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PCE Deflator points to equity market sell-off in 2014

16 Dec

The Personal Consumption Expenditure (PCE) Deflator is a United States-wide indicator of the average increase in prices for all domestic personal consumption. Along with the CPI, it is commonly used as a measure of inflation.

The PCE has very rarely dropped below 1.0%. Global macro-economic forces, however, are pushing the PCE down towards a very dangerous level. As countries battle to devalue their currencies they become more competitive as their goods are cheaper for foreign consumers to purchase. This cheapening of goods leads to downward pressure on the average price of goods.

The recent devaluation of the Yen has is a good example of how this is affecting prices in the US presently. The drop in the Yen has substantially increased the competitiveness of Japanese manufacturers in global trade. As Asian manufacturers struggle to retain market share they also drop the prices of their USD goods. This compounding effect raises serious issues for importing nations such as the United States as their manufacturers become less competitive and consumers become accustomed with the idea that goods will continue to cheapen, hence preferring to save for when they are cheaper than to invest and buy goods today.

The chart below shows that the PCE deflator (in blue) has been dropping consistently for the past 20 months. The yellow line shows the 5-year breakeven rate, a measure of the market’s future expectation of inflation, in this case in five years’ time. The breakeven rate shows that the FED has, so far, been very successful at buoying the market’s expectation of future inflation by promising to keep monetary policy very loose for a long time.

PCE Deflator

The issue, however, is that the enormous quantity of money printed by the FED is not making its way down to consumers. Instead, it has inflated equity markets and created the largest credit market bubble in history. At some stage the perception of the FED’s efficacy in easing will fade and inflationary expectations will fall to more realistic levels.

Equity markets on the edge of a precipice

This could cause a serious re-rating of equities as market participants set more realistic expectations of companies’ future earnings.

The chart below shows that inflationary expectations tend to move in sync with equity market movements.

Breakeven vs SPX

Unfortunately, as seen in the previous chart, inflationary expectations tend to follow the PCE deflator which is most certainly on a downward trajectory.

George Magnus, the well known economic consultant and former chief economist of UBS, recently wrote an interesting article in the Financial Times link highlighting the risks of ever richer equity markets fuelled by monetary easing in a world facing anaemic growth.

Investors should always expect return when taking risk. The current environment doesn’t offer a very rewarding environment for risk takers. Savy investors would be wise to take profits and watch the events unfold from the sidelines.

High Yield Bonds: The End Of a 25-Year Bull Market

13 Dec

High yield bonds are debt securities rated as below investment grade, i.e. BB or lower and therefore more likely to default than investment grade companies.
Issuers of high yield bonds may include start-ups, publicly listed or unlisted companies, highly leveraged firms that may be managed by private equity funds and capital intensive firms.

High yield bonds emerged in the 1980s as an attractive instrument to finance leveraged buyouts. Investor appetite increased over the period as interest rates fell as inflation was brought under control.

The market capitalisation of the high yield market is over $1.1 trillion, with 60% of issuers in the US. Most bonds are issued with an 8-10 year maturity with call dates attached, that allow the company to redeem the bonds earlier.

High yield at record exuberance

High yield bonds have experienced an unprecedented rally since their yields peaked at 23% in early 2009. Morte interestingly , however, is the extraordinary performance of high yield bond over a 25 year period:

HYields

While lower interest rates have substantially aided the reduction in absolute yields it is important to note that even on a spread basis high yield spreads are back to record levels, under 300bps.

HYspreads

One big mess

The outlook does not bode well for investors: High yield bonds have rallied substantially since 2009 and have become a mainstream asset class; yields are lowest on record and credit spreads are near all time lows; credit quality has deteriorated as highly leveraged issuers and private companies have come to market; average maturities are rising as companies take advantage of low long term rates and the potential upside has all but diminished as interest rates are unlikely to drop any further and spreads are unlikely to drop fall below current record levels.

As the 25 year high yield party comes to a close one thing is certain: investors stuck in the asset class will suffer substantial losses.

Move aside Bernanke. Bank of Japan blows away expectations with its boosted QE

5 Apr

On April 4th the Bank of Japan announced an enormous shift in policy and the largest monetary injection ever announced by a major Central Bank. The new governor, Haruhiko Kuroda, had been expected to come up against opposition from other policy members who had been tied to the BoJ’s previous philosophy on monetary policy. The reaction was so surprising not only because of the scale of action in itself, but also because of the approval Mr. Kuroda received from all but one of the nine board members.

The flood gates are not just open, they have been blown away.

