By the end of last year, three quarters of all borrowing was undertaken by Developed Market (DM) governments, notably the USA, European, UK and Japan while one Euro in six lent was by their own Central Banks. This gives an insight into the sheer scale of quantitative easing. The world of economics remains divided as to whether this will end in a soft landing, as enunciated by policymakers like Bernanke, head of the US Federal Reserve (Fed) or in a destiny with high inflation which many thought leaders believed inevitable. May and June have been convulsed by this divide ever since Bernanke indicated that the Fed may begin to taper off its huge money printing programme later this year, leading to volatility in the bond market, while equities also pulled back sharply.
So far the soft landing theorists have been right. They can point to lower commodity prices and to disinflation, in other words, very low inflation, tipping along at 1.5% or thereabouts and well under target inflation of 2%. The recent heavy decline in prices for precious metals, gold and silver was, in large part, due to a re-pricing of the risk of a collapse in the real values of fiat currencies on the one hand and the risk of another 2008 style event, on the other.
The Fed’s potential early deceleration of money printing also led to a scale back in the appetite for Inflation-Linked Government Bonds and which are, arguably, heavily oversold, pricing in inflation of 1% for the next decade in both the USA and the UK. I don’t buy that one bit and expect even in the short term, fresh buying from new allocations from Sovereign Wealth funds, Pension Schemes and Financial Institutions to push back up values as these are mandated to buy bonds and buy protection against inflation. Like most of us, I’m deeply sceptical of soft landing promotion as it invariably doesn’t reflect economic cycle transitions which tend to be far more dramatic and violent in nature, like shaking a skyscraper not knowing what’s going to fall down.
In short, in May and June the price of inflation protection was re-priced by markets betting on the soft landing scenario that presupposes the worst of the catastrophic risks are behind, such as a Eurozone rupture, systemic banking collapse or bubble burst in China and that the salad days have arrived where one should bet the house on equities. They presume that all of the excess money creation over the past four years will not lead to high inflation, as Central Bank wizardry is gently rolled back by reverse quantitative easing, gradually increasing interest rates while national governments repair their balance sheets with bigger tax receipts. Everything has to be exactly right for this to happen without calamity, either an inflation break out or a banking collapse. Think of landing the Space Shuttle, the flying brick, at Kerry Airport without engines and into a Force 10 Atlantic south westerly at night during an Irish winter. It’s possible …. But!
The Fed comments lead to a wall of money pushing out of bonds, including corporate bonds into equities, betting that the excess capacity, (also known as the output gap), in the global economy, which includes excess joblessness that depresses wage demands, will lead to a golden era for equities. This is a low inflation and low interest rate scenario, a steady-as-she-goes sustained growth in the global economy – a return to the cycle of the 80’s when markets experienced an uninterrupted bull market for six years before the 1987 crash.
The movement to equities has led to a decline in bond values as long term yields have risen, signalling increased interest rates just around the bend and upping the cost of long term mortgages. The Fed is likely to move against yields rising too far too fast given its reliance on the resurgent US housing market to contribute handsomely to the US consumer recovery story which is characterised by a return to per capita net worth above pre-crisis levels after four years of deleveraging and aided by the bounce back US stocks, the asset across the pond that determines the health of consumer balance sheets and the general feeling of financial well-being.
But all is not as it seems in the short window of the past two months. We remain in between two long term economic cycles. We know the shape of the last, beginning in the early 80’s and characterised by globalisation which aided a long term low inflation environment allowing central banks to keep borrowing rates low and rising them only to cool off over-heating. It worked a treat until everyone got in on the, borrow-for-tomorrow dodge, banks lost the run of themselves egged on by obscene bonus levels and regulation was non-existent. It ended in a heap in 2008. Arguably it ended in 2002 in the infamous Dot.Com bubble burst but was reflated into a gigantic bubble by the big Bush tax back programme and aggressive interest rate cuts.
The policy response to excess debt from the bubble burst has been to add ever more debt. In Ireland’s case we’ve gone from 25% Debt to GDP to 120%. The USA is at 107% and the list goes on. In essence, the huge hole created in the banking system which captured the debt implosion, has been filled by turning on the printing presses and much of the fresh deficit borrowing by Governments has been financed by its own central bank.
So what’s likely to happen next with inflation numbers?
