Download Focus Points July 2009

FOCUS POINTS
We have always thought that the expected rate
of inflation is a prime economic force that
drives the markets. If the economy and the
stock market have bottomed, as we think
likely, then our investment strategy for the
recovery must include our outlook for
inflation.
St. Louis Adjusted Monetary Base, Bi‐Weekly, Ending Wednesday, Billions of Dollars, Not Seasonally Adjusted
Defining Inflation:
It is generally agreed that inflation is a pervasive,
longer-term increase in prices, but that is about all
that is generally agreed upon. There is debate as
to whether or not asset price increases, e.g. gold
or real estate prices, constitute inflation or if
inflation only occurs when the prices of most
goods and services increase steadily. Then there
are those who want to exclude certain prices, e.g.
food and fuel prices, because their price data are
volatile and possibly misleading.
Even after one negotiates that thicket, there is not
universal agreement on whether or not any
inflation is helpful. Those who are in favor of
mild inflation argue that it encourages fixed
investments, can be offset by productivity
improvements, and can be neutralized by
indexing, if necessary. Those who are opposed
argue that inflation inherently increases until it
destabilizes the system, lowers the present value
of future returns because of higher discounting
rates, and rewards debtors by robbing creditors.
Lastly, there are three major camps regarding the
cause of inflation. The monetarists believe that if
government creates too much money – let’s skip
defining money, for now – that excess money will
raise prices. In the second camp are those who
argue that it is the strength of demand that sets
prices. If demand is weak, as it is during a
recession, then inflation is not a risk. The third
camp really just turns the supply/demand
equation around and argues that supply costs set
prices, particularly labor costs. Again, in a
recession, when costs are not increasing much,
this camp argues inflation is not to be feared.
These three paragraphs summarize lifetimes of
research and thought development, but we offer
them so you can understand our thinking. TSBJ
believes that a pervasive increase in the prices
of assets, goods or services is inflation, that any
inflation is bad because it lowers the value of
all investments, and it is always caused by too
much money.
SECOND QUARTER REPORT
JULY 2009
Defining Money:
The domestic money supply not only includes
currency but checking and saving accounts,
CDs, and money market funds, whether held by
citizens or foreigners. All of these non-currency
forms of money depend upon reserves in the
banking system. It’s a staggering total, but the
good news is that the bigger the concept of
money, the more stable the aggregate amount is.
That relative stability of the aggregate volume
allows monetarists to focus on rates of change –
how fast the supply of new money is growing
and how rapidly it is being used to accomplish
transactions. To stabilize credit markets,
many
governments
have
created
unprecedented amounts of new reserves,
vastly in excess of the amount of money
needed to accomplish transactions (see U.S.
chart). Currently most of these reserves are
being held by banks rather than being loaned
for purchases of assets, goods or services.
Furthermore, the rate of use of all money,
called its velocity, is low.
So right now,
excess reserves are just potential money, an
enormous inflationary powder keg with an
unlit fuse.
Conceptually the central banks of the world can
mop up all of these excess reserves before they
fuel an inflationary spiral if 1) they can retain
the political independence to act, 2) they act
early enough, and 3) they are willing to increase
interest rates while their Treasury Departments
are financing massive fiscal deficits. That’s a
tall order! We are doubtful that an inflation
spiral will be avoided in the next few years.
Inflation allows borrowers to repay debts in
currencies with less purchasing power, while
owners see the purchasing power of their assets
increase, so we continue to prefer equities
over bonds. We think bond portfolios should
emphasize security of income and principal,
recognizing that marginally higher returns can
be quickly overwhelmed if securities are downgraded, lengthened in term or suffer from spread
widening. We think a minimum duration is
appropriate. Even if not the cause of inflation,
the relative strength of supply and demand of
tradable items is important because it will
determine the pattern of inflation within the
economy. We are implementing our positive
equity posture by emphasizing companies
owning hard to duplicate assets because they are
the first to be in short supply.