Tag Archives: government

Monetary Madness: How Inflation Risk Changes The Game

Spring is a great time of year for sports fans. Spring training is transitioning to a new season of hope for baseball fans, hockey teams are making their final push to the playoffs, and college hoops fans get to immerse themselves in brackets and March Madness. A big part of what makes sports competition so interesting and exciting is something that is not exciting at all: They are all played under the conditions of common rules and standards. Time periods, playing areas and even equipment specifications are controlled. Arguments can ensue over such tiny discrepancies as a second or two on the clock or a couple of pounds of pressure in a football. While sports fans rightfully push back against discrepancies so as to ensure the integrity of the game, investors are far more quiescent when inflation alters the value of money. In exploring the issue of inflation, it helps to keep a couple of points in mind. One is that the dollar (or any form of money) is a standard of value just like a minute is a standard of time and a pound is a standard of weight. Since money is used to measure the value of our work, our skills, our belongings and many other things, changes to its value have implications that run deeply through the economy and through society. Another point is that despite the overarching importance of money as a standard of value, monetary officials have coalesced their policy making around an inflation target of two per cent per year. In doing so, they have succeeded in persuading people that two percent is a very small number and have inured much of the investing public to the risks inflationary policy. While two per cent per year may seem like an almost trivially small number, it becomes very meaningful when compounded over many years. This can be illustrated by a basketball example. Let’s imagine for a minute, that the powers that powers-that-be in the NCAA set a two per cent per year inflation policy on the distance of the free throw line from the basket. In the first couple of years, the line would only move about three-and-a-half inches per year and might not be so bad. But after just seventeen years, the free throw line would move out beyond the college three point line. The implications would be widespread and would fundamentally change the nature of the game. Indeed, many investors are sensing that the investment “game” may be changing. Based on an increasingly tenuous relationship between underlying economic fundamentals and stock prices and increased volatility in the markets over the last year, it is an absolutely appropriate concern. Jim Grant neatly summarized the situation as he sees it in the February 26, 2016 edition of Grant’s Interest Rate Observer: “In times past, the standard of value was fixed while economic activity was left to fluctuate. Now, it’s the trend growth in economic activity that – supposedly – is stable; monetary value is what gives way.” Insofar as this is correct, it suggests that the investment landscape has changed in a meaningful way. Since the value of analysis pertains most to variables that fluctuate, Grant’s view suggests that analytical efforts increasingly ought to be applied to monitoring and assessing the value of currency rather than to determining levels of economic activity. One way in which “monetary value giving way” makes investing more difficult is because it is poorly understood by many economic and monetary officials. John Hussman hits on this point in his weekly letter [ here ], “It’s endlessly fascinating to hear central bankers talk about the effect of monetary policy on inflation and the economy, because they confidently speak as if the models in their heads are true – even reliable. Yet virtually nothing they say can actually be demonstrated in historical data, and the estimated effects often go entirely in the opposite direction. This is particularly true when it comes to inflation and unemployment – precisely the variables that are the targets of central bank policy.” John Cochrane from the University of Chicago also recognizes this knowledge gap in his article “Inflation and Debt” [ here ], “Many economists and commentators do not think it makes sense to worry about inflation right now. After all, inflation declined during the financial crisis and subsequent recession, and remains low by post-war standards.” He follows that, “But the Fed’s view that inflation happens only during booms is too narrow, based on just one interpretation of America’s exceptional post-war experience. It overlooks, for instance, the stagflation of the 1970s, when inflation broke out despite ‘resource slack’ and the apparent ‘stability’ of expectations.” These comments converge on the same point: The two prominent schools of thought in regards to inflation, keynesianism and monetarism, both suffer from serious shortcomings. Cochrane notes that, “One serious problem with this view [keynesianism] is that the correlation between unemployment (or other measures of economic ‘slack’) and inflation is actually very weak.” In regards to monetarism, Hussman reveals, “Economic models of inflation turn out to be nearly useless for any practical purpose… it’s very difficult to explain most episodes of inflation using monetary variables.” Unfortunately, these flawed theories serve as the bread and butter of mainstream economists, including those at the