Month: March 2010

Predicting Inflation: Gold versus Bonds

tylerdynamist1 Comment

Predicting Inflation

In my most recent market commentary, dated 2/9/10, I discussed how sensitive market prices are to future inflation expectations. To the extent that you can discern whether the market expectations for future inflation is too high or too low, you should be able to beat the market by using tactical asset allocation. During the market chaos of early 2009, long run inflation expectations had fallen to 1.0%. If you were able to predict that the federal reflation efforts would be successful (at least in the short term) and that market inflation expectations would rise to where they are today (2.6%), you could have caught the market bottom and benefitted from the 70%+ run up in the S&P since that time. I was too pessimistic and missed most of the run-up.

In normal times, the market appears to view 2.5% as the natural long-term inflation rate. The Fed claims to view 1.5-2.0% as its desired inflation rate. In my market equilibrium model, I have used 2.25%, but have tended to favor a range of +/- 0.25% with the acknowledgement that market outcomes aren't that precise. My general argument has been that the market is too focused on inflation, and that deflation is the primary threat. Many market pundits, on the other hand, have been proclaiming that the market (particularly the Treasury bond market) is massively underestimating inflation.

There are two primary market indicators for future inflation expectations: (1) the Treasury-TIPS spread and (2) the price of gold.

What bonds are telling us

As of 3/26/10, the Treasury curve looks as follows:

If you compare this curve to the curve at year end 2009, you'll see that the nominal Treasury rates have moved up slightly (the 30-year rose to 4.8% from 4.6%), TIPS rates moved up (the 30-year TIPS rate rose to 2.2% from 2.0%) and inflation expectations fell slightly (fell to 2.6% from 2.7%, yes there is rounding involved here). The TIPS curve is steep and the inflation curve less so, which makes sense. Below is what I consider to be the "equilibrium" yield curve, using my 2.25% inflation rate as a target:

The bond market is basically saying that the Fed will be a little slow to remove accommodation (which is why short rates are below equilibrium), but that long run inflation expectations are well-anchored.

What gold is telling us

The gold market is telling us something different. A rise in the gold price tends to lead a rise in commodities prices, which in turn leads a long term rise in CPI. Gold also has a history of volatility and of overshooting its equilibrium, however.

Below is a chart of the price of gold since the 1950s:

The gold price was fixed at its Bretton Woods price of $35 per ounce from the early 1930s to the late 1960s, jumped to (briefly) over $800 per ounce in 1980, fell to a new equilibrium range of around $375 per ounce from the mid-1980s through 1995, fell again in the late 1990s to $250 per ounce, and then rose during the past decade to over $1,000 per ounce.

If gold wasn't so volatile, we could expect it to rise steadily over time as the Fed promotes positive inflation. It should be noted that during the entire century between the early 1800s and the early 1900s, there was no sustained inflation in the United States as the dollar was convertible into gold at $20 per ounce. It is only since the Great Depression that the government has actively promoted inflation. In fact, because of the productivity of the capitalist system, you would expect prices to fall over time as producers became more efficient, not to rise as tends to be the case.

All things being equal, if you were expecting the Fed to target consumer price inflation of 2.25%, and you expect productivity gains of 1.75% per year, you would expect the gold price to rise by a rate of 4% per year to indicate that the dollar is being devalued accordingly.

Despite all the volatility in the gold price and inflation since the 1960s, the long term trend shows that gold has led increases in CPI, less a producitivity factor.

In the chart above, we can see from the trendline equation that CPI has been falling at a rate of 1.8% per year relative to gold since the 1950s, but that the relationship has been volatile. Gold was undervalued relative to consumer prices in 1970 and 2000, was overvalued in 1980, and was fairly valued in the mid-1990s. In many of my models I find that the mid-1990s was a well-balanced economy, before Robert Rubin's dollar bubble and the following dot com and housing bubbles threw the economy off kilter, to put it mildly.

One more factor to take into consideration is that economy-wide prices don't adjust instantaneously. I've found that it takes about 10 years for the overall CPI to catch up to a sustained devaluation of the dollar relative to gold. The inflation rate for the next 10 years is therefore dependent on whether monetary and fiscal policy are tightened enough so gold falls back in line with the current consumer prices, or whether prices keep rising to catch up with the new equilibrium level in gold.

My calculations of the theoretical gold price and CPI reveal the following:

  • If gold has overshot to the high side as a function of the financial crisis, and the treasury market's inflation rates are correct, then the current equilibrium gold price would be $550-600 per ounce.
  • If gold has found a new equilibrium level at the current $1,100 per ounce, then we should expect a 10-year inflation rate of over 5%.

