The End of the Inflation Scare? [复制链接]

The End of the Inflation Scare? by Louis-Vincent Gave While most economists and strategists spend time worrying aboutgrowth, changes in inflation are usually a much greater driver offinancial markets than changes in economic activity. This is because: 1- A surge in inflation usually increases volatility of economicgrowth--which in turn reduces P/Es and the willingness of the privatesector to take risks. 2- As highlighted in The Myth of Reverting Margins,inflation typically takes a much meaner bite out of margins than arecession does. As we wrote back then concerning the US growth/marginrelationship: "Margins bear little relationship to the level of GDPor consumption growth. In fact, as the economy accelerated from themid-1960s to the early 1980s, margins plunged. Similarly, as theeconomy slowed from the early 1980s to the present, marginsaccelerated... It is inflation, not growth, which wreaks havoc onprofit margins (ironically, if everyone has pricing power, no one makesmoney).    3- Finally, a surge in inflation typically means interest rates willbe rising in the near future. Which means that investors get to losemoney on both bonds and equities. For example, from 1966 to 1980 (i.e.:the last "inflationary surge" period), US bonds shed -2% per annum andUS equities fell -4.9% per year. Unsurprisingly, given the above, fears are now running high that we may have reentered such an "inflationary bust" period (see The Inflationary Bust Threat).And to be sure, growth almost everywhere around the world is slowingwhile inflation in almost every country is still accelerating. Now everyone knows where the slowdown in growth comes frome-leveraging in the financial sector, overextended consumers needingto tighten their belts, transfers of wealth from the private sector tothe public sector through high oil prices, etc... And there are ofcourse myriad opinions as to how long the slowdown will last. Butmeanwhile, on inflation, our clients seem to be much longer onquestions than answers. Where does the current inflation spike comefrom? How long is it going to last? And can inflation abate without a"Paul Volcker" like monetary policy from the Fed? In this ad hoc comment, we aim to review some of these questionsand, as we always tend to do--answer these questions with yet morequestions of our own!

1- Where Does the Inflation Come From? Just like George Orwell's farm animals, all currencies are equal...though, of course, one is more equal than others. Indeed, the US$remains the world's reserve currency and, thanks to this status,foreigners cannot impose a particular kind of monetary policy unto theUS. As Treasury Secretary Connolly once said: "the US$ is our currencyand your problem". And lately, there is little doubt that the US$ hasindeed become the world's problem, with its fall in value associatedwith the spike in commodity prices, which in turn has triggered a sharpupturn in inflation rates all around the world, but especially in theemerging markets (where food and energy represent a much bigger pieceof the average family's spending than in most OECD countries).    But of course, the surge in commodity prices cannot be the soleexplanation for the recent surge in inflation numbers around the world.After all, an event like the spike in oil prices could also prove to behighly deflationary, since it takes money from the private sector andgives it to the public sector which will typically waste it (i.e.:Chavez financing Castro, Ahmadinejad subsidizing Hamas and Hezbollah,etc...). For a commodity price spike to be inflationary, it needs to beaccompanied by excess money creation. If it is not, all that we witnessis a change in relative prices across the economy (i.e.: oil prices up,auto and house prices down). This is why Milton Friedman once said that"inflation is always and everywhere a monetary phenomenon" while,around the same time, Jacques Rueff made the observation that"inflation is subsidizing expenditures that give no returns with moneythat does not exist". So given that we are now living through a surge in inflationaryprices, the questions we should ask ourselves is a) where the excessliquidity creation of recent years has come from? and b) whether excessliquidity continues to be pushed into the system, hereby guaranteeingfurther increases in inflation in the coming quarters and years?

