Why I Want Inflation?

Bernanke wants inflation for his reasons.  I want inflation for entirely different reasons even though it might be painful.

Inflation forces the world to rectify its imbalances.  Emerging Asia no longer will believe a 20-100% undervalued currency is good monetary policy.

Inflation forces leverage reduction.  Inflation increases interest rates and ends the infinite supply of money to overleveraged governments.  As a consumer, more debt means a lower credit rating which means a higher rate.  Higher rates are the built-in control mechanism to reckless borrowing behavior.

Inflation favors risk-taking.  Deflation favors risk-avoidance.  Risk-taking helps cure the tremendous misallocation of resources to “risk-less” bonds and gold in pursuit of real opportunity.

Inflation helps reduce dependence on limited scarce resources.  Higher prices on commodities make innovative renewable techniques attractive.

Unfortunately, “financial innovation” disrupted the higher prices that started in 2007-2008, so the world is 3 years behind.

30 minutes

Africa

Over the last couple of years as China and Emerging Asia have steadily directed their reserves to poor investments in bonds in the developed world, I have wondered when they would decide that investment in themselves and Africa would be more beneficial.  My reading on the African situation since decolonization in the 1960s has led me to conclude that its biggest issue was the lack of commitment from a stable source of capital.  This stable source of capital could very easily be long-term focused reserve funds of Asian nations.  If Asian reserve funds are willing to pursue bad investments for the long-term, it seems they should be very willing to pursue good investments despite short-term fluctuations.

Newsweek’s article How Africa is Becoming the New Asia offers two very interesting statistics in a great article:

China and India get all the headlines for their economic prowess, but there's another global growth story that is easily overlooked: Africa. In 2007 and 2008, southern Africa, the Great Lakes region of Kenya, Tanzania, and Uganda, and even the drought-stricken Horn of Africa had GDP growth rates on par with Asia's two powerhouses. Last year, in the depths of global recession, the continent clocked almost 2 percent growth, roughly equal to the rates in the Middle East, and outperforming everywhere else but India and China. This year and in 2011, Africa will grow by 4.8 percent—the highest rate of growth outside Asia, and higher than even the oft-buzzed-about economies of Brazil, Russia, Mexico, and Eastern Europe, according to newly revised IMF estimates. In fact, on a per capita basis, Africans are already richer than Indians, and a dozen African states have higher gross national income per capita than China.

A recent study by Oxford economist Paul Collier of all 954 publicly traded African companies operating between 2000 and 2007 found that their annual return on capital was on average 65 percent higher than those of similar firms in China, India, Vietnam, or Indonesia because labor costs are skyrocketing in Asia. Their median profit margin, 11 percent, was also higher than in Asia or South America.

Some other interesting graphs come from McKinsey's Lions on the Move

And this article in Forbes Asia Should Buy Into Africa's Growth finally gets to my point, stop buying mutually sacrificial developed bonds Asia and seek mutually beneficial investments in Africa.

 

2.5 hours

Japan Intentional or Accidental Pursuit of Deflation

Japan’s intentional or accidental pursuit of deflation has caused an imbalance far greater than Bernanke’s pursuit of inflation.  Japanese policymakers have allowed Yen appreciation versus all other currencies.  It appears that they recognize a couple of things:

1) Higher interest rates and inflation represent a much bigger risk to their credit risk, deficit funding, and aging population than deflation.

2) Developed markets are saturated by Japanese goods, and further Yen appreciation does not cripple those exports.

However, by recognizing these two items, they are allowing their competition and potential growth engine in the emerging markets to completely take advantage of them.  Hyundai and Samsung in Korea have a 30-50% price advantage over their Japanese competition.

Japan’s desperate attempt to avoid their inevitable collapse from higher rates and inflation is speeding their collapse caused by emerging market competition.  The markets eventually will impose the adjustment to the Japanese situation.  At least Bernanke recognizes the imbalance caused by undervalued Asian currencies and knows that inflation is the only mechanism to force Asian emerging nations to allow their currencies to appreciate to normal valuation even if it means hard decisions for the US eventually.

Lower interest rates encourage imbalances, while higher interest rates force the changes necessary to correct these imbalances.

Since the absolute worst of the Asian collapse in 1997, is Japan better off than the emerging Asian nations?

Since 2007, is Japan better off than the emerging Asian nations?

As a point of reference, here is OECD’s calculation of Purchasing Power Parity for the Korea versus Japan 184, which means the Korean Won is undervalued versus the Japanese Yen by 84%.  The Economist’s Big Mac Index shows undervaluation of Asian currencies versus the Yen to be 40-50%.

