Oh, THAT Italy!

By: Michael Ashton | Thu, Nov 10, 2011
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Equity markets today, especially in the U.S. (which fell -3.7%, underperforming many of their European counterparts), seemed suddenly to realize that the news from Monday and Tuesday about the deterioration in the circumstances of Italy was not irrelevant to the global investing community. From time to time, I think to myself "if I am ever asked by my alma mater to give a speech on efficient markets, here is an interesting exhibit," and this was one of those times. Nothing new happened today to suddenly trigger an equity rout, as far as I can see. Yes, Italian bonds collapsed further, with the 10-year note at one point about 70bps worse on the day before a rally pulled yields down to only 7.25% (according to Bloomberg). But it is hard to see why 7.25% is so dramatically worse than 6.75% the prior day. Perhaps it's the rate of change that finally got investors' attention.

While most European policymakers seem startled, if not downright shocked, at the dramatic turn of events in Italy - as am I; I really didn't see this happening so quickly - only a few seem to be making statements. German Finance Minister Schaeuble advised that Italy should request aid from the EFSF if it needs it, but also expressed a lack of concern since current Italian spreads to Germany are similar to what they were prior to Italy's joining the EU and stated his confidence that yields would fall again once confidence returned.

And it is comments like this that ought to be the scariest. Schaeuble is in the thick of the fight, but still professes to believe that this crisis is all about confidence (and mean old hedge funds). Others feel the same way, so they are doing things such as allowing banks to change assumed default probabilities of loans and other credit product so that the banks can claim to be better-capitalized. Surely this will give people more confidence and they can drive markets higher and we will all be happy. But obviously - at least, to most of us - this is not all about investor or consumer confidence. The sovereign issues are about unsustainable fiscal policies and leverage, adopted at times when money seemed free, and frankly the banking problems aren't much different in sour ce. I don't know how to unscramble that egg but I am pretty sure it cannot be done painlessly. But unscramble it must. The long-term solution to unsustainable fiscal policies and leverage is sustainable fiscal policies and savings (deleveraging). The short-term solution might well be default.

The S&P still trades at a dividend yield of only 2% and a Shiller P/E of 20 compared to a long-run average of 16. It doesn't trade like we're lacking confidence, until today perhaps. Stocks fell hard today and look tired technically. Volumes were heavier today but didn't even reach the levels of November 1st, much less what we were seeing in August or late September/early October. The VIX rose to 36, which is about the middle of the range it has held for the most part since early August.

Inflation swaps fell 7-10bps, and commodities dropped -1.35%. To some extent, it is a bit surprising how much commodities outperformed equities, since they have been lagging quite a bit recently; from a different perspective it is amazing that they're not doing much better. A friend today wrote insightfully, "Germany is just going to have to let the ECB print money and hope for the best, or put an end to [the Euro]." To which I would add the question: if the Euro breaks up, do you think the many newly independent central banks would not print? More and more, it looks to me like an endgame that doesn't include printing money is unlikely. Fiscal austerity and money printing would be half of the right prescription. Add to that the curious fascination that seems to be devel oping with the "Evans Plan" of allowing U.S. inflation to rise to 3-4% until Unemployment falls below (for example) 7%, and it is incredible to me that inflation protection is still so cheap. I feel like I am already repeating myself with this, and likely will grow gradually more shrill until the market eventually realizes it.

I said above that "fiscal austerity and money printing would be half of the right prescription." A better prescription would be fiscal austerity without money printing. Money printing will likely make things worse, not better, but it is a matter of faith among central bankers that printing money will help growth. When you only have a hammer, everything looks like a nail. This also explains the hypnotic fascination with the Evans-led concept that somehow if we just let inflation get away from us, unemployment will fall. Because, after all, look how well that worked in the 1970s!

I am continually amazed that such superstitious nonsense still has currency at high levels of economic thought. Let me make this really simple. The chart below shows chain-weighted GDP and the core consumer price index (if you use the headline index, the growth effect on oil prices creates an illusion of correlation, but if there is anything to the connection between growth and inflation is should certainly be seen on the index with those few items removed).

GDP vs the price index
GDP vs the price index.

It can be excused, perhaps, if an economist believed there was some correlation between growth and inflation in the years before the crisis. The correlation was artificial - the series both tend to rise over time - but there was at least some correlation. But 2008-2010 was a grand experiment. If growth and inflation are fundamentally joined at the hip, then the largest recession in three quarters of a century surely ought have caused the price index, already growing tepidly in 2007, to drop at least once. And the result of that experiment was unequivocal: prices continued on their merry way, slowing ever so slightly but not enough to reject the null hypothesis that growth had no effect on inflation. (Note: even I don't think that growth has no effect on inflation. The point is that we can't reject even such a radical null hypothesis as that.)

Einstein's hypothesis was supported by experimentation: the velocity of an object and its mass are related. The hypothesis of a relationship between growth and inflation, by painful experimentation, has been rejected.

There is, however, a long institutional tradition of monetary policymakers attempting to incentivize good fiscal behavior by providing "counterbalancing" monetary behavior. The Federal Reserve "rewarded" the budget-balancing in the 1990s by running looser monetary policy. (The budget balancing helped unleash strong growth, which the "Maestro" got credit for despite the fact that the real effect of his actions was to help provoke a dangerous, and ultimately damaging, bubble in equities.) It would not be at all surprising to see the same bargain being struck, with loose monetary policies "supporting" better fiscal policies. But this time, the monetary policies will have to be extremely loose. All of which is to say: I am not sure why I am allowed to buy commodities this cheaply when the end game is starting to become so clear.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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