Don’t Fight the Fed, or: How I Learned to Stop Worrying and Love Inflation

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The unofficial end of summer arrived yesterday with the Labor Day holiday. During the usually lazy “dog days,” the stock market behaved like a manic Jack Russell terrier. Wild gyrations are typical of market corrections, although this one has been more volatile than most. It started about 7 weeks ago, and based on market moves last Friday and yesterday in Europe, the terrier is still full of nervous energy. But at least we’re likely past the midpoint, as corrections rarely last beyond 12 weeks.

The worries are well known: a slowdown in global growth raising fears of a “double dip” and the sovereign debt crisis in Europe. The latter appears to be the main driver of recent volatility, which won’t likely calm down until Germany and other European governments do something bold. Even if that means a real Greek default or a partial breakup of the Eurozone, I don’t think investors will calm down until the crisis comes to a head. This will probably happen this month, as the markets are already forcing politicians’ hands.

For those of you who are interested in what’s really going on in the Eurozone, or why Germany would even consider bailing out Greece, the political analysts at Stratfor provide interesting insight. I can forward some articles on request.

Back to the Forties

Taking a longer view, the current period is looking more and more like the years during and after WWII (specifically, 1941 through 1957). The parallels are striking:

  • Then as now, the world had recently emerged from a major financial crisis and a deep recession.
  • Then as now, developed nations took on huge amounts of debt, well in excess of their GDPs.
  • Then as now, as governments become more indebted, individuals and corporations paid off debt and thrift stayed in fashion.

Back then, with unemployment still high and large swaths of Europe and Japan in ruins, if you suggested that the next 2 decades would witness the most rapid economic expansion since the 1890’s (real GDP growth of nearly 5% per year), you’d likely have been referred to the men in white jackets. But that’s exactly what happened, even with government debt at records levels.

How did we accomplish this? And are we doing anything similar now? To answer, I’ve got two “I” words for you: Investment and Inflation.

Investing in Our Future

Remember the Marshall Plan? An already highly indebted country (that would be US) invested $25 billion (equivalent to $1.45 trillion today) over 7 years into a shattered Europe to help it rebuild. In the process, we not only aided the Europeans, but also boosted our own economy, in part by creating customers for our exports.

Then there was the Interstate Highway System, signed into law by President Eisenhower in 1956. The cost was $475 billion in today’s dollars. It was financed mainly by taxes on gasoline. Today about 33% of all traffic flows on the Interstates. Money well spent? Think about it the next time you drive to Vegas.

Today Congress seems opposed to any new government spending, even if it’s an investment in our future. Maybe they’ll go for the public-private infrastructure partnership that President Obama will propose this week. However funded, investments in infrastructure and other long-term assets are very different from paying someone to make your life miserable by enforcing irrelevant regulation. Not all government spending is created equal.

Maybe the Investment part of the equation is too much to hope for. Without it, we’re not likely to hit 5% annual GDP growth, unless the private sector really gets moving. They certainly have the cash: $1.9 trillion currently in corporate coffers, enough to fund both another Marshall Plan and an Interstate Highway System. What will it take for them to spend it? Most likely, clarity from government on taxes, spending and deficits. This will come—eventually.

Learn to Love Inflation

But the Inflation factor is already at work, thanks to a Federal Reserve that actually knows what it’s doing. Some people bash Bernanke, but they don’t have a clue about macroeconomics (do you hear me, Ron Paul?). What’s the easiest way to reduce debt? Inflate your way out of it. Inflation raises the value of the asset side of your balance sheet, but the debt side never changes (or goes down as you pay it off). Say you have a house worth $1 million and an $800,000 mortgage, giving you a debt to asset ratio of 80%. Say you don’t pay down any of this debt over 10 years (you’ve got an interest-only loan), but during this time, inflation averages 5.9% per year (the average from 1941 through 1951). Your house is now worth $1.76 million and your debt stayed the same, for a debt to asset ratio of 45%. Miraculous! You’ve reduced your debt by almost half without paying off a penny.

This is how the US government got out of hock in the 1940’s and 1950’s. Yes, economic growth certainly helped then, and it may help again today. But even without a robust economy, inflation is a sure-fire way of reducing debt.

Ben and his deputies know this, and they’re intent on keeping inflation at decent single-digit levels for the foreseeable future. Since the end of the recession in mid-2009, inflation has run at a modest 2.4% per year. However, this year it’s running at an annual rate of 5.3%, pretty close to the post-WWII average. I’m betting a lot of my own money on the premise that a meaningful rate of inflation will continue for several more years.

In the meantime, interest rates are likely to stay low, just as they were in the decade after WWII. Back then, the Federal Reserve used a precursor to quantitative easing to keep the 10-year Treasury yield below 3% until 1956. Meanwhile, inflation averaged 5.9%, giving bondholders a –3.5% annual return after inflation. If you include the price depreciation of the bonds as interest rates rose, the return dropped to -4.5% per year. At that rate, you lost over 1/3 of your purchasing power in a decade.

Why did people essentially pay the US government 4.5% per year for the right to lend it money? Fear, ignorance, patriotism? I don’t know: you pick.

A Borrower, Not a Lender Be

Investors are making the same mistake today. 10-year Treasuries yield 2.0%. With inflation at 5.3%, you’re paying 3.3% per year to own these bonds. And it will get worse if inflation stays near this level and the price of the bond falls as yields inevitably rise. Long-term Treasuries look safe, but they will significantly erode your wealth over time.

Short-term investments were just as bad back then. 3-month Treasury bill yields didn’t stay over 2% until late 1955; you lost an average of 4.9% per year to hold them between 1941 and 1951, and made nothing after inflation until 1958. Today, 3-month Treasuries yield a microscopic 0.02%, costing you 5.3% per year to hold.

Meanwhile, stocks yielded more than Treasuries in the 1940’s and 1950’s.  And because their dividends increased over time, yields held up well even in the face of increasing stock prices. Dividend yields finally dropped below Treasury yields in 1958 and stayed that way—until today. Just last month, the yield on the S&P 500 exceeded 10-year US Treasuries for the first time in 53 years. To me, this represents a watershed moment.

Take a look at the graph below, where I compare the yield on 10-year Treasuries  (blue line) with the S&P 500 (brown). I adjusted it for companies’ payout ratios: the percentage of their earnings that are paid out as dividends. Historically, this has averaged 62%; today it’s only 29%. This means that companies have the capacity to pay much higher dividends than they currently do, even ignoring their huge cash hoards that could also paid out to shareholders.

Which would you pick: a fixed interest rate that’s 3.3% below inflation, or one that’s above inflation and likely to increase almost every year? There are plenty of healthy, growing companies currently yielding over 4.5%. (I did a quick screen on Yahoo Finance and found 802.) Given today’s low payout ratios, huge cash hoards, and lean operations, these dividends are likely to hold up even in a recession.

So don’t be a lender unless you’re being adequately compensated for doing so (there are bonds that have reasonable yields). Instead, be a borrower and watch your debt shrink over time with no effort on your part. Refinance your mortgage if the rate is over 5%, and consider taking some additional cash out. Take out a business loan to expand. Buy stock in companies that can borrow at rates lower than you’ll ever get.

As the saying goes, “Don’t fight the Fed.” And the Fed is doing everything it can to help borrowers right now. Don’t let the opportunity slip away to have inflation work in your favor for a change.

Ken

Dr. Ken Waltzer MD, MPH, AIF, CFA
Founder and President – Kenfield Capital Strategies (KCS)