Archive for the 'inflation' Category

INFLATION: Can you protect your portfolio?

Kurt Brouwer November 2nd, 2009

What happens when we enter high inflation?

My experience with inflation dates back to the 1970s and early 1980s.  Inflation averaged almost 8% for the entire decade of the ’70s, but it cranked up into double digits in 1979.  Let’s head back to those days of yesteryear — the early 1980s — and compare some key indicators to the situation back then.

Here is a good chart showing key interest rates plus inflation and unemployment, then and now:

Source: Carpe Diem

I suspect you could win some bets with some of these statistics.  How many folks remember that home mortgage rates hit 18% back then?  Or, another statistic that is not shown in the chart is that home mortgages rates averaged 12% from 1979 through 1985?

Is inflation an immediate problem?

Inflation is not a huge problem now as it was throughout the 1970s and early 1980s.  For example, inflation is now running in the Fed’s sweet spot of 1-2%.  However, given all the monetary stimulus and government spending we have seen, inflation is definitely a threat, but one that has not really manifested itself yet. I do not expect us to get back to the inflationary climate we saw in the 1970s, but none of us knows what lies ahead.

If you believe inflation is on the way, you also need to figure out where in the inflationary process we are.  If, like the early 1970s, you think inflation is underway and the Federal Reserve will not attack it for quite a while, then inflation hedges make some sense.  However, if you think the Fed might be planning to raise interest rates soon in order to counteract inflation, then inflation hedges could be a problem.  Here’s why.

If inflation went quite a bit higher, the Fed would eventually be forced to raise short-term interest rates.  Long-term interest rates would certainly go up and that would be bad for those holding long-term bonds.  Once interest rates begin moving up, then economic activity would probably slow down, bringing us into recession and that would hurt most other assets such as real estate and stocks.

For example, in 1979, the Federal Reserve (under Chairman Paul Volcker) decided to really attack inflation by raising the Fed Funds rate (short-term interest rates).  As you saw in the chart above, interest rates on home mortgages went way up.  As rates went up, economic activity fell off and we entered a recession.  In that environment, most assets fell (real estate, stocks, bonds).  Gold prices lagged the decline in other assets, but they also fell.

Gold  in 1980 — from darling to dog in two years

In fact, gold hit a high point in 1980 of $875 per ounce, but it fell as low as $463 within a few months.  Gold prices went back up into the $700 range, but by 1982, gold prices had fallen to a low of $298 per ounce.  That’s right.  From a high of $875, the price of gold fell to around $300 within a couple of years. Beginning in 1982, inflation fell quickly from the double digit level, but gold prices fell much more quickly as gold had a 60% price decline.

Now, gold is hitting new prices highs due, in my opinion, largely to the weakness of the U.S. dollar.  There are other factors at work in the price of gold, but for U.S. investors the dominant issue at work is the falling dollar.  The point here is that you need to make sure you are buying gold — or any other asset — for good, solid, long-term reasons.  A little further on I’ll give you my thoughts on the best way to buy gold.

What should I do about inflation?

If you believe high inflation is coming our way, how do you protect your portfolio? This piece from the Wall Street Journal covers some solutions and we add a few more ways to protect your portfolio from the ravages of high inflation.

However, be careful out there, because it is not as easy or straightforward as some would have you think.  The key takeaway I have for you is that you should seek investments that you believe are undervalued and likely to go up in value.  That’s how you keep your portfolio growing:

Inflation-Protection Strategies Offer Investors No Guarantees (Wall Street Journal, October 5, 2020, Jeff D. Opdyke)

Worried investors have been looking for insurance in the form of assets such as mutual funds and exchange-traded funds focused on gold, commodities and Treasury inflation-protected securities, or TIPS. In the past year, interest in TIPS funds in particular has been running at record levels, with some weeks recording more than $400 million in sales.

But many of these investments have never been tested during a bout of meaningful inflation. The last time inflation ramped up significantly was three decades ago. Yet TIPS have been around only since the late 1990s, and commodity funds are of even more recent vintage, as are the gold funds that invest in bullion or track the metal’s market price.

This is a really important point.  Wall Street is great at coming up with new and complex investment opportunities.  However, the track record on Wall Street innovations is not good.

Be cautious with new or untested investments

I think of it just like new operating systems for a computer.  I never rush to upgrade my computer with the latest, groovy operating system because I know there will be bugs.  I wait a few years usually before upgrading so that the bugs will largely be fixed before I make the switch.

I view innovations from Wall Street with even more skepticism than I do new operating systems for my computer.  In general, if it is new — and complex — and it’s from Wall Street, I pass.

