Sunday, April 5, 2009 0 comments ++[ CLICK TO COMMENT ]++

Deflation dead?

Is deflation dead? I don't think so but the market certainly has moved to a mild inflation stance. Bloomberg summarzies the situation in TIPS bond market:

In March, TIPS earned 6.1 percent, the best returns since the Treasury started selling the securities in 1997, according to Merrill Lynch & Co. index data. Worldwide, inflation- protected bonds had the second best month in at least a decade, rising 4.3 percent including reinvested interest, the data show.

At BlackRock Inc., Vanguard Group Inc., Pacific Investment Management Co. and Pictet & Cie Banquiers, concerns are growing that policy makers will struggle to control inflation once economies start to recover. The Federal Reserve, Bank of England and European Central Bank have increased money supply by an average 9.2 percent in the past year, or the equivalent of $2 trillion, to $24 trillion, according to the broadest measure each uses.

In the U.S., the consumer price index “could go back to 4 percent or even higher,” said Brian Weinstein, who oversees $9 billion in inflation bonds at New York-based BlackRock, the largest publicly traded U.S. fund manager. At the least, “the TIPS market is showing that we’re going back to trend inflation,” he said.

For those not familiar, TIPS, or Treasury Inflation-Protected Securities, are bonds that provide returns that are indexed to inflation. In countries like Canada, they are issued by the government under the label Real-Return Bond. TIPS bonds will do well if inflation is high, and will do poorly under deflation.

The article mentions that TIPS had their best month since they were first issued by the US government in 1997. However, TIPS sold off sharply late last year and hence are only back to their "normal" level. They were actually much higher when inflation was the rage early in 2008, when commodity prices were skyrocketing. The following chart from plots TIP, an exchage-traded TIPS fund (as usual an ETF is not quite the same as the individual security but it is a good approximation):

Unfortunately this chart doesn't go back to 1997, since the ETF was only issued in 2004, so it's hard to tell from this chart how the present compared to the late 90's or early 2000's.

In any case, the most noticeable thing is how severe the sell-off in the TIP ETF was in October. That was a once in a life-time drop. It recovered by the end of October but if it had stayed at 84, it would have been an extreme outlier. A stock market dropping 30% or 40% is not that unusual but a TIPS bond selling off that much would truly be a surprise. You can also see from the chart that TIP rallied strongly in early 2008 as everyone was jumping on the inflation bandwagon.

One compares TIPS against (plain) US Treasuries to deduce inflation expecation of the market. TIPS is very important because it is set by the free market. Although parties with large holdings, such as central banks, hedge funds, and so on, can influence these bonds, they are nevertheless the closest thing a market measure of inflation expectation. In contrast, a lot other inflation figures that are reported are calculated by the government, academia or by private industry.

I am not in the inflation camp but the market is slowly pricing in inflation. I think the real test is later this year, 3rd and 4th quarter, when we will know if the world economy is recovering strongly or is stuck in a long slump. I am personally maintaining a neutral stance with a tilt towards slight deflation. But as I have mentioned several times, many prominent investors, including many value investors* such as Warren Buffett, Seth Klarman, and David Einhorn, and non-value investors such as John Paulson, Marc Faber, and Jim Rogers, are in the inflation camp. So don't blindly follow my stance.

(* For what it's worth, I would not rely on macro views of value investors. They are generally very bad at making macro calls. For example, many were buying homebuilders and retailers even though many macro investors were saying we may be facing a consumer credit bust. It's one thing to buy distressed companies after they have fallen off a cliff, but many value investors were buying them before any of them really got cheap. Even Warren Buffett made some big mistakes buying ConocoPhillips near the peak in oil. I never really understood Buffett's bet on COP. If I'm not mistaken, he was also buying Burlington Northern Santa Fe, a rail, in the last year, and this is potentially a bad pick from a macro point of view because it is exposed to global trade. I'm not entirely sure what the transportation mix is for BNI but if world trade collapses and commodity prices collapse, some of these rails will do poorly. But I will cut Buffett some slack ;) because he sometimes takes huge stakes and you just can't wait for prices to decline. He may simply buy any time prices decline and big blocks are being unloaded. (Note: I'm not saying COP and BNI, or even the homebuilder and retailers, purchased were bad; all I'm saying is that it proves that their macro views are weak.))


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