In order to change the deflationary expectations so ingrained in the Japanese psyche only a major boost in asset and consumer prices would suffice. This is exactly what the BoJ is trying to do. By committing to doubling the monetary base over the next two years from 29% to 55% of GDP (Y135tn to Y270tn) – an increase of a over 1% of GDP per month compared to the Fed’s 0.5% – the BoJ has very dramatically stated that inflation will no longer elude Japan.

The effects to equity, bonds and the Yen should be sizeable. Indeed, we have already seen a sudden drop in the Yen and, more importantly, a dramatic fall in bond yields of longer duration (up to 40 years), where the BoJ is attempting to remove duration risk from the private sector, hence encouraging investment in real assets. Equities should continue to surge as capital flows away from the bond market but investors should be very wary of inflationary expectations. Should bond yields start to rise the great monetary experiment could very easily end in disaster.

Party while the music plays but beware that the endgame for Japan has been brought meaningfully closer than ever before.

What is inflation?

4 Mar

For those of you wanting a fantastic overview on inflation and what effects it can have on society, you must read Culture and Inflation in Weimar Germany.

Here is a short summary what inflation means:

In economic terms, inflation is a measure of the change of prices for goods and services over a period of time.

Different measures of inflation track different goods and services to give consumers and producers an idea of how the overall price of goods and services they use changes over time.

The three most frequently used measures of inflation are:

  1. The Consumer Prices Index (CPI)
  2. The Retail Prices Index (RPI)
  3. Producer Price Index (PPI)

The objective of all these measures is similar but each will vary slightly and, in different countries, their calculation might also vary a little.

CPI, for example, typically takes into account cheaper alternatives if a specific product get too expensive whereas the RPI does not, hence why CPI is usually lower. In the US CPI includes certain housing costs such as rent whereas in the UK, while RPI takes into account mortgage interest payments and council tax, CPI does not.

In the UK the measures of inflation are calculated by the Office for National Statistics and in the US by the Bureau of Labor Statistics.

Is inflation bad?

It depends who is asking.

Simply put, inflation will erode the purchasing power of your money over time. For example in 1970 $10 would have bought you over 16 Big Macs whereas today it barely buys you 2.

In more general terms, $100 in 1970 had the same buying power as almost $600 today. The Bureau of Labor statistics has an entertaining CPI Calculator to measure how much purchasing power the dollar has lost over time.

So is inflation bad?

As a saver, unless you are able to achieve a level of return equal to the level of inflation, your purchasing power will be eroded over time. Typically, interest rates will be higher than inflation meaning that investors are able to achieve a real return on their cash – i.e. a return, net of inflation, that is positive.

However, in today’s zero interest rate environment, with inflation running at approximately 2%, cash savers will get a negative real return of 2% – i.e. their purchasing power will decrease by 2% a year.

Savers are therefore forced into seeking real returns into real assets that entail risks (such as equities, property etc.) if they are to stand any chance of achieving a positive real return. Not great. But this is exactly what the Federal Reserve is trying to get people to do. By keep real interest rates negative, they force savers into investments that, they hope, will kickstart the economy once again. A risky strategy, but more on that later.

Is inflation good?

As a borrower inflation can have its advantages so long as it does not impact your ability to repay your loan.

For example, let’s assume you get a 30-year $100,000 mortgage to buy a house today. For every year that inflation erodes the value of the dollar, the size of your debt – in real terms – falls. Just like the example above, we can assume that if the next 30 years experience similar levels of inflation to the past 30, the real value of your debt will have fallen by approximately 60%.

Mortgages are usually structured to be paid monthly rather than at the end of the term, so the average fall would be closer to 30%, but the example illustrates very clearly that inflation can aid those who borrow in nominal terms.

I wonder why the Fed would want to spur inflation at this moment in time..? I’m sure it’s got nothing to do with the $16.5 trillion in nominal debt owed by the US government…

Does money printing really affect the price of gold?

28 Feb

Yes. Economic theory would suggest so and the proof appears to back the theory.

The quantity theory of money asserts that changes in the quantity of money cause a proportional change in the price level, expressed as:

MV = PT

Where M is money, V is velocity, P is price level and T is trade. PT combined would therefore  = GDP.

Economists are all fighting over whether QE will ultimately lead to inflation. I believe it will but it is fair to say that a huge number of factors affect the CPI, and it isn’t as simple as it sounds.

So let’s simplify it. Let’s just look at whether QE could lead to gold price inflation. Given both gold and the dollar are units of currency, one can simplify the equation to M = P or 1 unit of USD = 1 unit of Gold. Given that gold can’t be printed, a doubling of ‘M’, for example, should lead to a rise in P. i.e. P = 2M or 1 unit of gold now equals 2 USDs.

