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Inflation, Deflation, or Stagflation?

Posted by Larry Doyle on June 1st, 2009 11:06 AM |

I am an eternal optimist and, as such, I never want to see people’s spirits waver. I encourage people not to allow the current economy to “deflate” their hopes for better days. By the same token, I am a pragmatist and caution people not to view the recent bounce in our equity markets as reason for an overly “inflated” sense of optimism. In this same spirit, though, we need sufficient optimism along with practical analysis to avoid the perils of “stagflation.” Let me expound.

The debate between analysts touting prospects for inflation versus deflation is ongoing. Those concerned with deflation highlight increasing levels of unemployment pressuring wages, falling asset valuations, and slack consumer demand. Those concerned with inflation point toward the unprecedented levels of liquidity injected into our system via all of the government programs. The inflation hawks maintain the economy merely needs a small spark and inflation will spread in an uncontrollable arson-like fashion.

I actually believe there is a very real chance we get developments from both camps leading to the scourge known as stagflation. How may this play out?

Many respected analysts are promoting the concept of a new “normal” economy. This scenario entails an economy operating with enormous government deficits, an elevated level of unemployment, and little to no shadow banking system (securitization of loans and other assets).

In this new “normal” economy, GDP may only eke out small positive growth given these heightened pressures. Pimco’s Mohamed El-Erian writes of A New Normal:

This reflects a growing realization that some of the recent abrupt changes to markets, households, institutions, and government policies are unlikely to be reversed in the next few years. Global growth will be subdued for a while and unemployment high; a heavy hand of government will be evident in several sectors; the core of the global system will be less cohesive and, with the magnet of the Anglo-Saxon model in retreat, finance will no longer be accorded a preeminent role in post-industrial economies. Moreover, the balance of risk will tilt over time toward higher sovereign risk, growing inflationary expectations and stagflation.

Even as we come out of this recession, our economy will run increased risks of slipping into another recession given the lack of cushion provided by a strong consumer, the burdens of heavy government debts, and inability to easily access credit.

El-Erian adds:

For the next 3–5 years, we expect a world of muted growth, in the context of a continuing shift away from the G-3 and toward the systemically important emerging economies, led by China. It is a world where the public sector overstays as a provider of goods that belong in the private sector. (As one of our speakers put it, we have transitioned from a world where the private sector provided public goods to one where the public sector provides private goods.) It is also a world in which central banks and treasuries will find it difficult to undo smoothly some of the recent emergency steps. This is particularly consequential in countries, such as the U.K. and U.S., where many short-term policy imperatives materially conflict with medium-term ones.

As our global economy transitions to this new “normal,” I believe the likelihood of stagflation is quite high. For those who recall the perils of our economy in the early 1980s, stagflation is not a pretty picture. How does one manage investments and personal finances in an environment of stagflation?

Let’s deal with the component parts. Given sluggish growth, limited credit, and lessened opportunities, it is of paramount importance to cut expenses and minimize debt as much as possible. Servicing debt will be an ongoing challenge and increasingly problematic. Be proactive at this point in time in adjusting your finances to this reality.

Where will the inflation come from and how does one address it? In my opinion, the inflation “train” will arrive sooner than we think. Some of the savviest investors, including Financial Pacific Advisors’ Bob Rodriguez and noted Black Swan author Nassim Nicholas Taleb, are already positioning themselves for it. (The WSJ reports, Black Swan Fund Makes a Big Bet on Inflation).

How can people protect themselves from the inflation monster? Increase exposure to the following:

  – precious metals and commodities

  – critical infrastructure (power plants, agriculture, water, transportation)

  – necessary life items (drugs, medicines, food)

  – stronger and more fiscally prudent foreign markets

Decrease exposure if not get outright short

  – longer maturity (5yr and and longer) Treasury bonds

This stagflation story will have many chapters and I will be writing extensively on it. Please share your thoughts, opinions, and recollections of the early 80s economy so we can all move forward most effectively in navigating the economic landscape.

