Tuesday, November 7, 2017

The Big Reversal in Inflation?

Charles Hugh Smith of the Of Two Minds blog wrote a comment yesterday, The Big Reversal: Inflation and Higher Interest Rates Are Coming Our Way:
This interaction will spark a runaway feedback loop that will smack asset valuations back to pre-bubble, pre-pyramid scheme levels.

According to the conventional economic forecast, interest rates will stay near-zero essentially forever due to slow growth. And since growth is slow, inflation will also remain neutral.

This forecast is little more than an extension of the trends of the past 30+ years: a secular decline in interest rates and official inflation, which remains around 2% or less. (As many of us have pointed out for years, the real rate of inflation is much higher--in the neighborhood of 7% annually for those exposed to real-world costs.)

The Burrito Index: Consumer Prices Have Soared 160% Since 2001 (August 1, 2016)

Inflation Isn't Evenly Distributed: The Protected Are Fine, the Unprotected Are Impoverished Debt-Serfs (May 25, 2017)

About Those "Hedonic Adjustments" to Inflation: Ignoring the Systemic Decline in Quality, Utility, Durability and Service (October 11, 2017)

Be Careful What You Wish For: Inflation Is Much Higher Than Advertised (October 5, 2017)

Apparently unbeknownst to conventional economists, trends eventually reverse or give way to new trends. As a general rule, whatever fundamentals are pushing the trend decay or slide into diminishing returns, and new dynamics arise that power a new trend.

I've often referred to the S-Curve as one model of how trends emerge, strengthen, top out, weaken and then fade. Trends often change suddenly, as in the phase-shift model, in which the status quo appears stable until hidden instabilities cause the entire "permanent and forever" status quo to collapse in a heap.

The Bank for International Settlements (BIS) recently issued a report claiming that Demographics will reverse three multi-decade global trends. Here's a precis of the case for a globally aging populace and a shrinking workforce to reverse the downward trends in inflation and interest rates: New Study Says Aging Populations Will Drive Higher Interest Rates (Bloomberg)

Gordon Long and I discuss the demographic and financial forces that will reverse zero-bound interest rates and low inflation in our latest video program, The Big Reversal (The Results of Financialization Part III)

The demographic case is actually a study of labor, capital and savings. In essence, the authors of the paper are saying that the vast expansion of the global workforce (led by the emergence of China as the world's workshop) is a one-off that is about to reverse as the global Baby Boom generation retires en masse.

They also argue that the equally vast expansion of credit/debt that's powered the global expansion in the 21st century is also a one-off, as this monumental debt overhang has a characteristic peculiar to debt: it accrues interest, and as the debt balloons, even low rates of interest add up, weighing on weak growth and soaring entitlement spending.

Although it's not popular in today's debt-dependent zeitgeist to mention this, debt is not capital. Put another way: savings still matter, and as the older generation of workers retires, they will draw down their savings, a process that will make real capital (as opposed to lines of credit resting on fictitious/phantom collateral) more scarce and thus more costly for those wishing to borrow it.

Since it's a given that human labor is being replaced by robots and automation, the authors' call for higher wages strikes many as a false hope. If the human labor force is shrinking due to automation, why would wages for the remaining workers rise?

One little understood factor helps explain how labor can be scarce even as many jobs are automated: the easily automated work is commoditized, and low-touch, meaning that the human "touch" isn't the value proposition in the service.

But the value of high-touch services is added by the human presence. Do you really want to go to a swank bistro and place your order/retrieve your food from an automated service kiosk serving automated-prepared meals? Isn't the value proposition of the bistro that you will have a knowledgeable and experienced service and kitchen staff?

Granted, there may be people who will be delighted to be served in cubicles by robots, but since we're social creatures, this will wear thin for those who can afford more than an automated fast-food meal.

Even the most modest discounting of the hype about AI provides a more granulated understanding that not all work can be commoditized and indeed, nontradable work that cannot be commoditized will increase in value precisely because its value isn't created by the process of commoditization.

If the labor force shrinks at a rate that's faster than the the expansion of automation, wages will rise even as automation replaces human labor.

I explain this further in my book on work in the emerging economy, Get a Job, Build a Real Career and Defy a Bewildering Economy.