2- What Explains the Surge in the Amount of Money? As highlighted above, the US$ is "more equal" than other currenciesand, consequently, the Fed holds a "special place" in our currentfinancial system. Undeniably, the Fed is the world's most importantcentral bank and it is thus not that surprising that, as inflationarypressures accelerate around the world, most people are quick to blamethe Fed for "falling asleep at the wheel" and allowing money supply inthe US to grow unchecked. But is this a valid criticism? After all, as the charts below highlight, narrow money supply growthin the US (i.e.: the aggregate mostly under the control of the Fed) hasnot seen much of a rise in recent years (incidentally, the same can besaid about Japan and money growth is now decelerating fast in Europe):    While the Fed did print money aggressively between 2002 and 2005 (M1annual growth was above +5% and sometimes close to +10%), in recentyears, the pace of monetary creation has by and large been tame. So the‘excess money' had to come from somewhere else. Now as we never tire of pointing out, two sets of players can createmoney ex- nihilo in our system: central banks and commercial banks. Soif the excess liquidity creation has not been the central banks, thenthe explanation must lie with the commercial banks. And sure enough, in recent years, banks have ridden the 'financialrevolution' as hard as they possibly could and we have witnessed anunprecedented expansion in credit (witness the growth in C&I loansat US banks, red line below):    And, as we now know, money creation off the banks' balance sheetswas also, until recently, going strong. Witness, for example, the rapidexpansion in corporate paper outstanding in the period between 2003 and2007 (red line below):    To return to our old favorite, Irving Fisher's equation of MV=PQ, itseems obvious to us that the current increase in P (prices) has more todo with the past few years' extremely buoyant V (velocity) thanexcessive M (money) growth. A possibility which immediately raises thequestion of whether velocity will remain as buoyant over the next twoyears as it did in the 2003-2007 period.

3- Will Velocity Remain As Strong? As the chart below suggests, the answer to the above question is asimple "No". With bank balance sheets under severe strain, and withbank shares almost everywhere around the world plumbing new depths, anincrease in the willingness to take risk from private lenders would bevery surprising. And sure enough, after its longest period ever innegative territory, our velocity indicator is once again negative aftera brief respite:    This message of slowing private sector liquidity growth is alsoconfirmed when adding the loans at commercial banks with the issuanceof commercial paper (for a total private credit growth aggregate--blueline on following page). We have slumped from an annual growth rate of+13% in private credit one year ago to +2.8% today; a level not seensince 2003 (see chart).    So we are now in a situation where a) The Fed is not printing moneyand b) US financials are de-leveraging rapidly. Thus, if inflation is"always and everywhere a monetary phenomenon", one may conclude thatwhat we are now seeing in the inflation numbers is the echo of the2003-2007 credit boom, but that looking ahead, the inflation pictureshould start improving rather dramatically. But such a conclusion wouldmiss out on the other big contributor to global liquidity growth,namely the US current account deficit.

4- The Importance of the US Current Account Deficit Because the US$ is "more equal" than other currencies in our globalsystem, the US current account deficit plays a specific, and veryimportant, role in our global monetary systems. In essence, the UScurrent account deficit provides the world with its working capital.After all, at any given point, the world needs US$. For example, Nokianeeds US$ to pay for the chips it may buy in Taiwan. China needs US$ topay for the iron ore it buys from Australia and Sweden needs US$ to payfor the oil it buys from neighboring Norway... This is why, whenever we see an improvement in the US currentaccount deficit, somebody somewhere goes bust. Indeed, when the USexports a lot of dollars, then the rest of the worlds gets used to a"plentiful" liquidity situation... and when the US exports less money,then somebody gets cut off. So in essence, the current account deficit has always been themechanism through which the United States could reflate, or deflate,the global economy. When the US current account deficit improved, theUS deflated other countries and vice versa.    Now today, the US current account deficit still stands at a ratherlarge 6% of GDP. However, the composition of this deficit has changeddramatically: two years ago, around two-thirds of the US deficit wentto non-oil producers and one third was for petroleum products. Today,that situation is inversed to the point where one could argue that,while the US is still reflating oil producing countries (which hardlyneed it), it is now deflating non-oil producing countries by around 2%of GDP. Moreover, should oil prices start pulling back, we would moveextremely rapidly into a situation where the US current account deficitwas deflating the whole world (below is a chart we borrowed from The Economist)!    The fact that the US is no longer reflating non-oil producing countries is a very important change in our economies.Indeed, over the past few years, the prevalent belief amongst investorsof all stripes has been: a) the US runs a large current accountdeficit, b) that US interest rates are low, and that, consequently c)the value of the US$ could only fall. And if the value of the US$ couldonly fall, then borrowing in US$ to finance whatever real estateproject, factory, or financial market speculation made perfect sense.This is why, in a number of countries, we started to witness a growthin central bank reserves which far outpaced trade surpluses and foreigndirect investment inflows; all of a sudden, a number of large countriesstarted to save more than they earned!    But how can one save more than one earns? The answer, we have argued in the past (see The Surprisingly Strong Growth in Chinese Reserves)is simple: one borrows the difference. As mentioned above, if theperception is that the US$ can only fall against the RMB, INR, VND,MYR, etc... then why borrow in local currency to finance one's capitalexpenditures or investments? Much better to finance any spending in theever falling, and cheap to borrow, US$!    So what happens when a Chinese property developer, or a Vietnameseindustrialist, borrows US$ to finance his latest project? The firstthing he does is that he changes the dollars he does not need for RMB,Rupee, Dong, etc... And, at this point, the foreign central bank hasthree choices: 1- It can allow its currency to rise. This is what Brazil, South Korea... have done in recent years. 2- It can print money to prevent its currency from rising and then sterilize its FX intervention. 3- It can print money to prevent its currency from rising and justaccept the consequences of fast money supply growth (usually higherinflation and asset prices).    And by and large, this is what most nations on the other side of theUS current account deficit (i.e.: Asia and OPEC) have done. Andunsurprisingly, these are the countries that are today dealing with thelargest inflation threats. We would thus argue that the US current account deficit has been a double inflationary force for the world at large.First, the US current account deficit has pushed a number of countriestowards reflation, and secondly, the large US current account deficithas helped propagate the belief that the US$ could only fall, and thusencouraged large borrowings of US$ outside of the US. And the US current account deficit, combined with the willingness toborrow US$, has been an inflationary force for more than just Asia andthe Middle East. It may also explain the surge in money growth inEurope! Indeed, with central bank reserves growing very rapidly aroundthe world (despite a high oil price which, at the very least, shouldhave drained the reserves of Asian and European countries), centralbanks such as the PBoC or the RBI have likely spent the past few yearsdiversifying their reserves, which for all intents and purposes meansbuying the Euro... And, as we argued in our book The End is Not Nigh,this "diversification" of reserves means buying European governmentbonds or, in other words, subsidizing the expenditures of foreigngovernments with domestically borrowed money.    Et voila! We are now back to Jacques Rueff's definition of inflation being "a policy which subsidizes expenditures that give no returns (i.e.: government spending in Europe or the US) being financed with money that does not exist (i.e.: central bank reserves that have been borrowed, not earned)!"

