June 1, 2009
Anything But Academic
Last week, the 10-year Treasury yield spiked to about 3.75% before retreating on Friday, on concerns about the massive issuance of Treasury debt required to defend bank bondholders against any loss. To some extent the spike also reflected concern about inflation that might result from that issuance, but that is decidedly a longer-term problem, not an immediate risk. Delinquency rates on commercial, credit card, and real-estate loans are soaring well above last year's levels, so my impression is that immediate fears about inflation will be replaced by a fresh flight to safety within a few months.
Meanwhile, the debate about the inflationary implications of the bailout continues – again, this bailout is not really a defense of the global financial system, as much as it is a defense of bank bondholders against any loss whatsoever, quickly orchestrated and sold to a confused public as the only option, when it is nothing of the sort. In any event, the inflation debate has been interesting. On one hand, Paul Krugman – who has generally argued against the legitimacy of the bailout – argued last week that inflation risk is non-existent, since the funds provided to the banks have not been used for new lending. While it is very true that the funds have been largely invested in Treasury securities rather than being lent out (which almost has to be the case in equilibrium, as I argued a couple of weeks ago), the fact is that the massive expansion in government liabilities will ultimately be accompanied by a reduction in the relative value of those liabilities (i.e. inflation and higher interest rates). Krugman's argument boils down to the recognition that "monetary velocity" is currently very low - that is very accurate. The problem is that unless it remains low indefinitely, the more than doubling of the U.S. monetary base over the past year, along with the additional issuance of Treasury debt, leaves a far larger quantity of government liabilities to be absorbed until and unless those liabilities are extinguished by fiscal surpluses. The only way to absorb them without driving up the price level is to hold down velocity indefinitely, or to have an equal expansion in real economic output without any further expansion on the monetary side.
The price level is essentially the ratio of two marginal utilities – the marginal utility of goods and services divided by the marginal utility of government liabilities. We have seen no inflation in response to the huge issuance of Treasury securities because presently the marginal utility of goods and services is depressed (because people are still in the process of shifting away from credit-financed consumption), while the marginal utility of government liabilities is still elevated (because people are still averse to holding savings in the form of more risky assets). Unless the current, unusual profile of marginal utilities persists indefinitely, we can expect that a normalization of the relative utilities of goods and services to government liabilities will result in a large upward shift in the U.S. price level.
In the other academic corner is John Taylor, an economics professor at Stanford (and more to the point, one of my former dissertation advisors), who wrote in the Financial Times last week “To bring the debt-to-GDP ratio down to the same level as at the end of 2008 would take a doubling in prices. That 100 percent increase would make nominal GDP twice as high, and thus cut the debt-to-GDP ratio in half, back to 41 from 82 percent. A 100 percent increase in the price level means about 10 percent inflation for 10 years, but that would not be smooth – probably more like the great inflation of the late 1960s and 1970s, with boom followed by bust and recession every three or four years, and a successively higher inflation rate after each recession.”
As should be clear from my comments over the past couple of weeks, I'm clearly of the same mind – a roughly 100% increase in the U.S. price level over the coming decade.
There's an economists' riddle that goes “Why are the debates in academia so bitter?” – the answer – “Because the stakes are so low.” Now, very often, that's true. I remember a presentation that Paul Krugman gave at Stanford where he was talking about a model of economic development. Paul drew a diagram on the board, and as he described it, he drew a few little arrows indicating migration of businesses from one area to another. A respected economic theorist at Stanford, Mordecai Kurz (who never drew an arrow without a differential equation), immediately jumped up and shouted “You haven't described the dynamics!!” to which Paul responded that he was indicating a general movement of economic activity toward one place to improve efficiency. Dr. Kurz pounded the table and screamed “Then erase the arrows!! ERASE THE ARROWS!!” and then stormed out of the room and slammed the door behind him. I think that was probably the exact moment that I decided to go into finance.
Presently, however, the debate about the long-term economic fallout from this defense of bank bondholders is anything but academic. I recognize that I have been on a virtual rant about it in recent months, but the reason is that it is literally the most important fiscal and bureaucratic event that we are likely to observe in our lifetimes, and is very possibly the precursor to enormous future economic difficulties. You simply cannot have an economy lend out trillions of dollars in bad debt, and then make the lenders whole with public funds (while still facing a massive second wave of probable mortgage defaults) without destructive repercussions. There is very little chance, in my view, that the current downturn is over. We have enjoyed a nice reprieve – if over a trillion dollars in redistribution could not accomplish even a reprieve, it would be a surprise. It's clear that investors are hopeful that we can simply return to rich valuations, debt-financed economic expansion, and abnormal profit margins based on excessive leverage. From my perspective, this hope is as thin as those that we observed at the peak of the internet bubble, the housing bubble, and the profit margin peak of 2007.
As I noted last week, our risk measures have shifted from a borderline neutral stance to a fresh defensive stance. From a valuation perspective, stocks are slightly overvalued except on the basis of earnings-based metrics that assume a quick return to 2007 profit margins. Stocks are not richly priced, but they are no longer compressed in valuation. They are also no longer compressed from a technical perspective, and are instead overbought on a variety of measures. Without compression to allow prices to advance as a sort of “release valve,” the market now relies on actual improvement in the economy – not simply news that is “less bad than expected.” That's not to say that we can rule out such improvement, but at this point, the market relies on it. For our part, the average return-to-risk profile of the market, given current conditions, does not justify much risk taking. Moreover, in view of the larger picture of economic and credit conditions, the risks are lined up clearly to the downside. The stock market features unimpressive valuation, overbought conditions, and a reliance on positive surprises and easing risk aversion. That sort of market certainly can continue higher, but the potential for further return comes with a great deal of potential risk.
As of last week, the Market Climate for stocks was characterized by modestly unfavorable valuations and enough deterioration in (already tepid) price-volume action to place us on the defensive against potentially abrupt weakness. The Strategic Growth Fund does continue to carry just under 1% of assets in index call options as something of an “anti-hedge” to soften our defenses in response to any further market strength that might emerge, but our primary concern here is defending capital. Though the recent advance has not produced strong price-volume behavior on our measures, we've clearly observed much improvement since the lows, and I expect that this will make it much easier to recruit sufficiently favorable price-volume behavior in the months ahead. The ideal situation would be to observe a significant decline back toward the 700-800 area, which might provide a more durable base for subsequent strength. In any event, I expect that the market may remain in a very wide 25-35% trading range for some time – not just a few months. As I've noted before, a 1/3 retracement of the decline since the 2007 peak would represent a move to about 975, which is possible, but again, we would not speculate on that event, and for our part, we are mostly defensive here.
In bonds, the Market Climate last week remained characterized by modestly favorable yield levels and generally unfavorable yield pressures. I remain convinced that the enormous issuance of government liabilities we've observed is likely to result in a longer-term upward shift in the U.S. price level, but there is not an immediate reason to expect inflation pressure at horizons of less than a few years. That being the case, bonds – like stocks – can be expected to trade in a very wide trading range for some time, and we'll tend to extend our durations on further spikes in yields, while contracting them when yields decline significantly. For now, the Strategic Total Return Fund continues to carry a duration of just over 2 years, mostly in TIPS, with about 25% of funds allocated to precious metals shares, foreign currencies, and utility shares.
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