Equities as an inflation hedge

The history of the late 1960s and 1970s suggests that rising inflation was very bad for equity investors. From the end of 1965, when inflation started to heat up, through mid-1982, as inflation returned to single-digit levels, the S&P 500 index fell 62% in real terms. That disastrous performance, however, was almost exactly the same as the devastating real decline in the S&P 500 from its peak in 2000 to its low in March 2009. In other words, the bursting of the tech bubble followed by the bursting of the housing bubble were, in a sense, just as bad for investors as the 1970s collapse of the dollar and the emergence of double-digit inflation. 

Financial theory, however, suggests that equities should be a good inflation hedge, because nominal earnings tend to rise, over time, in line with the rise in the general price level. Recent action in the stock and bond markets appears to confirm this.

The above chart compares the S&P 500 index to the 5-yr, 5-yr forward expected inflation rate embedded in TIPS and Treasury prices (which happens to be the Fed's preferred measure of inflation expectations). There is a noticeable tendency for equity prices to rise as inflation expectations heat up, and to decline as inflation expectations cool off. This action is particularly evident over the past year, as equity prices have jumped some 30% and inflation expectations have moved up from 2.1% to almost 3.0%.

As I noted a few weeks ago, the Fed's decision to implement QE3 succeeded in stimulating inflation expectations, if not the real economy. And looking back, it is the case that the current equity market rally began shortly after this same measure of inflation expectations hit an all-time low of 0.5% at the end of 2008 and began to rise. One driver of the current rally, in other words, has been rising inflation expectations. The Fed gets some credit for boosting stock prices, just as they can now take credit for having artificially depressed mortgage rates. Whether this means the economy will be better off, however, remains to be seen, because a rising price level does not necessarily translate into rising prosperity. Come to think of it, this helps to explain why the stock market has done so well even though the economy is suffering through its slowest and weakest recovery ever: much of the "improvement" in equity prices is merely a by-product of reflation, rather than genuine recovery. There certainly has been a good deal of reflation already: recall that in late 2008 the TIPS market was priced to 5 years of deflation. From expecting 5 years of deflation to now expecting inflation to average 3% per year 5 years from now is a huge difference—a lot of reflation.

If inflation does indeed move higher, in line with expectations, then sooner or later Treasury yields are going to have to move higher and the Fed is going to have to put QE3 on ice. But as I've argued repeatedly, higher Treasury yields—and higher interest rates in general—won't be a problem for the economy or for the stock market, since they will be the natural result of a stronger economy and/or faster nominal growth.

As for inflation hedges in general: Gold, long considered the classic inflation hedge, has enjoyed a spectacular run over the past decade. So maybe it's already priced in a lot of inflation. Commodities in general have enjoyed fabulous returns. Gold and commodities are arguably very expensive inflation hedges today. Real estate is also a classic inflation hedge. Nevertheless, with prices only recently on the mend after suffering a roughly one-third decline in price, real estate is arguably cheap. And stocks are arguably cheap as well, to judge from the fact that PE ratios are below average, yet corporate profits are at or near all-time highs, both nominally and relative to GDP.

I'm  not a fan of inflation, but it's obvious that the market is doing much better today knowing that the specter of deflation has been all but banished. Faster nominal growth provides good support for equity prices and corporate bond prices (better cash flow prospects mean read reduced default risk), but I'd rather seen real growth be the major component of that faster nominal growth, rather than inflation. The Fed is working hard to get nominal GDP growth to move higher, but by themselves they are only likely to push the inflation component of nominal GDP higher. To get real growth moving higher we need better fiscal policy and more confidence in the future. That's what the elections next month are all about.

The ADP report is mildly encouraging

ADP's estimate of September private sector job gains was somewhat stronger than expected (162K vs. 140K), adding to the growing list of stronger-than-expected numbers we have seen since late last July The chart of the Citigroup Economic Surprise Index, below, documents this. In this context, it's looking like the payroll report this Friday will also beat the relatively modest consensus of 115K private sector jobs. Even if the ADP number proves accurate, however, at this rate the economy can barely keep up with population growth. Things could be worse, but at least the economy appears to be holding its own and it continues to avoid any sign of recession. In my view, economic growth is likely to be in the range of 2-3 in the current quarter, and if that relatively disappointing pace continues, the market will end up being surprised again. 1.6% 10-yr Treasury yields and -0.9% 10-yr TIPS yields continue to be priced to the expectation that growth will be zero or negative for the foreseeable future.

Service sector beats expectations

Coming at a time when the market is still skeptical of the economy's strength and many continue to see signs of an imminent recession, the September ISM Services report was surprisingly stronger than expected. It's not off the charts, of course, but as the chart above shows, a comfortable majority of firms see improving business activity. In fact, at 59.9, the September reading is substantially higher than the 56.3 average over the 15 year life of this survey. 

