Portfolio manager’s Letter February 2006
“Inflation is always and everywhere a monetary phenomenon.” – Milton Friedman
Since money is just another commodity, the more you increase the supply (the amount of currency circulation), the more you drive the price (value) down. This makes sense and how can you argue with the guy that wrote the book on monetary policy, and who won the Nobel Prize for his effort.
Yet this rule of Dr. Friedman’s now seems to have been suspended, if not repealed. Here we are in a world awash in cash, yet inflation seems to have been more or less banished. With the silly season in full swing, all the economic forecasts for 2006 are spewing forth from the usual places, and there seems to be a near unanimous agreement that inflation is not be a problem in 2006.
In an ideal world, the money supply would grow fast enough to support a reasonable level of economic growth, and provide a return on the capital invested that was adequate to compensate for the risk that the capital is exposed to. Whereas today there is a whole lot more capital sloshing around the globe than there are profitable ways to invest it. Risk premiums are at historic lows not because the world is a safe place to invest, but because there is too much money chasing too few good investments.
It would seem that the central banks of the world are creating more currency (or allowing there domestic banking systems to loan) than businesses can find a productive use for. Risk premiums (what you get paid for taking a risk) are low across many markets; after inflation and taxes, the current return from US Treasury Bonds may turn out to be negative. So is Mr. Market correct in his judgment that the current risks facing investors in the bond and stock market are very low?
I think it more likely that current low investment returns are a function of excess international liquidity and that because of this excess liquidity risk levels are not low, but quite high. The flow of cash has fed speculative activity across a broad spectrum of investment alternatives: bonds, domestic stocks, foreign stocks, large cap or small cap.
In 1973, following a sharp spike in commodity prices, inflation, as measured by the CPI, went from 2.9% to almost 12.2% in 15 months. I do not mean to suggest that this is likely or even possible today, but I think it is an exciting exercise to plug these figures into today’s environment. Since no inflation is figured into everybody’s models, there could be some nasty surprises where inflation suddenly increases. It might even blow the manhole covers off the derivatives sewer. I do not know if inflation is going to continue to grow as the year progresses, but if it does, it will be unexpected, and because of this, it could trigger a new bear market in both stock and bond markets.
Think about interest rates, would the FED be able to stop raising short term rates? What would happen to long rates if inflation starts to eat the whole coupon? Think about real estate what would happen to home prices in a market where interest rates are rapidly rising? Think about all those interest-only, adjustable rate mortgages. Think about rapidly rising risk premiums when central banks discover interest rate risk, and the mortgage market discovers default risk.
But not to worry, the FED has inflation under control. Alan Greenspan says that inflation is “properly measured is near zero”. No reason to be concerned about the global money flood. So far all that it has produced is a stock bubble, a bond bubble, a real estate bubble, and a commodities bubble. No big deal, inflation is under control.
Figures for the CPI in October show inflation is at a 15 year high of 4.7%. Of course, the FED prefers the “core rate” that was up only 2% year-over-year, but even 2% is considerably more than zero. Interestingly, consumers do not seem to agree with Greenspan’s assertion that “inflation is as properly measured is near zero”. The University of Michigan’s Survey of Consumers shows consumers’ inflation expectation at ten-year highs. Perhaps more significant is the fact that the FED itself does not seem to believe it either. If inflation is zero, how can a Fed funds rate of 4.25% be considered neutral?
The CPI measures a theoretical market basket of goods and services. However, if we look at how we actually spend our money and attach an inflation rate to some individual components, we get a different picture than the one presented by the CPI.
According to figures from the Bureau of Economic Analysis, personal consumption expenditures at the end of the third quarter of 2005 were running at an annual rate of $8.84 trillion. The table below breaks out four large areas of expenditure.
|Personal Consumption Expenditures
|2004 Expenditures (Trillions)
|Percent of Total Personal Consumption Expenditure
Published reports covering 2005 so far indicate that housing prices increased by 12% – 13% last year, health care by something like 7.6%, energy costs by 17%, and food by 7.7%. If I add these figures together and take an average, this 51.8% of our spending experienced inflation at a rate of 9.4% last year. This is not to say that inflation is currently running at 9% or anything close to that, but it does indicate that the real inflation is a rate may be somewhat higher than the 2% as characterized by the CPI core rate.
Would the government publish statistics that it knew to be wrong? Maybe not, but my guess is there is at work here a serious case of what Charley Munger defines as Incentive caused bias. The best interest of pretty much everyone inside the Beltway is served by low inflation. It keeps the cost of indexed programs, such as social security, low. And, as long as interest rates stay low it keeps the cost of servicing debt cheap. With $8.1 trillion in national debt, interest on that debt increases by $81 billion for each one percentage point increase in interest rates.
Suppose inflation is running at 4.7%, and interest rates on government securities are 5%. In that case, holding government debt is an act of charity, but one that I am sure everyone in Washington would like to encourage. If the cost of carrying that debt goes up, the deficit will increase faster. This is not going to make it easier for anyone to get re-elected. Currently, as far as the government is concerned, we have the better of two worlds: low-interest rates and a measured rate of inflation is less than the real rate. Inflation helps the debtor.
The real cost of debt is reduced because you get to pay off the debt with cheaper dollars. Today, our government is the biggest debtor globally, and inflation is the only way it ever has paid down its debt.
So are the bureaucrats going to complain? Are the politicians going to scream for reform of the data to gives us more a realistic inflation gauge? Don’t hold your breath.
Warren Buffett keeps saying that the markets are mostly efficient, but that the difference between mostly and completely is big enough to make a lot of people rich. The real inflation risk is simply not priced into this market for either equities or long bonds. Both these markets seem to assume that inflation will continue in the trend of the last twenty years. Risk premiums available across a broad range of investments simply do not pay us for the risks that are present in the economy today. Here we have an example of market inefficiency that may present us with lots of investment opportunities.