Monday, May 23, 2005

Bill Gross and the Coming of Stagflation

It is time to make a slight change in my past prognostication of “stagflation” in the USA economy and the resulting investment implications. I think the “stag” is here to stay for a while, but am changing my position on the “flation”. I derive quite a bit of my economic and interest rate insights from reading Bill Gross’s monthly commentaries. This month, Bill is making a change in his call on the future of inflation and interest rates, so I will too.

What does this call mean for a USA investor? Bill argues for a practical limit on real interest rates of 0% (real interest rate = inflation minus nominal short term interest rates). We are currently at 1% (as shown by TIPS), so he makes the case that there is very little room left for further real interest rate reduction by the Fed. The real interest rate in early 2003 was 4% (at the end of the last recession when real interest rates were typically high as the Fed stimulates the economy. This stimulation can also be seen in a steep Treasury yield curve). A declining real interest rate is reflationary or inflationary and signals monetary stimulation. Since there is little more room to stimulate, as given by the low real interest rate, there is little chance for a significant increase in inflation, so the argument goes.

From this line of reasoning comes Bill Gross’s and Pimco’s interest rate forecast for the next 5 years on the 10 year Treasury of 3% to 4.5%, nominal, with inflation at around 3%, as it is right now. This bodes well for Treasury bonds and other high quality debt instruments (municipals, high grade corporates). It is also modestly positive for stocks since low real interest rates make corporate cash flow yield (CF/price) relatively more attractive.

There is still a case for hard asset inflation for those assets that are supply-limited with high demand in the developing world. Oil may be one such asset, grains another (with an improving diet among the billions in Asia who are seeing a rising standard of living). There is also a longer term case for precious metals. When the world comes off “Bretton Woods 2” (as Gross tags it, the use of the US dollar as the world’s reserve currency) and switches back to some type of gold standard, as is predicted, it will greatly increase demand for gold and related precious metals. China is likely to make a gradual move away from the dollar as a benchmark over the next five years. Since there is no other reasonable paper benchmark (the Euro, unlikely; the yen…No Way!), either gold, or an index of commodities is likely the future reserve for the Chinese currency.

But the outlook for financial assets, and real estate is more of a financial asset than hard asset in today’s highly mortgaged / leveraged world, is not so good. Financial assets rely on a contraction of real interest rates to increase their value, and as Gross points out, the Fed-orchestrated contraction has run its course.

Neither can a case be made for any type of manufacturing product, either the capital goods to conduct manufacturing or the consumer and industrial products made by manufacturing. This is a world marked by excess supply of manufactured goods, with low cost labor in developing economies, a flood of capital into those economies to build manufacturing plant and the remains of the manufacturing expansion of the late 90s. It is this excess supply of manufactured goods that keeps a cap on inflation, limits employment growth in the developed economies, an also limits the upside for the stock market, especially the capital equipment and technology sectors.