Investment Ideas for an Inflationary Environment 27 comments
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Over the past several weeks I have posted a number of comments to SA posts on this subject. I have been urged to write my own article to get a wider audience and generate more discussion.
Over the past decade, a lot of money has been printed. It was not printed by the U.S. Treasury but in the form of debt instruments by investment banks and others. These debt instruments (which were not subject to any regulation or oversight) became currency which was spent on commodities, stocks, bonds and real estate, including houses. Because this new currency was so plentiful, all of these things had their prices inflated to bubble levels. When a few of the debt instruments became subject to default, a wide range of debt came into doubt and the liquidity of this manufactured currency dried up - financial institutions became reluctant to recognize that it had the value previously assumed. The new currency was no longer working the way it had been and demand for the inflated items (commodities, houses, etc) began to fall. When demand falls, and the supply remains constant (or increasing), prices fall. Falling prices produces additional default and we end up in a deflationary spiral.
The magnitude of the debt pyramid is in the tens of trillions of dollars. With the deflationary spiral, the notional value of the debt instruments is still at the high level, but the exchange value is falling as the underlying assets decline in value. The result is that, based on the exchange value, balance sheets of financial institutions go negative. They are forced to raise more capital or go bankrupt. Only a national government is able to continue in business with a negative net worth, although many will question for how long.
So the action that national governments take (with the aid of their central banks) is to take on more sovereign debt and print additional currency to provide liquidity to the otherwise bankrupt financial institutions. To do otherwise would put the entire financial system out of business via bankruptcy. The effect of the newly minted money is initially to supply capital to the reserve assets of the otherwise failing institutions. This money replaces the assets formerly on the books which have been diminished as described above. The money does not go into general circulation; it simply replaces money already spent on the inflated bubble assets. Since these assets are now worth less than before, the new money simply disappears into a "black hole" - it replaces the money represented by the lost value.
Through lack of regulation, people were allowed to spend money that didn't really exist. Now we are printing that money and it can not be spent again.
If not enough money is printed to replace the trillions of lost value in the debt instrument "currency" that was used to create the bubble valuations, the deflationary spiral continues. If more money is printed than is necessary, inflation will result from the excess money. Big problem: No one has a clue how much money will be enough.
I have suggested that the tipping point between not enough new money and too much new money is like a knife edge, rather than a balance beam or some other broader platform. A major challenge is to keep from falling off the knife edge. It may not be possible.
How does one invest in this environment? Here are a few ideas for falling off on the inflation side:
- Short the U.S. dollar. One vehicle is UDN. Another is FXY, long the yen/dollar pair.
- Buy commodities such as metals and oil. Some possible vehicles are stocks, such as PCU, BHP, FCX, RIG and PBR; and ETFs such as UYM, XME, USO, DIG and PXE.
- Short treasuries. Some vehicles are ETFs such as PST and TBT. Those with margin accounts can short TLT.
- Buy commodity-rich countries via ETFs such as: EWZ (Brazil), EWC (Canada) and EWA (Australia).
What is the timing for these moves? Do not rush. If we move into inflation it will be a multi-year trend and the trend has not started. The one area that is definitely worth nibbling at is shorting treasuries. (NOTE: I said nibbling – not gobbling.) Treasuries may continue to move higher but yields can not go below zero (I hope). The upside for treasuries is therefore limited, but the downside is huge. Those among us that are old enough have seen T-bill yields in the high teens and 30-year treasuries at 13-14%. That would be a horrendous collapse from here if it occurred again. If and when such a collapse starts will be time enough to start gobbling up the short positions. Try to be content to get the middle 50-60% of the move in a big way. It is too risky to try catch all of the move with a lot of your capital.
Other moves? In the first quarter of 2009, start nibbling at EWZ, EWC and EWA. These countries’ stocks are currently under extreme pressure by hedge fund selling, which will largely end by December 31, 2008. Start buying UDN when the dollar index drops below 84 (currently 85.76), buy some more at 82 and more at 80. I like to use 5% trailing stops on currency positions. Finally, I recommend leaving the commodity buys for the final leg of the strategy. A good point to start buying is when the CRB Industrial Index rises above 375 (recent value near 350).
