Perhaps what struck me most about the comments issued last week by the Federal Reserve was its initial wording concerning the central bank’s “dual mandate.” It was a small thing, but when you’re talking about ‘Fedspeak’ it often seems like you need the talents of a Talmudic scholar to parse what they’re actually saying.
Admittedly it wasn’t the first time they phrased it this way, but when they talked about their dual mandate they mentioned ‘employment’ before ‘price stability’, rather than vice versa. Employment came first. They had done the same thing in December, but at that time the economic data hadn’t been nearly as strong.
This time the commentary came in the context of economic data which truthfully has not been that weak at all. The level of unemployment claims haven’t been recessionary, recent readings taking us back to times before the 2008 calamity. Certainly factory production has picked up, for which we can credit the low dollar, and to some extent very low natural gas prices, as well.
Cheaper natural gas has clearly given a lot of our chemical producers, along with other industries which use natural gas as feedstock, a huge edge in the international markets (international gas prices are literally many times those in the U.S.) This doesn’t just mean we pay less for heating our homes, although to be sure, that’s a positive thing and certainly amounts to a type of ‘tax cut’ for consumers as well as businesses. Low gas prices also give us an edge in many export industries.
So overall the news on the economy has been much better. Yet, looking at the Fed’s comments, if anything they were more “dovish.” Not only was there the juxtaposition which stressed employment over inflation, but a somewhat greater assurance that QE3 was definitely on the front burner.
In the December and previous Fed announcements, the impression was that while QE3 was not to be ruled out, it was still on a backburner for the time being. Now the Fed seems to be following the course started several months ago, when one of the dissenters, Charles Evans of the Chicago Federal Reserve, was the first to buck the majority in favor of easier policy.
It’s somewhat ironic to see this sort of progressive monetary thinking coming out of the home of the Chicago School of Economics at the University of Chicago, known for its neoclassical, anti-Keynesian and free market approaches. But in any case, Evans did not attend the University of Chicago, and is evidently one central banker who doesn’t think with the crowd or become swayed by those around him. As far as his colleagues on the Fed, it now seems like the crowd has more and more come over to his viewpoint. Of course, this has also been helped by the new complexion of the Fed, which by our count now consists of eight doves and one inflation hawk.
We have argued for the past five or more years that there is no middle ground on the key issue here: eventually policy makers are forced to choose between inflation and deflation. And we’ve steadily maintained – and this is admittedly a political and sociological argument – that of the two, we strongly favor inflation.
In 2008 we were faced with exactly the same critical choice, and as everyone knows, the Fed at least implicitly decided to favor the principle of stable prices. The result is history.
Europe at this point, despite what we see as clear progress, still has a strong possibility of experiencing a Lehman-like story – though right now we think the odds are much less. And in fact, one of our arguments here is the willingness of the European Central Bank (ECB) to flood other banks with money. The European balance sheet has gone from high to even higher than our own in the U.S. And of course the Japanese balance sheet continues to increase by leaps and bounds.
Of course, another round of quantitative easing in the U.S. would clearly take our balance sheet from the stratosphere into outer space.
Money counts. And too much money chasing a decreasing supply of commodities will have predictable consequences. This is certainly the case in a world where there are constraints on the supply of resources. Resource prices last year notwithstanding, commodities have throughout this new century been highly levered to economic growth. Thus it seems clear that unless there’s a sudden break in this relationship, aggressive easing by monetary authorities will translate quickly into sharply rising resource prices (and by ‘quickly’ we don’t mean over the next 2-3 weeks, but rather the next 6-12 months). Which will indeed be an inflationary event, easily topping that of 2008, when inflation reached about 5 percent.
So far we’ve just been talking about the effects of monetary stimulus in the developed world. Add to this whole mix the stimulative effects provided by growth in the emerging economies of the developing world, and you have quite an interesting combination.
Indeed, since the beginning of the century one of the strongest correlates of commodity prices has been the performance of China’s stock markets. Moreover, it doesn’t really matter which one of them you look at, whether it’s Shanghai, which is more diversified, or Hong Kong, which weights banks higher than other groups. And easier Chinese policy combined with what’s going on in the developed world is unquestionably an inflationary event.
Bill Gross, the widely followed bond fund manager recently echoed my thoughts. In a recent commentary he spoke of a world in which we simultaneously have two distinct universes: one in which there is a clear threat of deflation (as evidenced by interest rates of close to zero), and another where there are equally clear threats of inflation. That says it very well.
Don’t get us wrong: Opting for inflation, if that’s the path we will continue to follow, is not a good thing. But it’s the lesser of two evils. And opting for inflation doesn’t necessarily mean that you have to put all your eggs in a golden basket, or a silver basket, or a red (copper) basket.
But we do expect commodities to perform very well.
At the same time, there are other characteristics and effects of inflation that can favor other groups of stocks as well as commodities.
We pointed out value stocks as a good choice in this respect in our last Market Update. As inflation is very kind to book values but compresses the differences in growth rates among companies, it is therefore not very kind to growth stocks, which lose a lot of their edge in times of inflation.
Following this line of reasoning, the best of all worlds would be stocks that are franchises.
Here you can have growth, and in some sense book value – but the book value may not necessarily be concrete and precisely quantifiable; it can often be defined in terms of brand name.
Think for example, of the New York Yankees. While we haven’t examined the Yankees’ balance sheet, there’s no question that if you look at the assets underlying the franchise they would not be very high relative to the value of the franchise on the market. The reason is because there’s no concrete value to the brand name.
And indeed, the brilliance of Warren Buffett has been to realize that his mentor, Benjamin Graham (who argued that you should always try to buy stocks priced below book value, preferably below liquidating value) failed to account for the value of brands in his computation of book value.
Buffett’s great insight was that one could discover and buy stocks dramatically below book value by appropriately valuing the worth of their brands. And in the process, gain a huge edge over ‘green eyeshade’ types who can’t see the forest for the trees.
In a market such as this, and if we continue to be right on inflation and it does continue to rise, the ideal portfolio in our opinion is populated by value stocks, franchises and commodities.
One key characteristic of franchises is that they have good pricing control, and therefore can maintain their growth by passing inflation right through.
Some franchises you may want to look at include:
Madison Square Garden (NYSE:MSG), especially (tongue firmly in cheek) if they can manage to get Phil Jackson as the coach of the NY Knicks, which would undoubtedly boost fan attendance.
Another strong franchise, and a stock we’ve recommended for as long as we’ve been publishing investment newsletters, is Berkshire Hathaway (NYSE:BRK.B). The key to its franchise is not so much its high book value, but the fact that it is so well capitalized relative to other reinsurance companies.
This nearly assures pricing control in a world in which increasing urbanization tends to compound the economic and insurance costs of natural calamities, whether they are earthquakes, hurricanes, tornadoes or any other major weather or geophysical events. Berkshire will remain in the catbird seat even in the wake of the most massive catastrophes, in which it is most likely to be the “last man standing” because of its incredible edge in terms of capitalization.
Another solid franchise is Qualcomm Inc. (NASDAQ:QCOM), which we’ve mentioned before and continue to view as a strong investment, based on its proprietary technology that’s licensed and widely distributed in global telecommunications markets.
There are, to be sure, other excellent franchises on our list, and we will talk in greater detail about them in a forthcoming issue.
Disclosure: Leeb Group, its officers, directors, shareholders, employees and affiliated entities and/or clients of such affiliated entities may currently maintain direct or indirect ownership positions in financial instruments (i.e., stocks, bonds, options, warrants, etc.) of companies or entities whose underlying exposure is in the companies mentioned in this article.