Sunday, April 6, 2014

Is Inflation Next?

by James Gruber

Hints from Q1
A normal market cycle?
A system unhinged
An investment framework

Inflation is dead. At least that’s the view of the vast majority of economists, investors, policymakers and financial commentators. The view has been given further currency in recent months via various speeches from IMF director, Christine Lagarde. She’s urged policymakers to fight deflation as it’s the major threat facing developed economies in 2014. The latest consumer price inflation (CPI) statistics, whether it be in the US, Europe or China, seem to support her view.

There are signs though that inflation shouldn’t be written off altogether. The price action of agricultural commodities and gold is suggesting as much. Oil hasn’t yet followed suit but should be closely watched. There’s also evidence of a tightening labor market in the US, which normally precedes wage increases and higher inflation. Admittedly, these are tentative signals rather than definitive evidence (which usually only comes after the fact).

But some of these things are indicative of mid-economic cycle behaviour – at least in the US. In this part of the cycle, there’s eventually a tug-of-war between rising interest rates and improving fundamentals. And later in the cycle, the economy usually gathers steam and inflation follows, with the central bank being late in raising rates to quell the inflation.

The US has largely followed the patterns of a typical economic cycle thus far. But Asia Confidential still suspects this isn’t just a typical cycle. The current economic system – where central banks can print money without constraints – is inherently inflationary. Until the system is reformed where limits are imposed, there are likely to be even greater swings in economic cycles and stock market prices.

What does this mean for inflation in the near-term though? Your author has previously suggested that deflation would precede inflation and this has proven correct. Our view now is that investors should probably be leaning the other way, preparing for inflation to take hold by the first half of next year. Keeping in mind that whether this proves right or not, today’s monetary regime almost guarantees inflation in the long run, as well even more extreme economic booms and busts.

Hints from Q1
The first quarter of the year is over and it’s time to take stock. Let’s have a look at the returns of various asset classes.

Cross asset returns 1Q14

As you can see, there’s the odd mix of strong performance from both bonds and commodities. This shouldn’t surprise regular readers of mine. This newsletter has been an advocate of agricultural commodities on both short and long-term time frames. This based on still tight supply-demand fundamentals and the favourable weather of last year providing only a temporary pullback in prices.

I’ve also suggested that bonds, particularly US treasuries, were due for a bounce back too. Admittedly, this was an early call made mid-last year. Too early as it turned out. And though the good performance may continue in the near-term, the pathetic yields on offer should make for poor returns in the long-term.

As for gold, your author has consistently recommended it as a hedge against currency debasement. I suggested junior gold stocks might prove the contrarian trade of 2014, given extraordinarily depressed sentiment and valuations. In the first quarter, these stocks were up 17% (via the ETF, GDXJ).

Among the big losers were Asian markets, including Japan and China. A Japan correction shouldn’t surprise given the enormous run that the market had last year. Note though that Japan has started the second quarter in style. Further out-performance, at least this year, will depend on more mass injections of printed yen.

As for China, that market has been among the worst performers for several years. It’s staggering how investors and commentators swallowed China’s strong economic figures from 2009 onward when the stock market was telling them all along that the economy was fast deteriorating.

The question is: what’s in store for the rest of the year? And the answer to that will partly depend on what happens to interest rates and inflation in the world’s largest economy, the US.

A normal market cycle?
Either consciously or unconsciously, most investors avoid reading people who have different views from their own. It’s a common investor bias called confirmation bias. And it usually makes for poor investment decisions. After all, testing your own arguments against those of others should be an essential part of any decision making process.

In this spirit, Asia Confidential always enjoys reading two prominent North American economists, Richard Bernstein and David Rosenberg. The former used to be Merrill Lynch’s chief investment strategist and now runs his own consultancy. The latter used to be Merrill Lynch’s chief North American economist before moving to a Canadian brokerage.

Your author finds some of their latest arguments particularly persuasive, if not being wholeheartedly in agreement with them. Let’s examine the persuasive bits initially.

Bernstein is known as a US economic and stock market bull. To his credit, he’s been largely right since 2009. To understand his bullish stance, there’s some context to get first.

Bernstein believes the US is undergoing a typical market cycle. These cycles follow a pattern cycle after cycle. And this one is no different, despite the common belief that it is.

The early part of the cycle is when monetary and fiscal policies focus on stimulating the economy. It’s normally associated with depressed stock market valuations. As well as improving economic fundamentals. During the early part of the cycle, financials and consumer cyclicals typically outperform as they’re most sensitive to lower rates and credit creation (and this has proven right since 2009).

The middle portion of the cycle involves a tug-of-war between rising interest rates and improving economic fundamentals. Stimulus is normally eased though investors become anxious about whether the economy can continue to grow without it.

During this mid-cycle, inventories built up during the prior crisis are run down and businesses start to invest. This usually results in outperformance from sectors such as industrials and technology.

Note that Bernstein believes the US is now entering this mid-cycle.

The latter segment of the cycle is characterised by a stronger economy and increased corporate profits. Inflation picks up and the Fed is invariably late in acting to increase rates, usually signaled by an inverted yield curve (where short-term bond yields are higher than long-term bond yields). Late cycle sector out-performers are typically energy and materials.

Bernstein thinks we’re a long way from the latter stages of this market cycle and US equities should continue to perform well under these circumstances.

David Rosenberg appears to be thinking on similar lines. Rosenberg is famous for his recessionary warnings prior to the 2008 financial crisis and many were surprised when he turned from US economic bear to bull last year.

Rosenberg believes that we should now be preparing for a stronger US economy and rising US inflation over the next 12 months. He says the fiscal headwinds of last year will subside and provide tailwinds this year. The jobs market is improving and ex-finance sector, employment should hit an all-time high in coming months. Consumers are done deleveraging and are now in a position to start re-leveraging. And business spend should improve as the nation’s capital stock is old and needs replacing.