The Japanese decision has been treated unkindly in the equity markets

via StockCharts.com

 

For the r geeks here is the code:

require(quantmod)
require(PerformanceAnalytics)

#get asian currency data from the FED FRED data series
getSymbols("DEXKOUS",src="FRED") #load Korea
getSymbols("DEXMAUS",src="FRED") #load Malaysia
getSymbols("DEXSIUS",src="FRED") #load Singapore
getSymbols("DEXTAUS",src="FRED") #load Taiwan
getSymbols("DEXCHUS",src="FRED") #load China
getSymbols("DEXJPUS",src="FRED") #load Japan

asian<-merge(DEXKOUS,DEXMAUS,DEXSIUS,DEXTAUS,DEXCHUS,DEXJPUS)

#do dailyReturn so that I can use pretty PerformanceAnalytics charts
#division puts currencies in Japanese yen from US dollar
asianreturn<-merge(dailyReturn(asian[,6]/asian[,1],subset="1996::"),dailyReturn(asian[,6]/asian[,2],subset="1996::"),dailyReturn(asian[,6]/asian[,3],subset="1996::"),dailyReturn(asian[,6]/asian[,4],subset="1996::"),dailyReturn(asian[,6]/asian[,5],subset="1996::"))

#label columns for graph legends
colnames(asianreturn)<-c("Korea","Malaysia","Singapore","Taiwan","China")

chart.CumReturns(asianreturn,ylim=c(-0.4,0.4),legend.loc="topright",main="Asian Currencies in Japanese Yen",ylab="",period.areas=list(c("Sep 97","Dec 97"),c("Jun 04","Nov 06"),c("Dec 07","Mar 09")),period.color="gray",event.lines=c("Dec 97","Nov 06","Mar 09"),event.labels=c("Asian Tiger Collapse","Carry Trade","Financial Crisis"),event.color="black")
mtext("Source: Federal Reserve FRED",side=1,adj=0)

chart.Drawdown(asianreturn['2006-11-30::',],legend.loc="right",main="Asian Currencies in Japanese Yen",ylab="Drawdown Since Financial Crisis")
mtext("Source: Federal Reserve FRED",side=1,adj=0)

 

 

3.5 hours

Bonds Caused the Damage but Bond Holders Thrived

Bonds caused the damage that led to the Financial Crisis in 2008, but through all the bailouts bondholders thrived.  Their punishment although delayed seems like it is nearing.

Supplement to Yen Post with Warren Buffet Quote

I’m not as big a fan of Warren Buffett as most, but I thought his comments from his 1987 annual report fit item 2 on my yen post.

“We continue to have an aversion to long-term bonds (and may be making a serious mistake by not disliking medium-term bonds as well). Bonds are no better than the currency in which they are denominated…”

Japan is the most leveraged of all the developed nations and their most reliable debtor their own aging citizens have entered the spending phase.  For their currency and their bonds to be attractive to other debtors, their rates need to be competitive with the United States and Germany, and their currency need to be appropriately valued.

If you do not like Japanese bonds, neither should you like Japanese yen.

Japanese Yen and US Treasuries

In the chart below, the close relationship of the Japanese Yen and US 10 Year Treasuries from 1993 to 2008 is clear.  However, the highly correlated instruments have moved opposite since the 2008 financial crisis. 

via StockCharts.com

I am struggling with what this means, and how I might benefit from the changed relationship.  I have imagined some of the reasons, but I’m still missing something. So far, my list:

1) Emerging market countries have diversified their reserves and bought more Japanese Yen, but this does not show up on IMF Reserves.

2) Yen and Treasuries are both now viewed as “safe” and “riskless”, so they are pursued as insurance similar to gold.  However, these only work simultaneously in a deflationary environment.  If inflation appears (I think it is here), but others clearly disagree, does the Yen get hurt with US Treasuries?

 

The credit default market clearly does not consider the Yen as riskless since Japan carries a higher default probability on its sovereign debt.

3) Momentum investors are buying the Japanese Yen as the best performing reserve currency simply following a trend model.  However in the multi-trillion currency market, I do not think this influence would be strong enough to force this imbalance.

4) Maybe the Japanese Yen is the only thing in Japan that actually goes up, so the Japanese Yen is the place in Japan to make money.

It appears that these reasons do not offer adequate explanation for the continued Yen rise, so I need to do more work and be a little more creative figuring this out.  Please let me know if you have any good explanations.