Fed. In short, many of the leading voices on inflation are misleading. The key incremental insight that both Hussman and Cochrane gravitate to is that the value of paper money, fiat currency, depends fundamentally on confidence in the system that supports it. As Hussman describes, “The long-term value of paper money relies on the confidence that someone else in the future will accept it in exchange for value, and ultimately, that’s a matter of varying confidence in the ability of the government to meet its long-term obligations… confidence in long-run fiscal discipline is essential.” Cochrane explains, “Most analysts today – even those who do worry about inflation – ignore the direct link between debt, looming deficits, and inflation.” Part of the reason is historical context. He follows, “While the assumption of fiscal solvency may have made sense in America during most of the post-war era, the size of the government’s debt and unsustainable future deficits now puts us in an unfamiliar danger zone – one beyond the realm of conventional American macroeconomic ideas.” This is a key point. As Cochrane acknowledges, the “assumption of fiscal solvency may have made sense in America during most of the post-war era”. But things have changed. Investors need to transition beyond “the realm of conventional American macroeconomic ideas” and seriously re-evaluate the country’s fiscal solvency risk – and, therefore, the potential inflation risk. The persistence of large structural fiscal deficits caused by unsustainable and ever-increasing entitlement obligations, in the context of a divisive political landscape, offers little hope that fiscal challenges will be addressed in time to preserve the value of the dollar. Finally, while inflation appears to be an accident waiting to happen, its timing is impossible to predict. Cochrane elaborates: “As a result of the federal government’s enormous debt and deficits, substantial inflation could break out in America in the next few years. If people become convinced that our government will end up printing money to cover intractable deficits, they will see inflation in the future and so will try to get rid of dollars today – driving up the prices of goods, services, and eventually wages across the entire economy. This would amount to a “run” on the dollar. As with a bank run, we would not be able to tell ahead of time when such an event would occur. But our economy will be primed for it as long as our fiscal trajectory is unsustainable.” Investors can take four key points away from this analysis. One is that even low but persistent inflation can have a meaningful effect over a long investment horizon. Just like in the basketball example, the effects seem small at first, but become quite significant over time. While two per cent per year inflation may initially seem like a small number, over an investment horizon of fifty years, such inflation will erode the value of a dollar to 37 cents. Historically, it hasn’t felt that bad because strong asset returns have more than offset the effects of inflation. However, if you don’t own assets that re-price to offset inflation, or if such strong asset returns fail to be realized in the future, inflation will be a far more painful experience. A second point is that the “fiscal solvency” element of inflation risk eludes most conventional economic thinking – and conventional economic thinking constitutes much of what informs investment advice, asset allocation decisions and public policy. The effect is that many of the guardians of investments (financial advisers, wealth managers, consultants, et al.) understate inflation risk, and sometimes significantly so. Regardless of how understated inflation risk becomes manifested in a portfolio, the outcome is the same: it leaves investors vulnerable to not having adequate purchasing power to meet their spending plans in retirement. Third, the emergence of inflation risks creates a new challenge for investment analysts and managers. Now, in addition to evaluating fundamentals, analysts must add a whole new skill set by learning to perform credit analysis on the US government. This involves determining the probability and degree of fiscal insolvency and to some extent, handicapping the tipping point as to when confidence in the dollar might run out. This additional exercise not only complicates the analysis, but also adds a great deal of uncertainty. Finally, the fourth point is that inflation risk, when viewed as fiscal solvency risk, is difficult to manage. As Cochrane highlights, investors do not get the luxury of early warning signs: “Like all runs [on the dollar], this one would be unpredictable. After all, if people could predict that a run would happen tomorrow, then they would run today. Investors do not run when they see very bad news, but when they get the sense that everyone else is about to run. That’s why there is often so little news sparking a crisis, why policymakers are likely to blame “speculators” or “contagion,” why academic commentators blame “irrational” markets and “animal spirits,” and why the Fed is likely to bemoan a mysterious “loss of anchoring” of “inflation expectations.” And for those still harboring notions that inflation can be controlled by a central bank, Cochrane adds, “Neither the cause of nor the solution to a run on the dollar, and its consequent inflation, would therefore be a matter of monetary policy that the Fed