Tuesday, March 4, 2008 2 comments ++[ CLICK TO COMMENT ]++

Two Specters That Will Haunt Investors In the Future

If you want an easy-to-read overview of the current credit problems we are facing, check out this excellent summary by The Federal Reserve of Bank of Dallas (larger font PDF here). What we are facing is nothing unexpected in my eyes. Money was too cheap for many years and risk was mispriced (this is the big mistake by the monoline insurers). What is happening now is that risk is being re-priced. Anyone who wanted to buy a house, irrespective of credit, was able to do so before; any business that wanted to tap the bond market did it; private equity was able to borrow large sums of money for purchases of questionable businesses at elevated prices; risky assets of various type were bid up (and hence returns were suppressed for these risky assets); and so on. A lot of mispriced assets are being re-priced properly now but there are some that will take a long time to play out.

Regardless of your economic outlook, there are two ghosts that will haunt investors in the future. These two threats are: (i) inflation, and (ii) re-pricing of emerging market bonds.


I have been in the disinflation/deflation camp for many years now. I personally don't think inflation will be a problem right now. Recessions, along with collapsing asset prices, generally leads to declining inflationary pressures. As long as the government doesn't meddle in the economy by introducing tariffs/embargoes/capital controls/price controls/etc, I don't see inflationary pressures in the developed world (note: in contrast, countries like China will face big inflationary problems because they have capital controls, have a pegged currency, etc).

Having said all that, inflation will be something that investors will need to watch a few years from now--or even as soon as next year (if the economy recovers by then). Investors are ignoring inflation right now (rightly so!) as you can tell by the inflation premium on bonds in the chart below:

(source: The Federal Reserve Bank of Dallas)

The ghost of inflation hasn't been seen for years. In fact, inflation premium on bonds are at a 35+ year low! Declining inflation generally leads to declining interest rates demanded by investors, and is bullish for stocks and bonds. The declining interest rates (due to declining inflation) is one of the major reasons stocks and bonds have done really well in USA and Canada for the last 20 years.

Needless to say, the party will end at some point. Contrary to some goldbugs and inflationist thinking, I don't think we will end up with rampant inflation. Instead, inflation will likely increase slowly over time. The regions where inflation will be a big problem are in the emerging markets (I can see huge inflation problems in China, India, and the Middle East).

What all this means is that returns on assets--especially financial assets like stocks and bonds--are likely to be lower in the future. Stocks will still outperform other assets but there won't be the wind at your back, as was the case in the 80's and 90's. If my thinking is right, it also likely means that bonds are going to be one of the worst investments in the next few decades.

Emerging Market Debt

Another ghost will cause problems for investors by increasing cost of financing emerging market economies. Emerging market debt spread (over US Treasuries) has been extremely low over the last few years.

(source: The Federal Reserve Bank of Dallas; original source: JP Morgan Chase)

I had been expecting the spread to widen for a few years now. I have been wrong but I am sticking with my view. It makes no sense for emerging market countries, which have almost always been extremely risky (if not economically then politically), to trade at such a low premium over a developed economy like that of the US. For centuries, emerging market debt have generally defaulted or turned worthless.

Everyone has been getting a free ride for a while now and this will end--likely abruptly. Some developing countries seem to have good fiscal balance but many don't. The low cost of financing for these countries masks a lot of underlying problems with government spending, growth, and inflation.

Some argue that the US economy and the US government themselves are not in great shape and that's why the spread is lower than in the past. That may be so, but can anyone seriously see themselves adequately compensated with a 2% yield over US Treasuries?

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2 Response to Two Specters That Will Haunt Investors In the Future

March 5, 2008 at 10:12 AM

I enjoy your blog very much, but, with all due respect, I believe that your understanding of "inflation" is flawed. For what it's worth, I think this is nearly-universally the case with market commentators.

For an alternative view of inflation properly defined and the consequences of applying a proper definition see:


Remember: the late '60s-to-early '80s time period was a terrible time for the US, economically, yet inflation roared. Why?

Some say it was soaring commodity prices. I would agree, except that I would say soaring commodity prices were in large part a symptom of Central Bank money supply expansion. Some saw what was happening in the mid-to-late '60s, the French, gold speculators, etc., yet the bond marklet remained complacent.

In fact, mainstream economic thought held it as axiomatic that inflation and uemployment were inversely correlated. They were wrong.

I'll venture a guess right here that Central Bank money printing in response to financial instituion duress will cause an inflationary problem and ultimate bond implosion that will knock your socks off. Could a recession slow this process down a bit? Sure. Can I give you the exact timing on how all this will play out? Of course not.



March 5, 2008 at 10:30 PM

Thanks for the comments Applesaucer...

I'm not an economist but I don't subscribe to the Austrian Economist views (but you guys have some good company in Jim Grant, Marc Faber, etc). No doubt that money supply causes inflation but here are two issues:

(i) I haven't seen any credible views saying what is (or isn't) too great of an increase in money supply. My impression is that many Austrian Economists have been predicting the collapse of the dollar for many decades (since US money supply has been growing for a long time). Nothing happened except at the start of this decade. The problem is that no one knows what is "too much". My impression is that modern economic theory calls for money supply to be printed close to the GDP rate but this hasn't necessarily led to any notion of inflation.

(ii) Money can flow almost anywhere and into any asset. So if USA prints money, there is nothing to stop inflation from being caused in China. Japan, for instance, has been printing money for an eternity and there has been low inflation (clearly the money was flowing out). Investors derive little benefit from looking at money supply. Just like how the FedRes stopped looking at M3 because it provides little information, investors don't gain much insight from money supply either.

The thinking I am more influenced by is what the research outfit GaveKal follows. They rely on the Fisher equation. The key insight from them is that the velocity of the money is important. Money supply can expand but if velocity declines, you are not going to get inflation.

For example, if you look at this chart of US money supply, it actually rose in the early 80's. I will admit that the rate of increase likely declined from the 70's, but it was still rising quite a bit. Yet inflation was declining in the 80's.


In my opinion, most of the inflation problem in the 70's was not just due to money supply. Yes that always plays a role but the main things that caused the inflation in the 70's were:

* goverment intervention eg. tariffs, oil embargoes, taxes, price fixing, rent controls, etc
* other intervention (eg. high wage increases due to unions--not a bad thing in and of itself but when too high, it causes inflation)

Just like how China is right now trying to combat inflation through price controls, many governments did that with oil in the 70's. Needless to say, inflation roared.

So, in the absence of government intervention, I just don't see inflation. I know the gold market is saying something else; and so is the rest of the commodity complex. But the deflationary forces (from collapsing asset prices and wealth destruction) are just too strong. The bond market is basically pointing towards deflation. We'll see what actually materializes...

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