LD

Full Throttle

Posted by Larry Doyle on May 27th, 2009 11:28 AM |

To say that we are in the economic fight of our lives would be a gross understatement. While we are feeding ammo into all our weaponry on the main deck, are we remiss in keeping a close eye on what is happening “in the engine room”?

Let’s go into the control room on the main deck and scope things out. On one wing, we see the plans to combat the problems in the commercial real estate market have suffered a setback. Bloomberg reconnaissance provides details: Top Rated Commercial Mortgage Debt May Face Cuts:    

The highest-graded bonds backed by commercial mortgages may be cut by Standard & Poor’s, potentially rendering the securities ineligible for a $1 trillion U.S. program to jumpstart lending. 

As much as 90 percent of so-called super senior commercial- mortgage backed bonds sold in 2007 may be affected as the ratings firm changes how it assesses the debt, New York-based S&P said today in a report. About 25 percent of the bonds sold in 2005, and 60 percent of those sold in 2006 may be cut.

“We believe these transactions are characterized by increasingly more aggressive underwriting than prior vintages,” S&P said. “Furthermore, recent-vintage CMBS, particularly those issued since 2006, were originated during a time of peak rents and values,” and may be more affected by falling rents.

Cutting the ratings would exclude the securities from the Federal Reserve’s program to bolster credit markets by financing the purchase of older commercial real-estate debt. To be eligible for the program, collateral can’t carry a rating below AAA from any rating firm.

This development is a MAJOR setback in our economic battle. An overhang of office space and underperforming real estate properties will be a significant drag not only on earnings for holders of the loans but also on the economies where these properties are located. (more…)

Increasing Inflation or Playing With Fire

Posted by Larry Doyle on May 19th, 2009 4:09 PM |

There is a reason parents tell their children not to play with matches. Small campfires can take down an entire forest. In similar fashion, heightened levels of inflation also have the potential to explode in a ball of fire. Are our central bankers playing this inflation-ahead1game as a means of addressing our massive government and non-governmental debt burden? In my opinion, they most definitely are rubbing those sticks together mighty hard. 

I have highlighted three means for central bankers to address excessive debt: default, restructure, devalue. Individuals and corporations are increasingly defaulting and will default at an increasing rate as evidenced by my post earlier this morning highlighting the surge in delinquencies. Individuals and corporations are looking to renegotiate and restructure debt burdens wherever possible. Our government is restructuring debt through the legislative process and not always consistent with generally accepted market and legal principles. Despite words to the contrary, I am convinced that Ben Bernanke and Tim Geithner are on course to devalue our debt, as well, via a promotion and acceptance of higher inflation.

I was somewhat surprised to read that two economists whom I highly respect are encouraging Bernanke specifically to raise the inflation target. Greg Mankiw, an Economics professor at Harvard, shied away from providing an actual inflation target but did offer that Bernanke should work towards a “significant” level of inflation. Kenneth Rogoff, also a Harvard professor and former chief economist at the IMF, believes Bernanke should target an inflation rate of 6%.

Rogoff and Mankiw are both highly regarded. In my opinion, they are calling for higher inflation because they are clearly concerned that the mix of stimulus programs (monetary, fiscal, and budgetary) will not be sufficient to jumpstart our economy. (more…)

What is Going on with LIBOR?

Posted by Larry Doyle on May 15th, 2009 12:47 PM |

Libor (London Interbank Overnight Rate), the cost of borrowing U.S. dollars in the overnight market, is plummeting. What is driving this move and what does it mean? A number of people in global finance are asking that very question. Let me offer my opinion. 

After Lehman failed in September 2008, confidence in banks declined precipitously, counterparty risk soared, and Libor screamed higher as well. 3 month Libor topped out at close to 5%. Historically, Libor is just marginally higher than the Fed Funds rate which is currently between 0-.25%. 

Today 3 month Libor is approximately .8%. This move lower is a clear sign of increased confidence in the banking system, isn’t it? In my opinion, this move in rates is a reflection of the following:

1. a realization that global governments will not allow major money center banks to fail.

2. a reflection of the massive increase in dollars in the system associated with all of the liquidity injected via Uncle Sam’s programs.

