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An inconvenient truth about inflation

One of my favourite expressions is "statistics if tortured sufficiently will confess to anything".

By Jonathan Pain, TEC Speaker, August 2007

Topic: Economics

It has always amused me how policymakers and economists, when talking about inflation, tend to remove all the items that have risen and then claim inflation is not a problem. In America we are told to look at "core" inflation which excludes food and energy. In the nation that eats more and drives more than any other nation, I find this a bit difficult. In essence we are being asked to assume that Americans don't eat and don't drive. The theory (some might suggest conspiracy) behind this approach is that since food and energy prices are both volatile and seasonal, they can be ignored.

But what happens when both food and energy prices just keep on rising and rising. A random sample of various items of food in the US over the last year shows us that butter prices are up about 30%, cheddar cheese is up 65%, chicken up 17%, beef up 13%. Year-to-date food prices in America have risen 6.7% whilst they rose only 2.1% in all of 2006. And it’s not just an American story as food prices are rising sharply in China, Britain, India and pretty much everywhere. So what's going on?

Well the inconvenient truth is that our desire to save the planet has led to a seismic rise in corn prices since it is currently the primary raw material for bio fuels. The price of corn futures has risen over 70% in the last 12 months and over 100% since 2004. Further compounding the issue is that since farmers dedicate more and more acreage to corn away from other crops, the price of everything else has risen too, due to the reduction in supply.

In addition to the above, we have the rising prosperity of developing nations, in particular China and India, which means these countries are more able to afford high protein diets. In short the world is set to experience a secular rise in food prices.

The "lets exclude everything that's going up" community will point out that in the US, food only comprises 13.88% of the CPI, and also they might remind us that American families today only spend approximately 14% of their income on food versus 43% in 1901 and 24% in 1929. The point is that "all other things being equal" higher food prices will serve to inflate prices. The problem is all other things are not equal. Energy prices are similarly rising very significantly with gasoline prices just beneath their Katrina high.

You know my view on oil prices. We shall in years to come have very fond memories of paying what we do today for a litre of petrol.

But it’s not just food and oil that's going up. What about coal, zinc, copper, iron ore and every other commodity? It’s a bit like the Monty Python scene in the Life of Brian, "What have the Romans done for us?" Okay, apart from education, health, law and order what have the Romans done for us? Apart from everything that's going up inflation is not a problem.

What about wages? It is my belief we are on the cusp of an acceleration in wage inflation as labour markets in the developed world are extremely tight. I strongly believe that the divide between rich and poor in places like America has simply become far too wide and that in the years ahead "labour" will demand a greater part of the profit pie. Over the last decade the integration of the two most populous nations in the world has delivered an historic and dramatic disinflationary dividend.

Manufactured goods prices plummeted as the ‘Made in China’ label appeared on everything we bought. The point is, however, that wages are now rising in China with reports of 10% increases over the past year in urban areas. And, please don't laugh, but in ‘The Year of the Pig’, pig prices have risen 71% over the past year, and the Chinese consume about 92 billion pounds of pork a year. In the years ahead, the disinflationary dividend from China will moderate, and, hence, no longer serve as such a powerful brake on global inflation.

Let's bring this discussion into the context of recent financial market gyrations. The last few weeks have seen a very sharp rise in developed market bond yields. There are, as always, a number of factors that have been behind this move, in no particular order.

The markets no longer expect a Fed rate cut this year;
Massive selling of US Treasuries by MBS portfolios due to the negative convexity characteristics of Mortgage Backed Securities;
The perception that the US economy will rebound from the anaemic first quarter performance of just 0.6 %, annualised;
Asian central banks reducing their purchases of Treasuries in the latest auctions;
The realisation that the Global economy can survive the US slowdown and that the world, ex USA, is booming; and
The scent of inflation is in the air.
All of the above led to a sharp rise in ten-year US bond yields, and, very significantly, we saw bond yields break a 20-year trendline (see chart 1).

Chart 1

The rise in yields is of significance in a valuation sense, since a stock price is the Net Present Value of future free cash flows. A rise in the discount rate (bond yield) will serve to deflate the NPV of those cash flows, and hence, stocks are faced with a higher valuation hurdle.

We have argued for the last several years that equities were cheap versus bonds, and according to the relative valuation measure EY/BY (earnings yield versus bond yield), particularly cheap. Now rising bond yields are not always a negative for equities, however dramatic moves usually lead to the equity market having to search for a new "equilibrium" valuation level between bonds and equities. This could in a way be described as the markets "discovery process" or attempt to find a new level which they are comfortable with. If earnings are rising sharply then the market has a higher level of tolerance for higher bond yields.

Conversely, of course, if earnings are seen to be slowing as bond yields rise then equities will be faced with a double negative.

One such environment was the "stagflation" of the seventies. This was a time of sharply higher oil prices and high inflation accompanied by recession. Now, I am not suggesting that we are on the brink of a seventies-style period of stagflation, but I am bringing to your attention that inflation, in my opinion, is on the rise, and that America will see an extended period of housing induced weaker growth.

Fortunately, as we have pointed out many times over the past few years, the global economy is better placed today to withstand a slowing in American growth, than at any time in history. This view was captured in our article, "Is it different this time?”. And of course it is different this time in Vietnam, China, India etc and similarly we continue to believe in the German and Japanese recovery stories.

Furthermore we continue to believe in the remarkable rise of nations in Eastern Europe. We also continue to believe in the rise of the Asian consumer.

So none of our thinking regarding the "big economic picture" has changed. What has changed is that we now believe we are on the "cusp" of a secular rise in inflation which in turn means that bond yields, particularly in the developed world, will rise in the years ahead. Similarly we are perhaps witnessing the unravelling of the so called Greenspan "conundrum". Bond yields, in the developed world, have been held at artificially low levels due to the excess of savings and central bank reserves in Asia which have, to date, primarily been invested in US Government securities.

Moving ahead we are likely to see nations such as China looking to invest their astonishing reserves into other asset classes such as equities, infrastructure, gold and other commodities.Similarly, household savings in Asia are likely to move increasingly into riskier assets. Yes these changes will be gradual but the important point is that the markets will have to adjust to the new reality. I sense a fairly profound change is taking place and that the twenty year chart we have attached serves to highlight that bond yields are now set to move higher in the years ahead. This will generate higher levels of volatility in all asset classes, since when markets shift from one point of equilibrium to another the path of exploration can be "bumpy".

All the best,
Jonathan Pain

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