A View from the Trenches, October 30th, 2009: "On stocks as an inflation hedge"
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With yesterday’s $1.94BN purchase of 2013/16 Treasuries, the Fed
finalized its $300BN purchase program. If you have been following my
comments since April, you will know I never thought this program would
come to an end. In fact, I can’t accept it has, given that nothing has
improved on the fiscal side. Thus, the big question now is how 2010
will be financed. Not that these $300BN would solve the problem, since
this is not a significant figure on a relative basis, but it surely
helps. From the other side, the policy side, I guess everyone by now
agrees that this program did nothing else but contribute to inject
liquidity to the market.
And with this in mind and the GDP (i.e. activity) numbers released
yesterday, the markets pulled back on the downtrend big time. I know
some analysts disagree with my positive comment here, but to me, the
reversal was important: It took place in every major market (equities,
corporate credit, fixed income, foreign exchange, agency debt, energy).
During a conversation with a friend and reader yesterday morning, I
was asked what my view was on inflation and whether or not equities
would work as an appropriate inflation hedge. I bring this issue up
today, because it is gaining some popularity lately. My answer was that
yes, equities are a hedge and that in fact, they have already hedged you against inflation. How so?
Inflation is not a reading on the CPI. It is not a jump in a price
index. It is not directly related with the level of activity, as
everybody wants us to believe. Inflation is a process in which relative
prices of assets change, driven by an exogenous demand that had not
existed until this process started, a demand that was ignited by a
central bank through the purchase of securities. When the relative
price distortion affects a market in particular, and it does, people
speak of asset bubbles. From then on, the changes in relative prices
take a life of their own, until they reach consumption goods. This may
take years, but before then, stocks see their prices increase a whole
lot earlier.
For instance, in 2009, one could reasonably track the relative price distortions as follows:
1. Central banks bought agency debt, mortgages = the spread of these
securities vs. Treasuries compressed to the extent that investors had
to shift their moneys to corporate debt, to reach for yield
2. Corporate credit spreads compressed, facilitating the refinancing of
short-term debt for longer-term debt. The process boosted equity
valuations (because equity is the call option on the firm’s assets).
3. The process regenerated the net wealth effect (a.k.a. Pigou effect), stopping the bleeding in housing prices and commodities
4. Going forward, if the virtuous cycle continues, capital expenditures should pick up, increasing production costs.
5. If the demand remains solidly driven by monetary expansion, increasing production costs will be passed on to customers
6. Readings on the CPI (Consumer Price Index) will show inflation.
Therefore, the rally we saw in equities worldwide since
March is already hedging those investors who bought and held them
against the loss in purchasing power that will occur, once
demand picks up to such level where companies are capable of passing on
rising production costs to final customers. The rally in equities would
have never taken place, had central banks not established their
quantitative easing programs.
On the other hand, once these production costs are passed on to
final customers, once the CPI readings show that prices are up and
start driving wage increases, it may be late to invest in stocks, if
the credit expansion caused by the government was a so called
“once-and-for-all exercise”, as the $300BN limited Treasury purchase.
However, stocks will keep rising in nominal value if the monetization
of fiscal deficits continues at a steady speed. Under this scenario,
inflation later spirals and becomes hyperinflation, as investors’
expectations incorporate this constant speed of money supply. Soon, if
hyperinflation takes place, stock valuations cannot keep up, because
hyperinflation destroys value, but that is a conversation for another
day.
The bottom line here is that if you think that central banks will
begin tightening and fiscal deficits will be dealt with swiftly, the
run in the S&P500 from 666 to 1,100 may be pretty much all the
hedge you will get from stocks, for the upcoming inflation.
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