strength, but odd nonetheless).

conclusions

Both economists interpret the data as indicating that there’s something very unusual about the occurrence of deflation, and that it seems to take negative economic shocks of much larger magnitude than the world has seen at any time in the post-WWII era–including now–for deflation to take hold.

The question is why this is the case.  Both Meier and Davies point to structural rigidities around zero.  As a practical matter, firms are reluctant to cut the wages of highly skilled employees, for fear they’ll leave when economic conditions improve.  They don’t want to cut the prices of their output, either.  Experience has taught them that it’s extremely difficult–in many cases, nearly impossible–to raise them back again.  In addition, in many cases legally binding agreements–government workers’ salaries, for example, or long-term materials supply contracts–mean price cuts aren’t possible.

On a macroeconomic level, it may be that inflationary expectations–there’ll be low inflation but at least some–have been very deeply established in our collective economic psyches.  World governments response to recent crises, much as we may want to criticize the details, may have been enough to preserve or reinforce these attitudes.

In any event, the experience of the last forty years says deflation is not likely to happen.

my thoughts

No deflation doesn’t mean everything is ok.  But if we take the idea that general price levels are not going to decline as a working hypothesis, we can draw conclusions that may have useful investment implications.  For example, if salary levels aren’t going to decline, then firms will only be able to lower labor costs by laying workers off, or by pruning high-cost but unproductive workers and replacing them with lower-cost, more productive ones.  Companies could also prioritize between high value-added tasks and low value-added ones–and focus all/most compensation increases to workers in the former areas.

One might also try to distinguish countries where limited economic gains may be a chronic problem and those (like the BRICs) where it will not.

In discussing its most recent earnings performance, Procter and Gamble seems to be saying that these sorts of patterns are already becoming evident in their customers’ behavior.  For example, PG is finding that consumers of mainline/premium brands are beginning to trade up.  Value-brand users are continuing to trade down.

My experience is that in uncertain economic times, investors tend to become mesmerized by worry over the worst possible outcome and do little else except wring their hands.  True, we need to be concerned about even low probability events that have significant negative consequences.  But typically this doesn’t take much time.  I think there’s potentially a lot of money to be made by looking for hot spots of growth even in a world that may not be expanding that quickly.  And there’s certainly money to be made by working out the economic implications of having something better than the worst-case scenario unfold.