In the short term, expect a continuation of disinflation but as the output gap tightens and money accelerates, watch out for high inflation to arrive almost unexpectedly. In advance, early indicators that the inflation trough in indices is ticking back up will be met by a swing to inflation protection once again. An inflation break out is likely within the next three to five years which is the time it is likely to take for all the excess central bank liquidity to wash through to the real economy. Inflation-linked bonds however will rise, in anticipation. In the short term “linkers” are likely to rally recovering much of their fall from their peak above current values as buyers take the view that inflation is going to be above 1% over the next 10-15 years in the US and UK, the mainstay of global inflation-linked bond funds.
Why excess money printing leads to inflation
An hotelier is working a small Irish hotel, fifty bedrooms and him, stuck in reception. In walks a German tourist, wanting to see each bedroom before deciding if he’ll stay. “Leave a €100 on the counter while you’re off around the hotel” the hotelier suggests. As soon as the German inspection begins, the hotelier nips across the road to pay the electrician €100 for a job he’d done. The spark stops the local plumber in his van and pays him the €100 he owed for a joint gig. The plumber pays the priest €100 for officiating at his daughter’s wedding and the priest slips into the hotel to pay the hotelier for his bar tab, at which point the German tourist arrives down the stairs announcing that he doesn’t want to stay. He gets his money back. The story is important because the velocity of money multiplied by the volume of money created determines the inflation rate. Since the burst, inflation has been a sleeping menace, keeping tracker mortgages low, national borrowing affordable and consumer prices under control.
For five years, bank credit was very tight, consumer spending has been low and a vast tsunami of money has remained moribund in a deeply constipated banking system. But the scale of cash build up from the surge in consumer saving, the huge leap in corporate reserves and vast money printing programmes by Central Banks, has never happened before in human history. The argument is that there is still no sign of inflation so everything is cool. The problem with inflation is that when it comes it can be quick, surprising and potentially potent if a tipping point is reached as it was for the Weimar Republic in 1923.
Policymakers would have us think that their medicine won’t hurt the patient but look around and it’s beginning. A wall of money from speculators and momentum investors has shifted out of safe havens into “risky” assets. Inflation is beginning first in equity markets, where it is evident that punters are paying a lot more for shares that they were buying much more cheaply several weeks ago. Corporate profit forecasts haven’t improved, what’s gone up is the price point, purely from rising demand. That’s inflation.
In the USA and in Britain residential property prices are rising as demand returns and bank lending loosens. That’s inflation. There is already some early evidence that the trough in consumer price indices has been reached. Prices for basics are rising despite raging competition between multiples for every extra Euro consumers are now willing to spend.
Meanwhile back at the Ranch, what’s happening globally?
The noticeable easing of worries about Europe, the USA and China has aided a run up in equities which now exceed the pre-crisis values in the US but remains heavily discounted in Europe, priced nearly a third lower. For this reason we’ve been allocating fresh funds and reweighting portfolios in favour of European equities and in recent months to value stocks as increased buying of high yield stocks has pushed their prices higher. The best case scenario is that Europe is poised to emerge from recession and offers the biggest upside to growth orientated investors comfortable with the wild swings that long term investment in equities requires if one is to capture their ability to outperform inflation in the range 5% to 7%.
The big hunt worldwide is for income, for yield, the avenues for which have narrowed as former lepers, so-called peripheral Government bonds like Ireland’s have much reduced yields. Yields are beginning to rise on long term bonds off floors not seen since records first began in Genoa in 1285. Fixed interest bonds, in particular, especially medium to long duration will continue to suffer over the times ahead. The recent bond turbulence is a useful drill for what is to come as interest rates rise and especially if inflation breaks to the upside.
After 30 years in the sun, Developed Market bond investors will need to forget about gains and look to minimise losses. Investing however in credit can still yield good results if it follows a roaming mandate across all markets and is well managed. For this reason we’ve been utilising the JP Morgan Income Opportunities Fund for fresh bond allocations in portfolios.
USA’s Bellwether is Housing
A sure fire sign of a resurgent US economy is continuing recovery in its property sector, aided by large scale repossessions and refurbishments. New housing starts have doubled, but still at levels 30% below those at the turn of the millennium, there is plenty of scope for further growth. First quarter GDP growth of 2.5% was contributed to handsomely by the crucial US consumer sector at 2.2%, the best result for some time. US companies, sitting on vast amounts of cash, are beginning to dissipate it into capital expenditure, dividends and share buybacks. Thus far historically low interest rates are being recycled to refinance existing debt. There is no sign yet of a surging credit market but its early days and US banks, now adequately recapitalised are keen to lend against property once again for strong customers. Given that long term borrowing costs are lower than rents, the appetite to buy rather than rent, will strengthen as credit becomes more widely available.
