The Problem With Rosie On Inflation

Before I start I wish to say that I highly respect David Rosenberg at Gluskin Sheff, one of the few mainstream economists to call the crash, and whose observations about the markets are always worth reading.

This morning he came out with a long-term analysis of inflation which I don’t think is right. I urge you to read his commentary, below, but in general he sees one to two years of continuing “deflationary” pressure that favors the bond market and he says “inflation” will be at zero. He then see the beginning of “inflation” as the result of war and the need of government to fund it. The result, he says, will be high inflation and perhaps hyperinflation.

While you would think as a fellow doom and gloomer I would hop on his bandwagon, but for the most part I think Rosenberg’s analysis of the forces behind inflation and deflation are wrong. He uses historical analysis to prove his point, but he doesn’t explain the underlying factors that cause inflation or deflation, which, as I have discussed before, have to do with increases and decreases of money supply by the Fed.

He assumes that Boomers will cut back on consumption and increase savings. I agree and I went into detail on that in my Megatrends and other articles. He says that will result in “deflation.” But deflation is a monetary phenomenon, not a savings problem or lack of consumption problem. We will see deflation because money supply is declining, and it has been declining since late last year.

Rosenberg conflates increases and decreases in prices with inflation and deflation.

Let’s use hypotheticals to analyze this.

Assume we have an economy with a fixed supply on money.

Hypo 1: Assume that from technological advances, the cost of consumer goods decline. That is, people spend less on goods than they previously did. Rosenberg assumes that is deflation. In fact it is a supply and demand factor resulting from economic competition. It doesn’t result in a decline of consumer spending. Since consumers have more money to spend on goods because of technological efficiencies they will spend more and the economy expands.

Hypo 2: Assume that Boomers, formerly big spenders and a significant part of the consumer market, now decide to cut back spending and save more. Retailers will see sales decline. They will lay off workers, have sales to reduce inventory, and hope for the best. It would be safe to say that retail goods will decline in price until supply meets demand. That’s not deflation; it is a supply-demand issue.

You have to ask: what happened to the money Boomers didn’t spend? Was it just locked up in the bank? No.

By saving, Boomers are saying, “We don’t wish to buy stuff right now and we will save our money for future consumption.” They plow money into savings accounts. As a result, interest rates decline because of the influx of Boomer cash into banks. Since consumer goods aren’t selling, that sector of the economy won’t borrow. What happens is that the manufacturers of industrial production goods, or goods that take a long time to make (such as homes), see the opportunity and borrow at the cheaper rate. They spend the money on commodities, machinery, technology, and labor. As the money spreads through the economy, eventually, consumption picks up, manufacturers and retailers of consumer goods see that and order consumer goods. Money is diverted from industrial production to consumer production. This is how recoveries begin. Some prices increase because of demand, others don’t. It’s not inflation. In inflation all prices rise over time because new money, money created out of thin air, is pumped into the economy.

Hypo 3: Assume all of a sudden everyone has $200 in their pockets rather than $100, does that make us wealthier? No. The amount of goods hasn’t changed but we have more pieces of paper chasing them. This is just an increase in money supply. No new wealth was created. One of the results of an increase in money supply (inflation) is that prices go up. If the government could make us wealthy this way, why not just print money? Who needs to be productive? Price increases are not the only result of inflation; many things occur that distort the economy and lead to booms and busts.

Rosenberg associates our current “deflation”, or as he sees it, declining prices, with lack of demand. He never mentions money supply. He assumes that we had low “inflation” in the last several decades because globalization and technology reduced production costs and reduced prices. That is like saying that since computers are dirt cheap today because of competition, that is deflation. No, it is a factor of supply and demand.

He then says that “deflation” will end when the government sees the need to fund its wartime expenditures. He says, “Increased credit demands to fund the war effort combined with the drop in productivity that goes along with blowing everything up is an inflationary stew.” He then says that, as families and the government rebuild their balance sheets, then you’ll have inflation.

I am not sure what he means here. If the government borrows more, there is a crowding out effect which makes credit more expensive for businesses. That would make it more difficult for the economy to expand. But this has nothing to do with inflation. According to his theory this would all lead to less consumer demand because of the resulting decline in GDP and that would be “deflationary.” This is a Keynesian view of the economy.

When you do have inflation is when the government prints money to pay for their expenditures because they feel they can’t tax folks more without getting voted out. The influx of fiat money is inflation. It doesn’t have to be war. It could be the massive entitlement and spending programs recently created by the Bush and Obama Administrations. They borrow to pay for it, but taxes will pay it back. They favor inflation because it makes debt cheaper.

The nice thing about Rosenberg is, that despite his errors, his timing on deflation/inflation might be pretty good. Money supply is now declining which is deflation. In my Inflation-Deflation article, I suggest that since money supply leads the economy by 6 to 9 months, we’ll have deflation and deleveraging will continue. When the Fed is convinced that GDP is declining, then they will pull out the stops and hit the “print” button through Open Market Operations which eventually will lead to an increased money supply and inflation. This monetary inflation will take another 6 to 9 months to impact the economy. So he may be right for all the wrong reasons.