5- Will the US Deficit Continue to be an Inflationary Force? Having established that one of the main factors of excess liquiditygrowth in the world (the willingness of the financial sector to lendvery aggressively) had now disappeared, can we rely on the US currentaccount deficit to continue providing excess liquidity to the world.Will an ever growing US trade deficit continue to force other countriesto reflate and lead to an ever lower US$? We tend to believe that theanswer to that question is a very firm "no". And, this for severalreasons: Reason #1: As reviewed on page 6, the US current accountdeficit is already improving. Moreover, since oil is now a biggerpercentage of the US deficit, should oil prices roll over, we couldwitness the most rapid improvement in the US current account deficitever seen. But even without oil rolling over, the recent weakness ofthe US$ argues for a continued improvement in the deficit:    As does the weakness in US housing:    Meanwhile, the prevalent belief of recent years that borrowing US$to invest in local currencies was a "no-brainer" is now undergoing asignificant test. For example, in recent months, the "long dong"strategy has undeniably failed (the black market now expects adevaluation of over 20% in the Vietnamese currency). The strategy isalso failing in India where the Rupee, to many investors' surprise, hasbeen amazingly weak in recent months.... In fact, an interesting development is occurring on the US$: fewerand fewer currencies have lately been rising against the US$ and thisdespite some pretty poor news from the US (MBIA downgrade, fears onLehman, weak housing, weak growth, high oil, fears of war withIran...). Now the typical pattern for an equity bull market is that, asit nears its peak, fewer and fewer shares make new highs even asindices keep on powering ahead. Major corrections are typicallypreceded by a narrowing breadth... And today, we are undeniablywitnessing a deteriorating breath in the "anti-US$" bull market: To cut a long story short, and with hindsight, the large US currentaccount deficit and the weak US$ were another very potent inflationaryforce in our system. But, at least at the margin, these inflationaryforces should abate, rather than acceler- ate, over the coming months.

6- Conclusion There is little doubt that, right now, inflation is proving to be amassive headwind for financial markets. And part of that "inflationheadwind" is the fear that the Fed, the ECB and other central bankswill have little choice but to tighten monetary policy in the comingmonths. This is most likely true of some central banks, but maybe notall? After all, looking around the world, the inflationary threat is asure thing in certain regions, and less of a threat in others:

• In the US: In a recent paper (see The Dollar's Successful Devaluation),Charles argued that the Fed had just managed to engineer a "gooddevaluation" for the US$, whereby the currency is brought down withoutan explosion in monetary aggregates and a rapid acceleration ininflation. This makes the economy competitive and local assetsattractive for foreigners. Since then, not much has happened to warranta change in this view. In fact, since then, the main development hasbeen the roll-over in velocity and renewed fears as to the health ofthe US financial sector. With velocity plummeting, we think that thebond market is broadly right to not anticipate an acceleration in USinflation.

