Thursday, December 20, 2007

Stagflation: A Christmas Carol Warning

Former Federal Reserve Chairman Alan Greenspan sounded a lot like Jacob Marley's Ghost from The Christmas Carol last weekend, warning how we are seeing “the early symptoms” of stagflation.

That’s right, the only word whose first letter strikes more fear into the heart of investors than the dreaded “R” word. Mr. Greenspan was behind the curve with his chain rattling on this one though; Mr. Bernanke’s Federal Reserve has been essentially saying the very same thing since mid-summer with its statements stressing concerns over higher inflation and slower growth ahead.

Most investors understand that growth is good and inflation is bad. For the newly initiated; however, this article explores at a very high level how this intuition is pedantically grounded in valuation theory, and why stagflation is truly an asset killer to be feared on the level of Scrooge's ghosts!

First, however, a couple definitions:

  • Inflation – Consumers experience inflation as rapid price increases relative to their purchasing power. This can be caused by several means. In the example du jour, strong demand for an oligopolistically controlled productive resource, read energy, pervades corporate cost of goods sold. However, for that cost increase to spread, note that firms must be able to pass it along to willing consumers.

    For these reason, most argue that true inflation must ultimately be supported by an expectation of more to come along with the injection of liquidity into the monetary system.

  • Growth – Expansion of corporate free cash flow, defined here as cash flow available for payment of debt, dividends and reinvestment. On an aggregate level, such growth is thought to be bounded by a nation’s gross domestic product.
The following sections discuss the effect of stagflation on several major asset classes, including Bonds, Equities, Commodities and Real Estate.

Bonds

In many ways, bond pricing is the easiest to get one’s arms around, so let’s start there. The simplest model for bond pricing looks likes so:

     Bond Price = Coupon Payment/ (1+ Required Rate of Return)

Because coupon payments are fixed, the higher the required rate of return, the larger the denominator and therefore the lower the price. Bond investors require compensation for inflation expected over the life of the bond. Therefore, as this expectation rises, so does the required yield and price drops.

As for growth impact, required yield also factors in firms’ ability to repay their debt. Slowing growth may increase the perception of repayment risk, further increasing the required yield and thus reducing price.

Equities

The basic model for stock valuation is fairly similar to bonds, except that it cues off of sustainable dividend potential and considers future growth, as follows:

     Stock Price = Dividend/ (Required Rate of Return - Growth Rate)

Or, put another way in terms of dividend yield:

     Dividend/ Stock Price = Required Rate of Return - Growth Rate

Focusing on the right side of the equation, note that whether rates are stated in real or nominal terms, the spread remains the same. Inflation cancels out! On an asset class level; however, we have to consider a different dynamic. For this perspective we need to look back to bonds and the idea that investors have a perennial choice among the two classes. The much debated “Fed” model for aggregate equity market pricing takes this choice into account, as follows:

     Market Price = Aggregate Dividend/ (10-Year Treasury +
         Equity Risk Premium)

Above we learned that bond prices quickly factor in inflation expectations. As bond yields rise relative to stock yields, demand for stocks as an asset class declines and, as the theory goes, so does price. Presto, inflation plays a role and a destructive one at that!

Several economists feel this has more to do with a growth effect whereby potential dividends are pressured during inflationary spikes as the costs of production rise faster than they can be passed along. Either way, the result is the same. Speaking of which, and back to the original stock pricing model, we see that growth is deducted from the denominator. The smaller the growth rate, the larger the denominator, and, once again, price declines!

Commodities

Commodities are thought to be tied more directly to Economics 101 - Supply & Demand pricing. It is much easier in this arena for producers to timely pass along cost increases. Take a look at food these days. Up to 40% of the retail cost of food is comprised of energy related components. Is it any surprise that prices at the grocery store have risen so quickly?

In this way, so long as they don’t rise so quickly as to squelch demand, commodities are thought to be largely insulated from inflation. The good news here is that everyday investors now have unprecedented access to this asset class through new ETFs such as iShares GSCI Commodity-Indexed Trust (GSG) and Deutsche Bank Commodities (DBC). Be advised; however, that gold no longer falls as strongly into this category as it once did. Nonetheless, it is still regarded as a good crisis hedge.

Real Estate

As my great grandmother said many times, "They aren’t making any more land!" Due to its intrinsic value, like commodities, residential real estate is also thought to be fairly well insulated from inflation. By the same token, as we have been recently reminded, demand may be squelched if borrowing rates to obtain and hold the asset rise too quickly.

Commercial real estate falls into a bucket somewhere between residential real estate and equities, albeit with a much greater emphasis on its ability to generate operating cash flow.

*     *     *     *
In his recent remarks, Mr. Greenspan pointed to rising import prices and declining productivity as offending tell tail signs of the “S” word. In fact, both CPI and PPI were recently reported to show extremely high year-over-year changes. At the same time, this week’s Philadelphia Federal Reserve and Conference Board leading economic indicator appear to reaffirm growth concerns.

On the other hand, a recent productivity report showed good strength, consumer spending remains high, and current market worries have yet to express themselves in measured GDP. Also, at this point in the cycle real estate trends are deflationary and jobs, although weakening, remain at historic levels.

Over time, markets tend to self-correct. A low, yet stabilized dollar may soon make our goods and services look relatively attractive to the rest of the world, keeping employment and earnings high. Witness all the sovereign fund investments reported of late.

A long enough period of stagflation almost always precedes recession. You can almost feel the tension in the Federal Reserve's statements as it rides the tightrope of its dual mandate to restrain inflation while supporting jobs. As we head into 2008 and in the spirit of the holiday, let’s hope for Mr. Bernanke's sake that Mr. Greenspan’s warning, like Marley's to Scrooge, is cautionary at best. The last ghost of Federal-Reserve-Chairmans-Past we want this economy visited by, is Mr. Volcker's.

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