Stagflation: Stagflation Rides Again

FUNDAMENTALS, EVEN FOR surprisingly long periods of time, frequently have very little to do with market moves. Markets can be driven by numerous factors other than pure economic fundamentals such as emotions and illusions. In recent times, it would appear that performance-driven momentum players played a key role.

In fact, the entire debate about the US dollar and its impending demise, which was hailed by front-page headlines in the printed media, including The Economist (December 4, 2004 issue) and, after some delay, the leading Swiss business magazine (Bilanz, January 26, 2005), is quite meaningless.

The key point of the US dollar bears is the rising US current account deficit. However, in terms of the movement of the dollar, from a shorter-term point of view the current account deficit is irrelevant. I am indebted to Robert Prechter, whose Elliott Wave Financial Forecast of December 2004 contained a figure that clearly indicates there is very little correlation between the current account deficit and the exchange rate of the dollar, even over the medium term.

When the current account deficit exploded in the early 1980s, the dollar rallied. And when after 1987 the current account deficit contracted, the dollar continued the downtrend, which it had begun in 1985, until 1994. But then, when the current account deficit soared again after 1994, the dollar rallied strongly until 2001.

So, all in all, over the last 30 years, there has been practically no correlation between current account deficits and the exchange rate of the dollar. I certainly don’t wish to be misunderstood, however. Like Professor Rogoff, I believe that, in the long term, economic fundamentals do matter in all asset markets. Therefore, countries that implement inflationary monetary policies and, as a consequence, have a growing current account deficit will in time endure a weakening currency.

Conversely, countries that don’t “overspend” or live beyond their means will benefit from rising current account surpluses and, in time, from a strengthening currency. However, buying or selling a currency based purely on the movement of a country’s current account position can, over shorter periods of time (one to three years, in my opinion), prove to be a costly proposition.

Stagflation: Looking at the Research

Numerous other factors, such as interest rate movements, central bank interventions, and speculative positions can also drive exchange rates. Similarly, buying equities in economies with the fastest GDP growth rates won’t necessarily yield satisfactory returns. Research conducted by Professors Dimson, Marsh, and Staunton of the London Business School, in association with ABN-AMRO, found that there is no positive link between a country’s GDP growth rate and future investment returns.

The researchers looked at 53 different stock markets around the world over periods of up to 104 years. They found that in no market was there a statistically significant correlation between previous GDP growth and future investment returns. The researchers also ranked countries according to their past GDP growth over five years, and studied subsequent returns. According to their research, investors would only have earned 6% a year in countries in the highest-growth quintile (the top 20%), whereas they would have earned 12% annually by investing in the countries in the lowest-growth quintile!

The study also found that dividend yields and the growth of dividends had a larger impact on stock prices than on economic growth rates. My purpose in mentioning the poor correlation between current account deficits and exchange rates, and the absence of any positive link between GDP growth rates and subsequent stock market returns, is not because I intend to focus specifically on the movement of the US dollar or of stock prices. All I wish to do is to reiterate the very difficult nature – the impossibility, even – of forecasting market movements.

In fact, I was amused to read a report by Steven Hochberg (The Elliott Wave Financial Forecast of January 7, 2005), entitled “The Technical Case for a Large Move in Bonds”, in which he pointed out that periods of extremely low volatility in the bond market usually lead to a sharp move in either direction.

Since the mid-1970s, household net worth (household assets net of debts) has soared by about ten times. The first question that springs to mind is whether the median US household or, for that matter, any household in a Western industrial society – is indeed ten times wealthier than in the mid-1970s. Equity and home prices may have risen significantly over the period, but is the average household really ten times wealthier, or is this rise in the value of households’ assets largely illusionary wealth?

The market value of owner-occupied household real estate as a ratio of disposable personal income is at a record high. In other words, since the 1970s, affordability has declined significantly! Moreover, the rise in home prices has also created more wealth inequity. According to Jose Rasco, the largest gains in net worth in recent years came from the top rungs of the income ladder. The top 10% income earners saw their net worth expand the fastest, rising almost 70% from 1998 to 2001.

The next 10% saw their net worth increase by 28%. This is most likely due to the fact that those two groups own the largest percentage of the two asset classes that appreciated the most: housing and equities. Moreover, the top 20% income earners also own other real estate assets that have appreciated in price in the last few years, providing them with even more opportunities to lever up those assets. It was the middle class that saw the smallest gains in net worth.

