Originally posted January 1, 2013.
From year end 2006 to the present, the top six central banks globally have printed close to $12 trillion in new money. Quite the feat given that they started with a collective balance sheet of $5 trillion. And it's not over yet, not by a long shot. One question we have heard again and again over this period is "where's the inflation?" Academically, the printing of money is currency debasement. Perhaps you'll remember from your college economics class the definition of inflation as being too much money chasing too few goods. This is exactly why the printing of money has historically been associated with the concept and often reality of price inflation.
One last characterization is in order. Has it really been that the price of physical assets has risen independent of any other factors during periods of central bank money printing? Is this one big coincidence? Of course not. Debasement of any currency means that it will simply take more of that currency to buy the same physical assets as the currency is now "worth less" than was the case prior to more of the currency being printed. So in a very real sense, it's not that prices are rising independent of any other factors, but more that currency values are falling - in this case more money chasing the same amount of goods. But the perception can be that prices are rising. Can we say that the whole concept inflation is integrally woven into human perceptions? We think that's a very fair statement.
If you would have told someone in the early 1970's that by decades end the general level of consumer prices in the US would be rising by double digits, they probably would have thought you had lost your mind. By 1980, a general perception was that inflation was running wild - it could not be stopped. As humans, we're susceptible to what is called "recency bias" as we tend to weight most heavily in our thinking and decision making what has occurred over the recent past. It took years of rising prices in the 1970's before inflation was a widely accepted belief. It took years of falling CPI rates in the 1980's for the general population to finally perceive that inflation had indeed been broken. The key point here is that perceptions are extremely important in human decision making (to say nothing of investment decision making) and these perceptions can change very slowly, much slower than is the reality of change itself in the character of the real economy.
Fast forward to the present. As mentioned, we have been bombarded by global central banker printed money over the recent past (last half decade). Everyone is fully aware that the US Fed and their global counterparts are now fighting deflation. A credit cycle bust globally has left debt encumbered assets susceptible to contracting values, most dangerous when the market values of those assets fall below the level of debt supporting them. Hasn't US real estate been a poster child example? And, of course, prior to the real estate downturn the popular perception was that "real estate prices always go up" as very few living had ever experienced a meaningful real estate bear market. The US Fed printing $2 trillion in new money since 2009 has simply offset a lot of contraction in private sector asset values leaving perceptions of inflationary pressures very subdued.
After 12 years of watching stock values go nowhere point to point, the popular perception of today is not one of ever rising stock prices. Everyone is now a believer that "real estate prices do not always go up". And after watching global central bankers print $12 trillion in six years with no headline inflationary fallout, markets do not react negatively when additional and so often unprecedented monetary expansion programs are announced.
Why is all of this important? We live in a world of very unconventional global central banker actions. Prime Minister Abe recently elected in Japan has promised unlimited money printing. This acceleration in policy now comes after two decades of deflationary fallout in Japan. After tripling its own balance sheet since 2009, the US Fed is now also conducting unlimited and heightened money printing until Fed defined unemployment and inflationary targets are achieved. And we know that plenty of monetary stimulus lies ahead in Europe as recapitalization of the Euro banking system has not even started. If you would have suggested to someone ten years ago that global central bankers would be printing money on an unlimited basis, and yet the markets would be unconcerned about potential inflationary consequences, yes, they would have thought you'd have taken leave of your senses. And yet here we are.
The point in this discussion is that we need to be very watchful of perceptual change regarding inflation and deflation in 2013 and beyond. We need to ask what could happen as a result of unprecedented central banker actions, not looking at what has happened already as a benchmark of what's to come. The problem with unconventional monetary policy is that once one starts, it's very hard to stop. Can you imagine the reaction of the financial markets if tomorrow the Fed announced, "we've tried printing money for four years now and it's not working, so we're going to stop"? In fact in Japan right now it's just the opposite. They've tried printing for decades, it has not worked, and so now they are going for broke.
