Increasingly Wicked Inflation
As the dollar continues its stately decline…or, as your Paris editor notes above, possibly approaches its rout…certain "reflatables" are poised to profit. But be careful how you choose them!
Inflation proper – an expansion of the money supply – has been going on for quite a while. It was the fuel for the late nineties boom. But a different sort of inflation is now beginning to emerge, a growing menace to indebted consumers.
What we are talking about here might be more accurately described as price inflation – a general and widespread increase in prices, or stated differently, a general and widespread decline in the purchasing power of money. In the dollar’s decline, we have started to see this…but it is only the beginning.
Bill Gross of PIMCO, the Warren Buffett of the bond world, has long been an astute observer of the bond market, and financial markets generally. His December 2003 Investment Outlook contained a nice summation of an investment thesis for 2004. In short, Gross is in the inflation camp…as am I.
Gross seems to take Fed officials at their word when they talk about "printing presses." Wisely, in my estimation. There are few things government cudgels do with much skill, but one of them is certainly destroying the value of their own currencies. History gives us plenty of examples, most famously the great German hyperinflation of the early 1920s or France in the 1790s. But there are recent examples, too, especially in Latin America and the old Soviet bloc countries. All paper monetary systems tend toward the valueless and crisis-ridden, as history proves.
In Gross’s view, the reflationary effort is only in its infancy and is not likely to immediately jump up and bite investors. [Note: reflation is the somewhat contrived term often used to describe an attempt to revive a previous inflationary boom by increasing or stepping up inflation.] Nonetheless, the stance for investors today should be one of preparing for increasingly wicked inflation.
Gross presents the following asset categories, which he ranks by his own personal preference. These include commodities and tangible assets, foreign currencies, real estate, TIPS, and global bonds and equities denominated in non-dollar currencies. Gross calls these "reflatables"…and if you are shopping for places to put your money, this list would be a good place to start.
Reflecting on his choices, in particular global bonds, Gross notes the likelihood that foreign currency gains will dominate returns, even if yields should move higher. Foreign credit markets present slightly higher yields to begin with, though one has to wrestle (sometimes) with estimating the additional political risk. Similarly, global equities offer cheaper valuations than U.S. equities. Gross notes that the UK’s FTSE yields 3.7% compared to 1.6% for the S&P, as well as selling for lower P/E multiples.
There is no doubt the dollar is weakening. Long held as the international currency of choice, it has been weakening for at least a year, and there are suggestions that it may be the beginning of a significant revaluation.
First, there is the simple raw evidence of market data. The dollar seems to make new lows against the euro every day; the dollar declined 20% against the euro in 2003. It also reached an eleven-year low against the pound and a ten-year low against the Canadian dollar. These are not isolated examples, but recurring strands of a larger fabric of soft comparisons against foreign currencies. From its peak in 2001, the U.S. dollar index, which charts the currency against a basket of six major foreign currencies, has declined more than 25%.
Another clue is found in the gold market. The yellow metal had a tremendous year in 2003 and now trades north of $410 per ounce – a level not seen in more than eight years – and is up more than 25% from one year ago. Gold is up 60% from its low of $255 per ounce in 1999.
Reflation: Buffett Selling the Dollar
In addition to cold numbers, there is anecdotal evidence of interest. Warren Buffett, for one, is selling the dollar. In his article for Fortune ("Why I’m not buying the U.S. dollar") Buffett writes, "Through the spring of 2002, I had lived nearly 72 years without purchasing a foreign currency. Since then Berkshire has made significant investments in – and today holds – several currencies. I won’t give you the particulars; in fact, it is largely irrelevant which currencies they are. What does matter is the underlying point: To hold other currencies is to believe that the dollar will decline."
When the Oracle of Omaha does something he has never done before, that is worth noting.
Buffett cites primarily the unprecedented size of the U.S. balance of payments deficit. Foreigners hold $9 trillion worth of U.S. dollar-denominated assets. Much of that is in U.S. bonds. The accumulation of this debt has surpassed all previous records. Foreigners are not likely to continue buying dollars at record-setting levels and any shifting in this trend will result in a further weakening of the dollar.
Buffett is not alone – Soros, Templeton, Jim Rogers and other investment luminaries are betting on a dollar decline. That is not a crowd one is going to make a lot of money betting against.