Much as in Europe, high yield US companies are pricier and the recent run up which has widened multiples makes the market look more vulnerable to pull backs as the year goes on and especially if good economic data falters. Investors will fresh cash are best advised to sit on the side lines and buy on the dips. That the USA has emerged from recession with strengthening tax receipt leading to lower than expected forecast deficits, is good news for the global economy. Growth in general stock indices in the range 25% to 30% over the past year has helped debt / asset ratios for US consumers, adding to improved consumer spending.
Europe, Ireland leads the Way
The tools announced last summer, ESM to break the link between banks and the sovereign and OMT to support limited bond buying for countries in difficulty in open markets together with Draghi’s promise to “do whatever it takes to save the Euro” has calmed rising bond yields for Spain and Italy. It has also forced austerity hawks to accept that markets will live with a slower pace of reform and restructuring provided countries are on the right path. By this new measure, Ireland sticks out as a country attempting too much too fast, locked as it is into a programme that was set in stone in the earliest days. Across the board European equities have had a strong year with returns ranging 25% to 42%, but still well priced compared to the US. The hunt for income or yield is likely to see Spanish and Italian debt get pricier as these come back into the core but all depends on action following words.
The volatile mix of the politics of the EU and its economics continues to leave scope for heavy setbacks as the battle continues between creditor and debtor nations, between hard and soft austerity. The outstanding question is how much social pain citizens in countries like Spain which has 60% youth unemployment, is prepared to take while its economy struggles at levels 30% less competitive than Germany.
Another Japanese Experiment
For twenty years we haven’t put a cent of client monies either in Irish assets, for pure diversification reasons or into Japan which has been mired in deflation and occasional false dawns in its stock markets. The 60% run up in Japanese stocks and a fall in the Yen over the past year largely a response to Liberal Democratic Prime Minister Abe’s massive quantitative easing experiment. Whether this primes the Japanese pump sufficiently to survive beyond QE is an open question. Previous attempts to break out of its long term joust with deflation following its bubble burst in the 80’s ended in failure, including Prime Minister Koizumi’s rally in the final six months of 2005. We’ll remain on the side lines continuing to recommend Asia Pacific but excluding Japan.
Non-OECD Markets & Commodities
The performance of Emerging Market indices generally lagged well below the USA and Europe over the past year, ranging 13% to 23% overshadowed by the big question about the rate of deceleration in the Chinese economy. China has been engineering an economic growth cool down from double digits growth to just under 8% for 2012. This has largely contributed to a fall in commodity prices, effecting feedstock economies like Australia whose currency has fallen in recent months to the Euro and Dollar. Welcome news from China has been the shift to consumer-led growth and away from capital spending but doubts remain about the legacy of poor lending especially to its municipalities and the potential collateral damage to the Chinese banking system, although China’s massive cash reserve is a welcome comfort should these fears prove well grounded.
We continue to favour regional EM equity funds over country-specific, preferring the international asset managers to decide on-going allocation to countries within the basket. Despite the slowdown in earnings growth across EM, the long term fundamental demographics that herald the emergence of its middle classes, make investment in EM a must in any equity portfolio.
Finally on the question of commodities, there is likely to be continued softening linked to falling EM economic growth forecasts. As ever commodities, although occupying a crucial diversifier in a balanced portfolio for growth investors, requires patience to ride the high peaks and troughs associated with mining stocks.
Property responds to economic turnaround and bank repair, beginning in the most liquid markets. There is ample evidence that US house prices are accelerating and US banks are beginning to lend once again. This is likely to be a continuing trend. Meanwhile UK residential is also showing signs of life. A recovery in Ireland remains some time-off until the glut of repossessions and distressed sales from Buy-To-Lets squeezed by tax relief tightening, is concluded. It has not yet even begun. For this reason we continue to invest client funds in specific locations in the fast recovering Metro Detroit region benefitting from rental yields more than twice those at home and scope for strong capital appreciation. The minimum investment is $0.5m for a portfolio of c.12 houses. For a prospectus on US housing investment contact our offices.