Rasco produced a table which shows that between 1998 and 2001, household income recipients in the US$20,000 to US$40,000 bracket increased their net worth by 3%, while for the US$40,000 to US$60,000 bracket net worth increased by 7.6%. Since 60% of households have a median income of US$39,900 or less, it is easy to see that wealth inequity has increased. (Income inequity has also widened as the 10% highest income earners saw their incomes increase faster than any other income group over the last ten years.)

Affordability for the median household aside, I think it is important for our readers to understand the implications of rising monthly mortgage payments. Mike Buchsbaum, a reader, referred to this when he wrote that the typical Bay Area buyer was committed to a monthly mortgage payment of US$2,344 in January 2005, up from US$1,940 one year before. This is so because rising mortgage payments didn’t take place in an environment of rising but stable mortgage rates. Imagine what would happen to monthly mortgage payments if interest rates were to go up?

Another reader of ours, Rich Toscano, who publishes (under the name of Professor Piggington) the most entertaining and informative San Diego Real Estate Chrono-Collapsometer (www. piggington.com), published a figure that corroborates precisely what Buchsbaum has written.

Rich produced a figure showing how monthly mortgage payments have risen by 75% since 1999, while prices are more than 85% above the trend-line, whereas at the bubble’s peak in 1989 they were only 16% above the trend. Toscano attributes this rise in real estate prices against the CPI to a combination of increasing average home size, a modest increase in real family incomes, and a multi-decade trend towards lower interest rates.

Stagflation: Strength Extended

I would add that population growth and, especially, ultra-easy monetary policies and loose lending standards (sub-prime lending), leading to a debt bubble, were also major factors. Numerous other economists have also observed the recent strong inflation-adjusted rise in home prices (real home price appreciation).

And while I can see that, because of population growth, home prices in some desirable areas could rise for a long time at a rate in excess of the rate of inflation, it is also evident that the current period of strength in real home price growth is already quite extended by historical standards.

Home prices do decline from time to time in real terms (rising at a slower pace than the CPI ), and that these periods of real price declines have always followed periods during which home prices rose much faster than the CPI and led to bubbles, such as in the early and late 1970s, and in 1989.

In fact, even in nominal terms, home prices occasionally decline (and sometimes substantially), a fact that may come as a surprise to some readers from whom I get emails saying that home prices always increase.

A reader of Richard Russell’s daily stock market comments, ‘Steve’, recently sent in a reader’s letter that contained the following:

“For the person that said housing never crashes let me pass on these facts that I know only too well. My wife and I purchased a new starter type home in Dallas in 1984 for about $102,000 (which is about $190,000 in today’s dollars) and within a few years the area did well and houses were selling for about $115,000. Naturally, we felt very smart about our “wise decision to purchase a home”. Along comes 1988 and an economic downturn in Dallas which knocked down oil, technology and banking. Jobs that had been easy to find at good money started to disappear and people in the neighborhood started to talk about moving to another area if necessary to find work. The nice, cute little neighborhood started sporting “for sale” signs and then when the local economy really got bad, families just started leaving the neighborhood without even selling their home. They just sent the keys to the bank. Suddenly a home like ours was selling for $48,000 and when I received a good opportunity in a different state I could find no buyers for our home at any price above $50,000. At that point in time my mortgage balance was around $92,000 (we had put 5% down) and it was not possible for me to take such a sizeable hit. To make a long story short, after losing money every year paying for hail damage, repairs to appliances and the like we sold the house in 1992 for $72,000 and had to cover the difference. That size of a loss on a home is very painful and really puts your savings plans in reverse.”

But not to worry, the same economists who will tell you that the US current account deficit is due to the US economy growing faster than other economies around the world, will also tell you that there is no housing bubble and that prices will continue to rise forever. That may be true in US dollar terms, but it’s unlikely in hard currency terms.

It is clear that real estate, irrespective of whether it is for commercial or residential use, doesn’t always appreciate and that the housing market is relatively illiquid. It is always easier to sell in a rising market than once the market stalls and transaction volume dries up or in a falling market.

Stagflation: Illusionary Wealth

Much of what households own in terms of home assets is “illusionary wealth”, and household consumption depends on the illusion continuing. In addition, the bond market is watching “visible” inflation closely. I say “visible inflation” because, for most people, it is incomprehensible that inflation could manifest itself also in asset markets such as real estate, commodities or equities, and not only in high wage increases and rising CPI figures, which are doctored in any case. (Whereas healthcare makes up 14% of GDP, it makes up only 6% of the CPI.)