Has the drop in Libor coincided with an improvement in the credit markets? No. Despite what pundits would tell you, credit spreads remain at elevated levels. In fact, on an inflation adjusted basis, rates are at the highest levels since the early 1980s. 

Why aren’t banks lending as much? Lack of confidence in the economy along with enormous embedded losses in their current book of loans. Those losses are real and will be rising. The elusiveness of bank credit is highlighted in a McClatchy article, Businesses Struggle as Bank Loans Remain Elusive, in the Newsworthy section of Sense on Cents.  

Thus, if a drop in Libor is not a reflection of improved credit conditions, what does it mean?

In my opinion, it is a precursor to a drop in the value of the dollar. Why?

Very simply, too many greenbacks floating around.  A decline in the value of the dollar is inflationary. Both core rates of producer prices and consumer prices reported this week were higher than expected. I’ll be watching.

Maybe a drop in Libor isn’t such a great development after all.

LD

Ticking Time Bomb

Posted by Larry Doyle on April 23rd, 2009 11:43 AM |

If a picture speaks a thousand words, then please take a look at the graph from the St. Louis Federal Reserve highlighting the recent growth in our domestic money supply:

None other than esteemed Harvard University economist, Martin Feldstein, is warning us about the impending threat of inflation. Some analysts view deflation as the near term threat, but it is not inconceivable that our economy has an initial bout of stagflation given the prospects of a sluggish economy. If and when the economy turns, we will then likely experience a rapid rise of inflation with a real threat of hyperinflation.

Bloomberg recently discussed these topics with Feldstein and reports, Harvard’s Feldstein Sees U.S. Inflation Danger After 2010.  

How do we prevent inflation from occurring? Picture Ben Bernanke and Tim Geithner trying to gracefully and smoothly manage a decline in the money supply from what appears on the above graph to be a likeness of the cliffs of Mount Kilimanjaro.

As Feldstein warns:

the Federal Reserve will have a challenge in heading off inflation because of how it’s conducted monetary policy during the crisis.

Instead of expanding the central bank’s balance sheet by purchasing easy-to-sell Treasuries, the Fed has snapped up mortgage securities that are likely to be tougher to use as a tool to soak up cash, Feldstein said.

In an earlier interview with Bloomberg Television, Feldstein said he didn’t anticipate a lending boom from banks judged to have passed U.S. regulators’ stress tests on their balance sheets.

In light of this threat, I think global interest rates may move sharply higher over the course of the next 1-2 years.

LD

Don’t Try This at Home

Posted by Larry Doyle on April 18th, 2009 5:08 PM |

Have you ever watched a stuntman spin a sports car in a sharp 180 degree maneuver? Many stunts come with the advance warning: Don’t Try This at Home.

Not that the current actions of both the U.S. Treasury and Federal Reserve are stunts, but their maneuvers also come with a serious warning signal . . . and it reads: INFLATION!!

Given the doubling in size of the Fed’s balance sheet, if and when the economy catches, the multiplier effect on our domestic money supply will be akin to throwing lighter fluid and a match on a field full of hay. That inferno can create a scenario worse than our current economic predicament.

The WSJ reports:

“The key to preventing inflation will be reversing the programs, reducing reserves, and raising interest rates in a timely fashion,” he (Fed Vice Chairman Donald Kohn) said.

Reversing the programs? With all due respect, if people think the Fed or anybody else is uniquely qualified to drain trillions in liquidity from our markets in a precise manner prior to inflation running rampant, then they are sadly mistaken. Please remember that one of the biggest factors in determining the rate of inflation is the mere expectation of inflation itself. In so many words, our economy may start to experience inflation prior to changes in certain fundamentals in the economy.

While the WSJ reports, Fed’s No. 2 Allays Worries About Stimulus, please remember that any medication that is overused, if not unintentionally abused, can be very dangerous if not fatal. We need look no further than the use of CDS (credit default swaps). CDS used properly provide a valid means of hedging risk. Similarly, increasing the money supply via an increase in the use of the Fed’s balance sheet and assorted Treasury programs can be an appropriate medication.