As an example, consider commodity-oriented exchange-traded funds (ETFs).  They are new and relatively untested, so be cautious.  One critical issue with commodity mutual funds or ETFs is whether or not they actually hold commodities or just a basket of futures contracts for a given commodity.  With precious metals, it is possible to actually hold a commodity such as gold.  However, some commodities such as agricultural products or even oil or gas are less likely to be owned directly by a given fund.  In many cases then, an ETF or mutual fund just holds future contracts or notes redeemable by a bank.

There are some mutual funds such as Pimco Commodity Real Return Fund (PCRDX) that seek to benefit from investments in commodity-related securities.  Here’s how Pimco describes the investment strategy:

PIMCO manages CommodityRealReturn Strategy by combining a position in commodity-linked derivative instruments backed primarily by a portfolio of inflation-indexed securities…Other fixed income instruments may also be used tactically in the portfolio. The commodity-linked derivatives capture the price return of the commodity futures market, while our active management of the fixed income assets seeks to add incremental return above those markets, along with additional inflation hedging…

This type of fund can give you exposure to commodity-related investments, but it is no walk in the park.  We use this fund a bit, but we do so knowing it can be very volatile.  For example, in 2008, it fell over 43%.

Tracking error

Commodity mutual funds or ETFs have the potential to go up in value due to inflation, but they are inherently volatile.  And, as we saw above, they often also invest in futures contracts and other so-called derivatives that can lead to unintended consequences as shown by this piece from MarketWatch.  It illustrates the point with examples of commodity or precious metals ETFs that had results wildly divergent from the actual commodity or metal they are tracking:

…The United States Natural Gas Fund (UNG) , for example, has tumbled 50% this year while natural gas prices are down about 12%…

Natural gas prices go down so you expect the fund to go down, but a loss of 50%? Ouch.

…PowerShares DB Oil Fund’s flexible strategy helps it navigate market conditions…Since the fund’s inception in early 2007, it has gained about 16% while oil prices have risen about 40%…

Nothing wrong with a gain of 16% since 2007, but that return significantly lags the actual increase in oil prices.  As long as you understand what a commodity or precious metal mutual fund or ETF does, then that’s fine.  I suspect many investors in UNG are a bit mystified though.

If you are interested in investing in precious metals, I would simply just own them directly.  That is, buy some gold coins or silver coins and hold them in a safe deposit box.  If you do go that route, you have the coins and there is no muss or fuss. As a second best choice, I would buy an ETF such as the SPDR Gold Trust (GLD), which, by its prospectus, actually buys and holds gold at its custodian in London.

Other ETFs or mutual funds investing in precious metals or commodities may simply be putting together a basket of futures contracts on the commodity in question.  That’s fine if you have faith in the ETF or fund provider, but how exactly those contracts will perform in volatile markets is a bit of a question mark.

The Wall Street Journal continues:

…Though long heralded as a hedge against inflation, gold hasn’t always gone along for the ride when U.S. consumer prices are rising. Consider data from Morningstar Inc.’s Ibbotson Associates research and consulting unit: The correlation of spot gold prices to an Ibbotson-tracked inflation benchmark is just 0.096. (Correlation is perfect at 1; the closer to 0, the less the correlation.)

Certainly, gold has done well in some inflationary periods, like the late 1970s, when the metal spiked above $800 an ounce. Still, investors would do better to view gold as an international currency that hedges against weakening paper currencies, particularly the dollar. For instance, the U.S. dollar index, tracking the greenback’s performance against a basket of currencies, has slipped more than 13% since March, when the index hit its peak so far for this year. Gold prices, meanwhile, are up more about 14% so far this year.

…But there’s another issue: What does your gold fund own?

Exchange-traded funds such as SPDR Gold Shares and related trust products such as Canada’s Central GoldTrust own physical bullion, held in secure bank vaults and regularly audited.

Others don’t own physical gold and instead seek gold exposure through derivatives. PowerShares DB Gold, for instance, tracks an index of gold-futures contracts…

In mutual funds or ETFs that invest through futures contracts on gold or silver, there are a number of risks.  The obvious one is that spot prices for a given precious metal and futures contracts for that metal have very different prices as we saw from the examples above.  In a rising market, the fund would often underperform spot prices.  That can be very disappointing if you bought a fund and the precious metal followed the trajectory you anticipated, yet the fund lagged far behind.

So, there is the issue of the internal structure and strategy of the fund or ETF.  But, there are also other issues.  The Wall Street Journal continues:

…Many commodity-based securities are exchange-traded notes, or ETNs, which pose a different risk. Unlike ETFs, which generally own a pool of hard assets or securities, ETNs own nothing. They are promissory notes issued by a bank, meaning they’re unsecured debt; the return you earn is calculated based on the movement of an underlying commodity index.