This is a massive divergence.

  • If the bond market is correct, then bonds and non-precious metal commodities are fairly valued, and stocks are slightly overvalued.
  • If the gold market is correct, then most bonds are overvalued, TIPS and commodities are way undervalued and stocks and even real estate are slightly undervalued.

So what market should we listen to, gold or bonds?

The bond market is more liquid and understands the deflationary risks of high leverage. While the argument can be made that Treasuries are overpriced (yields too low) due to the Fed's holding rates too low and to Chinese manipulation. If nominal Treasuries were being manipulated by structural factors, then I would expect TIPS to be yielding nearly 0% across the curve. As can be seen above, however, the TIPS yield curve is showing positive real yields right around their equilibrium levels.

The gold market is a bit more ideological, attracting those that tend to dislike the government in power. It should be said, however, that the gold market was far more adept at tracking the debt bubble of the 2000s than the Federal Reserve proved to be, right through to predicting the extraordinary measures taken in the bubble's aftermath. The political landscape, on the other hand, is implying that consensus is building to fight the deficit, reform entitlements and to rein in financial system leverage. While that may be wishful thinking on my part, it would be hard to make the case that the wind is shifting in the other direction. My view is that the health care bill will be one of the last acts of giving us things for some time. The next decade will be occupied mostly by our government taking things away.

Conclusion

The answer to the debate is not obvious. Risk management, therefore, should be the primary focus for investors. I'll do my regular quarterly market update in a few days, but the lesson for me would be to overweight TIPS, commodities and cash, and to underweight precious metals. At the very least, it is probably time to trim bond positions back to a neutral weighting (I have been overweight bonds for years now). It also probably makes sense to have at least a neutral weighting in stocks for the time being, if we are to assume that the ultimate inflation outcome likely lies somewhere between what the bond market and gold market is predicting.

I am not a financial advisor. These analyses are conducted for personal enjoyment only.

The GOP will not repeal ObamaCare

tylerdynamist2 Comments

Now that ObamaCare has passed, we can mostly put that year's worth of debate and rancor into the rear view mirror.  Contrary to what the GOP seems to be telling itself, the 2010 elections will not be decided based on the potential repeal of the health care bill.  It will be decided based on the array of issues that will be decided in 2011 and 2012, and based on how big a check the people want to put on the Obama administration.

First, with regard to health care:

  • The bill can't be repealed while Obama is still president
  • As I've written before (here, here and here), our exisiting health care system is deeply flawed and preposterously expensive (and getting worse), making it hard to defend the status quo
  • Any bill that comprehensively deals with such a large and complicated system (and has the ability to pass Congress) will be flawed and imperfect
  • Polls have consisently shown over decades that Americans care about this issue, that they are open to governent-run health care, that they are worried about costs, that they would like access to be universal (but not necessarily free), they favored the "public option" right up until the end
  • The people in the middle of the electorate (i.e. the ones that really matter) will prefer to see this bill tweaked rather than have it junked and return to the status quo ante
  • As we have seen with other entitlements, the principle of universal access is now established, and will not be taken away
  • People (rightly) don't believe that the bill will reduce the deficit, and the real threat to long-term solvency of the US come from the $38 Trillion present value of the unfunded Medicare liability (see here, page 70), so health care is now THE deficit issue going forward
  • The Medicare liability can't be reduced without reforming the way medicine is paid for.  It will not be about raising taxes or tweaking benefits.  It will either be about rationing by government edict (a less-sensational version of "death panels") or by using market forces to ration care.  The moral element of health care makes market purity difficult, however.
  • There will also be alot of experimentation around the edges: tort reform, punishing unhealthy eating, promotion of exercise, etc.
  • Health care will be one of the dominant economic issues for a generation…we want to continue to invest in health care innovation, but we don't want it to engulf the entire economy

As for the 2010 election, barring some foreign crisis, the issue set is as follows:

  • Financial reform (favors Democrats; the GOP will be crazy to block this and allow it to still be an issue in the 2011 election)
  • Trade with China (mostly favors Democrats; it is time to stand up to their mercantilistic practice of building currency reserves to promote exports at our expense)
  • The deficit (favors Republicans; divided government is best for fighting deficits; the issue will have more potency if interest rates rise and less if rates stay where they are)
  • Expiration of the Bush tax cuts, estate tax (mostly favors Republicans; although a strict anti-tax position could backfire if they are unwilling to compromise on deficit and entitlement reform)
  • Energy reform (mixed; people want compromise, like more domestic energy coupled with reasonable investments in efficiency and green energy)
  • Health care reform (favors Republicans; as long as they focus on reformist ideas like tort reform and HSAs and don't blather on about lost liberty and creeping socialism)
  • Entitlement reform (favors Republicans; divided government would force the compromises that are required, i.e. raising taxes and cutting benefits)
  • Jobs (mixed; "jobs" is not an actual issue, it is a shortcut taken by lazy pundits; the "jobs" issue favored Obama in 2008 because he was most likely to support fiscal stimulus; the stimulus chamber is mostly empty now, so there is no actual "jobs" issue on the table outside of the economic issues outlined above or other small-bore initiatives that might get brought up as window-dressing)
  • Social issues (mixed; the Democrats elected a good number of social conservatives in swing districts in the last two elections, and the Republicans weren't focused on these issues in NJ, VA and MA, either; it seems to be mostly about economics now)
  • Foreign Policy (not an issue; the President runs foreign policy)

Good news for Republicans, the following issues are now off the table:

  • Iraq
  • Universal health care

Please don't shoot the messenger with this.  I am trying my best to just give you my analysis, with as little personal bias as possible.  In this day and age, with the hyperbole thrown around by both sides (Bush is a Nazi! Obama is a socialist!), we must remember that the actual US electorate is pragmatic and centrist and is just doing the best it can with the choices it has available.

Reform the Tax Code Now

tylerdynamist1 Comment

The United States has a tax code that encourages borrowing and consumption at the expense of savings and investment. I believe this concept is pretty well understood. What is less understood is that the rest of the world does not. The much-derided (in the United States at least) European-style welfare states actually have less progressive tax systems than the US, as do the developed Asian countries of Japan and South Korea. This means they are more apt to discourage consumption and to promote exports with value-added taxes. Most of these countries have found a policy balance that produces neutral trade deficits. Countries like China and Germany, on the other hand, take it even further and use their tax code to actively promote massive trade surpluses, a key source of the "global imbalances" that are threaten the world economy. Even worse, within the US tax code we discourage domestic investment in general, yet we lavish subsidies on specific old-economy industries like real estate, agriculture and energy extraction and even encourage US multinationals to invest overseas instead of in the United States. Our distorted tax policy is a bipartisan failure that must be addressed soon or our country will begin to lose ground economically while struggling under a mountain of foreign-owned debt.

How we got here

Much of The Dynamist blog is devoted to analyzing long term trends in economic policy, market valuations and political cycles. One of the consistent themes (for examples see here and here) is that the United States needs to focus on reducing its structural trade deficit. When we run a trade deficit, we are importing capital (i.e. borrowing) from abroad. Importing capital is not inherently bad. If the US had a surplus of investment opportunities relative to its pool of savings, investment capital may come in from abroad to make up the difference. In such an event, the investments would presumably increase the long run growth rate of the US economy.

The trade deficits that the US has run since the mid-1990s, and in the 1980s before that can generally be attributed to policy distortion by the Federal Government or by the Federal Reserve. The Fed's policy of high real interest rates in the early 1980s and late 1990s drew in a great deal of capital from abroad. In the 1980s, it funded Reagan's tax cuts and military buildup. In the 1990s, it funded the investment in a large increase in US manufacturing production capacity. In the Dynamist's view, neither of these investments were bad things and they generally made the US stronger.

The problem came when the disinflationary high interest rate policy was unwound. In both the late 1990s and 2000s, the combination of falling real interest rates, a weakening dollar, a surge in liquidity and an upturn in inflation create a ripe environment for a junk bond and real estate boom. Finance-fuelled booms like these tend to leave behind banking crises, overleveraged LBOs and real estate overcapacity. In the 1980s, the S&L deregulation led to a commercial real estate bubble. In the 2000s, the flow of Chinese money into the agency debt of Fannie Mae and Freddie Mac, combined with the policy innovation of "securitizations" and credit derivatives created the housing bubble. While such investments aren't useless, they don't have much of an impact on future US productivity.

I've written before about how US economic policy since the Great Depression has basically promoted consumption and real estate investment at the expense of saving and business investment. Domestic tax policy is skewed toward taxing high earners and lenders and supporting lower earners, borrowers and leveraged equity owners, particularly in real estate and farming (this even after the income tax rate reductions of the Reagan and Bush eras). When examining how domestic policy leads to distortions to the external trade and capital accounts, it is worth comparing how our policies compare to those of our largest competitors.