could do much about. Our problem is a fiscal problem – the challenge of out-of-control deficits and ballooning debt. Today’s debate about inflation largely misses that problem, and therefore, fails to contend with the greatest inflation danger we face.” In short, managing inflation risk is an uncertain and probabilistic exercise akin to forecasting the weather: You can’t specifically forecast storms; the best you can do is to recognize that prevailing conditions may produce storm activity and to manage affairs accordingly. All of these points suggest that the “game” of investing has fundamentally changed. The emergence of large fiscal deficits exacerbated by exploding entitlement obligations is creating challenges to fiscal solvency that this country has never seen before. Political divisiveness offers little hope of resolution. As a result, the preconditions are ripe for unpredictable outbreaks of inflation. The implication for investors is to be aware of these relatively new challenges and to re-evaluate their strategy in the context of this understanding. If you were thinking that maybe you should revisit your portfolio and investment strategy, you are probably right. Click to enlarge Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Earnings Growth Based On Debt And Buybacks? Totally Unsustainable

My grandfather was never rich. He did have some money in the 1920s, but he lost most of it at the tail end of the decade. Some of it disappeared in the stock market crash in October of 1929. The rest of his deposits fell victim to the collapse of New York’s Bank of the United States in December of 1931. I wish I could say that my grandfather recovered from the wrath of the stock market disaster and subsequent bank failures. For the most part, however, living above the poverty line was about the best that he could do financially, as he buckled down to raise two children in Queens. There was one financial feature of my grandfather’s life that provided him with greater self-worth. Specifically, he refused to take on significant debt because he remained skeptical of credit. And with good reason. The siren’s song of “you-can-pay-me-Tuesday-for-a-hamburger-today” only created an illusion of wealth in the Roaring Twenties; in fact, unchecked access to favorable borrowing terms as well as speculative excess in the use of debt contributed mightily to the country’s eventual descent into the Great Depression. G-Pops wanted no part of the next debt-fueled crisis. Here’s something few people know about the past: Consumer debt more than doubled during the ten year-period of the Roaring 1920s (1/1/1920-12/31/1929). And while you may often hear the debt apologist explain how the only thing that matters about debt is the ability to service it, the reckless dismissal ignores the reality of virtually all financial catastrophes. During the Asian Currency Crisis and the bailout of Long-Term Capital Management (1997-1998), fast-growing emerging economies (e.g., South Korea, Malaysia, Thailand, etc.) experienced extraordinary capital inflows. Most of the inflows? Speculative borrowed dollars. When those economies showed signs of strain, “hot money” quickly shifted to outflows, depreciating local currencies and leaving over-leveraged hedge funds on the wrong side of currency trades. The Fed-orchestrated bailout of Long-Term Capital coupled with rate cutting activity prevented the 19% S&P 500 declines and 35% NASDAQ depreciation from charting a full-fledged stock bear. Did we see similar debt-fueled excess leading into the 2000-2002 S&P 500 bear (50%-plus)? Absolutely. How long could margin debt extremes prosper in the so-called New-Economy? How many dot-com day-traders would find themselves destitute toward the end of the tech bubble? Bring it forward to 2007-2009 when housing prices began to plummet in earnest. How many “no-doc” loans and “negative am” mortgages came with a promise of real estate riches? Instead, subprime credit abuse brought down the households that lied to get their loans, destroyed the financial institutions that had these “toxic assets” on their books, and overwhelmed the government’s ability to manage the inevitable reversal of fortune in stocks and the overall economy. Just like 1929-1932. Just like 1997-1998. Just like 2000-2002. Maybe investors have already forgotten the sovereign debt crisis from the summer of 2011. They were called the “PIGS” – Portugal, Italy, Greece and Spain had borrowed insane amounts to prop up their respective economies. The easy access to debt combined with the remarkably favorable terms – a benefit of being a member of the euro zone – started to come undone. Investors rightly doubted the ability of the PIGS to repay their respective government obligations. Yields soared. Global stocks plunged. And central banks around the world had to come to rescue to head off the disastrous declines in global stock assets. Throughout history, when financing is cheap and when debt is ubiquitous, someone or something will over-indulge. Today? Households may be stretched in their use of cheap credit, and they have not truly deleveraged form the Great Recession. Yet the average Joe and Josephine have not acted as recklessly as governments around the globe. In the last few weeks alone, the European Central Bank (ECB) announced an increase in its bond-buying activity as well as the type of bonds it is going to acquire, Japan has sold nearly $20 billion