“You’re loaning money to a bank, and the bank pays you the return of the underlying index,” Morningstar’s Mr. Burns says…

Hmmm.  Loaning money to a bank.  What could go wrong?

Going beyond precious metals or commodity funds, here are some thoughts on different asset classes of funds and how they might fare during inflationary times:

Money market mutual funds: One very good investment in times of high inflation is cash in a money market funds.  Assuming interest rates go up due to inflation, the return on the money market fund should go up too.  In a money market fund, interest rates are variable, so your money will begin earning higher interest as soon as rates go up.

Short-term & intermediate-term bond funds:  If you have some fixed income investments, as a first step for an inflation conscious investor, I would shorten the maturity of any bonds or bond funds you own and use short-term and intermediate-term bond funds primarily.  You could also put some assets in a fund that invests in Treasury Inflation Protection securities as mentioned above.

U.S. stock mutual funds: Stocks can do quite well in a moderate inflationary environment, in particular stocks of companies that have pricing power.  However, if inflation really takes off, eventually the Federal Reserve would have to raise interest rates and that would result in a recession in all likelihood.  Recessions are not generally good for stocks.

International stock mutual funds:  The points made above about U.S. stock funds apply generally to international stock funds too.  In addition, there is the currency issues.  That is, most international funds hold stocks in currencies other than the U.S. dollar.  As such, if inflation has a negative impact on the dollar, then those funds should benefit.  The flip side is true also though.  That is, if the dollar strengthens, then most international funds would suffer a bit due to their non-dollar exposure.  Right now, international stock funds are benefiting from higher share prices plus currency gains from the falling dollar.

Real estate mutual funds:  Real estate has been struggling for a couple of years now.  Residential real estate started falling first and now commercial real estate is taking a big hit.  Assuming you are a long-term investor and assuming you are worried about inflation, real estate funds are worth a look.  It may be premature at this point because real estate is still weak, but historically real estate has done pretty well during inflationary times.  I would wait a bit on this though.

In closing, I’ll make a couple of points.  First, there is no guarantee that we will go through a high inflationary period.  There is pretty solid evidence that inflation will be moving up at some point, but that does not mean we will get back to the type of inflation we saw in the 1970s.  Also, as you know, disinflation, not to mention, deflation, is still a possibility although probably a much lower one than inflation.  But, if the economy fails to re-ignite, we could drift into another recession in a year or two and that would mean most inflation-centric investments might suffer.

When it comes to investing, I believe a diversified portfolio works best because the future is not knowable.  That is, do not bet all your assets on one specific scenario such as high inflation.  You can certainly do things to lessen the impact of inflation on your portfolio, but do not put all your assets in one narrow strategy.

Disclosure:  Kurt Brouwer owns shares of Pimco Commodity RealReturn Fund (PCRDX)

Will you run out of money in retirement?

Kurt Brouwer October 28th, 2009

‘Life should  NOT  be a journey to the grave with the intention
of  arriving safely in an attractive and well preserved  body,
but rather  to skid in sideways - Chardonnay in one  hand -

chocolate in  the other - body thoroughly used up,  totally worn out and
screaming ‘WOO  HOO, What a  Ride’ 

 

I’m not sure who actually wrote this, but it does contain a very different perspective on planning for retirement, doesn’t it?  My only quibble has to do with the wine selection.  I always thought chocolate went best with a nice, full-bodied red.

Most of us do not have the perspective of the author of this pithy paragraph though.  In fact, one of the key concerns — perhaps the key concern — people have about retirement is whether or not they will run out of money.

In answer to that question, the answer is almost certainly no.  That is, you won’t run out of money.

Here’s why. Think of your gas tank in your car.  If you were on a long trip and the circumstances were that you were getting low on gas and no gas stations were available, what would you do?  Would you keep driving at high speed knowing that would burn gas quickly or would you cut back to the most efficient speed in order to conserve?  Answer: you’d conserve.

The same is true of conserving your assets in retirement.  If things looked tight, you would cut expenses and reconsider assumptions you had made long before a shortage would come about.  You would make changes, consider new options and, in a variety of ways, you would think outside the box.

Retiring outside the box

As an example of thinking or even retiring outside the box, I was chatting with a client who complained that his retirement expenses were unsustainable given his steady income and savings.

I was kidding a bit, but I said, “You could always move to Guatemala.”

The thinking behind that statement is that many American and Canadian retirees have moved south of the border to expatriate enclaves in Mexico, Guatemala, Costa Rica, Panama and Nicaragua.  Living expenses are generally much, much lower in those places.  The client laughed and told me he had given some thought to living half the year in Mexico.

In other words, though you may think you’re going to retire and maintain all your present circumstances, that may not be the case either because you want a change or because you need to change.

