Sunday, March 29, 2015

Thinking about inflation while in Argentina

It was while living in Argentina in the late 1970s that I was first exposed to what it is like to live with high inflation. So it's fitting that I reflect on how inflation works, now that I'm here again and have some time on my hands.

During the four years that I spent in Argentina (1975-1979), I think the rate of inflation averaged about 7% a month, or about 125% per year. That's enough inflation to impact your everyday life, and in a big way. My first memory of when the reality of inflation impacted me was the day I collected my first paycheck. I began thinking "what should I do with this money?" It wasn't too long before I realized that keeping the money in my pocket or under the mattress made no sense, since the money was losing value constantly. So my wife and I set off for the nearest warehouse store to buy "stuff" that we could store in the closet. Canned foods and powdered milk for our 1-year old infant ranked high on our list. We scoured the store and found a bunch of stuff, but we couldn't find any milk. I thought that was curious, because it was very popular (Leche Nido, by Nestle). But just then I opened a door to an adjacent storage room and saw boxes of powdered milk stacked to the rafters. So I asked the girl at the cash register if someone could fetch us a couple of boxes. "I'm sorry, sir," she replied. "The milk is not for sale."

That's when it dawned on me that everyone was thinking like I was: nobody wanted money, everyone wanted stuff instead. For the next several years I would juggle money balances between pesos and dollars and "stuff." When I saw something for sale that I needed and the price looked reasonable, I would buy it immediately, because I learned that if you waited to look for it in another store, the price could go up. During one episode of very high inflation, grocery stores would post prices on chalkboards, and change them throughout the day. It was a daily struggle to survive, because salaries and wages always went up after the prices for "stuff" went up; incomes lagged prices. 

Years later I would study the situation in Argentina during the time we lived here, and understand what was happening. In a nutshell, since the government was unable to finance its deficit by selling bonds, it simply ordered the central bank to print up a bunch of new currency in order to pay its bills (that's the same thing that's been going on here in recent years, as I noted last week). New bills flooded the country like Monopoly money. Money became like a hot potato that nobody wanted to hold. Better to change my peso salary to dollars at the beginning of the month, and then convert back to pesos when I needed to buy something. Better to save money by buying stuff than to save money in the bank. Since very few people back then had bank accounts, newly-minted bills just kept accumulating in the economy and losing their value. A $1 million peso note issued in 1978 was initially worth several thousand dollars, but by the mid-1980s, that same note was worth only 20 cents and was withdrawn from circulation.

Bottom line, the supply of pesos was growing rapidly at the same time that the demand for pesos was falling. This resulted in a huge increase in money velocity; the ratio of money to nominal GDP fell sharply for years and years. A 50% increase in the money supply could support a 70 or 80% rise in prices. The government would periodically try to slow the rate of inflation by limiting money growth to a rate lower than the prevailing rate of inflation, but it never worked because the velocity of money just kept increasing. More and more people held their money balances in dollars instead of in pesos, and spent their pesos as fast as they could. The government was essentially financing its deficit via an inflation tax: as long as you were holding pesos in your hands, they were losing value and you were effectively paying money to the government. So everyone naturally tried to avoid holding pesos. It was a vicious circle, as rising inflation destroyed confidence and the demand for money, and that in turn fueled higher inflation.

Fortunately, the U.S. is extremely unlikely to experience an Argentine-style inflation, for several reasons. For one, the federal deficit is easily financed by selling bonds, so deficits do not result in an unwanted increase in cash. Two, you can't flood the U.S. economy with newly-minted bills, because nobody uses much currency these days. If I were to receive $5000 in cash for whatever reason, I would just take it to the bank. Unwanted cash money returned to banks would be turned over the the Fed, where it would disappear in exchange for bank reserves credited to banks' accounts at the Fed. Three, there is no real alternative for most Americans to holding dollars (bitcoin might be someday, but not for a long time). 

But this is not to say that the U.S. can't suffer from rising inflation. Inflation in Argentina was aggravated by a significant decline in the demand for money. But in the U.S., the dominant monetary development of the past seven years has been a significant increase in the demand for money. Argentines wanted to minimize their peso holdings, but U.S. consumers (and many consumers around the world as well) have been actively building up their holdings of dollars. The demand for dollar money has been very strong, so an increase in the dollar money supply has not been inflationary. Inflation has actually been quite low, thanks to very strong money demand. 