in negatively-yielding bonds and the U.S. has downgraded its rate hike path from four in 2016 to two in 2016. Add it up? The world is going to keep right on going with its debt binge. Are we really that bad here in the U.S.? Over the last seven years, the national debt has jumped from $10.6 trillion to $19 trillion. In 7 years! If interest rates ever meaningfully moved higher, there would be no chance of servicing our country obligations. We would likely be facing the kind of doubt that occurred with the PIGS in 2011, as we looked for bailouts, write-downs, dollar printing and/or methods to push borrowing costs even lower than they are today. That’s not the end of it either. The biggest abusers of leverage and credit since the end of the Great Recession? Corporations. There are several indications that companies are already seeing less bang for the borrowed buck. For instance, low financial leverage companies in the iShares MSCI Quality Factor ETF (NYSEARCA: QUAL ) have noticeably outperformed high financial leverage companies in the PowerShares Buyback Achievers Portfolio ETF (NYSEARCA: PKW ) since the May 21, 2015 bull market peak. It gets more ominous. The enormous influence of stock buybacks by corporations – where companies borrow on the ultra-cheap and acquire shares of their own stock to boost profitability perceptions as well as decrease share availability – may be fading. For one thing, buyback activity has not stopped profits-per-share declines across S&P 500 companies for 4 consecutive quarters (Q2 2015, Q3 2015, Q4 2015, Q1 2016 est). Equally worthy of note, when the bottom line net income of S&P 500 corporations began to decline in earnest in 2007, buybacks began to decline in earnest in 2008. Bottom-line net income has been deteriorating since 2014, but favorable corporate credit borrowing terms has kept buybacks at a stable level into 2016. Nevertheless, once corporations begin recognizing that the buyback game no longer produces enhanced returns (per the chart above) – that stock prices falter in spite of the buyback manipulation efforts, they could begin to reduce their buyback activity. When that happened in 2008, the lack of support went hand in hand with a 50%-plus decimation of the S&P 500. The ratio of buybacks to net income in the above chart can become problematic when companies spend a whole lot more of their bottom-line net income on share acquisition. Maybe it’s a positive thing as long as stock prices are going higher. Yet FactSet already reports that 130 of the 500 S&P corporations had a buyback-to-net-income ratio higher than 100%. Spending more than you earn on acquiring shares of stock? That means very few dollars are going toward productive use, including human resources, research/development, roll-out of new products and services, equipment, plants and so forth. Maybe it wouldn’t be so bad if one could forever count on the notion that interest expense would be negligible. Unfortunately, when total debt continues to rise, even rates that stay the same become problematic. Consider the evidence via “interest coverage.” In essence, the higher the interest coverage ratio, the more capable a corporation is at paying down the interest on its debt. Yet if the debt is rising and the interest rates are roughly the same, interest expense increases and the interest coverage ratio decreases. Here’s a chart that shows challenges in the investment grade, top-credit rated universe. You decide. There are still other signs that show a potential “tapping out” for corporations. Corporate leverage around the globe via the debt-to-earnings ratio has hit a 12-year high. Aggressive financing in the expansion of debt alongside additional interest expense is rarely a net positive. On the contrary. Aggressive leveraging typically means a high level of risk. Granted, if corporations were taking on more debt to increase their value via new projects, expansion, new products, growth and so forth, it might represent high risk-high reward. In reality, however, everyone recognizes that the game has been about loading up on debt at ultra-low terms to acquire stock shares – a short-sighted practice of enhancing earnings-per-share numbers for shareholders. Click to enlarge In sum, low rates alone won’t make it easier for corporations to pay off their substantial obligations. Paying down debt is more challenging in low growth environments – 1.0% GDP in Q4 2015 and 1.4% GDP estimate for Q1 2016. Why might that be so? Corporations did not choose to put borrowed money into capital investments that might ultimately help service interest expense. Stock buybacks? Additional stock shares cannot provide the cash flow necessary for debt servicing the way that capital investments can. To the extent one has equity exposure, he/she would be wise to limit highly indebted, highly leveraged companies. The steadily rising price ratio between QUAL and the S&P 500 SPDR Trust ETF (NYSEARCA: SPY ) tells me that investors are wising up. In particular, they’re more concerned by poor credit risks across the stock spectrum. And while QUAL certainly won’t provide bear market protection on its own, it will likely lose less in downturns; it will likely hold its own during rallies. Disclosure: Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc, and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert web site. ETF Expert content is created independently of any advertising relationships.

