The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify, for those brought up as most of us have been, into every corner of our minds. – John Maynard Keynes
Much of the western world is mired in debt. American consumers are walking away from their suffocating mortgage payments in droves, and consumer credit outstanding has barely declined. To make matters worse, the U.S. is suffering from the highest level of unemployment since the Great Depression.
Many economists, market gurus, and television talking heads are waiting for the moment for inflation to strike. Here is the conventional wisdom: Hopelessly indebted, the country, aided and abetted by the Federal Reserve (the Fed), is expected to aggressively monetize (print money) its debt, wreaking havoc on the exchange rate. Bond prices are anticipated to fall, while commodity prices and interest rates are expected to rise. Under this scenario, inflation, as measured by CPI, is expected to climb faster than the “goldilocks” rate of 2% of the last few years (1% currently), and standards of living are expected suffer as general prices rise faster than incomes.
While we agree with the “inflation” thesis expressed in the preceding paragraph, we also see a world that is more nuanced than do most market commentators. While the above mentioned scenario may play out over the next few years, we see inflation as a current reality, and with significant consequences.
The most common measure of inflation uses a price index, like the CPI. Even the Fed has tunnel vision when it comes to inflation, looking at it only through the narrow prism of indexes that measure the nominal changes in final prices. We, on the other hand, believe that the idea of inflation encompasses both the nominal prices of goods and services as well as the levels of consumer incomes. So, in our view, stable prices, as measured by the various indexes, may actually represent inflation if incomes are falling. Our view, then, looks at the level of “living standards” which encompasses both income and price levels.
According to the CPI, we have experienced low and stable inflation over the last few decades. But, one only needs to look up the prices of cars, jeans, college tuition, healthcare, rent, and many other day to day items to realize that the average American’s expenditures have grown at a much higher rate than the reported inflation number (see shadowstats.com for an eye-opening education on “changes” (perhaps, manipulation) of this calculation). At the same time, the average American’s pre-tax income has remained stagnant for the last decade. Rising prices vs. stagnant incomes is, by our definition, inflation because the purchasing power of the average American has decreased over the last decade. While our definition may be relative, the result has the same deleterious impact on those it affects as does the tunnel vision definition of inflation.
When one thinks about inflation in terms of living standards, one realizes that inflation can occur in different ways and have different impacts on demographic or social segments.
- Currency Devaluation: In a currency devaluation, the immediate impact is on the cost and prices of imported goods. Eventually, the prices of domestic goods will rise as input sources, especially if they are foreign, drive up production costs. In April, 1933, FDR called in all the gold coins then in circulation, prohibited U.S. citizens from owning gold (not repealed until 1972), and paid the official price of $20.67 per ounce for the coins. Nine months later, FDR devalued the dollar by raising the dollar price of gold to $35/oz, a 69% devaluation in terms of gold. In our current experience, since 2002, the trade weighted dollar index has fallen 30% from 111 to 78, clearly a slow devaluation process. And while the dollar has recently shown strength on investor concerns over the value of the Euro, the long-term trend is clearly down. In fact, the Obama Administration’s goal is a higher level of exports, something that they plan to accomplish with a weaker currency. Unfortunately, in a world where demand is falling, every industrial country wishes to increase their domestic output (and therefore domestic jobs) via more exports, and we are witnessing a “race to the bottom” in terms of currency values. This is evident in investor increase in demand for gold as a monetary substitute and its consequent increase in value in terms of fiat currencies. We suspect that the Obama Administration’s frustration with the peg of the Chinese RMB to the dollar has to do with the fact that the dollar can’t be depreciated against it.
- Artificially Low Interest rates: In the U.S., we have a rapidly aging population. Many of these “baby boomers” are at or near retirement age. As they have aged, many have shifted a larger portion of their liquid assets into fixed income securities. It is also true that many of the ultra-wealthy, having already made their fortunes, have a significant portion of their assets tied up in fixed income. Comparing today’s yield curves with the yield curve of 2007 makes it is clear that fixed income investors are taking a haircut on yield. Three years ago, a bond portfolio of similar duration would have earned an investor between 2 and 4.5 percentage points more in interest return. On a million dollars, today’s fixed income investors are earning $20,000 to $45,000 less per year, pretax. For many fixed income investors, this has meant a 40%-75% reduction in income, depending on the duration of the portfolio. A similar reduction in income can be seen for corporate bonds. This represents a significant fall in consumer income. With the price indexes continuing to rise (although slowly), living standards have been impacted, and, as a result, these segments have endured the equivalent of a virulent inflation.
- It is clear that the Shadow Bailout (artificially low interest rates) has helped the banks repair their toxic balance sheets. It is also clear that the manipulation of interest rates through the Fed Funds rate, the provision of near zero rate loans by the Fed to the large banks, and the resulting near zero deposit rates to consumers has drastically lowered the incomes, and hence purchasing power, of a large portion of American savers. These reduced rates have also lowered the returns of pensions and endowments, further exacerbating their funding gaps, and putting future payouts in serious jeopardy. It is a tragedy that many hard working, trusting Americans will be forced to face a future with lower incomes and less purchasing power which will reduce consumption, the bedrock of American GDP. Lower incomes for the wealthy will also leave less money for investment (as will high taxes, currency issues and regulation), helping to ensure slower economic growth.
- Rising Debt Loads: When interest on debt, especially public debt, grows faster than income, the required interest payments must eventually come from the dwindling income pool. If interest rates rise, the problem becomes more acute and more immediate. This means higher tax rates, which reduce discretionary income and thus reduce living standards.
When viewed through a non-traditional lens, it is clear that slow devaluation, low interest rate policies, and endless debt have already created the equivalent of more traditionally defined inflation. Bond prices are “inflated” in much the same way that real estate and housing were in the last two bubbles. With heavy supplies looming large over the next few years, there must surely, eventually, be a mismatch between bond supply and investment demand, at least at today’s anemic yields. Living standards, for many, have already been reduced.
While we agree that our massive debts will eventually be monetized, and that a general inflation will more than likely be part of our future, we believe that a type of inflation is already manifesting its ugly head.
What can an investor do? Stay out of debt, keep some dry powder, and stick to the highest quality assets. Mind your margin of safety, and own a gold hedge if you can stomach the potential volatility.
Robert Barone, Ph.D.
June 9, 2010
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