Gordon and I add the systemic fragility introduced by financialization to the demographic argument. The entire global asset market--stocks, bonds, real estate and commodities--is at heart a pyramid scheme in which the rapid expansion of credit drives asset prices higher, and since assets are collateral for additional debt, the higher asset valuations enable a new round of hyper-credit expansion.

This pushes asset valuations even higher, which sets the stage for an additional expansion of credit, based of course on the astounding rise in the value of the collateral supporting the new debt.

Central banks have powered this pyramid scheme by buying bonds and stocks with currency created out of thin air. This chart of the Bank of Japan's astonishing balance sheet is a bit outdated; the BoJ has purchased so many bonds and ETFs (stock funds) that it is now a major owner of Japanese stocks and bonds.


Of course debt isn't just a central bank phenomenon; corporate and household debt have soared as well. The global debt overhang is unprecedented:


My view is that once this tsunami of new debt-based currency hits the real-world economy, inflation will move a lot higher a lot faster than most pundits believe is possible. Trillions of yen, yuan, euros and dollars have flooded into the asset pyramid scheme. Once this tide washes into real-world goods and services, the inevitable result is inflation.

The tectonic forces of demographics meeting the increasingly fragile pyramid scheme of financialized debt-inflated asset bubbles will more than reverse the 30+-year trends of ever lower inflation and interest rates: this interaction will spark a runaway feedback loop that will smack asset valuations back to pre-bubble, pre-pyramid scheme levels.
I obviously disagree with Charles Hugh Smith but let's go over his arguments carefully. First, back in August. Sid Verma of Bloomberg reported, New Study Says Aging Populations Will Drive Higher Interest Rates:
Aging populations in China and Europe are poised to transform the global economy by sparking a jump in interest rates that may set the stage for a showdown between the old and the young.

So say Charles Goodhart and Manoj Pradhan, painting a sweeping picture of the future economic landscape in a new paper published by the Bank for International Settlements.

In it, the London School of Economics professor and former Morgan Stanley economist push back against the popular view that an aging population will slow growth and drag down rates. The research contrasts with models cited by the Federal Reserve, which project that inflation-adjusted real rates are intrinsically tied to potential growth.

“The demographic sweet spot is already behind us, and both the equilibrium real interest rate and inflation have probably already stopped falling,” write Goodhart and Pradhan. “Future problems may now intensify as the demographic structure worsens, growth slows, and there is little stomach for major inflation.”

A three-decade rush of new workers from Asia and other emerging markets has juiced returns for bond investors thanks to weak price growth, creating a sweet spot for capital owners that’s now reversing, the authors write.

But demographic trends are poised to be the driving force for the price of labor and capital across large economies and a graying population will, in turn, drain savings ratios and offset a corresponding reduction in investment spending, which tends to fall when demand is lower.

That dynamic should spur a rise in the effective cost of capital, or real rates, the authors reckon, pushing back against a view held by Fed researchers that real rates will stay low amid weak potential growth.


A key reason for Goodhart and Pradhan’s belief that workers will adjust their savings rates while still in the labor force, thereby anchoring rates, is their projection that a social-safety net will stay in place in advanced economies. That would reduce the incentive for workers to up their savings, and spur a rapid ‘dissaving’ upon retirement.

There’s no shortage of counterpoints to this view, including savers’ enduring need for ‘safe assets’ that boosts demand for highly-rated debt and caps yields. Meanwhile, the purchasing power of retired consumers isn’t guaranteed if the young begin to fight back, while technological innovations may reshape the landscape for productivity and rates.

The authors acknowledge some of these counterpoints but argue demographics are consistently more powerful than typical models project.

As more companies give the proverbial retirement watch to a growing number of workers, tighter labor markets should also push wages up, helping to reduce inequality across advanced economies along the way, they say. As global savings ratios drain out, the debt time-bomb is ticking, they conclude.
Interesting research but the bond market seems unconvinced as long bond yields keep going lower everywhere including in Italy (click on image):


Admittedly, things are getting wonky out there as euphoria creeps into these central-bank-controlled markets but with global inflation inflation in freefall, the bubble economy set to burst and markets on the edge of a cliff, I maintain the greatest risk of all going forward is deflation striking the US.