Has gold been rising with money supply?

The chart below shows the US Monetary Base overlaid by the price of gold going back to 1960. Given the dollar was taken off the gold standard in 1968, one would expect some deviation between the two series, but the correlation is still very striking.
US monetary base vs Gold
(Source: Bloomberg)

Another interesting chart looks at the size of the Fed’s balance sheet. The white line shows the staggering expansion of the Federal Reserve’s balance sheet which has expanded by US$2.5 trillion since 2007. To put this in context, it took almost 100 years for the Fed to build its balance sheet to US$0.9 trillion and it then almost tripled this in the last four years.

However, if we look at the Fed’s balance sheet in gold terms (orange line) we can see that it hasn’t actually expanded by anywhere near as much. In fact it’s about the same size as it was back in 1997!

Fed Balance sheet price in gold
(Source: Bloomberg)

Unemployment remains high (U6 unemployment remains at 14.4%) and the economy is yet to recover. No, we haven’t even mentioned sequestration yet. The Fed will not be stopping QE any time soon and gold’s upwards trajectory is therefore unlikely to deviate too far from the trail of the US’s highly expansive monetary base.

Don’t be fooled by the FOMC minutes. QE isn’t going away quite yet.

25 Feb

Last week’s minutes from the FOMC’s January meeting showed divided opinion on the effectiveness of QE and how much longer it should be employed for.

But reading between the lines we can get a clearer view as to why the minutes drew attention to the split and what the resulting policy going forward may be.

Why the attention on the costs of QE?

Esther George, president of the Federal Reserve Bank of Kansas City, voted against continuing asset purchases at the central bank’s January meeting out of concern about “the risks of future economic and financial imbalances,” according to the minutes. Prices “of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels.”

Farmland in the Midwest was up 16% in 2012 (Iowa saw prices rise 20%), according to the Federal Reserve of Chicago, the third largest annual gain since the 1970’s.

Fed Governor Jeremy Stein is concerned with corporate debt as yields reach record lows, driven ever lower by investors seeking any form of yield. Equity markets have seen a significant rise, the S&P 500 is up almost 40% since October 2011, raising questions as to who is benefiting the most from the Fed’s ultra-loose monetary policy.

So what is the message between the lines?

In 2010 Janet Yellen  was asked to chair a new FOMC communications subcommittee to focus on central bank transparency to minimise confusion over Fed policy.

But its purpose extends far beyond that of providing markets with a transparent message. Instead, it has allowed the Fed to utilize communication as a further tool;

Communicating that certain members are concerned by specific financial imbalances enables the Fed to highlight that it is aware of these imbalances and can act if it needs to. Emphasising this concern can, they hope, dampen excessive speculation in certain areas without affecting the overall policy objective of maximising employment while maintain price stability.

Unemployment remains persistently high. The Bureau of Labor Statistics U6 unemployment figure, which unlike the reported unemployment number (U3), includes discouraged workers and those who would like to work, either full-time or part-time, but cannot due to economic reasons, is at 14.4% – some 40% above the long term average (see chart).

US unemployment U6

(Source: Bloomberg)

Inflationary expectation remain subdued. The attached chart, published in The Economist, shows that 10 year breakeven rates remain low, although Japan has seen a meaningful rise since 2011.

Breakeven rates

(Source: The Economist)

The message remains clear: until proof begins to emerge that economic figures truly reflect an improvement in the economy we will see very little change from Fed policy. Unless you believe that the fed’s communication tool can effectively dampen asset price bubbles, risk assets have some way still to go.

FOMC divided on when to end purchases

21 Feb

The minutes of the FOMC Jan 29-30 meeting show divided opinion on when to end asset purchases.

A ‘number’ of participants believe the costs of QE would materialize before the benefits, while ‘several’ participants argue that the risks of ending QE prematurely are very high.

End sooner?

The debate does raise important questions as an early scaling back of QE could materially affect a number of markets. Bond yields and mortgage rates are at or near historical lows, aiding businesses requiring financing and home owners who can refinance mortgages or purchase properties very cheaply. This ultimately helps drive a recovery in the housing market, a vital component to the health of the economy . Equity markets have also rallied significantly, boosting consumer confidence and sparking a revival in M&A, as seen recently by Mr Buffet’s recent acquisition of Heinz.

Maintain asset purchases until unemployment drops?

The ‘cost’ of QE, raised by a number of the committee, refers to the impact on future inflation that printing money is likely to have.

US inflation at 1.7%, at first, should not cause great concern. But the FOMC participants know how quickly expectations can change if central banks are seen to be irresponsible with regards to price stability, a significant objective of the Fed’s monetary policy.