We should also realize that every democratically elected government, when confronted with the choice between economic pain and keeping the illusion of wealth alive, will be inclined to print money and create inflation. This is particularly true in a society where, like in the US, 70% of households own their own homes, since in that case the majority of families don’t immediately feel the pain of home inflation.

But, as Edward Chancellor pointed out in a recent article in which he quoted the American economist George Selgin, if interest rates are not allowed to rise to their “natural level” (in the US, probably around 4.5-5% for the Fed fund rate), “by further boosting the money supply, prices must rise” and “the more the authorities pursue the same policy, the more prices rise”. Chancellor concludes that, in his view, these conditions (to let interest rates rise to the “natural level” of around 4.5-5%) “are too much to demand of the US economy after its decade-long credit bubble.

Household debt has been rising far faster than income in recent years. This growth rate cannot be maintained indefinitely. Secondly, households, corporations and financial players appear to have taken on debt in the expectation of permanently lower interest rates. Despite six recent rate increases, real interest rates in the US remain negative. If interest rates were to return to their ‘natural’ level we can guess what might happen to the prices of houses, junk bonds, and many other risky assets.”

I fully endorse Chancellor’s views. In a society where debts and future liabilities are excessive and where asset prices have become grossly inflated as a result of negative real interest rates, the pain of ending the party by raising interest rates voluntarily to the “natural rate” is simply too great and, therefore, very hard to imagine.

The more likely outcome is that short-term interest rates will continue to rise but remain below the rate of inflation and so, as explained, lead to additional price increases. Consequently, the next big move in bonds, which we discussed in our introduction, is more likely to be on the downside, since, as Bridgewater Associates’ Bob Prince and Jason Rotenberg wrote, the baby-step approach to raising rates “creates a lot of room for disappointment – that maybe inflation continues to rise instead of fall, or that the economy accelerates instead of slows.”

I would like our readers to consider under which condition – accelerating economic growth, or weakening economy – the bond market would likely perform worse. The benefit of an accelerating economy is that short-term interest rates could be increased more rapidly. Rising rates would depress asset markets, specifically the housing market somewhat, but falling asset prices would be cushioned by rapidly expanding income. (While not a very likely scenario, it’s one that we can’t dismiss entirely.)

In this case, long-term bonds wouldn’t like the strengthening economy but would feel comfortable about the rapid increase in short-term rates, discounting that rising rates would combat inflation and, at some point, cool the economy.

Thus, bond price declines and long-term interest rate increases might be muted. But if the economy indeed stalls, or shows signs of weakening, we should be prepared to see the Fed abandoning the baby-step rate increases and massively easing monetary policies again in order to support the asset markets.

In turn, this would lead to the accelerating price increases Edward Chancellor referred to above and, in my opinion, to a major collapse in bond prices. Moreover, in time, accelerating inflation would inevitably force short-term rates higher. The Fed might keep short-term rates below the rate of inflation for an extended period of time, as was the case in the 1970s, but nevertheless they would rise and would eventually have to be pushed above the rate of inflation.

What about the housing market in the two scenarios just described? Amidst an accelerating economy, home price inflation is likely to cool down (as is now the case in the UK see, and in Australia) because of interest rate increases. However, rising personal incomes would most likely prevent sharp price declines, as affordability would improve.

Conversely, if in the scenario of a weakening economy interest rates continued to remain below the rate of inflation and much below the “natural rate”, then it is likely that consumer price increases would continue to exceed income gains. Under these conditions, affordability and a collapsing bond market should lead to sharp real home price declines.

Stagflation: Real-term Negativity

In addition, as I have just explained, if CPI inflation were to accelerate, short-term rates would rise – yet would remain negative in real terms. Still with declining real incomes (because inflation would exceed income gains), rising short-term rates would exacerbate the price decline I just described.

Mortgage payments would become unaffordable and refinancing activity would totally disappear. In this respect, it is important to understand that a significant portion of home mortgage borrowings occurred over the last two years when home prices were already high. Therefore, for numerous homebuyers, the cushion of safety in the equity of their homes is likely to be very thin – particularly if variable rate mortgages were used for home purchases (since short-term rates would rise).

I might add that, since 2003, home mortgage borrowings have continued to increase but the rate of growth has come down considerably, which would suggest to me that the end of high home price inflation is around the corner. The homebuilder bulls will, of course, tell you about the just reported record housing starts but forget that new home sales have slowed down and are now running at a rate that is no higher than in 2003.