If we stay in deflation, cash is king. The value of the dollar will continue to rise as long as real assets fall in price.
Disclosure: No current positions in any securities mentioned (except cash). I (and/or clients) have held all of the mentioned securities in the past and will probably buy again in the future.
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This article has 27 comments:
A question on the basic premise. If the money being printed is just replacing the now valueless wealth created on institutions balance sheets how is that inflationary?
"Global demand for oil will rebound in 2010-2011 and prices may then exceed their peak levels of July 2008, the chief economist of the International Energy Agency (IEA) said on Thursday."
Inflationary times are arriving faster than most people expect.
What is your definition of inflation then, if not rising prices?
That is what the Fed is doing now.
Now if my son continues to smoke pot hoping that I will keep signing his IOUs and the drug dealer doesnot trust my IOUs what does my son do?
He will have to get a job and quit his bad habits.
This is what Americans need to do. Fed needs to stop signing these IOUs and citizens should stop spending if they donot have money and learn to save.
My proposition is that no one knows what is the right amount of newly minted dollars to just exactly fix the balance sheets because the value (or loss of value) for these credit instruments is uncertain. That is why I use the analogy of a knife edge. Too little money is printed and we remain under deflationary pressure. Too much money is printed and we have new inflationary pressure. Exactly the right amount will be very difficult (impossible?) to define.
Yes, TIPS would be a good holding in an inflationary trend. I am sure readers will be able to add other good vehicles for inflation.
You are both correct. An example of decoupling of inflation from oil prices was seen in 2008. Oil prices nearly tripled within a year's time (and other commodities spiked), but inflation was effected very little (about 1% increase) because of simultaneous deflationary pressures (falling real estate values, lack of credit and declining real personal income, to name three).
At other times, most notably the 1970's, massive increases in oil prices fueled a period of double digit inflation.
When Volcker raised interest rates to 20% to kill early 1980s inflation the result was recession because the cost of an input to ALL prices--the cost of money--was too high. Oil prices function the same way because oil fuels virtually 100% of the transportation sector and virtually all goods are transported.
Oil and money are inescapable component factors in all prices. When either of these gets too high they draw too much of an economy's spending power into their maw and crowd out spending on everything else. This unbalanced state manifests as a recession.
this is a global problem/action plan. beyond CRB, any other global indicators to watch?
Thanks for your prescient comment. A primary input to the inflation Volker was fighting was the tripling in the price of oil in the 1970's. Today, our service economy is much less sensitive to energy costs. You correctly point out that transportation costs will inflate with higher oil. You didn't mention it but food also has a high energy cost component in production, as well as transportation to markets. However, oil does not have as high an impact now as in the 1970's because a smaller percentage is used in maufacturing, which is a comparatively inelastic demand. Personal consumption has more demand elasticity and today that component of consumption is a larger percentage of oil usage.
This is born out by the small inflationary response to oil going from $60 to nearly $150 in a period of approximately one year.
One other thought, maybe you are too optimistic when you refer to ANOTHER recession if oil spikes again in 2010-2011. There are some more pessimistic outlooks that propose a 2-3 year recession is possible. In that case your next recession would be merely an extension of the current one and many would call that depression.
On Nov 28 12:32 PM derryl wrote:
> If oil spikes again beginning in 2010-2011 there will be another
> recession, no matter how far the recovery is advanced by that time.
> The US cannot possibly convert off oil to any significant extent
> in that timeframe so the US will still be import dependent.
>
> When Volcker raised interest rates to 20% to kill early 1980s inflation
> the result was recession because the cost of an input to ALL prices--the
> cost of money--was too high. Oil prices function the same way because
> oil fuels virtually 100% of the transportation sector and virtually
> all goods are transported.
>
> Oil and money are inescapable component factors in all prices. When
> either of these gets too high they draw too much of an economy's
> spending power into their maw and crowd out spending on everything
> else. This unbalanced state manifests as a recession.