You can have (almost) any thing you want, but not everything you want

In other words, there are definite tradeoffs in planning for retirement.  If your primary goal is just to have the money for a simple, comfortable retirement, then that’s probably fine.  But, if you begin adding on requirements, you may impinge on your primary goal.

Let’s say you are about to retire and you want to figure out how much you can spend each year during retirement.  Before getting into formulas or related concepts such as inflation, in my view, the key question is this:

What do you want?

When I ask that question, people generally have a pretty clearcut plan on certain issues such as:

  • I want to leave $_____ to my kids or my church or my charity while providing for a comfortable retirement
  • I’m mainly concerned about retirement income and if there is anything left over, it will go to our kids
  • I am worried that our retirement needs could become a burden to our children
  • I don’t want to leave any money to anyone; so I want to write my last check on my deathbed

The details may vary, but your retirement goal should be clearly stated.  For most people, the primary concern is providing for their own retirement expenses.  Beyond that, they either want to pass on some of their wealth or they don’t.

Once that issue is addressed, the next issue is how much can you spend on yourself — on your lifestyle — during retirement?  The viability of a retirement spending plan rests on three primary components — your spending, your steady income and your savings.

All three of these have to be considered together in order to come up with a coherent answer to the question, will you run out of money in retirement?  Obviously, we cannot know the future, so we are speaking in terms of probabilities, but it is useful to go through this type of analysis:

I. Spending during retirement: Let’s say you are on the cusp of retiring.  First, congratulations are in order.  You made it.  Next, let’s take a look at how you figure out what you’ll spend during retirement.  The best place to start is to figure out how much you spend now.  I know that sounds obvious, but many people don’t really know what they are spending.

We use a Microsoft Excel worksheet to help people go through this exercise so they don’t miss any major spending categories.  One of the biggest spending black holes is your home.  People spend a lot of money on upkeep and maintenance, insurance, property taxes, principal and interest payments and home improvements.  It’s easy to miss something.

Your home: Are you planning to stay where you are?  If so, home expenses may not change much, until you pay off your mortgage.  If you plan to downsize your home, will you buy a condo or rent.  For many retirees, renting is hard to imagine as they have owned a home for decades, but renting makes economic sense for many.

Your state or city?  If you are planning to move, are you considering another state.  If so, the cost of living in that state is important as are all the various taxes (income tax, sales tax, property tax).  There are places around the country — and around the world — where your money may go a lot further than it does where you live now.  Or, you may be considering a move to be close to family or even to bring about a lifestyle change.  A change such as this complicates things, but that’s OK.

Other easy items to miss are expenses that come once a year (such as many types of insurance) or expenses that occur irregularly, such as replacing a car or a furnace or a roof. Once you have a good handle on how much your spend now, you can estimate what you will spend in retirement.  In order to look forward in terms of spending, you have to make some decisions:

There are rules of thumb for adjusting your working level of income to see how much you will need in retirement, but I have not found them terribly useful.  I think it’s much better to track your current spending and then go through and make adjustments to deal with your contemplated lifestyle changes during retirement.

One of the best ways to estimate retirement expenses is to talk with those who are already retired.  This is not a huge revelation, but I have found that many folks are reluctant to ask family members or friends or others about what life in retirement is like or to find out how their spending compares to spending before they retired.  Most retired folks that I know are happy to help others and share their knowledge.  So, if you have questions, just ask.

II. Steady Income: Figuring this out is generally the most straightforward part of the process.

Social Security: Most people will have Social Security income during retirement and the Social Security administration sends out a specific statement for your personal Social Security benefit at retirement.  The only big decision for Social Security is whether or not to take it immediately or to wait until full retirement age.  This chart from the Social Security administration illustrates how your initial monthly benefit can change depending on your age when you start taking Social Security.

Source: Social Security Administration

As you can see, assuming a retiree has a full benefit of $1,000 per month at age 66, the actual benefit could be higher or lower depending on what age the retiree actually elects to start taking the benefit.  Many articles I have seen recommend waiting until age 66 to get the full benefit.   That may not necessarily be the best choice for many people because you have to give up four years of Social Security benefits to get the higher amount.  The reason it may not make sense for you to wait until full retirement age is that the crossover point could be about 12 years.  That is, it takes 12 years at the higher benefit amount to make up the amount you missed by not taking benefits at 62.

For example, using the numbers in the chart above, at age 62, you would get $750 per month for four years for a total of $36,000.  On the other hand, if you wait until age 66 for full benefits, you would get an extra $3,000 per year ($250 per month).  Without getting too fancy, in actual dollars it would take 12 years to make up the money you missed by waiting.

If you plan to work until 66, it probably makes sense to wait to take benefits until that age.  However, many people may want to take benefits at 62 just to bring in some income.  That method will give you more money until the crossover point is reached in about 12 years.