What (Returns) To Expect When You’re Expecting

Investing decisions should always be made in the context of your overall financial plan. And although we know short-term forecasts are futile , a retirement plan needs to include some assumptions about returns and risk over the long term. To help with this important task, my colleague Raymond Kerzérho , PWL Capital ‘s director of research, has just updated our white paper, Great Expectations: How to estimate future stock and bond returns when creating a financial plan . As we explain in the paper, there are two main approaches to estimating future stock returns. The first is to rely on a historical premium: over the last 50 years, stocks have delivered returns of about 5% above inflation, so one could simply expect that to continue. The second approach raises or lowers that expected premium depending on whether stocks are currently undervalued or overvalued. You can apply similar methods to expected bond returns, using either the long-term premium (about 2.7% over inflation) or the current yield on a benchmark index. Both methods are flawed, but an average of the two is likely to be a useful estimate. Imagine that you are doing retirement projections going out 30 years. Using an expected return of 4.5% for bonds based on their long-term average seems wildly optimistic. But on the other hand, assuming bonds will yield just 2% for the next 30 years (based on their yield today) seems unnecessarily conservative. An average of these two estimates (3.3%) is a reasonable compromise. You can dig into the paper for all the details, but here are the numbers we’re using for inflation, bonds and stocks in our plans these days: Estimated long-term returns (as of December 2015) Asset class Expected return Inflation 1.80% Canadian bonds 3.30% Canadian equities 7.10% U.S. equities 6.30% International developed equities 7.20% Emerging markets equities 9.80% Source: PWL Capital And here’s how those numbers combine in various balanced portfolios. In the table below, we’ve also included the standard deviation (a measure of volatility) for each asset mix, and the maximum drawdown (or cumulative decline) experienced in similar portfolios since 1988: Expected return and risk of various portfolios Equities/Bonds Expected Return Standard Deviation Cumulative Decline 0% / 100% 3.30% 3.90% -11% 10% / 90% 3.60% 3.80% -10% 20% / 80% 4.00% 4.00% -10% 30% / 70% 4.40% 4.50% -10% 40% / 60% 4.80% 5.30% -14% 50% / 50% 5.10% 6.20% -18% 60% / 40% 5.50% 7.20% -23% 70% / 30% 5.90% 8.20% -28% 80% / 20% 6.30% 9.20% -33% 90% / 10% 6.70% 10.30% -39% 100% / 0% 7.00% 11.40% -44% Sources: PWL Capital, Morningstar Direct How low can you go? In this new edition of our paper (which was first published almost two years ago), we’ve added a postscript to help put these numbers in context. If you’ve looked at the returns of a balanced portfolio over the long term , you may be surprised (and disappointed) by the expectations we describe in the paper. Even since the late 1980s, traditional index portfolios delivered annualized returns in excess of 7% or 8%, even with a conservative asset mix, compared with our expectation of just 5.1% for a portfolio of half stocks and half bonds. Why so gloomy? The first important point is that over the last 20 to 30 years, bonds enjoyed a long bull market as interest rates trended steadily downward (10-year Government of Canada bonds yielded close to 10% in 1988). This cannot be expected going forward, so we think it’s reasonable to plan for conservative portfolios to deliver significantly lower returns in the foreseeable future. It’s also reasonable to expect equity returns to be lower than they have been since 1988. By traditional valuation measures, stocks are relatively more expensive today: for example, the S&P 500 had a price-to-earnings ratio of 14 at the beginning of 1988, compared with 24 at the end of 2015. Finally, inflation was 4% in 1988, compared with just 1.4% in 2015. The numbers in the tables above are nominal returns, which are not adjusted for inflation. Remember that a 6% return with 2% inflation is very similar to an 8% return with 4% inflation. When viewed in terms of purchasing power, the gap between historical returns and expected future returns is not as wide as it first appears. Disclosure: Holdings include: ZRE, HXT, XRB, XMD, VAB, VTI, VXUS.