• In Euroland: Just like in the US, the bond market does notseem to really anticipate a massive surge in inflation. And given thevery overvalued currency and the inverted yield curve, this makes senseto us.
• In the Middle East: The one region of the world which isstill experiencing reflation from the US current account deficit is theMiddle-East (and to a lesser extent Russia). The unwillingness ofpolicymakers to revalue their currencies (see The Arab Pegs)and the inability of local central banks to sterilize their FXintervention means that the local economies are condemned to continueexperiencing inflation as long as they refuse to revalue theircurrency. More worryingly, a pursuit of the current fixed exchangerate, inflationary policies could lead local economies into the samekind of boom-bust cycle that Vietnam (and maybe India?) are now havingto endure.
• In India and Southeast Asia: If the US went through a ‘gooddevaluation' (i.e.: a lower currency without a spike in inflation,triggering an increase in foreign and domestic investments andproductivity gains), then it increasingly looks as if India andSoutheast Asia have just gone through a ‘bad devaluation' (i.e.: alower currency which brings about fast money growth, higher inflation,deteriorating trade balances and foreign investor flight). As such,certain countries (India, Vietnam...) are now stuck in the unfortunateposition of having to defend their currencies, which is rarelyconducive to either economic, or asset price growth.
• In China: Inflation is undeniably a problem but, thus far, it seems to be mostly contained to food and energy prices (see A Dummy's Guide to Chinese Inflation).Meanwhile, the only pressures on the RMB are still of a positivenature. Thus, if either the US$ rebounds or commodities roll over (two events that are likely to happen simultaneously), China's inflation problem could dissipate relatively quickly. Chinese and HK shares would then soar.
• In Japan, Korea, and Taiwan: Japan, Korea and Taiwan haveseen little "hot money" inflows in recent years and have also beenbetter at letting their currencies rise against the US$ (this year, theNT$ is one of the world's best performing currencies with a +6.5% risewhile the KRW was one of the best performing Asian currencies between2004 and 2006). In general rule, these countries today have far less ofan inflationary problem than the rest of Asia:

   While the markets had started to rally in April and early May, thespike in oil prices fuelled fears of faster inflation and triggered athreat of coming rate hikes from the Fed and the ECB. In turn, allthese events weighed down equity markets around the world. However, aswe have tried to show in this paper:

• The inflation threat is very different between countries. At mostrisk today are the Middle East, India and Southeast Asia. Meanwhile,inflation is far less of a threat in the US, Japan and North Asia.
• Given the fact that the forces behind the recent pick-up ininflation are now turning around (strong willingness to take riskamongst financial firms, growing US current account deficits, overallweakness in the US$), inflation could well start abating in the comingquarters. Moreover, with the turnaround in velocity and the implosionin the banking systems, it seems increasingly likely that neither theFed, nor the ECB will be willing/have to match their recent hawkishnesswith rate hikes.
• As inflation rolls over in the OECD, the leadership of equity markets should go through a serious adjustment.

Your meditating on inflation analyst, John Mauldin

Disclaimer                         John Mauldinis president of Millennium Wave Advisors, LLC, a registered investmentadvisor. All material presented herein is believed to be reliable butwe cannot attest to its accuracy. Investment recommendations may changeand readers are urged to check with their investment counselors beforemaking any investment decisions. Opinions expressed in these reports may change without prior notice.John Mauldin and/or the staffs at Millennium Wave Advisors, LLC andInvestorsInsight Publishing, Inc. (InvestorsInsight) may or may nothave investments in any funds, programs or companies cited above. PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OFLOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGEDFUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS,YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOMEPRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENTPRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BEILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATIONINFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYSIN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAMEREGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND INMANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWNONLY TO THE INVESTMENT MANAGER. Communications from InvestorsInsight are intended solely forinformational purposes. Statements made by various authors,advertisers, sponsors and other contributors do not necessarily reflectthe opinions of InvestorsInsight, and should not be construed as anendorsement by InvestorsInsight, either expressed or implied.InvestorsInsight is not responsible for typographic errors or otherinaccuracies in the content. We believe the information containedherein to be accurate and reliable. However, errors may occasionallyoccur. Therefore, all information and materials are provided "AS IS"without any warranty of any kind. Past results are not indicative offuture results.