Inflation or deflation? cyclical versus secular forces

What is the issue?

Government’s and monetary authorities around the world are flooding the markets with liquidity. Massive fiscal stimuli are about to be implemented in major economies such as the U.S., the UK and China. In normal market conditions the combination of these two factors would be considered hugely inflationary. Yet, as shown by the following chart the market is pricing in an unprecedented period of low inflation. The current spread between 10 year treasuries and 10 year TIPS suggests an annual inflation rate of 0.15%.

What is going on here?

First off, it is important to recognise that these prices are not entirely fundamental. A recent trend which seems to have gone somewhat unnoticed in the equity market is the massive shift by foreign central banks out of US securities with any hint of credit risk and into treasuries. This started in 2007 as foreign demand for US corporate bonds collapsed. Most recently the shift has come out of agency securities into treasuries, particularly by China and Russia. Brad Setser from the Council on Foreign Relations calculates that since the end of September, central bank holdings of treasuries are up by over $210bn, while holdings of agencies are down by around $130bn.

So we can be reasonably sure that some part of the current Treasury-TIPS pricing conundrum is explained by foreign central bank asset allocation decisions. Without this, implied ten year inflation would not probably look quite as low as it does.

Nevertheless, the Treasury market is huge, and these foreign central bank flows are not sufficient to explain all of the recent bull market in Government bonds. Many other supposedly “rational” market participants have also loaded up on treasuries (and not on TIPS). So unless we assume this is all just panic, it is fair to infer that the wider market expects very low inflation to be a reality that will continue for some time.

Cyclical and secular forces are working in opposite directions

My approach to the problem is to think about it from both a cyclical and a secular perspective. I think this is important because there are very different forces at work here.

From cyclical view – i.e. the next 12-18 months – deflation seems very likely. This period is clearly going to be characterised by a considerable deleveraging and credit contraction. Moreover, saving rates in the UK and the U.S. are likely to rise back to the levels of the early 1990s as consumers are unable to obtain credit and become more risk averse. With such macro trends it is very difficult to imagine the price level going up.

The only argument against this is that unprecedentedly low level of nominal interest rates will drive consumers to spend more. Yet, as most of the historical evidence shows (Japan, 1930s etc) what matters most is the level of real interest rates, which in an environment of falling prices will remain substantially positive.

Therefore, from a purely cyclical perspective, I expect the outcome for the price level (at least in the U.S. and the UK) to be at least as bad as where consensus seems to be.

However, my secular view is very different. Here I can see a number of important forces working in the opposite direction. I would highlight four in particular:

1) Money supply growth could expand rapidly if/when recovery begins
Thus far the expansion of central bank balance sheets and leverage ratios has merely served to offset the decline within private sector financial institutions. Looking at broad measures of money supply such as M3/M4 growth suggests money supply growth has been flat to negative. But once financial institutions’ balance sheets have been repaired credit creation will start again. From a monetary perspective this will be inflationary unless the central banks can very rapidly shrink their own balance sheets.

2) Capital scarcity means many surviving industries will have pricing power if/when recovery begins
In many cyclical industries this recession will cause much capacity to be removed from the market. This has already started to happen in some industries (e.g. insurance, asset management, retailing) and will soon spread to more late cycle industries (e.g. industrials). We should not expect this capacity to be brought back quickly once demand starts to tick up again because banks will be much less willing to make capital available than before. If they do, it will likely be more expensive. Therefore many surviving industries are likely to become more oligopolistic in terms of pricing, a situation conducive to demand driven inflation.

3) Government fiscal stimuli will accentuate capital scarcity
While the planned Government fiscal stimuli may be good for employment, they will likely have the usual “crowding out” effect on private investment. As capital is diverted to (unproductive?) Government spending, the availability of capital for private sector will be further reduced. This will serve to accentuate 2) above.

4) China is unlikely to continue exporting deflation
We should not forget that the recent benign period of low inflation has been partly a result of the Chinese (and other EM countries) policy of export led growth. They have kept their real exchange rate artificially low in order to promote exports and investment at the expense of consumption. This led to deflation of many manufactured products. It also led to a global savings glut which kept long term interest rates artificially low. This benign set of macro forces is very unlikely to return. If China attempts to return to its export-led growth strategy it will find that foreign demand is no longer there for its exports (a global paradox of thrift). On the other hand, if China attempts to shift to a policy of domestic consumption driven growth, this will necessitate real exchange rate appreciation, and hence higher export prices. It will also entail a low level of saving, implying lower demand for treasuries and higher long term interest rates.