It’s rather disappointing to see this kind of analysis from an economist I admire and follow.

Here is his article:

From Breakfast with Dave, July 28 , 2010

THOUGHTS ON THE LONG-TERM OUTLOOK FOR INFLATION

Let me start out by saying that I do not believe that bonds are any “better” an investment than stocks, at least in principle. They both have their advantages.

For bonds, the advantages are that they provide an income stream – the principal and the interest payments are guaranteed in the case of most government securities; and in the case of the corporate sector, it inevitably comes down to the quality of the credit and the longevity of the company in question. In addition, the yield at the time of purchase is almost always at some significant positive spread over CPI inflation.

Stocks represent ownership in corporations that have assets and strive to make a profit, often paying out a portion of the profit in the form of dividends and retaining earnings to grow the business and increase the dividends in the future.

But the primary purpose of this comment is to suggest what things may look like when the Great Bull Market in Bonds, which began in 1981 with 30-year Treasury Bonds yielding 15.25%, finally comes to its glorious end.

For starters, I think it is safe to say that the bull market in bonds will end reasonably close to the point in time that inflation (or deflation) bottoms. This is because we have determined that by far the major economic factor that correlates consistently with the direction of market-determined interest rates, at least for long term Treasury Bonds, is CPI Inflation (headline and core).

The bond market, like politics, is an emotional issue and not well-liked in general by Wall Street because it has a negative correlation to the stock market most of the time. For a growth bull, the bond is the “enemy”. The economic environment that most favours the long end of the bond market tends to be low or no growth and bonds have traditionally been an asset allocation decision that is bearish on the stock market.

As a result, fear mongering often takes the place of thoughtful and objective analysis when it comes to bond market commentary. One way or another, the long end of the bond market has continually been characterized as high risk for the last 30 years that it has been outperforming the S&P 500. That’s a little unfair – after all, it is the benchmark risk free asset for funding actuarial liability when taken to the extreme of a 0% Coupon Treasury Strip.

Let’s move on and make a sensible and objective effort at making a long-term forecast for core CPI Inflation. Based on our analysis, we could well see core inflation receding from around 1% now to near 0% in the next 12-to-24 months, which would imply an ultimate bottom in the long bond yield of 2.5% and 2% for the 10-year T-note. We should add that as long as the Fed funds rate remains at zero, reverting to a normal shaped Treasury curve would generate similar results for the long bond and 10-year note at the point at which the inevitable “bull flattener” reaches its climax. As we saw in Japan, this will take time, but yields at these projected levels will very likely come to fruition in coming years.

So what will be the cause of the next secular uptrend in inflation or hyperinflationary shock? It pays to look back at history. Prior to the inflation of the 1970s-early 1980s, periods of very high inflation were primarily associated with war. Increased credit demands to fund the war effort combined with the drop in productivity that goes along with blowing everything up is an inflationary stew.

Wars were typically followed by brief periods of deflation followed by stable prices until the next war. In the 1970s several factors other than war led to the brief bouts of hyperinflation and they are much debated. What is perhaps most important to recognize is that whether it is war, OPEC or rampaging Baby Boomers, history supports the notion that high inflation, at least at the core CPI level, tends to occur in brief bouts.

A quick look at the core CPI chart shows that for all but a brief period since WWII, inflation has been well below 5%. But it was the period from 1970 to 1980 that contained all readings above 5%. Coincidentally, this was the period in which the Baby Boomers were buying their first refrigerators to go along with a bungalow as they formed their households.

By 1983, core CPI was back down to 5% and never looked back, but the psychological damage was already done. Inflationary expectations were indelibly etched into the mindset of the Baby Boom cohort. So everyone positioned themselves for inflation by leveraging up their asset purchases. Inflationary expectations were the rationale for overconsumption and depleted savings rates.

What resulted was an interesting dichotomy. Asset prices inflated during the 1980s, 1990s and into the 2000s. Although the secular bull market in equities ran out of steam early in the last decade, most other asset prices (particularly residential real estate) went parabolic into the peak of the secular credit cycle in 2007.

Core CPI on the other hand, has been continually slowing since the peak of 13.6% in 1980 and even at the peak in the ratio of household debt to disposable income in 2007, was running no higher than 3%. Unlike geopolitical disruption or demographic shocks, asset bubbles and the credit cycle tend to have an important secular behavioral impact on society and therefore, the economy.

The credit collapse of the 1930s around the globe dramatically altered social norms related to consumption, speculation and saving. Those who were adults with families in the 1930s shunned debt and believed in “pay as you go” for the rest of their lives. By way of comparison, the inflationary shock of the 1970s enticed the Baby Boomers into a spending and speculative binge. Rather than save, they executed a failed strategy of speculating their way to a dignified retirement.

Now the clock has run out and household behavior is poised for a dramatic change. If the 55 year-old Boomer resolves to work longer and harder, cut the budget to save more and liquidate debt, can we really expect the politics to maintain the status quo? This type of behavior from the developed world will exert enormous deflationary pressure. In addition, the huge amount of debt and entitlement expansion that has occurred at the government level, particularly in response to the financial crisis, will be an enormous drain on economic growth as taxes are raised to service the debt and budgets are dramatically cut.