The benefits of printed money are often short term, but potential consequences linger. In Japan, zero percent interest rates have allowed the Japanese Government to borrow and spend for decades. Japanese government debt exceeds GDP by over 200%. You'll remember Greece imploded at a 100% ratio. Politicians in the US have also partaken as US Federal debt has doubled since 2006! Easy to do at near 0% cost of money. In fact, the longer the US Fed keeps short term interest rates (Government financing cost) near zero, there simply is no incentive to stop borrowing and spending nor is there incentive to restructure. The deflationary mindset continues to dominate perceptions. Perhaps THE key question for investors ahead will be when does this change and how will we see it?
Although we're not there yet, at some point this deflationary mindset will begin to shift and this shift will be extremely important for investors. As we've mentioned in the past, change at the margin is one of the most important issues for investors. Trying to "see" very meaningful change prior to that change becoming a mainstream perception is something almost akin to the Holy Grail in investment management. Normally, we would expect to see the reality of increasing inflationary pressure in rising domestic interest rates. This was exactly the expression of the market's displeasure with inflation in the 1970's. But unfortunately in our current circumstances, we're not going to see this even as the deflationary mindset ultimately shifts to an inflationary bias as the Fed controls short term interest rates and is now the largest singular buyer of longer maturity US Treasuries, helping to artificially keep longer term interest rates low. As Jim Grant has opined, the interest rate risk management traffic lights are out. Do not expect to see the ultimate mounting of inflationary pressure in headline interest rates.
Our suggestion to you is that we need to "read" the markets in order to anticipate a shift in perceptions of deflation. First and probably most simplistic is to watch interest rate spreads between Treasury yields and like maturity TIPS (Treasury Inflation Protected Securities). This spread is called the TIPS implied breakeven inflation rate. Quite elegantly, the difference between coupon yield on the Treasuries and the like maturity TIPS leaves us with the market's "pricing" of inflationary expectations.
The fact is that the Fed announced QE3 and the recent follow on $45 billion monthly Treasury purchase program at the highest level of implied breakeven inflation in the current cycle. It will not take much further upside movement for this ratio to "break out" to new highs. Will something like that accelerate a shift in perceptions?
But additionally, certain behavioral patterns have emerged over not only the 2009 period to present, but really stretching all the way back to 2000 that reflect the deflationary mindset or perception. Stocks have been in love with Federal Reserve money printing, as have bonds. Under every QE program initiated by the Fed stocks have vaulted higher and interest rates have headed lower. Gold has usually responded by rising in price and prior to the Euro mess, the dollar would likewise respond as one would believe in an acceleration of printed currency by declining in value relative to foreign currencies.
Again, the reason we're bringing up this issue of the potential for a shift in deflationary perceptions toward and inflationary bias is that what we would have expected to happen with financial market reaction to QE3 and the recent follow on Treasury purchase program did not. For now, stock prices peaked the day QE3 was announced in September and have not been able to move higher since. The day the Fed announced $45 billion in monthly US treasury purchases, interest rates rose. Gold has been correcting since the Treasury purchase announcement and the dollar for now has risen against major foreign currencies. Although these are still all very short term market responses, collectively they speak to a financial market attempting to price in an inflationary bias as opposed to a deflationary outcome. All very short term in nature, but our task in a period where the risk management traffic lights (free market interest rates) are turned out is to be on the lookout for meaningful financial market change at the margin. This may indeed be one of the most important issues for 2013.
For a number of months now, we've urged investors to look beyond the fiscal cliff at the character of the real global economy. We know global corporate revenues are slowing at a time when profit margins rest at historic highs. The Fiscal Cliff itself in one sense cannot have a "positive" outcome for all as there will be some tax increases and most probably spending cuts. These are drags on the real economy. The saving grace perception in all of this is that the Fed will keep interest rates low and continue printing money. There is a sense of perceptual balance as long as investors have a deflationary mindset. When perceptions ultimately shift toward more of an inflationary bias, that's then when financial markets will have a bit of indigestion. Again, we're not there at present, but will 2013 see a period of perceptual adjustment relating to the long held deflationary bias? We'll be intensely monitoring this ahead and believe it to be one of the most important focal points looking into the New Year.