As the chart above shows, the ratio of M2 to nominal GDP has increased by about 30% since the Great Recession. It was a traumatic event for the entire world, and it triggered a huge and unprecedented increase in the demand for money. But note: money demand growth has slowed significantly in the past year or so.

Bank savings deposits, shown in the chart above, have almost doubled in the past seven years—accounting for most of the increase in M2—despite the fact that interest rates on savings deposits are almost nil. Deposits have surged because the public wants to hold more money. Banks pay almost nothing for those deposits because the demand for them is intense. But note in the chart that deposits were growing at a 12% rate for almost 5 years, and the rate of increase has slowed to about 7% in the past year or two. The demand for increased money balances is less strong these days. The trauma of the Great Recession has faded, and confidence is returning.

The potential source of higher inflation in the U.S. can be found in the charts above. The huge increase in money demand since the Great Recession has resulted in the public accumulating huge stores of cash and cash equivalents relative to annual income. This money did not fuel inflation because the public wanted to hold it. But should there come a time when the demand for those cash balances starts to decline, that's when inflation pressures could start to build. 

Meanwhile, there is growing evidence that the demand for money is indeed beginning to decline on the margin.

Since the beginning of last year, bank lending has picked up noticeably. This not only reflects improved confidence (banks more willing to lend, businesses and consumers more willing to borrow), but also—importantly—a decline in the demand for money. This may be counter-intuitive, so think of it like this: When you are very confident about the future the last thing you would think to do would be to increase your money balances. You only increase your holdings of money when you become uncertain about the future. When you want to hold more money (e.g., cash, cash equivalents, money market funds, T-bills—things that don't change in value and are highly liquid) you don't want to have more loans; you want to pay down loans and generally deleverage. When your desire to hold money drops, then you want to borrow more and leverage up; (i.e., borrow more money).

As the chart above shows, bank lending to small and medium-sized businesses has been expanding at double-digit rates for the past year or so. C&I Loans are up at a 15.6% annualized rate in the past three months, and they are up at a 12-13% annualized rate since the beginning of last year. 

Increased demand for loans, and increased lending, are signs of increased confidence and a decline in the demand for money. That's very important, because the Fed has ensured, via its massive provision of bank reserves, that there is absolutely no shortage of money in the banking system; banks have a virtually unlimited ability to make loans and create money, if they choose to do so.

If the Fed doesn't take appropriate measures to bolster the demand for bank reserves (by increasing the interest rate it pays on reserves) and the demand for money in general (since there is so much of it out there right now), we could find ourselves in a world where the supply of money exceeds the demand for it, and that is what could fuel a rise in inflation.

I've said it before and I'll say it again: The return of confidence is the Fed's worst nightmare.

Friday, March 27, 2015

Corporate profits are still very impressive

With today's release of the latest Q4/14 GDP estimate, we learn that corporate profits—despite the damage suffered by energy-related companies from the plunge in oil prices in the second half of last year—were still quite impressive: $1.84 trillion after tax on an quarterly annualized basis, and about $1.83 trillion the year as a whole. That puts profits very close to all-time record highs, both in nominal terms and relative to GDP. Yet standard PE ratios are only modestly above their 55-yr historical average. This anomaly—record-setting profits vs. only slightly above average multiples—has persisted for years, and it calls into question the oft-repeated claims of those who argue that stocks are in "bubble territory."

To fully understand this argument, I recommend reading a series of many similar posts over the past 5-6 years. I'm using the same charts over and over, and making the same basic argument, which is that corporate profits have been extraordinarily strong for years, but the market has been (and is still) unwilling to assign an unusually high multiple to those profits. This tells me that equities could be fairly valued at current levels, and at the very least they do not appear to be "overvalued."

The chart above compares after-tax corporate profits as reported by S&P 500 companies using GAAP standards (blue line) to total after-tax corporate profits of all companies as measured by the folks at the BEA (red line). Note that the scale of each y-axis is similar (the top value is 100 times the bottom value), and note also the apparent divergence of the two lines beginning in the early 1990s. I explain here some reasons for this divergence (e.g., different tax regimes and different accounting standards have combined to understate corporate profits when calculated by GAAP methods). Regardless of the divergence, corporate profits by either measure are at or near record levels.

