Paul Volcker Taught Us How to Tame Inflation

I started writing a monthly investment update for the investment firm I was with in 1975. I didn't know what I was doing at first, so the older people in the firm would feed me what to say, and I would write the update.  This was just a few years after the OPEC oil embargo and inflation had shot higher. As the months rolled on and inflation continued to rise, I found fewer and fewer of the old-timers were stepping up to tell me what to say, so I became a student of the Federal Reserve in order to have something halfway intelligent to say. That was no help for several years.  Inflation remained persistently high. At times, prices changed on grocery shelves and gas pumps while I was standing in front of them, ready to make a purchase.  Interest rates kept going higher and higher, and none of the Federal Reserve's rate hikes seemed to make any difference.  

An inflation mentality set in on Wall Street, Main Street, and Ivy Street. Inflation became a way of life. We had silly government programs such as Whip Inflation Now (WIN) and a lot of other kinds of cute sloganeering that was not rooted in any economic truth because very few people really understood inflation and how it worked. 

We all became followers of the money supply.  M1, M2, and M3 discussions went on at social gatherings like somebody somewhere knew what it all meant.  "Too many dollars chasing too few goods" became the wink and a nod answer to all things inflation.

There was one man who did understand what drove inflation and how to control it. His name was Paul Volcker. Volcker was promoted to chair of the Federal Reserve in 1979. He immediately began a series of rate hikes that would drive the Fed Funds rate up from around 11% in September 1979 to 20% in March 1981. The 6’7”, cigar-chopping man taught us all that in dealing with inflation, the right course of action was to use a leading interest rate strategy instead of a lagging strategy.  In effect, Volcker made it clear verbally and by his actions that wherever inflation went, he would push interest rates even higher. His leading strategy was truly remarkable, and it broke the back of the inflation panic that had been raging through the economy for years. Inflation peaked at 14.8% in March of 1980 and by 1983 had fallen below to near 3 %. 

Today, we face another inflation crisis and the same 'we got this thing under control' illusion that I watched play out for years in the late 1970s.  Modern Monetary Theorists, who spoke so boldly of 'we got this economic thing' and advocated dumping huge quantities of dollars onto anyone who could breathe, have become silent. They should have done so much sooner.

Inflation is as much of a psychological phenomenon as it is a monetary phenomenon. The present Fed has been saying 'we got this thing' for too long.  They are losing both the psychological battle as well as the monetary battle. They must come out of today's meeting with two huge changes in what they say and what they do.  First,  they must say "Paul Volcker taught how to tame inflation, and we are now following his playbook." Second, they must raise Fed Funds by at least 1% and promise even more 1% hikes in the future. Jerome Powell must ignore the politicians, jump straddle inflation, and fight it with tools history shows us have worked.  If he continues to bow down to the politicians and make small interest rate hikes, we may be fighting inflation four years from now.

I believe the stock market understands what needs to be done and will soon find a bottom if the Fed takes a tougher stance. If the Fed keeps nickleing and diming us along, stocks will likely keep falling because big investors know that the longer we allow the current lagging interest rate strategy to prevail, the worse will be the ultimate recession.

The illusion of 'we got this thing" should end today."         

Barnyard Forecast: More Bull to Come or Is the Bear Growling?

Our last published Barnyard analysis appeared approximately 1 year ago in September of 2013.  At that time, the Barnyard Forecast resulted in 6 out of 8 points, indicating that the market would be favorable over the next 6-18 months.  That has come true, with the S&P 500 up nearly 20% since then.  We expect many will be surprised by the latest Barnyard Forecast.

During this week’s Investment Policy Committee meeting, we updated our “Barnyard Forecast” model.  The Barnyard Forecast is a basic model we use to determine whether the current environment is accommodative, neutral or restrictive towards stock market growth. Since 1990, the Barnyard model has correctly predicted the general direction of the market over the next 6 to 18 months with approximately 80% accuracy.

The Forecast gets its name from the acronym of its components: economy, inflation, earnings, and interest rates = opportunity for stock market appreciation (E+I+E+I=O).  Each factor is rated as positive (2 points), neutral (1 point), or negative (0 points) for stocks based upon historical relationships between that component's economic data and its likely effect on the Federal Reserve's monetary policy and market reactions.  The total points are then added up to arrive at a score between 0 and 8.  A score above 4 indicates a positive environment for stocks.  

Economy - 2 Points

When the economy is growing slowly, the Federal Reserve's projected actions over the next 12 months should favor stocks.  The Forecast score is positive when economic growth is less than the optimal, non-inflationary rate of economic growth of 3%.

Economic growth has improved significantly since the 1Q 2014 numbers.  However, year-over-year GDP growth remains below the 3.0% mark.  At this moment, we’re at about 2.5% with the 3-5 year range between 1.5% and 3.0%.  Economic growth would need to be at least 3.0% before the Federal Reserve would start taking any action to raise rates.  In our view, even 3.0% might be too low in light of the other data coming from the economy.  The bottom line: the economy is still not growing fast enough to warrant monetary policy tightening.  Positive for stocks – 2 points. 

Interest Rates - 2 points

Historically, the yield curve spread (difference between long-term and short-term interest rates) has been a predictor of economic performance.  As long as the spread remains positive, stock markets tend to rise.  When it turns negative, that is a danger signal for stocks.  

