Inflation/Deflation
Over the next decade, the critical element in any investment portfolio will be the correct call regarding inflation or its antipode, deflation. Despite near term deflation risks, the overwhelming consensus view is that “sooner or later” inflation will inevitably return, probably with great momentum. This inflationist view of the world seems to rely on two general propositions. First, the unprecedented increases in the Fed’s balance sheet are, by definition, inflationary. The Fed has to print money to restore health to the economy, but ultimately this process will result in a substantially higher general price level. Second, an unparalleled surge in federal government spending and massive deficits will stimulate economic activity. This will serve to reinforce the reflationary efforts of the Fed and lead to inflation.
These propositions are intuitively attractive. However, they are beguiling and do not stand the test of history or economic theory. As a consequence, betting on inflation as a portfolio strategy will be as bad a bet in the next decade as it has been over the disinflationary period of the past twenty years when Treasury bonds produced a higher total return than common stocks.
Van R. Hoisington, Lacy H. Hunt, Ph.D.
Hoisington Investment Management Company
Quarterly Review and Outlook: First Quarter 2009
As stated above, the two most prominent causes for future inflation held by inflationists are an expanding Fed balance sheet and swooning fiscal deficits. Two of the most prominently held deflation arguments are spare capacity in terms of manufacturing and in labor. Today’s article does not rehash the two inflationary arguments but instead presents two new inflationary concerns indirectly by addressing the two deflationary arguments. For the context of this article, inflation and deflation are defined by price levels and not money supply levels.
Spare Manufacturing Capacity
One of the arguments that deflationists have as to why prices will stay low is the incredible degree of slack in manufacturing capacity. Currently there is sizable slack in manufacturing capacity as the utilization rate fell to 69.26% in March, a new all-time low that surpassed all of the recessions in the last half century.
Source: Federal Reserve Board
While the record low capacity utilization rate was the main headline when the report came out, little attention has been spent looking at secular shifts in U.S. manufacturing and why the low utilization rate may not stay at depressed levels for long. It is no secret that the U.S. economy has shifted from a manufacturing economy to a service economy as manufacturing’s share of total employment has fallen from roughly 30% in 1950 to less than 10% currently, while service employment has risen to more than 84% of total employment.
Source: BLS
But what may not be as widely known is the incredible transformation that has taken place this decade as our manufacturing base has utterly disappeared. While manufacturing capacity rebounded above 80% after the 2001 recession and was accompanied by a move in industrial production’s year-over-year (YOY) growth rate into positive territory, what did not rebound was manufacturing employment, something that had not been seen in the economic recoveries over the last 50 years.
Source: Federal Reserve, BLS
Source: Federal Reserve
How could capacity utilization increase while at the same time the economy was shedding manufacturing jobs? One word, globalization. We exported our manufacturing capacity overseas as companies reduced costs and increased profit margins. If company XYZ had ten factories going into the 2000 recession and was using eight of them at full capacity and two were idle, its utilization rate would be 80%. However, if company XYZ decides to permanently close five factories and then buy the lost input capacity from five overseas factories that can produce at a cheaper cost and has one of its five remaining factories idle, its manufacturing utilization rate is still 80%, though it is now receiving 60% of its inputs from overseas when before it made 100% of its inputs domestically. This is what happened in the last recession and is likely to happen in this downturn as U.S. companies shift from making their inputs domestically to buying their inputs from foreign factories that can produce at cheaper costs due to their abundance of cheap labor.
This last decade truly saw a major exportation of U.S. manufacturing jobs overseas not only in durable goods manufacturing employment but also in non-durable goods manufacturing, which had been stable in the prior three decades. You can see this in the figure below which shows a dramatic decline in both durable and non-durable goods manufacturing employment after the 2001 recession (red line below). When looking at the various non-durable goods industries, two industries that showed dramatic declines were textile mills and apparel. Both industries were shedding employment at more than a 15% YOY decline rate, with neither industry’s employment growth rate rising above -5% in the prior expansion. All one has to do is look at their shirts, shoes, pants, socks, underwear, hat, etcetera, and you will find the product was manufactured in China, Taiwan, Thailand, Mexico, or some other foreign country.
Source: BLS
Source: BLS
While durable goods manufacturing employment moderated in the prior expansion, non-durable goods employment declined unabated with total manufacturing employment declining in every year so far this decade. I wouldn’t expect positive employment growth in any ensuing recovery as the shift of our manufacturing base is likely to continue as cheap foreign labor remains in abundant supply and shipping costs remain low. If we continue to ship our manufacturing base overseas then a rebound in the manufacturing capacity utilization rate will be easier to come by than most would expect, and thus not present as large of a deflationary force as some would contend.
Source: Federal Reserve, BLS
Source: BLS, U.S. Census Bureau
Spare Labor Capacity
The other argument being made for deflation to remain the predominant force over the coming years is the incredible degree of labor underutilization as the unemployment rate currently stands at 8.5%, the highest level since the early 1980s. However, if you include those who are working part-time not by choice as well as workers who have given up looking for employment because they couldn’t find any, then the true slack of labor underutilization is even higher. The U6 unemployment measure takes these groups into account and is currently resting at 15.6%, the highest level since the measure was introduced last decade.