Rosenberg suggests that we’re in the early stages of bargaining power moving from employers to employees. He sees a tightening labor market, with the recent pick up in hourly earnings as evidence of this.

He also believes prices of rent, food, energy and health care services are all heading higher. Combined with increased wages, this should lead to sustained inflationary pressure in coming quarters.

Rosenberg says the next decade will look more like the 1970s than most people think. Though structural and demographic factors will limit how high inflation can go. He believes inflation could revisit the highs of the previous economic cycle, at close to 5% for CPI.

Like Bernstein, Rosenberg thinks the Fed will be late raising rates to quell the inflation, and an economic downturn may then follow. But that’s some time away.

Rosenberg differs from Bernstein in believing US stock gains will be more muted after the large run-up in recent years. Needless to say, he’s bearish on US long bonds given his views on inflation.

A system unhinged
The two economists provide a convincing case why this US economic cycle will follow previous cycles. Though I’m not entirely convinced they’ll turn out to be right. There’s every chance that this cycle may be even more extreme than those of recent times. Here’s why.

If you look at the history of the US Federal Reserve since it was created a hundred years ago, it’s been one of sustained inflation and heightened asset price volatility. Volatility has undoubtedly increased during that time.

The reason for this can be traced back to the paper money system. Before 1914, central banks couldn’t print money without additional metallic reserves, principally gold (though also silver in ancient times). 

With the advent of the Fed, the link with gold was gradually wound back. And in 1971, that link was broken altogether when the US floated the dollar. Since then, the Fed has been able to print money, without constraints.

This has suited the politicians just fine. With an eye always on the next election, any economic downturn has been met with substantial money printing to cushion the blow to their electorates. It’s been a seemingly easy answer to the problems of the day.

However, inflation and increased economic instability have resulted. It’s created the illusion of prosperity even when that prosperity may rest on increasingly shaky grounds.

If we turn to the 2008 financial crisis, the worst economic downturn in the US since the 1930s was met with unprecedented money printing. Not only from the Fed but central banks worldwide.

Thus, how much of the US economic recovery since is artificial is impossible to tell. But we’re about to find out, given the Fed’s planned tapering program.

There’s a chance that the US economy won’t be able to handle higher inflation and higher rates. There was a glimpse of this when 10-year bond yields recently hit 3% – the US housing market almost instantly stalled.

Importantly, the massive stimulus programs conducted globally have made the economies of countries outside the US more unstable. Look at Asia, where stimulus has fueled domestic credit bubbles which are starting to unravel.

The current economic system is prone to inflation and instability. Until there are limits imposed on the money printing capacities of central banks, the situation may worsen.

In other words, if Bernstein and Rosenberg are correct about this being a typical US economic cycle, inflation is on the way. And if they’re incorrect, the broader system will almost guarantee serious inflation down the track anyway.

Whichever way that you cut it, preparing for inflation ahead would seem sensible. The question is whether we get a deflationary bust before seeing further central bank intervention then leading to inflation. I’ve been a previous proponent for such a bust, though now see that as a less probable outcome.

In my view, the largest deflationary risk for the world isn’t China but Japan. Despite being heavily shorted, the Japanese yen continues to weaken and Shinzo Abe needs it to fall a lot further if he has any hope of hitting his inflation targets. The risks from Japan exporting deflation, via a much weakened currency, shouldn’t be underestimated.

An investment framework
Given the economic scenarios outlined above and the range of potential outcomes, it makes sense to have a diversified investment portfolio. This is a bit cliched so let’s get more specific.

Stocks perform well during rising inflation, until the inflation rate hits a certain point. In the US, that point is 4%.Therefore, stocks should be part of portfolios at this juncture (that may change later on).

The US stock market has run hard and valuations aren’t cheap. Other markets look better. On a 12 month view, I like Japan. Though highly skeptical of Japan’s stimulus program, it’ll likely benefit the local stock market. Hedge any yen exposure, however, as the currency could be heading much lower.

Other Asian markets are also worth owning. For instance, South Korea appears very cheap, at 1x price-to-book, with some world class companies on offer.

Parts of Europe look prospective too. The likes of Italy and Ireland appear both misunderstood and mispriced, particularly the banking sectors.

As for bonds, short-term bonds are safest as they aren’t susceptible to higher interest rates. Long-term bonds in most countries are risky if inflation picks up. The problem is that even if inflation and rates remain low, many long-term bonds offer such pathetic yields that returns are guaranteed to be paltry.

Cash is probably the world’s most hated asset class. People holding cash have lost out big since the crisis. The potential for higher inflation risks even greater relative losses. But I think it’s still worth holding some cash in case that doesn’t happen.

Commodities are an interesting one. They arguably benefit from inflation. My preferences are agriculture, silver, gold, oil – in that order. Industrial commodities should be avoided as their super cycle, turbocharged by Chinese over-consumption, is over.

Other assets which will benefit from inflation should also be considered. In many countries, commercial real estate remains reasonably priced. Official and industrial are be preferred over retail property, given the structural issues facing the latter (with the Internet taking retail market share).

AC Speed Read

-  Market consensus suggests deflation remains the greatest threat to the global economy.

- There are signs though that inflation may be on the way in the US at least, as the labor market there tightens and commodities gather steam.

- There’s an informed view that the US economic cycle is following a typical pattern, which points to soon rising interest rates and inflation.

- We’re not convinced this is a typical economic cycle but think the broader monetary regime remains inherently inflationary and economically unstable.

- Whichever way you cut it, it would seem sensible to prepare for inflation ahead.

That’s a wrap for this week,

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