Friday, October 17, 2014

The Fed’s Inflation Target Is Losing Credibility

[Published at Seeking Alpha on Oct. 13, 2014]

  • The Fed has been missing its inflation target for over two years.
  • Both bond yields and expected inflation have been falling.
  • Given Yellen’s weak leadership, the prospects for reflation are dim.
  • The equity premium is rising.

This is how the FOMC describes its mandate with respect to inflation:
“The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Commit­tee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal con­sumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.”

However the Fed has failed to achieve the 2% target for the past two and a half years despite what it believes has been “massive monetary stimulus”. The most recent reading of the targeted inflation rate is 1.5%, which is 25% below the 2% target. The consistent failure to achieve the inflation target is eroding the Fed’s credibility and is lowering inflation expectations thus raising the real funds rate which is contractionary. The Fed is tightening in the face of a weak recovery.

So far this year, the 10-year Treasury yield has declined by 70 bips from 3.0% to 2.3% while 10-year expected inflation has declined by 30 bips from 2.3% to 2.0%.

The reason that the Fed has failed to hit its target is the combination of single-digit money growth and declining velocity. The economy is in a classic Keynesian liquidity trap which requires radical policy measures. Because both Bernanke and Yellen decided to give the hawks a veto over policy, radical measures are off the table and the Fed is heading in a decidedly European direction. Ten-year German bunds currently yield less than 1% which suggests that Treasury yields may have further to fall.

It is noteworthy that as bond yields have been declining, equity yields (e/p) are rising as the market has recently declined. Thus the equity premium is both high and rising. This would be an excellent juncture to take profits from longer-term bonds and buy equities with the proceeds. While bond prices may rise further, equities are much more compelling given the current ~5.5% risk premium.

The Selloff Is Noise; Do Nothing

  • The market’s price swings are normal and within historic range.
  • Value is unrelated to price, and is rising.
  • Do nothing now, but keep an eye out for deflation risk.

There is nothing happening in the equity market these days that should matter to a buy-and-hold investor. If you’re a day-trader or a chartist, that’s different. But if you have your saving invested in the broad market, nothing is going on and you should do nothing.

The history of the post-Crash bull market is a history of steady price appreciation periodically interrupted by volatility. There have been many selloffs since March 2009, all of which were corrected. There were big selloffs in 2010, 2011, and 2012. This year, we have had slumps in January, April and July. Now we are having another one. The bottom of the January-February slump was 15400 (DJIA), while today’s price (10/15) is ~15,900.

Price fluctuations do not matter for the buy-and-hold investor, because the intrinsic value of a stock is independent of its price. Notwithstanding the EMH, the market’s price often deviates from its value--sometimes for very long periods, such as the fifties when it was underpriced and the sixties when it was overpriced.

Today the market is either fairly valued or is in value territory, depending upon how one evaluates the data. The CAPE says it is overvalued, but it has been saying that since the Crash. If you followed the CAPE, you would have missed the 9000 point run-up in the Dow over the past five years. Today’s high multiples reflect the very low yields on offer in the bond market. Year-to-date, bond yields have declined by one-third from 3% to 2%, while expected equity returns remain around 8%.

The ERP is a much better valuation index than the CAPE, and it continues to flash somewhere between “fairly valued” and “under valued”. At present, Damodaran’s ERP is around 5.5% (and rising), which is roughly the mean value for the post-Crash period. It’s been higher and it’s been lower, but it is not low. It was lower before the Crash, and was 2% in 1999 at the height of the tech bubble. I would worry if the ERP fell to 4% or below.

What is happening in the market now is mainly noise, assuming that the Fed can muster the will to prevent deflation or near-deflation. On that assumption, we are seeing a rising equity premium as the earnings yield rises and bond yields fall. That suggests doing nothing.

The number to watch is PCE inflation which needs to stay where it is (1.5%) or to go higher. Should it fall below 1%, the forces of deflation might become too strong for the Fed to correct, given its feckless leadership and hawkish consensus. The declines in gold, oil and commodity prices are worrying. The ball is squarely in the Fed’s court to take action to prevent deflation. (I discussed this problem in a recent article.)
EMH: the efficient market hypothesis that says that equity prices correctly discount all available information.
CAPE: the cyclically-adjusted price earnings ratio calculated by Robert Shiller at Yale, which uses ten years of inflation-adjusted earnings instead of the trailing 12 months.

ERP: the equity risk premium, which measures the difference between expected equity returns and bond yields. This measure is calculated by Aswath Damodaran at NYU.

Tuesday, October 7, 2014

Venezuela On The Brink

The looming collapse of the Venezuelan economy provides an interesting case study. While many aspects of its crisis are typical in Latin American balance of payments crises (such as large fiscal deficits financed in foreign currency), there are other aspects that are peculiar to Venezuela.

The principal peculiar feature is that Venezuela (unlike all other Latin American economies) makes nothing and imports everything. The only export and the only source of government revenue is oil. The price of oil fluctuates, and oil production has been declining despite large reserves. If Venezuela were a capitalist country following orthodox policies, it could adjust to current account imbalances via the price mechanism: as oil revenue fell, the currency would depreciate and imports would be reduced by rising prices. In extremis, the currency could fall far enough that non-oil exports would develop and import-substitution would occur.

However, markets do not function in Venezuela. It is a socialist economy with a fixed exchange rate and domestic price controls and subsidies. The currency cannot depreciate, and hence demand is managed by rationing and shortages. An orthodox economist would prescribe a steady pace of currency depreciation and steadily rising domestic prices. However, the Chavista regime was elected by and is supported by the poor who depend upon cheap imported staples and cheap domestic gasoline. The regime has been unable to adopt a conventional adjustment program and is instead heading toward a classic--and potentially catastrophic--foreign exchange crisis.

Venezuela’s liquid dollar reserves are extremely low and its access to the international debt market is limited to concessional loans from China and/or Russia. The bolivar has fallen to one US cent on the black market, versus the official rate of sixteen cents.

Moody’s assigns a rating of Caa1 to Venezuela’s dollar bonds, which means that they are at risk of default. On September 15th, Moody’s said that the Caa1 rating “reflects increasingly unsustainable macroeconomic conditions, including high inflation and multiple exchange rate regimes. As government policies have exacerbated these problems, the risk of an economic and financial collapse has greatly increased….Despite the government's relatively small external financing requirements, rising government liquidity risk reflects the deterioration of market access and elevated borrowing costs on Venezuela's external debt. Foreign exchange reserves have fallen to very low levels”.

So it would appear that the central scenario for Venezuela would be the exhaustion of foreign exchange reserves, default on external debt, collapse of the currency, and substantially higher real domestic prices. The ability of the government to provide its people with subsidized staples would be greatly curtailed, with potentially dire consequences for political stability.

With respect to the prospects for external support, the standard IMF/World Bank adjustment package seems unlikely given the kind of policy changes that would be required. Additional loans from China and/or Russia could postpone the crisis further, but would not resolve it. The underlying problem can only be addressed via severe domestic austerity, which would have undesired political consequences.

The regime has imported many Cuban officials to staff its security services, and it has been moving steadily in the direction of overt dictatorship. Opposition politicians have been jailed and the press is under siege. But it is unclear to me whether the state of affairs is such that the regime could survive an economic collapse in the way that the Castro family has. It should also be pointed out that Venezuela supplies Cuba with the cheap oil on which it depends for survival. That supply could be jeopardized if it meant subsidizing Cubans at the expense of the Venezuelan masses. Thus, a Venezuelan crisis would likely be followed by a Cuban crisis, which is a further reason why there will be no IMF bailout since the US would welcome regime change in both countries.