However, have you ever heard a patient indicate an exact point in time when they knew they were using medication inappropriately, if not in an abusive fashion? Have you ever witnessed a patient who has misused medication to be able to turn his life around on a dime?

I appreciate Mr. Kohn’s confidence in the Fed’s abilities, but neither he nor the Fed have experience in dealing with a situation like this.

Don’t think for a second that the cure can’t be worse than the disease.

LD

Let’s Meet the 2008 Bond Manager of the Year

Posted by Larry Doyle on April 8th, 2009 3:09 PM |

One of our Economic All-Stars is Bob Rodriguez of First Pacific Advisors. In the spirit of being totally equitable, I should have also posted Tom Atteberry’s name next to Bob’s. Bob and Tom were jointly named 2008 Morningstar Fixed Income Managers of the Year.

Bob is currently taking a leave of absence from First Pacific but Tom is equally outstanding. I had the pleasure of making his acquaintance while I worked at JP Morgan. Tom Atteberry is a pro’s pro. He spoke to Bloomberg earlier today and made these comments, which I took in longhand, so I am not quoting but I listened very carefully. Tom opined:

1. The current environment is the worst time to get into bonds. Why?

2. The creditworthiness of individuals and companies across the economy will only get worse from here and that deteriorating credit is not currently priced into the market.

3. U. S. government debt (Treasuries) represent NO value at current levels. If a fair expected rate of return is between 2-3% and a longer term rate of inflation is also between 2-3%, the rate on a 10 yr. maturity Treasury note should be in the vicinity of 5%. That note is currently trading at 2.85%. Don’t overpay for an asset just because somebody else is, in this case the Federal Reserve. (more…)

I Have Some TIPS For You

Posted by Larry Doyle on April 6th, 2009 1:00 PM |

In the midst of the massive government intervention in the economy and markets, the Federal Reserve is providing measures of liquidity that are truly “off the charts.”  This liquidity, in the form of U.S. dollars, is flooding the economy. If and when the economy gains a little traction and the money multiplier kicks in, the growth in our money supply will skyrocket. What happens in the face of any market with increasing supply? Prices decline. In this case, the price decline in the value of the U.S. dollar spells INFLATION.

Many investors are questioning how to best position themselves for a potential increase in inflation. Various analysts are recommending commodities, real estate, and precious metals. However, while each of those assets can be a great store of wealth in the face of rising inflation, an investor is faced with a mix of fundamental and technical variables in determining the value of the asset. As a result, the correlation between rate of inflation and the performance of assets within those classes is not perfect. Is there an asset perfectly correlated with inflation? Come closer, I will give you a tip as to the asset class correlated to inflation.

 Treasury Inflation Protected Securities, yes TIPS, are U.S. government securities indexed to the rate of inflation.   (more…)

Putting the Genie Back Inside the Bottle

Posted by Larry Doyle on April 5th, 2009 11:43 AM |

The genie, in the form of the Federal Reserve, has granted the markets a lot more than three wishes over the course of these challenging economic times. What are some of the wishes granted so far? Let’s review:

1. cutting the Federal Funds rate to a range of 0-.25%.

2. backstopping a wide array of short term funding operations, including the Commercial Paper market, Money Market funds, and Swaps market.

3. opening the Federal Reserve discount window for investment banks prior to their conversion to commercial banks.

4. utilizing a massive Quantitative Easing program to purchase government, mortgage-backed, and government agency securities in an attempt to bring interest rates down and jumpstart borrowing by consumers and corporations.

5. working in concert with the Treasury and FDIC to implement the TARP (Troubled Asset Recovery Program), TALF (Term Asset-Backed Lending Facility) and PPIP (Public-Private Investment Program).

In the process of implementing all of these activities, this genie, the Federal Reserve, in the person of chairman Ben Bernanke, has gone places no genie has ever gone before.

The question before the court is whether the free market can ever get the genie back in the bottle. Additionally, aside from getting the genie back in the bottle, these wishes granted by the genie aren’t exactly free. How so? (more…)






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