Reflation: Tough to Hedge
With continued weakening of the dollar playing a significant part of the investment backdrop, investors find themselves in a tough spot. During the boom of 1995-1999, it was easy enough to refrain from buying tech stocks, for example. The risks today seem more nebulous and far-reaching, and hedging seems more difficult. It is easy to understand the bullish case for reflatables – but it is more difficult finding concrete investment ideas that represent good values in these areas.
Looking at commodities, for example, many gold companies seem expensive and lack Ben Graham’s margin of safety. They have become speculations on the price of gold – a good speculation, perhaps, but a speculation nonetheless. Better to own the metal itself, at this point, but that is not easy to do.
Investors can widen their search and explore other tangible assets. But again, in most of these instances, the readily available and liquid investments are going to be in commodity-oriented companies that have their attendant risks and are not pure plays on the underlying commodities themselves. Real estate is similar, except that most people have real estate exposure with their investment in their own homes.
A weakening dollar naturally implies that several (many?) foreign currencies will do better relative to the dollar. Hence, investments in non-dollar-denominated foreign securities should do well relative to the dollar, all else being equal. The problem is that international investing (especially the emerging market variety) has its own risks, often overlooked.
In summary, Bill Gross’s "reflatables" have a great deal of investment appeal at the theoretical level. Finding concrete ideas and opportunities that meet a rigorous test for a margin of safety is more difficult. That is always the more difficult task.
for The Daily Reckoning
February 19, 2004
Editor’s note: Christopher W. Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Christopher’s essays have appeared in a wide variety of publications, from the Mises.org Daily Article series to here in The Daily Reckoning.
Christopher has recently launched his own investment letter, "Capital and Crisis" – a cost-effective advisory for contrarian-minded financial observers. Inside, you will find promising investment ideas relating to movements in currencies, stocks, bonds and commodities…but also financial phenomena such as booms, busts, inflation, deflation, central banking and/or financial history.
This essay was adapted from the first issue of Capital & Crisis.
"I enjoy the Daily Reckoning…" begins a friendly reader from Britain, "…However I must pose the Question, when is the big drop going to take place?
"Any regular reader would, several years ago on reading the ‘reckoning’ forecasts, have put up his umbrella, canceled all trading, withdrawn into a defensive shell, and taken up residence in a cave situated on K9.
"And in the meantime missed out on a great bull rally.
"Thank you for the Daily Reckoning regular ‘The end is nigh’ messages. We for countless years have had chaps strolling up and down Oxford St. daily giving the same message by sandwich boards. Anyone in their right mind knows that this crazy economical dreamland cannot carry on for ever, and that one day the piper will call for
"In the meantime, we have to trade to live. So in the meantime, I trade what is happening, not that which I think should happen. And it might be a good idea for Bill Bonner & Co. to encourage such action in his otherwise excellent messages."
Of course, fish gotta swim, birds gotta fly…and traders gotta trade what is happening NOW.
But, here at the Daily Reckoning, we have neither gills nor wings. We have no sure answer to the Question. And if we thought we could help readers trade successfully…well, we’d be tempted to charge for it.
No, our beat here is merely trying to figure out what is happening. We want to know, partly because we are curious, partly because we greedy, and partly because we are just looking for entertainment.
What is really going on, we ask ourselves? What does it mean? Why is it happening? What OUGHT we to do about it?
We step back to get a better view…or climb a pile corpses. Either way, you could hardly expect us to be able to spot a decent trade at this distance!
It has been four years since the 3rd millennium and the Great Slump began. Stocks, generally, began to fall in January of 2000….10 years after Japan’s slump began. In Japan, it took the next 14 years to squeeze out the spirit of optimism and wring out the inflation that had puffed out asset prices. Stock and real estate investors lost 70%…80%…90% of their money.
In America, Nasdaq investors took similar losses. But they were largely "paper losses." Many investors saw their ‘profits’ wiped out…but their stocks and options were right back where they started. And they were still pretty sure that stocks were the place to be ‘for the long run.’
And then the Feds came to the rescue with truckloads of cash. They spread it around Manhattan as though it were bales of cotton on a bayou dock. A desperate investor, jumping out of a high window, would fall right into it and not feel a thing. He just got up, dusted himself, and went back to ruining himself with more confidence than ever. Now, he was not merely a genius, he told himself, but a survivor.
When the bull market on Wall Street began, you could buy the entire list of Dow stocks for the price of a single ounce of gold. By the time the bull market had hit its bubble peak, it took more than 30 ounces of gold to buy the Dow. In the last 4 years, that number has come down…but only slightly…to 25.