What about the low volatility in the equity markets? Does this low volatility, as in the case of the bond market, also signal a “high potential for a powerful move”, and if so in which direction? In 1996 and 1997, volatility increased but the US stock market continued to rise, albeit the emerging markets collapsed.

In 1998, volatility increased as stocks sold off around the LTCM crisis. Again, as in the case of the bond market, low volatility doesn’t predict the direction of the next “big move”. However, extremely low volatility combined with record low credit spreads, low cash positions among financial institutions, the prospect of rising interest rates, extreme complacency among investors around the world, persistent insider sales, deteriorating technical indicators and very high bullish sentiment, does significantly increase the probability that the next big move will be on the downside.

In addition, strength in oil and basic stocks is masking weakness in a large number of financial stocks. Fannie Mae appears to be breaking down, and mortgage, credit card and sub-prime lenders, and providers of financial guarantee products such as Capital One Financial (COF), Countrywide Financial (CFC), Accredited Home Lenders (LEND), New Century Financial Corp (NEW), MBIA Inc. (MBI), and MBNA (KRB), all appear to be rolling over. JP Morgan Chase (JPM) – heavily exposed to derivatives – is also not performing well.

Usually, strength in oil stocks and weakness in financial stocks isn’t a favorable omen for the stock market. In addition, weakness in the shares of mortgage lenders isn’t a positive indicator for the housing industry. We are short some of the financial shares mentioned above and are looking to re-enter the homebuilders from the short side on any sign of weakness (which may happen soon). I also would like to mention that sharp breaks in speculative shares such as Travelzoo (TZOO), Research in Motion (RIMM), and Overstock (OSTK) are indicative of a vulnerable stock market.

But what is there to buy? Financial institutions should buy volatility (VIX) and credit spreads, as sometime this year they are likely to explode on the upside. In addition, as I have mentioned in earlier reports, grain prices are depressed and could begin to rise at any time. Where does that leave us?

As I said at the outset, it is virtually impossible to explain, much less predict, floating exchange rates across major currencies at horizons up to 18 months, but at longer horizons, two to four years, some macro-fundamentals come to the fore. I suppose the same applies to other investment markets.

Extremely low volatility in both bond and stock markets around the world, as well as corporate and emerging market credit spreads, are near all-time lows. We expect bothvolatility to increase and credit spread to widen in the course of this year.

Low volatility and tight credit spreads are symptoms of complacency and a high appetite for risk. As a contrarian, this suggests to me that there are too many people skating onthe ice pond and that the ice is likely to break at some point.

The bond market is vulnerable to numerous disappointments. In fact, as discussed, I regard the bond market to be particularly vulnerable if economic conditions weakenagain. Amidst weak economic conditions, the counterfeit money printing operations of the Fed will once again run day and night in order to support the inflated assetmarkets that have driven US consumption and GDP growth since 2000.

Expansionary monetary policies should then produce an environment of a weak economy, renewed US dollar weakness, and domestic inflation – in short,stagflation. In a strong economy bonds will also decline, but less so because short-term interest rates will rise substantially and depress asset markets in real terms. Paradoxical asit may seem, inflationary pressures are likely to be higher in a weak economy than in a healthyexpansionary phase where higher capital spending would lead to the expansion of manufacturing capacities.

For now, global economic indicators are giving conflicting signals. OECD economic indicators have turned down and European economies remain weak, but Dr. Copper has made a new high.

Housing price inflation should ease and decline below the rate of CPI inflation (decline in real terms) under both a scenario of a strong and weak economy. In a leveraged system,even small interest rate increases can have a meaningful impact on asset markets. We would avoid homebuilding stocks and are looking to short them.

Financial stocks are expected to under perform the market and a significant underweight position is recommended. Low volatility in stock markets around the world also signals a high potential for a powerful move. Given the fact that risk premiums are near all-time lows, an impulsive downward move is more likely than a strong and sustainable uptrend.

We have in recent letters also warned of increased geopolitical tensions. The catalyst for the next big move in asset markets may well come from some unfavorable (or favorable, but this is less likely) geopolitical development, rather than from purely economic factors.

In an environment of inflated asset prices, bargains are hard to find. Grain prices are near 20-year lows and offer substantial upside potential over the next two years.

On a relative basis, Asian currencies and assets remain undervalued and should besignificantly over-weighted. On a relative basis, gold and silver also seem to be inexpensive compared to the S&P 500 and oil.

Dr. Marc Faber
March 22, 2005