Another "surprisingly strong" number in this report was not so cheerful, however. The 68.1 reading for the prices paid index was way above the 59.6 15-yr average for this survey. It's now flirting with the levels we saw in mid- to late-2000s, when consumer price inflation moved up from a low of 1% in 2002 to a high of 5.6% in 2008. At the very least, this index has all but ruled out any risk of deflation.

The September employment index was fairly neutral: 51.1 vs. an average of 50.6.

As this last chart shows, the U.S. economy continues to look much better than the Eurozone economy. Truth is, things here could be a lot worse, and they could be a lot better too. But we're not in danger of recession.

Car sales remain very strong

September vehicle sales handily beat expectations (14.87 million vs. 14.5), reaching a new post-recession high. Since the bottom in Feburary 2009, sales are up at a 15% annualized pace, and they are up 13.5% in the past year. That's huge, and it is the very picture of a V-shaped recovery after a devastating and unprecedented decline.

When sales expand at double-digit rates for over two years, this creates a positive shock that ripples throughout the economy: manufacturers, dealers, auto parts makers, and raw material suppliers all do better than they expected, and many have to ramp up production and hire more workers to meet unexpectedly strong demand.

Obviously, numbers like this don't support the imminent recession meme.

Household financial burdens fall to 30-yr low

According to the Fed's latest calculations, as of June 30, 2012, households' debt and overall financial burdens had fallen to a 30-yr low. From the peak in Q3/07, the burden of households' total financial obligations has fallen by almost 17%: from 19% of disposable income to 15.8%. This is big deal.

"Financial burdens" are calculated by comparing debt service payments and total financial obligations to disposable income. This is very different from the numbers bandied about in the press, which compare total debt to income or GDP in order to argue that there is still a lot deleveraging to come. The problem with the latter is that it is an apples-to-oranges comparison, since total debt is a stock—a fixed amount—whereas income is an annual flow. The Fed's method compares flows (annual payments on the stock of debt) to flows (annual income). Owing $100,000 with an interest rate of 10% is much more burdensome than owing the same amount with a 3% interest rate, just as it is easier to service a debt with a 10% interest rate when one's income rises 10% a year, than it is when one's income rises only 3% a year.

The data for June showed a modest reduction in financial burdens of all types. But financial burdens have declined significantly in the past 5 years, and are now back to levels last seen in the early 1980s. Households have accomplished this rather impressive task by a) paying down debt (i.e., deleveraging), b) defaulting on debt, c) refinancing and taking on new debt with much lower interest rates (mortgage rates are at all-time lows), and d) increasing their disposable income. With the exception of the unfortunate cases in which households have had to default on their debt obligations, the story is a virtuous one, and it has been driven by an increase in overall risk aversion, increased work, and an increase in savings.

It is also worth noting that a significant amount of deleveraging has effectively occurred even as the economy has managed to grow (albeit slowly). Deleveraging does not have to be synonymous with deflation or recession. Deleveraging occurs when the demand for money increases, and the demand for money tends to increase during periods of rising uncertainty. Increased money demand can be satisfied by increasing one's holding of cash and cash equivalents and/or reducing one's debt. (Conversely, increasing one's leverage is equivalent to a decline in one's demand for money, since debt is equivalent to "shorting" money.) Deleveraging can be bad for an economy's health if the central bank fails to respond to the increased demand for money. The Federal Reserve was slow in responding in late 2008, but they more than made up for that mistake by engaging in two unprecedented quantitative easing programs (with another just beginning) which have resulted in the creation of $1.4 trillion of excess bank reserves to date. When the supply of money equals or exceeds the demand for money, then an economy can undergo lots of deleveraging without major problems, and that is precisely what has happened since 2008.

There have been some major adjustments made in this economy in recent years, and this lays the groundwork for a healthier economy in the years to come. What's lacking now are the proper incentives to spur growth. 

ARRA was all about income redistribution

From a supply-sider's perspective, it's no wonder that the American Recovery and Reinvestment Act didn't do much to stimulate the economy. Fully 63% of the "stimulus" spending was income redistribution in disguise (i.e., tax benefits and entitlements). And if you reclassify things such as education, housing assistance, and health as transfer payments, then over 75% of the $840 billion allocated to "stimulus" was essentially income redistribution. Only 8%—$65.5 billion—went for transportation and infrastructure (i.e., the "shovel-ready" projects that would put American back to work). Not a dime went to increase anyone's incentive to work harder or invest more.

