Spring is a great time of year for sports fans. Spring training is transitioning to a new season of hope for baseball fans, hockey teams are making their final push to the playoffs, and college hoops fans get to immerse themselves in brackets and March Madness.
A big part of what makes sports competition so interesting and exciting is something that is not exciting at all: They are all played under the conditions of common rules and standards. Time periods, playing areas and even equipment specifications are controlled. Arguments can ensue over such tiny discrepancies as a second or two on the clock or a couple of pounds of pressure in a football. While sports fans rightfully push back against discrepancies so as to ensure the integrity of the game, investors are far more quiescent when inflation alters the value of money.
In exploring the issue of inflation, it helps to keep a couple of points in mind. One is that the dollar (or any form of money) is a standard of value just like a minute is a standard of time and a pound is a standard of weight. Since money is used to measure the value of our work, our skills, our belongings and many other things, changes to its value have implications that run deeply through the economy and through society.
Another point is that despite the overarching importance of money as a standard of value, monetary officials have coalesced their policy making around an inflation target of two per cent per year. In doing so, they have succeeded in persuading people that two percent is a very small number and have inured much of the investing public to the risks inflationary policy.
While two per cent per year may seem like an almost trivially small number, it becomes very meaningful when compounded over many years. This can be illustrated by a basketball example. Let's imagine for a minute, that the powers that powers-that-be in the NCAA set a two per cent per year inflation policy on the distance of the free throw line from the basket. In the first couple of years the line would only move about three and a half inches per year and might not be so bad. But after just seventeen years, the free throw line would move out beyond the college three point line. The implications would be widespread and would fundamentally change the nature of the game.
Indeed, many investors are sensing that the investment "game" may be changing. Based on an increasingly tenuous relationship between underlying economic fundamentals and stock prices and increased volatility in the markets over the last year, it is an absolutely appropriate concern.
Jim Grant neatly summarized the situation as he sees it in the February 26, 2016 edition of Grant's Interest Rate Observer: "In times past, the standard of value was fixed while economic activity was left to fluctuate. Now, it's the trend growth in economic activity that—supposedly—is stable; monetary value is what gives way." Insofar as this is correct, it suggests that the investment landscape has changed in a meaningful way. Since the value of analysis pertains most to variables that fluctuate, Grant's view suggests that analytical efforts increasingly ought to be applied to monitoring and assessing the value of currency rather than to determining levels of economic activity.
One way in which "monetary value giving way" makes investing more difficult is because it is poorly understood by many economic and monetary officials. John Hussman hits on this point in his weekly letter [here], "It’s endlessly fascinating to hear central bankers talk about the effect of monetary policy on inflation and the economy, because they confidently speak as if the models in their heads are true - even reliable. Yet virtually nothing they say can actually be demonstrated in historical data, and the estimated effects often go entirely in the opposite direction. This is particularly true when it comes to inflation and unemployment - precisely the variables that are the targets of central bank policy."
John Cochrane from the University of Chicago also recognizes this knowledge gap in his article "Inflation and Debt" [here], "Many economists and commentators do not think it makes sense to worry about inflation right now. After all, inflation declined during the financial crisis and subsequent recession, and remains low by post-war standards." He follows that, "But the Fed’s view that inflation happens only during booms is too narrow, based on just one interpretation of America’s exceptional postwar experience. It overlooks, for instance, the stagflation of the 1970s, when inflation broke out despite 'resource slack' and the apparent 'stability' of expectations."
These comments converge on the same point: The two prominent schools of thought in regards to inflation, keynesianism and monetarism, both suffer from serious shortcomings. Cochrane notes that, "One serious problem with this view [keynesianism] is that the correlation between unemployment (or other measures of economic 'slack') and inflation is actually very weak." In regards to monetarism, Hussman reveals, "Economic models of inflation turn out to be nearly useless for any practical purpose ... it’s very difficult to explain most episodes of inflation using monetary variables." Unfortunately, these flawed theories serve as the bread and butter of mainstream economists, including those at the Fed. In short, many of the leading voices on inflation are misleading.
The key incremental insight that both Hussman and Cochrane gravitate to is that the value of paper money, fiat currency, depends fundamentally on confidence in the system that supports it. As Hussman describes, "The long-term value of paper money relies on the confidence that someone else in the future will accept it in exchange for value, and ultimately, that’s a matter of varying confidence in the ability of the government to meet its long-term obligations ... confidence in long-run fiscal discipline is essential."