Let me be crystal clear here, euphoria in markets can go on longer than we think if central banks buy every dip but if it's not backed up with real fundamentals, it will be quickly fizzle and turn really ugly which is why now is the time to prepare for the worst bear market ever.

Are there opportunities in stocks? Yes there most certainly are but you've got to pick your stocks very carefully and if you don't know how to trade, you will get killed in these markets, I guarantee it.

For example, Weight Watchers (WTW) and Xoma Corp (XOMA) are up big today and are having a spectacular year but TripAdvisor (TRIP), TrueCar (TRUE) and Keryx Biopharmaceuticals (KERX) are down huge today.

I track many stocks across many sectors every day so I can tell you real-time what's moving and what's not. Sometimes I share my thoughts on StockTwits but I have no time, especially when trading and blogging concurrently.

These are markets which are extremely dangerous and I know because I watch them so closely. One wrong move trading or one wrong concentrated position and you're dead, quite literally.

This morning, I was tempted to buy  Keryx Biopharmaceuticals (KERX) at the open. Seth Klarman and David Abrams, the one-man wealth machine, own close to 30% of the shares and Stevie Cohen also added big during the last quarter (beware of Stevie Cohen when trading stocks).

I actually like this biotech, have made nice profits swing-trading it in the past, but I said forget it, stuck to my good old US long bonds (TLT) knowing not to touch a stock when the sharks are circling with their naked short-selling and high-frequency nonsense.

By the way, I am well aware in order to make big money these markets, I need to take super concentrated risks and trade high beta biotech shares but for the last few months, I just shoved my money in US long bonds (TLT) and ignored all the reflationistas spewing nonsense on television.

In fact, as I stated recently in the coming renaissance of macro investing, the only volatility I foresee in US Treasuries is upside volatility in prices as yields plunge to a new secular low, sending US long bond prices (TLT) to record highs.

But if Charles Hugh Smith is right and inflation is getting set to rear its ugly head again, there is little doubt long bond yields will rise under that scenario.

Remember, the Fed controls the short end of the curve (short rates) but inflation expectations determine the long end of the curve (long bond rates which go out 10, 20 and 30 years).

The Fed has been hiking rates and signaled it will reduce some of its asset purchases which is why rates on the one and two year US bond are up a lot over the last 12 months but inflation expectations keep dropping which is why long bond yields are declining.

If short rates keep rising and long bond yields keep dropping, we will see an inverted US yield curve which doesn't aurgur well for risk assets going forward (initially, no problem, but if the inverted yield curve persists, there's a huge problem).

Nowadays, all the talk is about Saudi Arabia's game of thobes and how oil prices are rising. I was watching Jim Cramer on CNBC this morning saying how he loves what's going on in energy stocks (XLE) because of what's happening to oil prices.

Good for him, I am short energy (XLE), short emerging markets (EEM), short commodities and commodity currencies, especially the loonie (FXC) which I predict is headed below 70 cents US over the next 12 months as Canada enters its worst recession ever (sorry folks, you're dreaming if you think otherwise).

When people tell me about inflation, they always throw oil prces in my face. Oil has been climbing lately mostly owing to geopolitical tensions but the argument that higher oil prices will be inflationary is a specious one in a debt-laden economy.

Why? Because if oil prices go over $80 a barrel again, and gas prices start rising fast, it will choke off aggregate demand and counter any tax cuts coming, if they finally come.

Importantly, in a debt deflation economy, higher oil prices are deflationary, not inflationary, and the powers that be in Saudi Arabia and Washington know this all too well.

The bond market knows this all too well too which is why long bond yields keep dropping and long bond prices (TLT) keep rising regardless of what is going on in Saudi Arabia or North Korea.

