Shifting Regimes And Those at Risk of Toppling

By: Michael Ashton | Tue, Oct 9, 2012
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Equities weakened today, while commodities strengthened (and especially energy commodities). Although it is only one day's trading, this messes around a little bit with the popular themes at the moment regarding why stocks are so high despite widespread expectations for a lackluster Q3 earnings season.

One theme has it that the stock market is doing well because the economy had been looking pretty good, especially with Friday's positive (although not terrific) Employment Report, even if Q3 turns out to be disappointing. After all, stocks are supposed to discount the future, not the past, right? In line with that theme, today's pullback might represent a weakening of sentiment about global growth. The IMF revised downward its forecast for global growth to 3.3% this year (and advanced economies only 1.3%). However, if that's the reason then surely commodities ought to have suffered as well, especially gasoline. On the contrary, gasoline rose 2.6%, with November RBOB coming within $0.60 of a contract high set in March.

Another theme is that quantitative easing has been levitating stocks, despite weak fundamentals. But that doesn't hold water either, since quantitative easing ought to be pushing commodities higher at least as much as it is pushing equities (which, after all, tend to trade with weak multiples in high-inflation regimes). The chart below (source: Bloomberg) shows the last year's trading in the S&P, gold, and the DJ-UBS generally, normalized to October 10th = 100. While all three of these markets have rallied since the first implementation of the "soft" Evans rule back in June, stocks have clearly outpaced the markets that traditionally respond best to monetary largesse. So stocks are not likely up here because of QE, although that excuse probably helped over the last month.


It could, of course, be an equity-specific high valuations and probably unsustainable gross margins...but that doesn't play well in Peoria so even though it is the simplest answer, it probably isn't one the majority of analysts will put forth. It would be bad for business!

More subtle is the possibility that the inflation regime is moving from one that is accommodative to equity valuations (low, stable inflation) to one that is less accommodative. A 'regime shift' in inflation expectations is consistent with the way that inflation markets are trading - although breakeven inflation weakened very slightly today, 10-year BEI have rallied back to near all-time highs after the set back in the second half of September. It isn't that the regime shift has happened today, and I'm not claiming that, but that it may be in the process of happening as the stock market is looking and acting toppy while inflation markets are showing some vibrancy.

It is hard to say why regime shifts happen, and the econometrics doesn't tell you why - it just gives you ways to measure it and model it after the fact. It may be something incalculably complex, or something as easy as a news story that causes investors to reassess the context of the risks they are taking. A story, for example, about the rapidly rising prices in Iran and the collapsing rial.

It is hard to measure just exactly what inflation is in Iran. The latest figures from the central bank are from April, and show that inflation in the first four months of the year was running at a 44% annualized rate. But from all accounts, this has accelerated recently, and the behavior of consumers in the article linked to above smacks not of 3% monthly inflation, but of a much higher rate.

The reason that some people are calling this 'hyperinflation' is because the black market exchange rate for Iranian rials has apparently collapsed (I personally am not in touch with the black market so I have to take that on faith). The official rate, shocker of shockers, hasn't changed much; since February you've been able to get about 12,350 rials for the dollar (see chart, source Bloomberg).

Now, whether or not the exchange rate is 12,000 IRR/$ or 40,000 IRR/$ isn't as important to the average Iranian as the exchange rate of IRR for stuff - that is, the price level. This fact has led to some analysts making the rather wacky claim that inflation isn't really that bad since the exchange rate doesn't really matter to most Iranians. According to the story linked to here,

The politically-important lower-classes...are shielded from devaluation of the dollar because their day to day lives don't even involve dollars. Salehi-Isfahani told Business Insider, "The Iranian currency is very worthwhile for poor people. They go to work, they get their daily wage, they go buy their chicken and bread, and they get the same that they got the day before."

That's crazy. If prices are changing for the upper class, I can't think of how the lower class could possibly be insulated from those price changes. Economies just don't work that way. If there is one exchange rate for one set of goods and another exchange rate for a different set of goods, it implies a changing exchange rate between those goods, unless there is to be arbitrage. So, to make up an example: perhaps the price of an egg is table in rials, except that a few months ago it was enough to buy bus fare and now you can trade it for a car, because both can be exchanged for enough rials to equal $1. See anything absurd about that? The relative prices matter, and you can't stop barter, and therefore you can't have different exchange rates in different parts of the economy without completely screwing up the economic system - probably worse than if you just let the inflation do its thing, which would at least not destroy the relative prices of goods to each other.

Moreover, the anecdotal stories don't point to a low level of inflation, whether it's called "hyperinflation" or not. Any way you slice it, when inflation is 40%+ whatever wealth you have saved up for a rainy day is vanishing quickly, and in Iran this is undermining an already unpopular regime (although probably not quickly enough for Israel!).

The simple realization is: when inflation starts getting out of control (and wonder of wonders, M1 money supply in Iran has risen at roughly a 34% per annum pace since 2007), all your stored-up wealth had better be in real things, or you won't have any stored-up wealth. This is more true at 60% inflation than at 6% inflation, but even 6% inflation will halve the real value of your wealth in less than a decade. In that context, in context of the mere risk of such an outcome, I've wondered for a long time why more investors don't look to protect a bigger portion of their portfolios with inflation-linked solutions. Maybe that regime is finally shifting (the inflation expectations regime, that is, not the Iranian regime) as we have an example that we can see today, rather than harkening back to the 1970s.

Incidentally, if you're thinking about inflation investing, you may be interested in the following item. In the August "Beyond the Numbers," a publication put out by the Bureau of Labor Statistics, there was an article entitled "Consumer Price Index data quality: how accurate is the U.S. CPI?" If you know any of those people who grouse and grumble about hedonic adjustment (the net effect is almost zero) and about the substitution of chicken for steak (the BLS makes no such adjustment, which is an 'upper level' substitution; the BLS only suggests that if the price of Purdue chicken goes up you might buy a different brand of chicken), then suggest this piece to them. It describes and addresses some of the biases in the CPI and how the BLS deals with them. Those that take the time to read this (relatively brief) piece will understand a lot more about how the number is actually computed, as opposed to how some hacks claim it is computed, and hopefully such an understanding will open up a wider universe of potential investments in the 'inflation control' toolbox.



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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