Cochrane explains, "Most analysts today—even those who do worry about inflation—ignore the direct link between debt, looming deficits, and inflation." Part of the reason is historical context. He follows, "While the assumption of fiscal solvency may have made sense in America during most of the post-war era, the size of the government’s debt and unsustainable future deficits now puts us in an unfamiliar danger zone—one beyond the realm of conventional American macroeconomic ideas."
This is a key point. As Cochrane acknowledges, the "assumption of fiscal solvency may have made sense in America during most of the post-war era". But things have changed. Investors need to transition beyond "the realm of conventional American macroeconomic ideas" and seriously re-evaluate the country's fiscal solvency risk - and therefore the potential inflation risk. The persistence of large structural fiscal deficits caused by unsustainable and ever-increasing entitlement obligations, in the context of a divisive political landscape, offers little hope that fiscal challenges will be addressed in time to preserve the value of the dollar.
Finally, while inflation appears to be an accident waiting to happen, its timing is impossible to predict. Cochrane elaborates: "As a result of the federal government’s enormous debt and deficits, substantial inflation could break out in America in the next few years. If people become convinced that our government will end up printing money to cover intractable deficits, they will see inflation in the future and so will try to get rid of dollars today—driving up the prices of goods, services, and eventually wages across the entire economy. This would amount to a “run” on the dollar. As with a bank run, we would not be able to tell ahead of time when such an event would occur. But our economy will be primed for it as long as our fiscal trajectory is unsustainable."
Investors can take four key points away from this analysis. One is that even low but persistent inflation has can have a meaningful effect over a long investment horizon. Just like in the basketball example, the effects seem small at first, but become quite significant over time. While two per cent per year inflation may initially seem like a small number, over an investment horizon of fifty years, such inflation will erode the value of a dollar to 37 cents. Historically, it hasn't felt that bad because strong asset returns have more than offset the effects of inflation. However, if you don't own assets that re-price to offset inflation, or if such strong asset returns fail to be realized in the future, inflation will be a far more painful experience.
A second point is that the "fiscal solvency" element of inflation risk eludes most conventional economic thinking - and conventional economic thinking constitutes much of what informs investment advice, asset allocation decisions and public policy. The effect is that many of the guardians of investments (financial advisers, wealth managers, consultants, et al) understate inflation risk, and sometimes significantly so. Regardless of how understated inflation risk becomes manifested in a portfolio, the outcome is the same: it leaves investors vulnerable to not having adequate purchasing power to meet their spending plans in retirement.
Third, the emergence of inflation risks creates a new challenge for investment analysts and managers. Now, in addition to evaluating fundamentals, analysts must add a whole new skill set by learning to perform credit analysis on the US government. This involves determining the probability and degree of fiscal insolvency and to some extent, handicapping the tipping point as to when confidence in the dollar might run out. This additional exercise not only complicates the analysis, but also adds a great deal of uncertainty.
Finally, the fourth point is that inflation risk, when viewed as fiscal solvency risk, is difficult to manage. As Cochrane highlights, investors do not get the luxury of early warning signs: "Like all runs [on the dollar], this one would be unpredictable. After all, if people could predict that a run would happen tomorrow, then they would run today. Investors do not run when they see very bad news, but when they get the sense that everyone else is about to run. That’s why there is often so little news sparking a crisis, why policymakers are likely to blame “speculators” or “contagion,” why academic commentators blame “irrational” markets and “animal spirits,” and why the Fed is likely to bemoan a mysterious “loss of anchoring” of “inflation expectations.”
And for those still harboring notions that inflation can be controlled by a central bank, Cochrane adds, "Neither the cause of nor the solution to a run on the dollar, and its consequent inflation, would therefore be a matter of monetary policy that the Fed could do much about. Our problem is a fiscal problem—the challenge of out-of-control deficits and ballooning debt. Today’s debate about inflation largely misses that problem, and therefore fails to contend with the greatest inflation danger we face." In short, managing inflation risk is an uncertain and probabilistic exercise akin to forecasting the weather: You can't specifically forecast storms; the best you can do is to recognize that prevailing conditions may produce storm activity and to manage affairs accordingly.
All of these points suggest that the "game" of investing has fundamentally changed. The emergence of large fiscal deficits exacerbated by exploding entitlement obligations is creating challenges to fiscal solvency that this country has never seen before. Political divisiveness offers little hope of resolution. As a result, the preconditions are ripe for unpredictable outbreaks of inflation. The implication for investors is to be aware of these relatively new challenges and to re-evaluate their strategy in the context of this understanding. If you were thinking that maybe you should revisit your portfolio and investment strategy, you are probably right.