Taking money from one person (e.g., those who bought all the Treasury debt issued to fund the deficits created by the "stimulus" spending) and handing it out other people so that they can, for example, more easily buy a house, trade in their old cars, reduce their tax owed, or buy food, all on a one-time basis (thus not effecting permanent or long-lasting changes in people's willingness to work or invest) can hardly be expected to grow the economy. Growth of the kind that raises living standards requires more than just spending money or boosting demand; it requires spending money in a way that results in utilizing existing scarce resources in a more efficient manner: e.g., working harder, working smarter, making more with less, creating new products and services. A bureaucratic reshuffling of income is highly unlikely to unleash the miracle of growth; only the private sector can do that.

In short, ARRA was a laboratory experiment in the power of the government spending multiplier to grow the economy by "stimulating demand." It ended up proving that the multiplier is way less than one. American taxpayers borrowed $840 billion only to learn that the payoff was only a small fraction of the additional debt incurred. We wasted almost a trillion dollars of the economy's scarce resources, and that's a big reason why the recovery has been so disappointing. If we had instead "spent" the money on lowering tax rates for everyone (e.g., we could have eliminated corporate taxes for three years with the ARRA money spent) in order to give them a greater incentive to work and invest, the results could have been dramatically better. The tax cuts might even have paid for themselves in the form of a stronger recovery over time.

You can see all the distressing facts and figures at recovery.gov. I've reproduced some key charts and a summary of the data below (click each to enlarge):

Still no sign of recession

For much of the past few years, the market has been on "recession watch." First it was the Eurozone, where sovereign debt defaults threatened to bring down the eurozone financial system, which in turn threatened the global financial system and ultimately the global economy. Then it was the slowdown in the Eurozone and Chinese economies—with several economies (e.g., Spain, Greece) entering recessionary conditions—that threatened to set off a chain reaction of slowdowns around the globe. Then a series of weaker-than-expected U.S. employment reports starting in March, followed by the U.S. ISM manufacturing index falling below 50 last June, suggested that these fears were being confirmed. Meanwhile, fears of the looming U.S. "fiscal cliff" likely contributed to a decline in capital spending, all the while the folks at ECRI have been insisting for over a year that a U.S. recession is not only imminent but inevitable. 

Some key indicators, however, have refused to follow the script.

The September ISM manufacturing index came in stronger than expected (51.5 vs. 49.7). As the chart above suggests, conditions in the manufacturing sector point to real GDP growth of 2% or more in the current quarter, comfortably above the recession levels. That's still relatively miserable growth, of course, but the important thing is that there is no sign of recession, and that's what the market has been most worried about.

Even in the Eurozone, manufacturing conditions have improved of late. The Eurozone PMI is still flirting with recession territory, but it's improving on the margin.

Perhaps most importantly, there has been a significant improvement in Eurozone swap spreads in recent months. It would be very unusual for swap spreads—a key indicator of systemic risk and a leading indicator of economic health—to improve to this degree if the Eurozone and U.S. economies were simultaneously deteriorating.

The manufacturing employment survey suggests that the outlook for the sector remains relatively healthy. If conditions were deteriorating, the employment index would be much lower than it is today.

The upturn in the export orders index—which remains relatively weak—at the very least suggests that a global downturn is not feeding on itself.

The prices paid survey of manufacturers shows no signs of outright deflation, another thing markets have been fearing.

Indeed, as the above chart of the CRB Spot Commodity Index shows, commodity prices have been firming for the past four months, yet another non-confirmation of the global slowdown story and good evidence that there is no shortage of money that might otherwise serve to hobble the economy.

When looked at from a long-term perspective, as shown in the chart above, commodity prices as well as gold prices remain very strong relative to where they were just 10 years ago. Who would have believed, back in 2002, that over the next decade gold prices would more than quintuple, and commodity prices would more than double, even as the market grew ever more fearful about the outlook for growth?

With 10-yr Treasury yields still at 1.6% and with real yields on TIPS firmly in negative territory, the market is priced to very weak or negative growth for the foreseeable future. If growth continues to run at 1-2%, instead of turning negative, I believe the equity market will have little choice but to trade higher. Holding cash that pays nothing, at a time when the earnings yield on the S&P 500 is almost 8%, utility stocks (e.g., XLU) are paying dividends of 4%, REITS are paying over 3%, investment grade bonds (e.g., LQD) are yielding almost 4%, and high-yield bonds (e.g., HYG) are yielding over 6%, only makes sense if you strongly believe that there is lots of downside risk in risk assets over the next several years—enough to outweigh their significant yield advantage. In other words, you need a recession in order for cash to beat alternative investments—slow growth is not going to do the trick. And of course, if the economy should actually improve, well then it's off to the races.

Full disclosure: I am long equities, utilities, REITS, and corporate bonds at the time of this writing.