As we sit here under the starry skies of Latin America…we wonder. If the ratio of 20 years ago were ever to be seen again…either gold must go up 25 times, or stocks must go down 96%. We don’t know, but we guess that it will take a little of both…and that some gloomy day, sometime in the future, maybe the Dow will be around 2,500…and maybe an ounce of gold will sell for the same price.
Something big began 4 years ago. The U.S. had climbed a mountain of credit in the preceding 25 years; now, it is headed down. Somehow, sometime, someway…it will work its way down to the valley of despair that lies ahead. Several times in the past, investors were sour enough to think that a dollar’s worth of stock market earnings was worth only $5 or $6 of share price. Why wouldn’t they think that way again? They once thought, too, that America’s leading stocks – all 30 of them – were worth no more than a single ounce of the yellow metal. Why wouldn’t they think so again?
The work of the Great Slump is far from over, we conclude. Yes, you can trade the rally. But don’t forget to step back and have a look around occasionally. Otherwise, you might forget who you are…and what you are doing.
Why should stocks be 25 times more valuable – in terms of gold – than they were in 1980, you might ask yourself? Neither stocks nor gold are intrinsically more valuable. No important new use has been found for that which glitters. Nor has any new advantage been discovered from owning stocks. Stockholders do not necessarily live longer or weigh less. People do not admire the cut of their suits or their skill at Parcheesi any more than they did before. Nor is a buyer of gold any dorkier than he was in the final years of the Carter Administration. We are all the same race…the same people…with the same hearts and the same fears. We still live on the same planet…and under the same stars…
…and suffer the same slumps…just as in Japan.
Over to you, Dan…
Dan Denning under the cold, gray skies of Paris…
– Pause. That’s what stocks seemed to do yesterday. The Dow closed at 10,672. April gold was down a few bucks to close at $412. You can’t blame stocks for being tired…they’ve come a long way, baby. And when they stopped yesterday, in the rarefied air of one of the strongest rallies in the post-WWII era, they couldn’t have liked the lay of the macro-economic land.
– First, the Commerce Department reported that January housing starts were down nearly 8% from December’s record…but perhaps that’s simply a seasonal phenomenon. The Mortgage Bankers Association reported that its purchase index, a measure of new loan requests, was up 2.9%. Still, the National Homebuilders Association reported that its Housing Index, a measure of sentiment in homebuilders, fell from 69 to 65.
– Is the home-building boom ending? Is the mortgage financing bubble fixing to pop? One month does not a trend make, but at the very least, housing activity – both building and buying – is coming off record levels. We’re starting to see signs that interest-rate-sensitive demand might be slowing, even while home building supply keeps increasing. As Scott Winningham, an economist at Stone and McCarthy Research Associates, said in a Reuters article, "There’s a growing divergence between new home sales, and homes being started and those still on the market."
– Of course, as interest rates go, so goes mortgage activity. And on the interest rate front, stocks will have to digest the news last night that for the first time in the history of the Republic, the government debt is over $7 trillion.
– Bond prices haven’t reacted to the news yet. But the obvious question is: will rising government debt force the Fed to finally "defend the dollar" and raise rates before it wants to? After all, seven trillion is a pretty big number…though one Treasury Department official claimed, "there’s nothing special about [it]." But according to Congressman Baron Hill of Indiana, "It is simply immoral to run a national debt exceeding $7 trillion, every penny of which our children and grandchildren will be responsible for paying back."
– Naturally, since we live in bizarro investment world, the dollar rallied on the news that America’s government is fiscally and monetarily incontinent. After trading at a record level of $1.29 to the euro, the greenback recovered, presumably as euro traders took some profits.
– The fireworks, however, are just beginning, and a big move down in the dollar may be in the offing shortly. Otmar Issing, the chief economist at the European Central Bank, delivered a monetary slap to Alan Greenspan yesterday in the Wall Street Journal. "…We have repeatedly experienced situations," writes Issing, "in which market participants found it more rewarding to follow a trend than to bet against it despite their own view that the development was not sustainable. It is worth noting that with hindsight, i.e. after the collapse, almost everybody seems to agree that a ‘bubble’ has burst. Is it not difficult, then, to accept the argument that it should be totally impossible to make any judgment ex ante? Should it not be the role of central banks to communicate concerns in an appropriate form and thereby to try to contribute to a more sober assessment of asset price developments?"