After this thought exercise, I still believe that the situation is tenuous and certainly cannot find any good reasons to own the Japanese Yen.

 

2.5 hours

Billion Prices Project @ MIT – Watch out Bonds and CPI!!!!

This is an extremely valuable set of information particularly when it shows something not being priced in to the markets, especially bonds.  I have been checking weekly/monthly waiting for a pop, and here it is.  Watch out bonds and CPI!

Everyone please go to the site and play with the numbers for yourself.  Also, please share this with anyone who cares.

 

20 minutes

Gold as Currency in Inflation

Another visualization inspired by This is Indexed.

Nothing New But Don’t Think It Should Be Ignored—Warren Buffett and MCO

This has been discussed at http://www.businessinsider.com/moodys-ceo-dumped-stock-sec-wells-notice-2010-5, but I have not seen a chart or timeline of events.

March 18, 2010 – SEC issues Wells notice to Moody’s but public does not know

March 18, 2010 –  March 26, 2010 Warren Buffett sells > 1,000,000 shares of Moody’s

May 7, 2010 – Moody’s discloses Wells Notice and stock is down 28% from Buffett’s sales price

 

Also, the interesting phenomenon is the huge selloff while the public was completely unaware of the Wells notice.  Who else knew?  S&P 500 did not turn down until the end of April 2010, so that is not an adequate explanation.

 

For the R Geeks here is the code (I cheated on two of the labels):

library(quantmod)
library(TTR)
library(PerformanceAnalytics)

tckr<-"MCO"

start<-"2008-06-30"
end<- format(Sys.Date(),"%Y-%m-%d") # yyyy-mm-dd

# Pull tckr index data from Yahoo! Finance
getSymbols(tckr, from=start, to=end)

MCOdaily<-dailyReturn(MCO)
Return.cumulative = cumprod(1+MCOdaily) - 1
Return.cumulative = (1+Return.cumulative) * 34.44 #price of MCO at start of period
colnames(Return.cumulative)<-c("Moody's")
chart.TimeSeries(Return.cumulative, colorset = "darkblue", legend= NULL, period.areas = cycles.dates, period.color = "lightgreen", event.lines = risk.dates, event.labels = risk.labels, event.color = "red", lwd = 2, main="Moody's Stock Price",sub="Green Shaded Represents Sales",xlab=NULL)

abline(h=15.87,col="red",lty=2)

cycles.dates = list(
    c("2009-07-21","2009-07-22"),
    c("2009-09-01","2009-09-02"),
    c("2009-10-28","2009-10-29"),
    c("2009-12-07","2009-12-18"),
    c("2010-03-18","2010-03-26"),
    c("2010-09-10","2010-09-20"),
    c("2010-10-12","2010-10-21"))
# Event lists - FOR BEST RESULTS, KEEP THESE DATES IN ORDER
risk.dates = c("2008-11-07","2010-03-18","2010-05-07")
risk.labels = c("Buffett buys 31.5mm shares for $499mm","SEC issues Moody's Wells","Moody's reports Wells")

 

45 minutes

Not Sure I Understand the Fuss About Munis

Recently, munis have received lots of press due to a perceived crisis.  However, from iShares description of iShares S&P National AMT-free Municipal Bond Fund (MUB), it appears that the press and investors just don’t understand one of the most important basics of fixed income—duration.

Fundamentals as of 1/24/2011

Weighted Average Maturity
11.81 yr

Weighted Average Coupon
4.77%

Effective Duration
7.61

Standard Deviation (3 year)
as of 12/31/2010
6.93%

Duration tells you the expected price change from a move in interest rates, so in the case of MUB with effective duration of 7.61, MUB should lose in price 7.61% for every 1% move up in interest rates.  7.61 duration (equivalent to a 7-10 Year Treasury) is what I would consider very interest rate sensitive and much more susceptible than the Barclays Aggregate at 4.98.

If we look on a graph (courtesy of Stockcharts), muni behavior has not been all that strange or unusual compared to the iShares 7-10 US Treasury (IEF).  So far, it just appears to be a bounded random blip that has already corrected itself.

via StockCharts.com

Now, of course if you have a leveraged closed-end fund, the pain is worse, but that is the danger of leverage.

Another way to look at it statistically would be to graph the rolling correlation (thanks R and PerformanceAnalytics).

This also does not look strange or unusual, especially if we compare to the 2008 panic.

The moral of the story is pay attention to duration if you invest in bonds.  The same thing is happening in the Investment Grade Corporate Index at a near-record duration (LQD is 7.01), so be very careful there too.

1.5 hours