Thursday, December 4, 2008

Why I'm optimistic (2)

About a month and a half ago I reiterated the reasons I was optimistic and why we had probably seen the worst of the financial crisis. Things did get a little worse, however, as the equity market recorded a new low a month later. I should have remembered this chart, which makes a couple of very important points: 1) the last three months of every year are almost always the low-water mark for prices, while the first three months of every year are almost always the high-water mark; and 2) the volatility of inflation has picked up enormously since 2001. (The chart shows the three-month annualized change of the nonseasonally adjusted consumer price index.) But even though I was premature, I still believe it pays to be optimistic, and I still contend that we have seen the worst of the news.

Mike Churchill, a very smart analyst friend and investor, notes that this same pattern (lower prices in the latter months of every year, higher prices in the early months of each year) is repeated in a number of markets. "Ten of the last century’s 14 bear markets bottomed in the two-month span between early October and early December, and major rallies ensued in nearly every case. Home prices peak every June and bottom every November-January. Crude prices are almost always weakest in Oct.-Dec."

With yields on all non-Treasury bonds at exceptionally high levels, and with increasing signs that those yields may be starting to come down or at least stabilizing, investors are going to be awfully tempted to climb on board the yield train for what could be a fabulous ride in the first quarter of next year.

Back to the chart above, which sends a powerful message to TIPS investors: inflation is very likely to turn positive in the months of January-March. That in turn means that the "inflation carry" on TIPS (the part of TIPS' yield that comes from the nonseasonally-adjusted CPI factor) is very likely to turn positive in the months of March-May, since there is a two-month lag in the TIPS adjustment process. And considering that TIPS can be financed today at a cost of less than 1%, thanks to massively easy monetary policy, the prospect of positive inflation carry is going to be way too much to resist. Big-money investors will be able to buy TIPS yielding 3% or more using leverage that costs 1% or less. I suspect this will all add up to a pretty impressive rally in TIPS prices well before March as investors rotate back into TIPS in preparation for the strong gains to come. It may also be the start of a new move in general to re-leverage. Smart speculators know that the best time to increase one's leverage is near the tail end of any massive deleveraging period—you want to buy the things that everyone is desperate to sell, and vice versa.

The other thing to note in the chart is the huge increase in inflation volatility in recent years. The most obvious culprit, of course, is energy prices, since oil comprises about 5% of the CPI and it has increased from $20 in 2001 to $150 earlier this year, only to collapse back to the mid-$40s today. But oil doesn't cause inflation, only monetary policy does. What this chart exposes is the failure of monetary policy to deliver stable prices. Monetary policy was exceptionally tight in the late 1990s, and that led to collapsing energy and commodity prices, which then began to rebound in 2001 as monetary policy shifted to become exceptionally easy by 2003. Everyone began jumping on the inflation train, which resulted in subsequent bubbles in housing, oil, and commodities in general. The "inflation trade" was the big story a few years ago, and now the big story is the unwinding of the inflation trade, otherwise known as "deleveraging." A more steady hand on the monetary tiller would likely have avoided much of this chaos.

And as history has taught us repeatedly (a lesson I failed to heed sufficiently), bad monetary policy is bad for growth. Inflation is bad for growth because it induces speculative activity instead of investment. Inflation results in too many houses and too many mines and too many oil wells being drilled. These excesses then need to be worked off as prices cycle back down, and that is what is slowing the economy today. Inflation is also bad for growth because it creates uncertainty about future prices. Today, for example, the markets today are torn between predictions of significant deflation for the next several years and predictions of a huge inflationary fallout from central banks' new-found zeal for quantitative easing, as they desperately seek to neutralize the deflationary effects of collapsing asset prices. The huge disparity in future inflation expectations can be seen directly in the deeply negative inflation expectations embedded in TIPS prices and the lofty, inflation-anticipating level of gold prices.

Nothing lasts forever, of course, and the current bout of deflation is likely to pass in a few months; oil is not going to zero and seasonal factors and easy money are going to be working to lift prices. Once the market realizes that deflation is unlikely to be a permanent fixture on the investment landscape, confidence (fueled in part by greed) is likely to return. The first quarter of next year might also be the time when housing prices stop falling, and that would do wonders to restore confidence in the banking system.

All we need for a major rally in bond and equity prices is stability—prices need to stop falling. That would expose the huge yields available on almost everything, and that will reward investors that have the confidence to buy today. When you reward confidence, you are likely to get more of it, and thus would start a virtuous cycle that could restore the economy to health in fairly short order.

Still, one lesson of the above chart is that erratic monetary policy is going to be the bane of the economy for some time to come. That will keep growth at sub-par levels for the foreseeable future, but it needn't prevent a quick economic recovery or an impressive market rally.


SpeakToMe said...

Isn't an expanding triangle a particularly dangerous technical pattern?

I ask because it occurs to me that the expanding volatility in CPI prices had better slow -- a new high or a new low from here would most likely be accompanied, either way, by very disturbing real world economic activity.

Scott Grannis said...

You can bet that the November and perhaps the December CPI will be negative, and that will drive the 3-mo annualized figure much lower than shown on the chart. But I think the math will dictate that the December reading will be the low point. Unless oil prices reverse and start galloping up, the first quarter figures should definitely be more subdued (on the upside) than the current figures.

Nevertheless, as you note, all of this is very disruptive for growth, and perhaps I did not stress that enough. Growth will be -4% in the current quarter, and even if it rebounds soon, the economy is likely to be "below potential," as the Phillips Curvers like to say, perhaps all of next year.