My favorite course in college was economics, where the best college professor I ever had, Dr. Ted Woodruff, taught me Monetarist and Keynesian economic theory. Interestingly, the relationship between monetary policy, fiscal policy, and inflation is central to what might be the most critical debate of the New Year.
In a nutshell, both Monetarists and Keynesians argue that excessive monetary stimulus and deficit spending will eventually lead to higher interest rates and inflation, once the economy has reached its full-employment supply constraint. According to their logic, excessive growth in the supply of money will result in "too much money chasing too few goods," and therefore, inflation. Now, a little bit of inflation isn't necessarily bad if it is accompanied by rising economic growth. But a little bit of inflation is not what the inflation bears are forecasting. Most are predicting hyper-inflation, perhaps approaching or even surpassing the double digit inflation the U.S. experienced in the 1970s.
Looking at the numbers during the inflationary 1970s...
The 2-year US Treasury interest rate peaked at about 12% in 1979 and the Price/Earnings ratio for the market at that time was around 6x. By comparison, the yield on the 2-year Treasury today is 1.1% and the market P/E is around 15x. The inevitable conclusion here is that if the inflation rate accelerates toward a level last seen during the forgettable decade of the 70s, then interest rates are going up significantly, and stock prices are going in the opposite direction.
But hold on a minute... Are there any factors in force that might break this link between monetary expansion, deficit spending, and inflation? I believe there are several.
First, Fed Chairman Bernanke and the Obama Administration are not unaware of the inflation risks involved with current monetary and fiscal policy. Despite the never-ending political rhetoric, the Fed will gradually reverse course once they are confident in the economic recovery. I know this begs an obvious question - Can the federal government turn off the monetary and fiscal stimulus at the right time and pace in order to prevent accelerating inflation without choking off the economic recovery? For sure no easy task, especially given that our economy is largely in unchartered waters. Admittedly, not every policy initiative will lead to the desired results, but some of it will. That, for better or worse, is how the system works.
Along these lines, once political pressure to attack the deficit reaches a certain point, Congress and the administration will address the deficit more seriously as well. And yes, that is a very complex and difficult issue, with no easy solution, and one we will all be facing for some time.
Second, individuals are still reeling from the real estate meltdown and the worst decade in the stock market on record. Not surprisingly they are saving more relative to previous spending patterns and paying down debt instead of maxing out on a wallet full of credit cards. This sea change in consumer spending patterns is a by-product of the Great Deleveraging Cycle I've written about in previous editions. Importantly, I think this is a generational transition from living beyond our means to living well within our means. Because while we like government handouts, we would rather not need them, and the vast majority of people still have more faith in their own ability to build a financial safety net than they do in the viability or sustainability of any government entitlement program.
Third, despite all the TARP funding, banks, remain hesitant to lend to all but the most worthy borrowers, generally speaking. This rebuilding of bank balance sheets may take a while, as we cycle through the problems related to commercial real estate, credit cards, and a sluggish overall economy.
The Velocity of Money... Money does not cause inflation; it is the rate at which it flows through the economy that impacts inflation. Economists call this "velocity." If individuals aren't spending it and banks aren't lending it then the velocity of money will remain low. For the record, the velocity of money has fallen dramatically since 2006.
And finally... The capacity utilization rate is at a 40-year low. On a global basis there is tremendous slack in the system. This is decidedly deflationary. At the same time, the unemployment rate, at 10%, remains well above the long-term average. Moreover, the growth in the underemployed, those people forced to take lower paying jobs, adds to the deflationary argument.
As we enter 2010, we will be watching all these factors closely and will undoubtedly have more to share regarding these critical economic variables in future newsletters. In the meantime, our continued focus on industry-leading companies seems to be a prudent strategy in these uncertain times.
In this context, I do feel that the gap between industry leaders and laggards will continue to widen. One measure of this phenomenon is the trend in market share where we are seeing increasing evidence that many industry leaders are continuing to distance themselves from their weaker rivals.