Spreads between long-term and short-term rates are currently very positive.  The 2-year U.S. Treasury is yielding around 0.5% versus nearly approximately 2.5% on the U.S. Treasury, a positive spread of 2.0%.  Since we are nowhere near a negative yield curve, this component of the model strongly suggests a favorable environment for stocks.  2 points.

Earnings - 2 points

Earnings growth is a statistically significant driver of stock market prices.  Over the long-term, earnings growth for U.S. corporations has been 7%.  The Forecast scores growth greater than 7% as being positive for stocks.  

In September 2013, the 2^nd quarter earnings were only 3% - well under the 7% level.  This time around, earnings growth is markedly improved.  Last quarter’s earnings growth was close to 9%.  Earnings growth projections are for even better grow over the next 12 months.  Companies have continued to grow despite the lackluster economy.  Positive for stocks - 2 points.

Inflation - 2 points

The Federal Reserve's optimal level for core inflation is approximately 2% to 2.5% year-over-year.  Core inflation under 2% allows the Fed to stimulate the economy without creating inflationary problems and is positive for stocks.  Inflation greater than 2% is negative for stocks.

Mr. and Mrs. America tend to watch the Consumer Price Index (CPI) and core CPI (excludes energy and food).  However, the Federal Reserve pays more attention to the Personal Consumption Deflator, which tends to run about 0.5% less than CPI.  At the moment, CPI is about 2.0% and the Personal Consumption Deflator is around 1.5%.  Unless inflation ticks up at least another 0.5%, we don’t anticipate the Fed is going to raise rates.  Positive for stocks - 2 points.

= Opportunity for Stocks - 8 out of 8 (Positive)

Adding each of the 4 factors totals a perfect score of 8, which indicates conditions are very favorable for stocks.  Our Barnyard Forecast has historically done a good job of indicating the general trend of the market.  While there are many unknowns surrounding the Federal Reserve's next moves, our Investment Policy Committee agrees with the Forecast's projection of continued positive returns for the market over the next 6 to 18 months.

What About Bonds?, Part II: Inflation and Interest Rates

This is the second installment in a series of blogs aimed at providing answers to our most frequently asked questions regarding bonds, interest rates, and inflation.  The format is Q&A. Nathan Winklepleck, co-editor of the Blog, is moderating the discussion by sharing these inquiries with Joe Zabratanski, Senior Fixed Income Manager, and Greg Donaldson, Chief Investment Officer.  

Nathan: There is a lot of jargon in the fixed income world. I think it would be beneficial to our readers if we began by defining "inflation" and "interest rates" and explaining what each one means in this context.

Joe: Great idea.  I’ve found over the years that the term “interest rate” can mean many different things to many different people, so before we get started, let’s make sure everyone is on the same page. An “interest rate” is simply the rate charged by a lender to a borrower for the use of money or an asset. The term applies to many investments including the interest rate on U.S. savings bonds, bank certificates of deposit, savings accounts, home mortgages, and car loans.  From an investor standpoint, interest rates are the rate of return we are paid in exchange for lending money to a business or government. The interest rate in this context can vary significantly depending on the maturity date (length of time until we get our money back) and the risk of default (the possibility that the borrower will be unable to repay our money). Today’s discussion will focus on  interest rates as they relate to U.S. Treasury bonds.

We can define “inflation” as the rising price level for goods and services. If the groceries in your shopping cart cost $100 in Year #1 and inflation for that year is 2%, those same items will cost $102 the next year. Over time, your original $100 will purchase fewer and fewer groceries. You can think of inflation as the general decline in the real purchasing power of money.

Nathan: In the last installment we discussed the inverse relationship between bond prices and interest rates. You described it as a teeter-totter effect: as interest rates fluctuate up and down, bond prices move in the opposite direction.  What is the relationship between interest rates and the level of inflation?

Why Weak Economic News Might Be Good for Stocks

As we mentioned in last week's article, we are providing our most current outlook on global economic growth.  We will update our projections periodically to reflect our latest views.

Economic indicators have been very confusing for investors.  “Good news” about economic growth has been perceived by the markets as “bad news”, as it could lead to reduced monetary stimulus from the Federal Reserve.  In this article, we will identify some key economic information and separate each point into good news and bad news, then come to a final consensus as to our specific views about the economy and how it will impact stock market growth moving into 2014. 

1. Slow Economic Growth

Economic growth in the United States has been mostly flat coming out of the recession in 2008-09.  In the 2^nd quarter of 2013, real GDP growth was a mere 2.5%.  The economy has been “muddling along” for quite some time.  We anticipate slow economic growth will continue into 2014. 

Nowhere Else to Go: Rising Rates Won't Be Enough to Curb Stocks

Fed Taper Talks Drive Rates Higher

Since Fed taper talks began in early May, 10-year U.S. Treasury yields have risen from a 1.6% to 2.9%, an increase of nearly 100%.  At their current pace, rates will be near 4% by year-end.  Worries that the Federal Reserve might taper their Quantitative Easing program have speculating futures traders betting on higher rates in the near-term.  We don’t believe it.

The question is not as much where rates are headed, but how quickly they will get there.  We agree that
rates will eventually normalize.  However, we do not believe rates will continue to rise towards 4% in the same linear path they have held over the past few months.  Even the most aggressive analyst’s interest rate projections don’t have interest rates reaching 4% until 2015.  In the short term, we believe the 10-year U.S. Treasury yield will likely stabilize within a trading range of around 2.5% to 3.0%.