Global tax rates

A couple of months ago, The Economist had an interesting table outlining the tax policies of various countries (it can be found here, by those with a subscription). I worked with the numbers a bit so we could compare the state's take (including state and local taxes) relative to GDP across various types of taxes. I don't have the underlying data, nor do I know the policy details behind how various countries collect taxes, but in rough terms the data give one a good idea about the thrust of tax policy.

I took the average of five European-style welfare states (Britain, Canada, France, Germany and Italy), two developed Asia industrial powerhouses (South Korea and Japan), the US, China and Germany stand-alone. Their sources of tax revenue relative to GDP are shown below:

Source: The Economist, author's calculations

Unsurprisingly, governments in the United States collect a smaller amount of taxes as a percent of the economy than the four European countries and Canada. To compare apples-to-apples, however, the 6-8% of GDP that flows to privately-funded health care in the US should be added to the relatively regressive "social contributions" line item, for health insurance costs are deducted directly from our compensation just like Social Security and Medicare taxes. That would move US taxes to within 4-6% of European levels.

Surprisingly, the total tax take from "progressive" sources like income, capital and property in the United States is almost identical to that of Europe. The big difference between the two systems is in the "regressive" taxation of consumption. The European-style welfare states use value-added taxes that collect consumption taxes to the tune of 10.4% of GDP. The US taxes consumption, mostly in the form of state sales taxes, at only 4.4% of GDP. In other words, the US has a more progressive tax code than the European-style welfare states. The result is Europe as a whole runs a trade balance and the consumption-driven US runs a trade deficit.

The developed Asia countries of South Korea and Japan tax their economies by a similar percent as the US and have similar percentages for social contributions. The difference is that developed Asia taxes income less and consumption more than the US, with a difference of about 3 percentage points in each category.

Now look at China. It has a weak social safety net, and collects nothing in terms of "social contributions". It then gets nearly two-thirds of its tax base from consumption taxes, with most of the rest coming from taxes on companies. No wonder China has huge levels of savings and investment and low consumption levels. Combine that with a policy to suppress currency values and you have the ideal recipe for large trade deficits.

Germany is another great promoter of global imbalances, particularly within Europe, as has come to light with the recent Greek debt crisis. It collects a huge portion of its tax base from regressive consumption taxes and social contributions, while collecting less than the US in progressive income, capital and property taxes. Additionally, of the developed countries it takes the lowest percentage from companies. By taxing employment so highly via social contributions, and taxing companies at such a low level, Germany is encouraging "capital deepening", or investment in its great export machine. Germany's high consumption taxes have also encouraged the lowest level of consumption of the major developed economies.

Domestic distortions

Even within the US tax code, the US discourages domestic business investment relative to encouraging US multinationals to invest abroad; punishes businesses in general with the second-highest corporate tax rate in the world while it lavishes massive subsidies on individual sectors like agriculture, energy extraction, and real estate; forces companies to write off investments in productive capacity over long periods of time while other countries offer massive incentives for multinationals to invest. In the past 30 years, the US has gotten away with its disincentives to business investment funded by domestic savings by replacing domestic savings with foreign savings flowing through its levered-up capital markets casino.

Reform the Tax Code

It was nice while it lasted. We got lots of investment, bigger houses, a beefed-up military, technological innovation, and debt-fuelled consumption with low domestic savings. Now that the bill has come due, we either need to encourage more saving or live with less investment. Opting for the latter is not the path to long run prosperity. The tax code needs to be reformed to tax more consumption (which could include a carbon tax, an export-promoting value added tax and/or larger deductions for saving), not to increase income taxes and to reform the corporate tax code to replace the subsidies for specific old-economy industries with incentives for investment in domestic manufacturing capacity and R&D.

For corporate taxes, I would propose a general reform that would lower the statutory rate by eliminating special-interest subsidies and the deferral of international income, while also allowing the full, immediate expensing of business investment and R&D. I would also support the deductibility of dividends, while returning the tax rate on individual dividends back to the income tax rate. This reform would discourage corporate cash-hoarding for buybacks and ill-conceived acquisitions. (If you can't convince the capital markets to fund an acquisition, you probably shouldn't do it.)

In a globalized economy, large differences in tax policy cause trade and capital flow distortions. The US can no longer pretend it is an island unto itself. Our tax code is harmful enough to our national interests as it is, it gets even worse when allows the rest of the world to take advantage of us.