When compared to GDP, after-tax corporate profits are doing extraordinarily well from a long-term historical perspective—far above their long-term average. It's almost never been such a good time to own equities.

The chart above uses the NIPA measure of after-tax corporate profits as a proxy for earnings of the S&P 500, constructing a measure of price/earnings by dividing the S&P 500 index by NIPA profits and normalizing the series so it has the same long-term average as the commonly-used measure of PE ratios. If the NIPA measure profits is closer to the true underlying realities of corporate profits, then PE ratios today are simply average, and orders of magnitude less than they were at the height of the dot-com "bubble" of 2000.

This last chart is the standard measure of PE ratios, for context. According to this, PE ratios are only modestly higher than their long-term average (18.3 today vs. an average of about 16). But think once again what this means: despite the fact that corporate profits have reached exceptionally high levels for several years running, PE ratios are only average or slightly above average. This is not at all what you would expect to see if the market were overly enthusiastic about the future. No, this is a market that is still very skeptical of the ability of corporate profits to sustain current levels, much less continue to grow. In fact it could be symptomatic of a market that is actually priced to a decline in profits from current levels. The market is setting the bar relatively low.

Equities are no longer a steal, but neither are they even close to being egregiously overvalued. I've argued for more than a year that profits growth would be likely to slow, and that further progress for the stock market would be driven mainly by an expansion of multiples, and that is a pretty good description of what the reality has been. I look for more of the same: slower profits growth, maybe even flat-lining, but higher multiples. Today's PE ratio translates into an earnings yield of about 5.5%, and that is still very generous given the prevailing level of Treasury yields. As the chart below demonstrates, equity risk premiums are still unusually high (currently 3.5%) when viewed from an historical perspective. This is still a market ruled more by caution than by enthusiasm.

Wednesday, March 25, 2015

When $100 gets you a sandwich and a Coke

The amount of currency in circulation in Argentina is just over $300 billion pesos, and it is comprised almost entirely of six different denominations of bills, as show above (coins are essentially worthless and hardly ever seen). According to the Argentine Central Bank, about two-thirds of all the currency in circulation is of the $100 peso variety, with the other third spread between the five smaller denominations. If my experience here is any guide, it is rare to see a $2 bill, and the occasional $5 bill is, in practice, the smallest denomination that most people are able or likely to use. Ironically, the smallest denominations are the hardest to come by, and when you do see them they are so frayed and flimsy that many of them are held together by scotch tape.

To put this in perspective, $100 pesos today is worth about $8 dollars (US) on the black market, and about $11 dollars at the "official" rate. Imagine how it would be if consumers in the U.S. were limited to buying things in increments of 40 cents ($5 pesos), and if the largest bill available were worth less than $10. My friend (the one whose daughter got married yesterday) today told me that in order to pay for the wedding and all the people involved, he had to disburse an amount of bills (most things are still paid for in cash here) that would fill almost two shoeboxes. It's become almost comical, and reminiscent of the stories of hyperinflation we have all heard when people had to use wheelbarrows to carry enough currency to pay for daily expenses.

Why are things so crazy? For one, it's the inevitable result of a classical monetary inflation. But it's also because the government doesn't want to officially recognize that inflation has been running at 25-30% for the past six years—printing larger denomination bills would be equivalent to legitimizing all that inflation. That's silly, of course, since you can't cover up an inflation that is fundamentally driven by an almost 30% annual increase in pesos in circulation (see chart above) over the past six years by printing tons of small-denomination bills. Prices are going up at a significant pace, and it doesn't matter what denomination the bills have.

In an attempt to remedy this idiocy, an opposition politician recently proposed a law that would create bills of $500 and $1000 pesos. The government will certainly oppose this measure, but eventually it will pass in some form or other because otherwise the average citizen will need a huge wad of currency in his or her pocket just to make it through the day. Meanwhile, a $100 peso note will buy you a sandwich and maybe a Coke.

For us Americans it's not so bad, since $100 pesos will also get you a decent bottle of wine in most restaurants, or even a decent steak. And despite the inflation, Argentines are wonderfully nice people and the food is terrific.