Source: BLS
While there is a great degree of slack in employment that will lead to declining wages, it appears that wage inflation is playing a smaller role in overall inflation levels as our economy shifts its focus towards a service economy. This can be seen when looking at the chart below of the correlation between wage inflation and the CPI index over the last fifty years. While the two series showed a relatively tight fit in the first 20-25 years, the subsequent 20-25 years shows greater variation in the trends of the two series.
Source: BLS
From 1965 to 1982 there was an 88% correlation between the two series as wage inflation was a significant source of overall inflation during the inflationary 1970s. The correlation between the two series fell to 35% in the following 20-25 years as wage inflation played a smaller and smaller role in overall inflation levels, which can be seen in the variability between the two series annual growth rates in the second figure below.
Source: BLS
Source: BLS
What appears to provide a greater link to overall inflation levels than wage inflation is import inflation, which would make sense as more and more of the goods we consume comes from overseas rather than being produced domestically. For example, from 1992 to the present the correlation between the inflation rate and wage inflation was a mere 12% while the correlation between import inflation and the CPI inflation rate was 82%, showing that import inflation played a far more significant role in overall U.S. price levels than wage inflation.
Source: BLS
Source: BLS
If import inflation is to play a greater role in overall inflation levels than wage inflation in the years to come, then monitoring the USD will be key. Over the last decade the YOY growth rate in the trade weighted USD has displayed a negative 73% correlation with important inflation, though with a lead time of three months. As many commodities are priced in USDs the linkage between the CRB Commodity Index and the Import Price Index is not surprising. A falling dollar leads to rising commodities and rising import prices.
Source: BLS, Federal Reserve Bank of Atlanta
Source: BLS, CRB
As the USD plummeted to multi-decade lows in late 2007 and early 2008 commodities staged an impressive rally with import inflation soaring to over 20% YOY. However, the strong rally in the USD since then has led to the reverse as import inflation has fallen to roughly a negative 15% YOY rate. Since the USD started to rally last summer it has undergone a 38.2% Fibonacci retracement and is running into resistance at the 2005-2006 highs. The trend in the USD is still in tact (green line below) and will have to be monitored closely in the weeks and months ahead. A break above 90 would imply greater import deflation while a break of the current trend and a decline to the prior lows would begin to arrest the deflationary forces in import prices with the CPI inflation rate possibly moving back towards a positive growth rate.
Source: StockCharts.com
If the USD is the greatest key to the inflation/deflation debate (again, defined in terms of the price level and not money supply levels), then perhaps the biggest concern we face in terms of inflation will not be dictated by the underutilization of our manufacturing or labor capacity but instead by macro economic differences between the U.S. and its foreign counterparts that can lead to swings in exchange rates.
Over the last 15 years we have been beholden to foreigners to finance our ballooning fiscal and trade deficits by the purchase of U.S. assets and US Treasuries in particular. You can see this in the figure below that shows that foreigners now make up more than 50% of the total US Treasuries outstanding.
Source: ContraryInvestor.com
As foreign countries begin to stabilize after this global recession ends, and as their domestic consumption levels play an ever larger role in their GDP levels there will be a smaller need to buy up our US Treasuries, removing support for the USD. We can already see this beginning to take place as China’s retail sales growth rate was growing by more than 20% YOY before markets imploded last year, with their growth rate still elevated at 14.7%! Important to note is that Chinese automobile sales hit more than 1.11 million units in March, a new record.
China Retail Sales (Y/Y % Chg)
Source: Bloomberg
China Automobile Sales (Total Unites)
Source: Bloomberg
Two trends that will continue to support rising domestic consumption levels in China are rising per capita disposable income of urban households and a greater migration of the Chinese population from rural to urban areas. These trends are well in place and likely to continue into the next decade, making China less and less dependent on exports to the US each and every passing year, with less of a need from China to purchase US Treasuries to hold is exchange rate with the USD.
China Per Capita Disposable Income of Urban Households (Yuan)
Source: Bloomberg
Source: Bloomberg
While the YOY comparisons with the CPI index will ensure a negative inflation rate for the next several months (think 5 oil last June relative to current prices), the trend of the USD and not spare manufacturing or labor capacity is likely to determine US price levels in the next several years.
I fully agree with the Hoisington Investment Management Company that “Over the next decade, the critical element in any investment portfolio will be the correct call regarding inflation or its antipode, deflation.” And while it is true as the firm points out that Treasury bonds produced higher total returns than common stocks, the same cannot be said of gold. While gold severely underperformed long-term US Treasuries from 1980 to 2001, gold has had far superior returns than bonds since 2001. Even a devastating decline in gold to 8/oz would still leave gold in its bullish trend relative to long-term bond prices. Whether inflation or deflation will be the dominant force in the coming years will most likely be determined by the USD, which will also determine whether paper or hard assets will be the superior investment. As such, I would advise keeping your eyes fixed on the USD.
Gold to 30-Yr UST’s
Source: StockCharts.com