Many folks will have some part-time or full-time employment income during the early years of retirement and that could impact your decision on when to take Social Security benefits among other things.  For more on this issue, you can go to the Social SecurityAdministration’s Retirement Benefit site.

Other pension benefits:  If you are lucky enough to have an outside pension plan from your employer, then that is an additional source of income during retirement.  In addition to the pension income, you may also be eligible for additional benefits such as retiree health insurance.  One very important question to consider with an outside pension is whether to take the monthly income option or to take a lump sum distribution, assuming that option is available to you.  If you are at all concerned about the level of funding for your pension, taking a lump sum may make sense.

III.  What assets do you have?

This refers to your investments, whether IRAs, 401(k)s or personal savings or investments.  We typically include retirement assets if you have them in an account in your name.  We include monthly pension income above under Steady Income.  Looking at your assets means you would also potentially include other assets such as your home or a business or anything else you have that is valuable.  You may want to remain in your home now, but it is still a resource if you have some equity in it.

If there is a gap between your spending (Section I) and your steady outside income (Section II), then your portfolio has to be tapped to make up the difference, if you cannot cut expenses that is.

People often ask what is a reasonable return for retirement assets and that is hard to forecast because returns vary dramatically from year to year and from one type of asset to another.  If you have your investments in a diversified portfolio, then you could consider historical rates of return, that is the long-term average return for each type of investment.  We look at those historical returns and then make adjustments according to our view of conditions in the future.

What kind of spending assumption should I make?

What we often do is look at a 4-5% withdrawal rate from your portfolio.  That is, if someone has a long-term portfolio, then he or she should be able to withdraw 4% per year from that portfolio without drawing it down to zero over the course of a normal retirement.  The way the math works on this is to assume a return from a diversified portfolio of say 8%.  Then, from that 8% return, deduct your inflation assumption.  Say, that’s 3% and the remainder, 5%.  Assume some income taxes, albeit at a fairly low rate, and 4% is left that can be spent without dipping into your principal on an inflation-adjusted basis.  In this scenario, you would be able to pull out 4% per year and also to keep your principal intact even with the ravages of 3% inflation.

However, you may not be as concerned with inflation as you get older depending on your initial goal.  For example, if you plan to write your last check when you check out, then keeping your principal intact will not matter much to you.  Or, if your primary concern is your own retirement span and whatever is left over, if anything, could go to your children or a charity, then again keeping up with inflation may not concern you too much.

In these cases, you could spend quite a bit more than 4% because you don’t mind dipping into principal and because you don’t care if the portfolio value does not keep pace with inflation.

Another alternative we have seen is that retired folks take out more than 4% in years when investment returns are good, but they cut way back on withdrawals from the portfolio in down years.  That can work if you are disciplined.

Living longer & margin for error

One point to bear in mind also is longevity.  The good news is that life expectancy is going up and people are living much longer.  Initially, most recipients of Social Security did not last all that far beyond 65.  Now, people are routinely living well into their 80s or 90s.  That is one reason why Social Security funding is a problem.  But, it is also a problem we need to consider as part of a retirement plan.  How long are you planning to live?  Or, what life expectancy would you like to assume.  A reasonably healthy couple, each of whom are at age 65, will likely be around for quite a while, and one member of the couple could easily live 20 years or more.  Therefore, retirement planning needs to account for a potentially long life span.

I believe you also need to have a cushion in your planning to account for the possibility of getting lower investment returns or other factors such as higher inflation or a long, long life.

Summing it all up

When you begin thinking about these issues, the temptation is to go right to one of the retirement calculators you can find online (see here or here or here for examples).  That’s fine.  Do it.

But then, you actually have to sit down and do your own personal math.  Track your expenses.  Make adjustments based on what you hear from retired family or friends.  Add in your steady income from Social Security or other sources.  And, finally, make a conservative assumption of what you can take from your portfolio to make up any difference between spending and steady income.

As you can see, this is a very personal decision as your goals could be quite different from those of family members or friends.  If your situation is complicated or if you want a more rigorous retirement analysis, you would need to go to your CPA or financial advisor for help.

Have fun and if you have an interesting tale let me know.

Can Paul Volcker Ride to the Rescue Again?

Kurt Brouwer September 30th, 2009

Paul Volcker was the Federal Reserve chairman back in the early 1980s.  He had been appointed by President Jimmy Carter in 1979.  His task was to squelch inflation and that he did by sharply hiking short-term interest rates.  Unfortunately, the economy took a huge hit as a result of his inflation-fighting efforts, but he did kill off inflation for a generation.  That feat alone gives him enormous credibility in terms of our banking and monetary system.