It seems the Fed is stuck between a rock and a hard place and the debate will continue for some time yet. Participants will ultimately be forced to make the least worst decision.

Given Mr Bernanke’s lifelong focus on analysing the causes of the great depression, it would be a great surprise if the Fed did prematurely end asset purchases. QE, after all, is part of Mr Bernanke’s detailed and meticulous plan to ensure that we never return to the deflationary depression of the 30’s – Read here Bernanke’s 2002 speech.

His plan may well work, but at what cost?

Keep an eye on the FOMC minutes this Wednesday

18 Feb

Fed minutes from the meeting of January 29-30 are released this Wednesday.

Markets will be focusing on whether there will be any mention of future plans for ending purchases.

This seems unlikley, however, given the persistently elevated level of unemployment and subdued inflation numbers. CPI is also out on Thursday with consensus estimates for inflation to remain at 1.7% in the US.

Let us know what you think.

Trust, hyperinflation and the end of the dollar

13 Feb

Economists love debating the reasons for inflation. Many argue that money supply alone can result in inflation, whereas others believe it is down to capacity constraints in an economy or advancements in technology. The reality is that the causes of inflation are immensely diverse and one reason is never the sole contributor, nor is there a unique common cause of inflation in previous hyperinflationary times.

Instead, hyperinflation is typically caused by a very severe exogenous shock, that then usually forces policymakers to take overly aggressive action in order to overcome their difficulties.

War, the collapse of regimes and currency pegs all feature as severe shocks in previous cases of hyperinflation. Clearly we have none of these yet, but the credit crisis was as close to a severe shock as one could possibly imagine. And how have policymakers responded? Br printing money. We are now 5 years into the crisis and the rate a which central banks globally are printing money is only accelerating.

So why haven’t we seen hyperinflation yet?

It takes time. For the last 40 years Monetary supply in the US (M2) has been growing at an average pace of about 6.75% a year vs. average annual inflation of 4.3%. Clearly the increasingly efficient economy and advancement of technology of the past 40 years have been deflationary enough to keep the CPI below money supply. John Edwards, of Shadowstats, argues that M3 is a better indication of inflationary expectations but sadly the US stopped reporting this some years ago.

m2 and cpi

In any case, if we overlay the monetary base chart over the M2 chart, it is clear that 4 years ago these decoupled SUBSTANTIALLY! This is the effect of QE which has essentially flooded the US monetary base with newly created dollars. It takes time but this will eventually feed through to M2.

monetary base and m2

As it does feed through, prices have to re-adjust (i.e. rise) as people’s perception of the value of that currency diminishes. As trust in a currency’s value disappears, so do people’s willingness to hold onto it, opting instead for alternative currencies or real goods such as property, gold etc, once again compounding the effects of rising prices. And so the spiral goes.

I have no doubt the FED intends to halt QE before we get close to this. But as every episode in history has suggested once the floodgates are opened it is very very difficult to close them again.

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What is the United States inflation rate?

6 Feb

The Bureau of Labor Statistics reports the CPI-U index. The reported end December number of 1.7% tells us that the price of goods and services has increased by that much over the past year.
Interesting, but it doesn’t tell us much about the future rate of inflation and therefore how it will affect our future purchasing power.

A better indicator of future inflation, one that the Federal Reserve keeps a close eye on, is the 10 year breakeven rate. The breakeven rate is a measure of the expected rate of inflation over a certain period of time. It is calculated by measuring the difference between the nominal yield of government bonds and the real yield of inflation linked government bonds. In this case, the 10 year bonds.

The expected rate of inflation for the next 10 years shows that investors expect inflation rates to rise from 1.7% to 2.6%.

This doesn’t appear at first to be a big change, but as the chart below shows, 2.6% is as high as inflationary expectations were before the crisis, when the economy was growing at a speedy rate and unemployment levels were low.

US inflationary expectations

Given that the economy is stalling and the unemployment rate is at 7.9% what other factors could explain this rise in inflationary expectations?

One likely cause is the FED’s QE program, which has expanded its balance sheet by US$2.5 trillion since 2007. To put this in context, it took almost 100 years for the Fed to build its balance sheet to US$0.9 trillion and it then almost tripled this in the last four years! This new money has essentially been created out of thin air and, as it continues to find its way into the real economy, its effects will increasingly be felt by consumers. The simple economic principle of prices being determined by supply and demand tell us, very simply and elegantly, that once the supply of dollars increases so substantially, surely its price must fall. Or in other words, the price of good relative to the dollar must rise considerably to balance the oversupply of dollars.

Inflationary expectations could rise considerably from here. Watch this space!

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