– Translation: "Hey Mr. Greenspan, sober up, you’ve got an asset bubble on your hands, you big lush." It appears a strong currency makes central bankers rhetorically cocky. But Issing is right. He has essentially rebuked his colleagues in the U.S. with this sentence – "…It should not be overlooked that most exceptional increases in prices for stocks and real estate in history were accompanied by strong expansions of money and/or credit. Just as consumer-price inflation is often described as a situation of ‘too much money chasing too few goods,’ asset-price inflation could similarly be characterized as ‘too much money chasing too few assets.’"
– The Fed is beginning to reap what it has sown in the monetary whirlwind. And the dollar will be the chief (although not the only) victim. The chief beneficiaries will be currency speculators…and, of course, gold. As Thomas Donlan said in this week’s Barron’s, "You don’t have to wish for gold coins clinking in your pocket to realize that gold is still a relevant measure of wealth, no matter how many economists denounce it as a barbarous relic. Without some attachment to harder values, the half-life of paper money is Hobbesian – ‘nasty, brutish and short.’
– Donlan continues, "Every day, millions of traders, speculators and investors pass judgment on the dollar and its stewards as much as on the supply and demand for whatever they happen to be buying or selling that’s priced in dollars, euros, yen, yuan, rupees or wastepaper. When the dollar goes down, that’s a sign we’re going wrong. As any Argentine must know by now, the markets, like the mills of the gods of old, grind slow, but they grind exceedingly fine. At the moment, the markets threaten to grind the dollar to powder."
– Enjoy the pause…while it lasts.
And back in sunny Nicaragua…
*** Gold fell $3.70 yesterday. It is still at $412…and still a bargain. But we are alarmed by the number of people who think the dollar is on course for steady decline. Even the major media – TIME and BusinessWeek – are talking about a continued drop of the greenback. This can only mean two things. Either the dollar is ready for an important rally…or it is ready to collapse.
*** Ah paradise…! We discovered this place, what, 5 years ago…or more. We lay in a hammock…with no phone…no TV…no Internet…What a pleasure it was to walk on the lonely beach…and then read a book….and let ‘Rome in the Tiber melt"…
But then we became accidental, reluctant developers – building a clubhouse…roads…houses…tennis courts…pools…riding stables. All very well to have a beautiful setting…but we needed things to do!
And so, on this vacation, your editor spends his days in meetings – discussing all the things that need to be done in order to make sure there are things to do. There are phones…TV…and Internet. And the latest…a WIFI connection…so that your editor can work on his laptop computer no matter where he is – even on the beach itself. Now, nowhere – in this corner of God’s green earth anyway – can a man get away.
Your editor has barely seen his family…he has barely felt the sand beneath his feet or the sun on his back…but he has gotten a lot of work done. Is this progress…or what!
*** Following his comments on China last week…our friend, Karim Rahemtulla, writes about his mother country…
"Prior to 1997, I had never visited India nor paid much attention to the region. After all, the Indians that I knew were all fleeing the country for better opportunities abroad. But, Asia was in vogue in the early to mid-nineties, and I felt the need to make a trip over there and to other parts of Asia to check it out in person…
"…After a late night arrival in Delhi, I woke up the next day for a walk around. I wore new white sneakers, a pair of walkers bought just for the trip. I got my first take on Indian capitalism very soon after leaving the hotel. A street urchin approached me and told me my sneakers needed cleaning. I was wearing shorts and a polo shirt – I guess I stood out as a tourist from a mile. I didn’t have to look down – after all, the sneaks were new. I said no and began walking away. He persisted and so I finally looked down, and lo and behold… something gross was smeared all over one of my sneakers. There were few cows walking around on the streets, so I know I did not step in a cow patty. To this day I know the little guy had intentionally pitched something on my sneakers just to make a sale.
"’Ok. Go ahead, clean it up.’ It took him about 20 seconds of mixing some concoction from his little box to come up with a cleanser to miraculously make my shoes look like new again ( I wonder if Proctor and Gamble gets its formulas from some backstreet chemist in Delhi.) His price – $3 dollars. I gave him a dime and told him to take a hike. He did while firing off expletives in Hindi in my direction. Hey, I may be a tourist, but I do know the value of a good hosing. I guess in a country where 80% of the population (at least 1 billion out of 1.3 billion) are poor, the art of making something out of nothing has been perfected!
"Let me digress for a minute. I am not opposed to investing in India, China or Asia in general. I am opposed to investing without a darn good guide who knows what is happening on the ground. There are too many ‘me too’ investments that pop up from these countries with nothing more than a trumped-up story of gold in them thar’ hills. So, please, invest away, but do so with eyes wide open and ears to the ground."