Now, of course, Volcker is back in the news as an economic advisor to this administration.  However, they are apparently not taking his advice as this ABC News report suggests [emphasis added]:

White House adviser Paul Volcker today criticized the Obama administration’s sweeping financial regulatory reform proposals, specifically one that he warned could lead to future bailouts by designating certain firms as “too big to fail.”

In testimony prepared for a hearing Thursday morning before the House Financial Services committee, the former Federal Reserve chairman expressed doubts about the administration’s proposal to designate certain firms that pose a threat to financial stability, subject them to stricter supervision, and make them submit resolution plans in the event of failure.

“The clear implication of such designation whether officially acknowledged or not will be that such institutions, in whole or in part, will be sheltered by access to a Federal safety net in time of crisis; they will be broadly understood to be ‘too big to fail’,” Volcker said.

This designation, Volcker said, will only serve to encourage more risk-taking, thereby leading to even worse crises in the future.

“What all this amounts to is an unintended and unanticipated extension of the official ‘safety net,’ an arrangement designed decades ago to protect the stability of the commercial banking system,” Volcker stated. “The obvious danger is that with the passage of time, risk-taking will be encouraged and efforts at prudential restraint will be resisted…”

…The former Fed chief also expressed opposition to the administration’s proposal to remove responsibilities other than monetary policy from the central bank…

Chairman Volcker (a shorter version):

First, let’s make banking boring again.  No bank should be too big to fail.  And, second, don’t mess with the Federal Reserve.

What was it like back in the early 1980s?

To see what Chairman Volcker was up against, let’s head back to those days of yesteryear — the early 1980s — and compare some key indicators to the situation back then.  Here is a good chart showing key interest rates plus inflation and unemployment, then and now:

Source: Carpe Diem

I suspect you could win some bets with some of these statistics.  How many folks really remember that home mortgage rates hit 18% back then?  Or, that they never went below 12% from 1979 through 1985?

Double Digits in 1980-82: Inflation, Unemployment & Mortgage Rates

In the late 1970s and early 1980s we had sky-high inflation, unemployment and mortgages rates. At that time, Chairman Volcker, had to raise interest rates to unheard-of levels. These rate hikes led to a prolonged economic contraction that was the worst since the Great Depression of the 1930s. This description from Wikipedia gives a sense of how severe the reaction was [emphasis added]:

“…However, the change in policy contributed to the significant recession the U.S. economy experienced in the early 1980s, which included the highest unemployment levels since the Great Depression, and Volcker’s Fed also elicited the strongest political attacks and most wide-spread protests in the history of the Federal Reserve (unlike any protests experienced since 1922), due to the effects of the high interest rates on the construction and farming sectors, culminating in indebted farmers driving their tractors onto C Street and blockading the Eccles Building…”

The image of farmers blockading Washington D.C. with tractors is hard to imagine now, but those were tough times.  The reason Volcker raised interest rates so aggressively was that inflation went wild in the late 1970s. For example, inflation hit 11.3% in 1979, 13.5% in 1980 and 10.3% in 1981 before Volcker’s harsh medicine began to kick in and inflation moderated to 6.2% in 1982.

As inflation ratcheted higher, so did home mortgages rates. Thirty-year fixed rate mortgages went up to nearly 13% in November 1979 and did not fall under 12% again until November 1985. The peak rate for mortgages was 18.45% in October 1981. 18.45%!

But, even though high interest rates began knocking down inflation, soaring rates also led to sharply higher unemployment. The unemployment rate peaked at 10.8% in December 1982. However, it had been soaring for years and it remained at 8% or higher until January of 1984. Given all this, it is not surprising that investors and consumers were very negative in that time period 1980-82.

As you can see from the chart above, there is a huge disparity between interest rates, inflation and unemployment today versus the early 1980s.  It is true, that government statistics on inflation and unemployment have changed since then.  Nonetheless, interest rates and inflation were much higher back then.  Unemployment was probably about the same although some would argue it is higher now due to changes in the methodology of calculating unemployment.  

In that period, the Federal Reserve had to fight pervasive inflation and the only means available was to raise interest rates.  As a result of higher interest rates, bond yields soared and bond values plummeted.  Higher interest rates hurt the real estate market and values fell.  Higher rates also hurt the stock market.

Inflation is not a huge problem now as it was throughout the 1970s and early 1980s.  For example, inflation averaged nearly 8% per year for the entire decade of the 1970s.  And, it began accelerating into double digits for the period 1979-81.  Clearly, that was a huge threat.

Is deflation underway?

Today, we have two competing issues:  current deflationary trends and likely future inflation influences (see Pimco Warns of Deflation To Come).

