Here’s my initial reaction to Fred Sheehan’s last post on Bernanke:
inflation in goods, deflation in assets.
I think this is something that Fred got into in one of his previous posts.
Inflation versus deflation discussions are the rule for columnists, economists and Bubble TV. This false distinction is potentially harmful for investors and shoppers who think they must decide between the two, then act. Inflation and deflation act contemporaneously. The relative movement of what is inflating and what is deflating (e.g., common stocks vs. gas, bonds vs. bread) influences, and possibly changes, the way we live.
Gold and Treasurys
I have been thinking about this frame on the inflation/deflation debate since Fred wrote that post. This bifurcation is one reason I had advocated a barbell strategy of overweight gold and Treasurys last September after my April 2009 bank stocks idea and the broader market’s uptick became well advanced. Bill Gross also advocated the Treasury side of this trade.
But I have been concerned about the medium-term risk/reward on both sides of this trade. Gold was hitting new highs every day for two weeks as of yesterday. And the ten-year bond, while well off its 2010 low yield of 2.48, still has an unfavourable risk/reward now. James Montier says it best:
It is possible to build a speculative case for bond investment (i.e. riding the deflationary news flow down), however, as ever this leaves participants with the conundrum of Cinderella’s ball as described by Warren Buffett “The giddy participants all plan to leave just seconds before midnight. There is a problem though: They are dancing in a room in which the clocks have no hands!” Personally I prefer to stick to investment rather than speculation.
It’s not whether the asset price deflation case is ‘right.’ I think it is and have been saying a double dip is 50-60% odds as a result of the real economy effects of the resulting deleveraging. The question is whether the potential upside in bonds warrants an overweight investment given the potential downside. Last year at this time, the answer was yes. But, yields were 3.4% then. The same goes for gold. When I see gold vaulting up nine days in a row, I think ‘overbought.’ I still think gold is a good longer-term buy, however.
I should point out this was the same logic I used regarding stocks last year. It’s not like the S&P couldn’t go to 1200 as Lazslo Birinyi was saying. It could and did. The question was risk/reward:
Do you really think there’s huge upside here? After a 60% run to the upside? Laszlo Birinyi does and sees 1200 before year end. I’d rather sit this one out. The downside is a lot greater at these levels than the upside. I would say lighten up on risk all around. High quality over low quality. Low beta over high. Consumer staples over discretionary.
Reaching for yield and risk
What I believe has happened is that the risk-on trade has become infinitely more attractive in this low nominal rate environment. Look at the Wall Street Journal article on pension underfunding as a case in point.
The median expected investment return for more than 100 U.S. public pension plans surveyed by the National Association of State Retirement Administrators remains 8%, the same level as in 2001, the association says.
The country’s 15 biggest public pension systems have an average expected return of 7.8%, and only a handful recently have changed or are reconsidering those return assumptions, according to a survey of those funds by The Wall Street Journal.
Corporate pension plans in many cases have been cutting expectations more quickly than public plans, but often they were starting from more-optimistic assumptions. Pension plans at companies in the Standard & Poor’s 500 stock index have trimmed expected returns by one-half of a percentage point over the past five years, but their average return assumption is also 8%, according to the Analyst’s Accounting Observer, a research firm.
The rosy expectations persist despite the fact that the Dow Jones Industrial Average is back near the 10000 level it first breached in 1999. The 10-year Treasury note is yielding less than 3%, and inflation is running at only about 1%, making it tougher for plans to hit their return targets.
–Pension Gaps Loom Larger, WSJ.com
So, people started moving down the risk curve as each asset class inflated. First, it was bank shares, then the broader market. After the 80% uptick in shares, this rally lost steam and people were looking for other (non-residential/commercial property) assets to invest in. There was high yield, emerging markets and now agricultural land.
"You want to throw your money into something you can’t touch?" said Evers, 50. "Or do you want to put your money here, into soil and sun, into food that feeds people around the world?"
It’s the fourth time this year Evers has wandered through these trees and given his spiel to pension fund managers, hedge-fund operators and hungry investors on behalf of Hancock Agricultural Investment Group. He’s reeled it off many more times over the phone.Farmland has become hot. Average U.S. farm real estate prices — including the value of land and buildings — have nearly doubled in the last decade to $2,140 an acre, according to the U.S. Department of Agriculture’s National Agricultural Statistics Service. Wells Fargo, the nation’s top agricultural business lender in total dollar volume, said demand prompted it to increase farm lending 12% from 2008 to 2009. Since the recession began in December 2007, financial analysts say, agricultural investments have easily outperformed the Standard & Poor’s 500 index.
Wealthy Americans and private funds alike are gobbling up Washington apple orchards, Illinois cornfields and Louisiana sugar plantations. So are foreigners. In California, investors from countries including Spain, Switzerland, China, Egypt and Iran collectively boosted their holdings 2.5% from February 2007 to February 2009 to 1.08 million acres — about 5% of the state’s total farmland. Overseas, U.S. and other investors are snapping up tens of millions of hectares of farmland in Africa, Central America and Eastern Europe.
Sounds good – especially as an inflation hedge or as a Financial Armageddon trade. Michael Burry is on this trade as well as the gold play. But this trade in farmland is getting very crowded. You know that’s the case when it hits the L.A. Times.
All I’m saying is that low nominal rates inflate asset markets artificially. When markets rise in a parabolic fashion, you have to worry that a nasty (permanent) correction is coming. We saw this post-Tech bubble as low rates prompted over-investment in housing, a bubble and then the asset revulsion. We have a ways to go in many of these asset classes. However my advice is "Caveat Emptor."