>
>
I'm not so sure about your reference to credit default swaps and derivitives as alternative currencies, and that money has thus been "printed" like crazy. If we don't draw the line somewhere, insurance policies, stocks, and bonds might be fit into such a definition of money! I prefer to look at M1 (up over 10% YTD) and consider everything else to be activity measures. To say that the expansion of the mortgage and credit default swap businesses amounts to the same thing as a government printing currency notes is confusing and I'm sure someone from the gold standard camp will soon chime in on how this means inflation will obviously hit 50% next year.
Banks and insurance companies underwrote bad loans and bad contracts. The losses from these mistakes resulted in reduced availability of loans, which resulted in reduced business activity nationwide, which resulted in fire sales of inventory, unwinding of carry trades, and unwinding of commodity contract and investment trades. All this made even more loans and CDS's default in a downward spiral. Most people now agree that such a situation requires a Keynesian attempt at stimulus, but as you point out, the question is how much.
I am reassured that "helicopter" Ben has the tools needed to prevent deflation. That's where the printing press comes in handy - but there are other, more powerful tools too such as treasury auctions. The question is, when they overshoot and create too much M1, how quickly can they sell enough treasuries to absorb all that excess? Aren't they already selling treasuries to finance the bailouts/stimulus/wars and isn't this counterproductive? Can they reduce M1 before inflationary expectations set in?
I suspect that these questions are why your recommendations are for the inflationary scenario.
Thanks for making some good points.
Let me explain my basic premise: debt is a form of money. When a bank issues a mortgage, it is in effect creating money. This is because, in our fractional reserve system, only a small fraction of the loan is required to actually be held in "real money" by the lender. Thus, for $100 of U.S. Treasury money in reserves, the bank can release much more currency into the economy, say $1000.
Now let's look at the bank's balance sheet. It now shows as assets the $100 reserve plus the $1000 lent. On the liability side it has the $1000 it created. As the loan is repaid the assets change by tracking the unpaid principal value, which is declining over time, and by adding retained interest earnings. On the liability side, the debit of created dollars is diminished as the loan is repaid, exactly equaling the corresponding decreasing asset. In otherwords, the money the bank created with the mortgage disappears as the mortgage is repaid.
A major problem arises when the mortgagee defaults. Now the asset is diminished but the liability is unchanged. If the mortgaged asset can not be sold through foreclosure for a major portion of the outstanding principle, the bank can become insolvent: liabilities exceeding assets.
Now, if the Fed or the Treasury come to the rescue by printing some treasury currency or issuing treasury debt to recapitalize the bank, this money goes into the required bank reserve to recreate a positive net worth. It does not go into circulation except to the extent that the bank now has reserves again and can issue more debt. However, chastened by its close call with death, the bank will now be much more cautious in issuing more debt.
Now, let's recognize that our current financial structure is so complex that this simple example of a mortgage gone bad is too simple by orders of magnitude with so many zeros before the decimal point (of the magnitude multiplier) that I can't estimate the magnitude. In such a complex system, how does the Fed and the Treasury know when it has printed enough dollars to exactly give the recapitalization dollars needed and no more? Answer: The government looks for the flow of credit in the financial markets. Because of new-found risk aversion, lenders are now more concerned with survival than profit. Reserves are accumulated against possible future defaults of other previously issued debt rather than creating new debt. The government does not see the desired increase in credit needed to stimulate the economy, so it prints more money. Eventually (and eventually is sooner rather than later), the flood of money is so great that the risk aversion dam breaks and the flood spreads into the economy.
The knife edge target of just enough money is very difficult (impossible?)to hit. That's why I am starting to line up my high inflation investment ducks.
You ask if creating this over abundance of money is counterproductive. The answer is yes. But, failing to create enough to recapitalize the bank is worse than counterproductive; it is destructive. If this destruction occurs for the entire financial system structure, the result is apocalyptic and we basically start over. We came close to this in the Great Depression. No one wants to go there again, because this time it would be far worse because national debt is so large and could not be serviced in the absence of a functioning economy. It would also be much worse as a personal experience because the subsistance dislocations would be more severe. We have a much smaller percentage of the population in a position to live off the land - the family farm and substantial rural population has become history.