Right now, the government is more concerned with deflation than inflation as this report from the Congressional Budget Office indicates.  The CBO made this statement in the summary section of its recent report on the President’s Budget [emphasis added]:

…For the next two years, CBO anticipates that economic output will average about 7 percent below its potential-the output that would be produced if the economy’s resources were fully employed. That shortfall is comparable with the one that occurred during the recession of 1981 and 1982 and will persist for significantly longer-making the current recession the most severe since World War II. In CBO’s forecast, the unemployment rate peaks at 9.4 percent in late 2009 and early 2010 and remains above 7.0 percent through the end of 2011. With a large and sustained output gap, inflation is expected to be very low during the next several years…

The CBO estimates that inflation will be very low for ‘the next several years’ due to the output gap mentioned in the quotation above. That is, if global GDP is 7% below potential then there should not be a lot of pressure on pricing until the output gap is closed.

Will Paul Volcker’s voice be heeded?

However, even though inflation is not a pressing problem today, there are plenty of serious concerns we have about the integrity of the banking system and many other factors. Paul Volcker’s wisdom and experience are badly needed now and I hope the administration heeds it.

Unfortunately, I’m afraid that — so far — his recommendations are not getting the hearing they deserve.

Pimco Warns of Deflation To Come

Kurt Brouwer September 29th, 2009

Though inflation fears are popping up all over the place — particularly in ads for inflation-hedging investments such as gold — Pimco’s Bill Gross still believes economic activity is weak and he is warning of deflation ahead, not inflation.  This Bloomberg pieces gives his thoughts [emphasis added]. Be wary though of the headline because I believe it is incorrect as I point out below:

Pimco’s Gross Buys Treasuries Amid Deflation Concern (Bloomberg, September 29, 2020, Thomas R. Keene and Susanne Walker)

Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said he’s been buying longer maturity Treasuries in recent weeks as protection against deflation.

“There has been significant flattening on the long end of the [yield] curve,” Gross said in an interview from Newport Beach, California, with Bloomberg Radio. “This reflects the re-emergence of deflationary fears. The U.S. is at the center of de-levering as opposed to accelerating growth.”

...He boosted the $177.5 billion Total Return Fund’s investment in government-related bonds to 44 percent of assets, the most since August 2004, from 25 percent in July, according data released earlier this month on Pimco’s Web site. The fund cut mortgage debt to 38 percent from 47 percent…

This piece is a good example of why you should be wary of headlines and media reports in general.  The reporters were probably correct that Pimco bought a modest amount of Treasury securities opportunistically when rates hit an attractive level, but they gave the impression that a major move into Treasuries was underway.  And, the headline writer added to that erroneous (I believe) impression.

The piece got it right in the final paragraph above when it pointed out that Pimco is putting more emphasis on government-backed securities (such as Fannie Mae bonds or other government agency bonds) and interest rate swaps and other similar instruments tied to government-backed securities. Government agency bonds are guaranteed by the Treasury, but they are very different from Treasury bonds or notes.

Getting back to the main theme, like Gross, I too wonder and worry about deflation.  It’s not that I do not see a threat from inflation in the future because I do see inflation ahead.  But, inflation is not much of a factor right now whereas deflationary forces are still quite strong.  With the potential for deflation, we also have a higher likelihood of lower interest rates.  Whereas, in an inflationary environment, we would typically have higher interest rates for most fixed income securities.

What is inflation and what is deflation?

Inflation means that we are experiencing a general increase in the price of goods we buy.  Deflation is the opposite, that is, a general decline in the prices of various assets and the goods we buy. Inflation is very common in most developed countries, but deflation is rare.  The last time we had protracted deflation was in the Great Depression of the 1930s.  Now, the slumping economy has weakened demand enough that, at least, most goods and services are under some pricing pressure. Overall, the cost of living (Consumer Price Index) is still up a bit, but that is primarily due to recent increases in the cost of energy.

Why is general deflation so scary to our government?

Falling consumer prices are a good thing, but there are concerns about generalized falling prices, i.e. deflation.  A generalized state of deflation is viewed with fear and loathing by the government because it can be very disruptive.  Falling prices for goods and services mean companies struggle financially and are forced to cut spending and employment.  Falling prices for assets such as real estate means that homeowners see their equity vanish and that leads to lower levels of consumer spending.  As real estate prices fall, banks and mortgage holders also suffer.  This leads to a hoarding of capital and decreased lending activity.  And, as economic activity under a deflationary environment falls, more unemployment results, thus leading to yet further reductions in consumer spending.

In short, deflation can become a downward spiral and our government will use every tool it has to quickly root out deflation and prevent it from taking hold because, to paraphrase Sun Tzu from The Art of War:

If the deflation is protracted, the resources of the State will not bear the strain.