These four forces lead me to conclude that we are likely to enter a period where inflation and long term interest rates are significantly higher than they have been over the past cycle. Indeed I would not be surprised if there is a long-term bear market in Government bonds, much like that which was experienced in the 1960s-70s.

Conclusion: implications for equity portfolios

The key issues for portfolio construction are: a) should we try to play this theme at all?; b) timing

a) This is really a question about whether or not to take an explicit macro view. In macro terms, the bias in favour of structurally higher inflation and long-term interest rates is quite bullish. It implies that we are going to avoid the Japan style debt-deflation scenario, and that there will be a recovery. However, some people would argue that the Government bond market is merely pricing in two possible outcomes – debt deflation and even lower long-term interest rates versus the recovery/inflation scenario. I would argue that economic history favours the latter scenario – the U.S. economy is very flexible and resilient and has historically managed to find its way back onto the growth path. But I may be being too optimistic.

b) Timing is difficult. It is probably too early to start gearing up for a period of structurally higher inflation given the risk of a low level equilibrium trap and/or a major policy blunder. But I do think the markets will price this is in really quickly. If and when our central case becomes an economic recovery, it would make sense to start positioning portfolios for structurally higher inflation and long-term interest rates.

Scarcity of capital, and what it means for industry

The current financial crisis has made capital, one of the key factors of production, a much scarcer resource. As long at this continues, it is likely to fundamentally alter the structure of many industries.

Scarcity of capital erects both a new entry barrier and a new exit barrier. This has implications for pricing power and industry consolidation.

There are three important factors that will determine which industries are most affected: 1) how much capital they need to operate; 2) the length of the capex/payback cycle; 3) the type of market structure.

A key question for investors is whether capital scarcity should be expected to subsist into the next cycle. If so, many market structures are likely to become substantially less competitive. This could present some interesting investment opportunities.


Scarcity of capital: what does it mean for industry?
Capital is now scarce. Banks are de-leveraging globally, and will surely continue to do so at least until the end of 2009. New debt financing will therefore be very difficult for companies who want or need it. Other sources of capital such as equity are also likely to remain scarce, or at least be very expensive, except for companies with highly rated shares. Furthermore, even once the deleveraging process it is over, it is questionable whether capital will ever be as freely available as it has been previously.

Capital scarcity has two important consequences for market structures:

1) A significant barrier to entry has been erected. While capital always becomes scarcer in economic downturns, it is increasingly becoming apparent that capital is going to be much scarcer now than it has been in past downturns.

The main consequence of this new barrier to entry is increased pricing power. The inability of competitors to enter markets should render the existing players very well geared to any upturn in economic activity.

2) The other side of the coin is that barriers to exit have also been raised. The inability to raise capital means that exit prices for uncompetitive or unprofitable assets are extremely low. There are few buyers. Moreover any buyers that do exist know that they have huge leverage over price.

The main consequence of this new exit barrier is increased industry consolidation. I would expect in many industries that the smaller, capital-starved operators will either end up going bust or being absorbed by competitors who still have a balance sheet. Of course this happens in any cycle, but it is likely to be more severe this time around.


Scarcity of capital: which industries are likely to be most affected?
I think there are three factors that will be particularly important in determining the scale and speed with which particular industries are affected.

1) The level of capital consumption in the industry. For example sectors that require lots of capital to operate successfully will surely run into problems first. We have already seen the banks affected, and now it is spreading to other financial balance-sheet businesses like asset managers and insurance.

2) The length of the payback period. For example, business models that require a continual inflow of capital for a (sometimes speculative) pay-off in the future are surely likely to suffer. Obvious examples here are biotech and tech. Venture capital generally is also likely to be affected. We could also see companies with very long capex cycles affected, perhaps leading to underinvestment, with implications for pricing in later years.

3) The market structure of the industry. Businesses that operate in markets characterised by “monopolistic competition” could see a significant change in terms of pricing power (assuming they survive). This is because monopolistic competition tends to ensure that pricing is reasonably competitive – despite the name, monopolistic competition is actually much closer to perfect competition (many buyers and sellers, limited level of non-price competition, low barriers to entry). However, if capital remains scarce, then the threat of entry is no longer a factor controlling pricing. It is therefore possible that many companies operating in industries previously considered to be very competitive may have a surprising amount of pricing power in the next cycle (examples of monopolistic competition include retailing, financial services, restaurants etc.).