The problem with Charles Hugh Smith is like so many others, he fails to understand the baffling mystery of inflation-deflation and he most certainly doesn't understand why deflation is headed for the US and which factors are driving this mega trend of a prolonged period of debt deflation:
  1. The global jobs crisis: High structural unemployment, especially youth unemployment, and less and less good paying jobs with benefits.
  2. Demographic time bomb: A rapidly aging population means a lot more older people with little savings spending less.
  3. The global pension crisis: As more and more people retire in poverty, they will spend less to stimulate economic activity. Moreover, the shift out of defined-benefit plans to defined-contribution plans is exacerbating pension poverty and is deflationary. Read more about this in my comments on the $400 trillion pension time bomb and the pension storm cometh. Any way you slice it, the global pension crisis is deflationary and bond friendly.
  4. Excessive private and public debt: Rising government and consumer debt levels are constraining public finances and consumer spending.
  5. Rising inequality: Hedge fund gurus cannot appreciate this because they live in an alternate universe, but widespread and rising inequality is deflationary as it constrains aggregate demand. The pension crisis will exacerbate inequality and keep a lid on inflationary pressures for a very long time.
  6. Globalization: Capital is free to move around the world in search of better opportunties but labor isn't. Offshoring manufacturing and service sector jobs to countries with lower wages increases corporate profits but exacerbates inequality.
  7. Technological shifts: Think about Amazon, Uber, Priceline, AI, robotics, and other technological shifts that lower prices and destroy more jobs than they create.
These are the seven structural factors I keep referring to when I warn investors to temper their growth forecasts and to prepare for global deflation.

By the way, this weekend an astute reader of my blog sent me Matt Taibbi's latest comment in Rolling Stone, The Great College Loan Swindle, which is a must-read for all of you reflationistas.

He also shared this with me:
“I'm a huge Matt Taibbi fan. This is a fantastic article. He forgot to mention one important fact. It was Hillary Clinton - through the pressures of her banking buddies - that brought into law the inability of people to discharge student debt through bankruptcy.”
Crooked Hillary is definitely no friend of debt-laden millennials trying to get a higher education (Trump is an egomaniac but Hillary is pure evil). 

And as I discussed in my comment on America's dangerous dual economy, financially vulnerable millennials could spell disaster for the US economy:

The unemployment rate dropped to 4.2% in September, its lowest since February 2001, and yet consumer loan defaults keep creeping up.

In fact, the divergence between the labor market on one hand, and consumer credit performance on the other is at a record (click on image). What figures?



UBS analysts led by Matthew Mish and Stephen Caprio set out to answer that question, and their findings highlight the financial difficulties many millennials are facing.

According to Mish and Caprio, there are two cohorts that have been left behind by the labor market: lower income households, and millennials.

"The most underappreciated factor explaining consumer stress is the two-speed recovery in US consumer finances," they said.

The two strategists dived into the Fed's latest Survey of Consumer Finances to calculate a bunch of metrics, including the the levels of debt to assets and income across different age cohorts. Those ratios are near record levels, with the millennial debt-to-income ratios in line with 2007 levels (click on image).



And that might not tell the whole story. The Fed survey suggests 38% of student loans are not making payment, while the structural shift from owning a home and paying a mortgage to renting means that more households are paying rent and making auto lease payments. In other words, they might have significant outgoings that aren't being captured in the debt figures.

"We believe this is particularly problematic when assessing the financial obligation ratios of US millennials and lower-income consumers," UBS said.

So what does this mean? Here's UBS:
"Longer term, the two-tier recovery in consumer finances suggests key segments of the US population (lower income, millennial households) are more financially vulnerable than aggregate consumer credit metrics imply. In turn, these groups will be more sensitive to fluctuations in labor market conditions and interest rates ceteris paribus."
That's a touch worrying, especially at a time when interest rates are going up.

For context, millennials hold 18% of debt outstanding, according to UBS, and make up 19% of annual consumer expenditures. Together, the two cohorts "left behind," lower-income households and millennials, make up about 15% to 20% of debt, and 27% to 33% of expenditure.

So if they're struggling, it has the potential to negatively impact the economy pretty significantly.
This research supports Ray Dalio's warning on the danger of looking at averages when making important policy decisions. It also supports my theory that things are nowhere near as strong as these record-breaking stock markets suggest.

So, with all due respect to Charles Hugh Smith of the Of Two Minds blog, I remain of One Mind when it comes to the inflation-deflation global tug-of-war, deflation is winning and it will wreak havoc on pensions and the global economy.

Below, Charles Hugh Smith of the Of Two Minds blog talks to Gordon Long about why higher rates and inflation are headed our way. I say bullocks and so does the bond market which ultimately gets the final say on the great inflation-deflation debate.

No comments:

Post a Comment