As Gross pointed out in his September Investment Outlook,

As of now, PIMCO observes that the highest probabilities favor the following strategic conclusions:

  1. Global policy rates will remain low for extended periods of time.
  2. The extent and duration of quantitative easing, term financing and fiscal stimulation efforts are keys to future investment returns across a multitude of asset categories, both domestically and globally.
  3. Investors should continue to anticipate and, if necessary, shake hands with government policies, utilizing leverage and/or guarantees to their benefit.
  4. Asia and Asian-connected economies (Australia, Brazil) will dominate future global growth.
  5. The dollar is vulnerable on a long-term basis.

The Feds are fighting deflation very hard for the reasons noted above, but the deflationary pressures are such that we are not likely to see inflation for some time.  That’s good. Unfortunately, deflationary pressures also mean that we will probably have a modest, rather than robust, economic recovery in 2010.

See also:

Burgeoning Bond Funds

Economy Turning — slow growth ahead

Full Disclosure:  Kurt Brouwer owns Pimco Total Return (pttrx)

Households Cut Back; Government Debt Grows

Kurt Brouwer September 28th, 2009

During this recession, Americans are paying down their mortgages, paying off car and truck loans and moving back to old fashioned thrift.  And, Yet, despite all the cutbacks on the part of Americans, the country’s debt load has gone up due primarily to government borrowing.  Yet, even with all the new government debt, the country’s headlong race into indebtedness has slowed considerably:

Source: New York Times

The rate of growth in new national debt, is down to 3.7%, which is low by historical standards.  This piece by Floyd Norris from the New York Times gives some detail [emphasis added]:

THE United States government is borrowing money like never before. The national debt rose by more than a third over a one-year period, far more than it ever did at any time since World War II.

…This week, the Federal Reserve published its quarterly report on debt levels in the economy. While Uncle Sam borrowed more, others borrowed less. The accompanying chart shows that total domestic debt — the amounts owed by individuals, governments and businesses — climbed just 3.7 percent from the second quarter of 2008 through the second quarter of this year. That is the smallest increase since the Fed started these calculations in the early 1950s.

Moreover, domestic debt declined in the second quarter, falling 0.3 percent to $50.8 trillion. The figures are not seasonally adjusted, making quarter-to-quarter comparisons risky, but it was the first such decline since the first quarter of 1954, when total debt was less than $500 billion.

…Until this recession, the idea that American individuals would ever cut their overall debt levels seemed as likely as an August snowfall in Miami. But that was before the bottom fell out of the housing market, something that Florida condo developers had considered to be equally unlikely.

Over the year, total household debt fell by 1.7 percent, and mortgage debt — the largest component of household debt — fell a bit more, at a 1.8 percent pace. This is the 10th recession since the Fed began collecting the numbers, but the first in which the amount of home mortgage debt fell. Some of that decline, of course, came from foreclosures that canceled debt and left lenders with big losses…

Without the huge slug of debt put on by the government, our overall indebtedness would be falling.  Some economists and pundits think government borrowing is the only thing between us and disaster.  That may or may not be, but in my opinion it is disaster deferred not disaster avoided.

Even though households are cutting back, the U.S. Treasury just reached a new — albeit dubious — record:

The U.S. Treasury issued a new record of $7 trillion in bonds for the fiscal year that will end next week:

U.S. issues $7 trillion debt, supply to stabilize  (Reuters, September 23, 2020, Burton Frierson)

The U.S. government will have issued $7 trillion in bonds by the time the current fiscal year ends next week, but it expects the debt deluge to stabilize by mid 2010, a Treasury official said on Wednesday.

…However, this expansion may take place in an environment where investors consider leaving the safe-haven Treasury market for riskier assets, and debt issuance is likely to level off mid next year, said Treasury Acting Assistant Secretary for Financial Markets Karthik Ramanathan.

“In fiscal year 2009, which ends next week, Treasury will have issued $7 trillion in gross issuance — that’s in a 12-month period,” Ramanathan told a financial markets conference in New York…

A trillion here and a trillion there.  After a while, it adds up.  Not all of these bonds were brand new.  In fact, most of the bonds issued replaced bonds that were maturing.  Nonetheless, the new debt issuance is huge.  Reuters continues:

“This issuance was necessary to meet nearly $1.7 trillion in net marketable borrowing needs, nearly $1 trillion more than what we raised last year,” he added.

That’s sizeable.  $1.7 trillion in net new borrowing.

Finally, the headline of this piece cracks me up.  ‘U.S. issues $7 trillion debt, supply to stabilize.’  Since the Treasury determines what the supply is, I guess that’s like saying, “We’re borrowing scads of money now, but we plan to borrow less in the future.”  OK, that’s nice, but we’ll believe it when we see it.

Ordinary Americans have proved they can cut back, but it remains to be seen what happens when the recession ends and the recovery begins.  The reverse is true of government borrowing.

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