For this reason, it is appropriate to consider the possibility that the next secular uptrend in inflation must await the rebuilding of the household and government balance sheets to levels that launched the last uptrend. That, by the way was about 30% debt to disposable income in 1950, 60% in 1970, and realistically, it could take a generation to get back to that range from current levels of around 125%.

The outlook is not entirely dependent on the behavior of the developed world’s consumers and governments, however, if we are really trying to envision the next 20 years, the emerging market consumers (in places like China and India) have extremely low debt levels and high savings rates. Changes in emerging market consumer behavior should be, on balance, a source of counteracting inflationary pressure. Then again, the forces that most contributed to disinflation in the last three decades were globalization and technological innovation that lead to dramatic improvement in productivity and lower unit costs.

There is no reason to doubt that these forces will continue to be moderately supportive in the near future, even if higher marginal tax rates and reduced labour mobility (due to the fact that one-in-four Americans with a mortgage have negative net equity in their home and are thus “stationary”) end up constraining the noninflationary growth potential in the United States (and Europe).

While the disinflation from 1980 to 2007 was mostly supply-side related, the deflation pressure now is coming from the demand side – a deficiency of aggregate demand caused principally by the contraction in credit (40% of the private market for securitized consumer and mortgage loans has vanished over the course of the past two years).

So, putting it all together, it is reasonable to conclude that prices are most likely to be stable for a generation. By stable, I mean flat and perhaps oscillating around plus or minus 2% (look at Japan, where there has been no such downward price spiral – the CPI sits right where it was 18 years ago). Because the economy is still gripped with overcapacity in several sectors, real estate and labour in particular, we may be headed towards an outright deflationary backdrop over the near- to intermediate-term, but a deflationary spiral seems overly pessimistic considering all the good things in the mix, including a reflationary policy backdrop which certainly helped establish a price floor in Japan in recent years.

That said, a “V” shaped recovery has always been off the table from our perspective because we still have so far to go in the secular credit collapse, so all the balance sheet expansion that the Fed has done and will do in the future should continue to offer up little more than an antidote. In turn, a reversal of CPI or core CPI trend to the upside for the next couple of years seems like a low- probability event, particularly given the demographic and retirement pressures that increasingly favor savings over spending in the broad consumer sector.

And what about the end of the Great Bull Market in Bonds? It could come pretty soon. You heard right. Long-term Treasury Bond yields could reach a secular bottom in the next couple of years. And what will it look like?

Well, rates will likely be much lower than anyone expects and, as typically occurs at secular market peaks, the public will probably swear by long bonds at the primary lows in yields. After all, what other safe investment has delivered inflation plus 2% or much better, guaranteed, in the past 30 years? But in order for the public to adore 2.5% yielding long Treasury Bonds, it will first have to believe in stable or modestly deflating core CPI as a long-term forecast. At last count, households still have a near-3% long-run inflation expectation according to the most recent University of Michigan survey.

The public will also need to be fed up with risk and, judging by the performance of stocks and real estate in recent years, who could blame them? And for the Baby Boomer at 55 or 60, “Gambler’s Ruin” isn’t an option. We can see that they are already voting with their feet as the mutual fund flows clearly indicate – increasingly towards income and away from capital appreciation strategies.

Finally, the public will probably need to be afraid to be out (of the bond market, that is). That will most likely be due to a “flight to quality” as we continue suffer the secular bear market in stocks and real estate and suffer the economic setbacks of renewed recession sooner than many pundits think.

One last thought on stocks: Like I said before, bonds are not better than equities. They are different. Every asset class has its time to be the leader. It goes without saying that the best time to allocate to equities is at the point of maximum pessimism and when the market is trading very inexpensively as it was at previous post-war secular bear market bottoms.

We know that historically, that “moment” has coincided with valuations below 10x on trailing “reported” earnings and dividend yields above 5% as measured by the S&P 500 Index. Note that while many a pundit cites the consensus as being $96 EPS for “operating” earnings for 2011, it is closer to $76 on a true “reported” basis (so apply a 10x or even a 12x multiple on that estimate!).

We also know that the conventional wisdom is oh, so wrongly linear at inflection points, so not only is the market cheap at these secular lows, but the future is much brighter than generally perceived. Pulling the trigger at that magic moment when bonds have peaked (yields have bottomed) and stocks can’t hurt you anymore, with dividend yields secure at twice the Treasury rate, would be nice. But you never know for sure at the right time, or you think you know for sure but are too early.

For now, we are not even close. Sentiment toward long bonds and inflation are still extreme and recent survey data show the typical balanced institutional portfolio manager with a 68% allocation towards equities. As for bonds, the yield on 30 year Treasury was recently core CPI plus 3%; 4% for a BBB corporate bond; and a 6% real yield in the BB space. The S&P 500, meanwhile, sports a P/E multiple of close to 15x and the dividend yield is barely over 2%.

In this light, it would seem highly appropriate to maintain a SIRP – Safety & Income at a Reasonable Price – strategy for the near- and intermediate-term, while keeping a close eye on the exit plan from this recommendation, though that could still be a few years down the road.