Scarcity of capital: a visual interpretation
The following diagram illustrates my understanding of this process. Over time, I would expect more and more industries to be affected by the scarcity of capital. In the first stage, it is the balance-sheet business models that are most immediately affected. By this I mean companies that need huge amounts of capital to generate a decent return on equity – i.e. financials. In the second stage, it affects industries with long pay-back periods or long capex cycles. Finally, in the third stage it starts to even industries previously considered very competitive simply because there is little or no possible of entry. At the present time I would suggest we are about half way through stage 1.




Some additional thoughts and conclusions

This is only one of many possible outcomes
I am not arguing that the above is certain to happen. Indeed we may never make it much beyond stage 1. It all depends on whether capital remains scarce. Indeed, once capital returns we could expect the process to reverse itself. However, as long as capital does remain scarce, the process will continue, with more and more industries affected.

Are these changes in market structure permanent or transitory?
This is absolutely crucial for valuation. If capital is to remain scarce for the next cycle then many industries will be radically altered – they will move from being reasonably competitive to being more oligopolistic.

On the other hand, if capital returns as soon as the up-cycle starts again then many of the changes will be merely transitory. For example, insurance or asset management will revert to the monopolistic competition model, implying that any earnings or cash flow benefits will be temporary.

Lack of capital + lack of capacity = cartel
There is a possibility in some extreme cases of industries becoming almost cartelised in terms of pricing. If capital remains scarce and, importantly, there is also under capacity, then we should expect the incumbents to exercise their new found pricing power. They will not compete, they will collude. This could present some interesting investment opportunities for investors.

Which sectors could go this way? One possibility is banking – e.g Lloyds/HBOS’s should have huge pricing power in the mortgage market when/if the market turns up again.

What will be the attitude of the regulators?
It might be objected that market concentration and the exercise of pricing power will simply be blocked by regulators. This should definitely be a consideration. However, I also expect that the Government will turn a blind eye to many of these competition issues in favour of promoting employment and the survival of big companies and industries.

The Curse of the Benchmark

So Xstrata shares have fallen below £6, down from a peak of just under £45 barely 5 months ago. Having been wrong for so long on commodities (or rather seen the bubble carry on going) I do at least derive some satisfaction from having got something right in this market, even if some my firm’s funds have been burnt badly with the recent commodities blow up.

What I find most interesting about this recent price action is not so much the speed of the collapse but the size of it. With the Xstrata shares at less than £6, one has to ask the question, how could the bubble possibly have gone on for so long? Unless the market is currently seriously mispricing the shares (which is certainly a possibility which I’m currently investigating), it defies comprehension that people could have genuinely believed the shares were undervalued at £45.

Another interesting question is whether or not I was actually correct to be bearish. And here it depends entirely on your timeframe. When I interviewed for my current job back in June 2006 (it feels like a lifetime ago now!), one of the arguments I made was that the current commodities boom was an investment fad, based on a false extrapolation of Chinese growth rates out into perpetuity. For sure I was not denying that China was going to carry on growing. Rather I was suggesting that it would become more efficient in its use of inputs and that supply would respond to the growing demand. After all, over the very long run (past 250 years), commodity prices have not risen at all in real terms, so why should we suddenly expect this to change?

While this now appears to have been the correct position to take, if a little early, the fact remains that had I actually been in a position to implement my belief within a portfolio, the results career-wise would have surely been catastrophic. Lets imagine a parallel universe where, upon joining the firm, I was immediately given a high profile portfolio to run. The previous manager had been massively bullish mining and commodities. Performance was fantastic and the clients were all happy.

So I immediately sell down all the mining and commodity related positions, only to see, to my horror, that Xstrata – the previous manager’s biggest overweight position - more than double in value again! Performance falls apart and clients start leave. Then toward the end of 2007 the CIO (who is also a commodities bull) gives me a stern warning that such underperformance will not be tolerated for much longer. But being a value investor I argue my case and stick to my guns. Finally mid way through 2008, management have had enough and I get the boot. Assets under management have collapsed due to poor performance, so my services are no longer required. Of course the next week the collapse begins, but it is too late.

This is what I call “the curse of the benchmark”. You can be absolutely right about something fundamentally, but if you are too early then the benchmark will kill you. I really dislike this side of professional fund management. I do not think that a fund manager should be obliged to hold stocks that he or she thinks are overvalued just because they make up a big chunk of the benchmark. If I would not buy something with my own money then I should not buy it for my investors. Thankfully for me this is only a hypothetical story, but for many it has no doubt been a reality.