We’re not there yet, but we are close.? The FOMC is likely facing inflation problems at the same time that it faces problems in the financial system.? Goods price inflation versus Asset price deflation.? There is a term for this, but it is easy to be marginalized if one uses the S-word too readily.? So I won’t.
On the other hand, I am almost done with James Grant’s Money of the Mind.? Several themes come to mind here regarding government policy in the late 20s and early 30s, most notable that the government tried to force credit onto an economy that had too much credit already.? First they tried to get the private sector to do their bidding.? When the private sector would not cooperate to the desired degree, the government entered the lending business itself.? This probably prolonged the Depression by not allowing bad debts to get liquidated on a timely basis.
But, if I use the D-word with respect to today, it is even worse than using the S-word as far as credibility goes.? So I won’t, except for historical reference purposes.
The thing is, though, the FOMC is running out of options.? Pretty soon, it will have to decide which pain is greater: goods price inflation, or asset deflation.? Given the current political demographics, I believe they will choose goods price inflation, while saying the exact opposite, or doing the intelligent equivalent of a mumble.
Final note: current FOMC policies are a bit of a joke.? The temporary nature of them (TAF), plus the reduction in T-bill holdings, particularly during year-end, when liquidity is needed for the “holidays” of some, is unusual to say the least.? If the Fed is serious about reflation of assets, they need to do a permanent injection of liquidity, and stop messing around with these temporary half-measures.
PS — All that said, if I were Fed Chairman, I would presently aim monetary policy to a yield curve that had a 1% spread between 2-years and 10-years, and then I would leave it there.? There would be screaming for a year, but the excesses would get bled out of the system.? After that succeeded, I would narrow the spread to 0.5%.? The economy would remain stable for a long time.
Hello David,
Just to be 100% clear, does “[Fed] will have to decide which pain is greater: goods price inflation, or asset deflation. Given the current political demographics, I believe they will choose goods price inflation…” mean you think they will choose goods price inflation as the greater pain, or the politically palatable option going forward?
I’m guessing you meant they will choose goods price inflation as the palatable option, not that it is the greater pain. Yes?
Allan, yes, that is what I meant. Sorry for the ambiguity.
Incidentally, I’ve been reading and thinking a lot about how to invest in an “s-word” economic environment. It’s a tough thing. Saving is not enough. The returns on short-duration cash/bonds are negative. As insult to injury, the taxes on TIPS should inflation really get going make for negative returns there too. One really has to proactively invest to keep ahead in that environment.
I know you’ve written on this a bit already (and maybe this is my bias showing) but I think the more on this topic the better. Positioning one’s portfolio for this possibility seems like relatively cheap insurance if it doesn’t come to pass. The costs are mostly (entirely?) the foregone gain/oppurtunity kind, whereas not being ready for it, should it occur, means the costs are real. I’ve found it very difficult to come up with investment ideas to position oneself for negative real interest rates coupled with a earnings recession. The annual limit on I-bonds is being lowered so much as to make them inconsequential. Real estate is in a post-bubble depression. All I really see available are basic commodities and ag. So I’m open to more detailed posts on this.
Allan,
I don’t suppose these will strike you as original ideas, since it appears that you have given a fair amount of thought to this subject, but a couple of possibilities, besides your suggestion of commodities (no comment on their current advisibility of investing in them), are to diversify away from the currency experiencing the stagflation, and choose equities that have pricing power, given demographic trends and your postulated economic environment. A couple of specifics would be commodity influenced currencies such as the CAD and AUD, and healthcare types of stocks. One caveat with healthcare though: you’d have to choose companies with low P/E multiples, because high P/E multiples melt like ice cream in the sun in a high inflation environment. Hope this helps.
Steve
In a stagflationary environment, commodities are the best choice and commodity stocks are still cheap now and not pricing in this kind of environment. Commodity stocks are still priced as though the long term price of the commodities will move back down and the analyst reports reflect the same assumption. Before this is all over, I believe these stocks will be priced as though the value of the commodities will continue to increase in value and trade at a premium to their cash flows. To maximize your return, my recommendation would be stocks with long-life reserves in politically safe environments. Stocks like Suncor with a 50 year proven reserve will do well whereas an Exxon which actually refines more oil than it produces will not not do so well.
I’ve been giving a lot of thought to foreign currencies, but when I looked at what the Norwegian krone did during the 70’s it wasn’t pretty. Maybe it’s not a good match with AUD & CAD, but since the North Sea oil wells came online as the 70’s started and ramped-up throughout the decade, I would expect it to be.
The problem I see with foreign currencies is two fold: 1) I think they will devalue in tandem with the US (note the Fed’s recent announcement about the new coordinated anonymous discount window) maybe not as bad, but negative real rates nonetheless 2) even if a single country wanted to have a strong currency when the rest of the world is competitively de-valueing, what are they supposed to do with the inflows? I think they’d be overwhelmed and would be forced to succumb to the peer pressure.
I’m open to correction. 🙂
I have two comments other than simply stating that this string of comments is excellent.
First, I think a major distinction between the current situation and the late 20’s/early 30’s is that we have a fiat currency. It seems to me that the retraction of liquidity David cited is a watershed moment potentially. While it is impossible to know for sure, connecting dots suggests that the coordination of foreign central banks may have been contingent upon the US gov’t expressing some policy support for the dollar – at least in the interim. I agree with David that when push comes to shove and real economic crisis breaks out (whenever that eventually is), goods inflation via a devaluing currency is the choice all govt’s have always chosen.
As for investing in such an environment, I can only share what I am doing with my own and my clients’s money. Personally, I trade futures and subscribe to the Jim Rogers school of investing/trading. I hold very few positions but watch them very closely, use significant leverage and try to wait until a maximum amount of ducks are in alignment. Currently, I am long ag (sugar primarily) and short the Euro vs the US dollar.
For clients (for whom my aggressive leverage is obviously not suitable) we mimic some of the themes. For example, we have been long the new Elements Rogers Ag Commodity Index (RJA). We also focus on absolute return strategies. We diversify heavily in this regard. We combine outside managers like Hussman Strategic Growth (HSGFX), Ivy Asset Strategy (WASYX) and Pimco All Asset All Authority (PAUIX) with some in-house strategies. Most of the absolute return oriented mutual funds are garbage but there are some diamonds in the rough. For our in-house strategies, we are currently and have been long healthcare and short financials. We have owned a big position in the Yen since February and have owned Annaly Mortgage (NLY) for a long time (too long during the Fed hiking cycle – lesson learned!). We’ve also been active in the precious metals area but have only a minimal core position at present.
That is our version at present but it is certainly an evolutionary process. Ultimately, I would say that focusing on risk management and capital preservation in real terms is critical for most people and that the common financial advice is absolute crap and dangerous. Allocating 60% to stocks and 40% to bonds and hoping for the best is a prescription for financial ruin during a stagflationary environment. Such an allocation would have resulted in about a 60% loss of purchasing power during the 1966-1982 bear market.
James,
Thanks for the input. It gives me some interesting specifics that I can do some follow-up work on.