From Stagnation to Stagflation
With economic growth as measured by real final demand so weak, any increase in inflation which is not associated with a higher rate of real growth will represent a transition from the economic stagnation of the past few years to an even more unsatisfactory state of affairs, a dreaded “stagflation”, which came to plague the US and, to a lesser extent, global economy in the late 1970s. But wait, some might object, US CPI reached double-digits in the late 1970s/early 1980s, surely this is not a fair comparison? To which we reply: Good point. Let’s make certain that we are comparing like with like and adjust for changes that have been made to the CPI calculation methodology in the interim, as these have been substantial.
A respected independent economist, Mr. John Williams, maintains an excellent website publishing what he has termed “Shadow Government Statistics”, which show how the economy is performing today, using statistical methodologies from the 1970s for GDP, CPI and so on. These statistics allow for a proper comparison of contemporary and past US economic data. The results are illuminating, to say the least. Whereas the official, current rate of CPI is at a “59-year low” 1.1% y/y, when applying the same statistical methodology that prevailed in the 1970s–comparing like with like–in fact US CPI is currently 8% y/y! 8%! And there is a substantial food and import price inflation shock about to arrive!
TIPS may not be pricing in 8% y/y inflation or higher, but why should they? They don’t pay the old CPI as a coupon, they pay the current CPI. As such, TIPS implied inflation rates simply can’t tell us that we are perhaps already deep into an economic stagflation comparable to the late 1970s!
For those skeptical that this is a legitimate line of inquiry, consider some ominous parallels between current financial market developments and those of the late 1970s:
• The dollar is weak nearly across the board;
• The gold price has soared to records;
• The prices of commodities generally are now also rising rapidly;
• The stock market is rising;
• Yet all of the above are occurring alongside generally weakening US leading economic indicators
The evidence strongly suggests that US CPI is not 1.1% y/y but rather somewhat higher. But if US CPI is in fact somewhat higher then this implies that the real rate of GDP growth is commensurately lower, as real growth = nominal growth – price inflation. Yet with official GDP growth as weak as it is, then that would imply that, in fact, true real GDP growth is outright negative. Impossible? Well, consider some other interesting economic facts:
• The economy is not adding jobs and, in fact, employment remains far below the peak reached in 2007;
• State sales tax revenue growth is negative, implying negative real retail sales growth;
• The Conference Board consumer survey of inflation expectations is around 5%
Isn’t it far, far easier to understand the behavior of financial markets and the broader range of economic data hiding behind the headline figures, by assuming that CPI is somewhat higher, and real GDP growth somewhat lower, than official figures suggest? We leave it to the reader to decide.
If the real state of economic affairs in indeed as bad as Mr. Williams’ data imply, then we are, in fact, already deep into a stagflation which is only going to get worse. The financial market implications are significant.
First of all, it is likely to become increasingly evident that current US bond yields are far too low to compensate investors for the increasingly rapid loss of purchasing power. As such, either yields are going to have to rise or, to the extent that the Fed stands in the way, the dollar decline.
Second, corporate profits are going to suffer in a severe squeeze between sharply rising input prices on the one hand and poor real final demand on the other. This is likely to weigh on equity markets although equities are likely to outperform bonds as corporations, in particular those producing/providing relatively non-discretionary goods and services, are able to pass on some costs to consumers.
Third, within equities, financial shares are likely to underperform, possibly dramatically. The more severe the stagflation becomes, the more likely that, eventually, interest rates are going to rise. While goods-producing firms able to export might benefit in time from a weaker dollar and lower relative wage costs, financials do not benefit directly from such developments. Rather, their valuations are a direct function of the level of interest rates. A glance at the relative performance of US financials during Fed Chairman Volcker’s 1979-82 assault on inflation, via higher interest rates, is instructive in this regard.
Fourth, commodities are likely to remain the best performing asset class. Gold and other precious metals may, or may not, lead the way, as their prices are already elevated relative to those for other commodities. Crucial here will be the perceived risk of the US financial system. If confidence in the financial system deteriorates substantially, precious metals are likely to be the best performers. If financial conditions are relatively stable, a more balanced and widespread outperformance of commodities becomes more likely.
Needless to say, this is not a benign investment environment. Those living on fixed incomes are going to see their purchasing power substantially eroded over time. Those who think that stocks are cheap due to highly misleading comparisons with the unsustainable asset bubbles of the past are going to be disappointed. Adding to the misery for stock market investors will be the “green-tape” associated with new environmental and natural resource regulations; a more aggressive regulatory regime generally; tremendous political and hence tax policy uncertainty; and an astonishingly widespread culture of corporate fraud, which has no doubt been substantially facilitated by the complete lack of even basic enforcement of US contract and securities laws before, during and following the financial crisis of 2008.
While the above comments are rather specific to the US, certain other developed economies, including parts of the euro-area, the UK and Japan, have issues which are in many cases similar and in some cases even worse. And while emerging markets are likely to continue to outperform on trend, at least in relative terms, investors should be cautious regardless of where they are looking for value around the world.
For those readers who have been following the Amphora Report, no doubt this edition represents another rather depressing installment. We are long on criticism and rather short on proposed solutions. From time to time we do try to offer reasons for hope and, this time around, we close with a few.
First, we note that alternative, non-Keynesian economic thinking is beginning to find its way into the mainstream press. Regular readers of the Wall Street Journal (US), Financial Times (UK) and Daily Telegraph (UK) have probably already noticed this. Policymakers are more likely to listen to these sorts of media sources than those of the blogosphere, however pertinent, sophisticated and credible the latter.
Second, economic policymakers in a growing number of countries, in particular in Europe but also in certain emerging markets, are beginning to take proactive measures to place their economies on a more sustainable path, even if this places them in direct confrontation with the US. Germany is an important case in point, as are France, Brazil and India. We would even place the UK in this group.
Third, some influential business leaders in the US are now speaking out against plans for additional stimulus, arguing instead that more fundamental economic restructuring is now necessary, however painful it might be in the near-term. This is a welcome contrast to the near universal acceptance of the business community back in 2008-09 that, without substantial fiscal and monetary stimulus, the US would somehow become an economic wasteland overnight.
Fourth, while we are not partisan in our politics, we welcome the growing political activism in the US, Europe and elsewhere. In all cases, there is much more citizen engagement and fundamental debate taking place around all manner of economic issues. While in certain cases demonstrations are turning violent, it is important to understand that this is an unfortunate symptom of supposedly representative political systems not living up to the spirit of their specific constitutions or of their democratic traditions generally. Long may the activism continue.
These are all important developments. The first step toward curing an addiction–in this case artificial, unsustainable and ultimately counterproductive economic stimulus–is to recognize it for what it is. As the media, policymakers, businessmen and all citizens wake up, the odds grow that we might just manage to avoid an even worse fate than that which already awaits us as the consequence of colossal past policy mistakes.
No, there is no easy way out. There is no free lunch. Indeed, that lunch is going to get much more expensive before long.
[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]