To survive as a society and a nation, inflation is the preferable ogre and I'm quite sure we will go there because the "just enough new money" target is not likely attainable and we can not afford entrenched deflation. Inflation enables a monetization of the national debt, creates a managable (although unpleasant) burden for most segments of our society and avoids the specter of total collapse.
The far side of this has been lived through before. Paul Volker was the high priest who exorcized our last inflationary cycle. Prepare the way, we may need a new high priest in the coming years.
In the meantime, enjoy any benefits you can salvage from deflation because I don't believe that, when we miss the knife edge, we will end up on the deflationary side.
An excellent resource is data published by the Economic Cyclic Research Institute (ECRI):
www.businesscycle.com/.../
Steve Hanson (also known as "The Hand") has some excellent posts on Seeking Alpha discussing ECRI data and related items. A recent post is
seekingalpha.com/artic...?
thank you. i had just read the two items by mr hansen in today's SA. i've added you both to "list".
your response to CHRIS B was also very constructive to anyone with doubts/questions about "what's up in this dilemma". to some, your initial objective [para. 1-this article] is a success.
For quite some time now I have read, with great interest and growing respect, your comments on this site. By writing this article and responding to the comments of others you have raised the bar on intelligence, clarity and literacy at Seeking Alpha.
Thank-you.
Thank-you for all the thoughtful and respectful discussion on the subject of the article. I would add to the comment of gib and say that you have all added to the excellence of SA. This can not be said of all comments I have read over the past months.
Based on your recommendations sounds like you are preparing for increases in the general price level (remember, inlfation is an increase in the money supply which causes increases in prices in general). If rising prices are your forecast I agree. Eventually, some of the new money being created will find its way into circulation "buying things." The Fed's and the Treasury's goal is to reinflate the economy so we should all be prepared for a depreciating dollar in the near future.
RE: AlexR's comment:
Alex, of course the Fed smells inflation as they create it by printing money. That is the definition of inflation an increase in the money supply "creating money out of thin air." Inflation is ALWAYS a monetary phenomenon. How can the legitimately Fed fight inflation when they create it?
Although it may be difficult to estimate, there must be some (e.g., developers, builders, real estate firms and their employees) who cashed out, at least in part, during the bubble. When they decide to consume, it will be inflationary.
Bad advice.
I agree that the forex market might not provide the desired safe haven in a period of inflation (and shorting the dollar is essentially a forex bet) because inflation or devaluation in other currencies could be even higher. High inflation and devaluation in the forex markets are different phenomenon and can occur independently.
Of the two, I think there is a lot better evidence for rising prices in the future than there is for a particular currency to increase in value vs. the buck. Oil and TIPs are more direct ways of investing in inflation, so to speak. Real estate and precious metals also gained popularity for inflation protection in the 70's, but real estate is still overpriced by at least 20% today and the value of precious metals has no metrics and is purely psychological, so I'd skip them both this time around.
I did nibble at some TBT based upon this premise and the fact that yields are pricing in a massive depression (I have some longer expiration puts on the US$ as well). My issue now is the fact the fed will start buying long term treasuries pushing TBT lower. The fed is trying to create inflation but I just don’t think it is going to work for at least another 9 months. As I type I am trying to decide if I should sell my TBT holding but when I see yields this low I think we have a bubble in treasuries. I do like LQD here as I think investment grade corporate yields will fall and just bought some today.
Anyway great article!
Although I suspect we might be heading there due to the new administration.
rkdpolitics.blogspot.c...
"I want to vehemently deny the insinuations that we are in a financial crisis. What is important to make clear is that Petrobras is not in any cash-flow crisis," CEO Gabrielli said.
Oh good. Always positive when something is vehemently denied.
"Through lack of regulation, people were allowed to spend money that didn't really exist. Now we are printing that money and it can not be spent again."
I agree with you on the knife edge tipping of deflation/Inflation though I think it will be more due to length of time that it will take to start up shutdown mines, etc. than over printing of money. Once the recovery starts we will be short on commodities because of lack of capacity, not too much money. This also implies that the Fed will have a hard time controling this inflation. Perhaps a repeat of the Recession of 1937 will occur?
We'll see.