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Why the most important hedge is against unexpected inflation

High asset prices stem from low inflation and interest rates




It is hard to say precisely when a cherished theory of inflation lost its sway. But if you had to pick a moment, it might be during an exchange last July between Alexandria Ocasio-Cortez, a first-time congresswoman who had risen quickly to prominence, and Jerome Powell of the Federal Reserve.

The occasion was the twice-yearly testimony by the Fed’s chairman to Congress. The unemployment rate, noted Ms Ocasio-Cortez, had fallen by three percentage points since 2014, yet inflation was no higher. Might the Fed’s estimates of the lowest sustainable jobless rate have been too high in recent years? “Absolutely,” replied Mr Powell. The once-strong link between unemployment and inflation, known as the Phillips Curve, was a “faint heartbeat”, he said.

Inflation now seems no more pressing a worry than other diseases of the distant past—smallpox, say, or scurvy. Even central bankers, who are paid to be anxious, tend to fret that inflation in rich countries might stay too low, not that it might suddenly surge. Investors may see it differently. The whole edifice of asset prices is founded on the expectation that inflation—and thus interest rates—will stay low. An unexpected rise in inflation ought to be the thing investors are most determined to guard against.

Inflation clearly does not behave as it used to. It no longer goes up automatically when unemployment goes down. Perhaps this is because people have come to expect low inflation. Wages and prices are marked up less often and so are less responsive to slackness or tightness in the jobs market. Global supply chains mean local bottlenecks have less influence on prices.

For much of the decade that has just ended, central banks kept interest rates unusually low.

This has had as little effect on inflation as low unemployment has. One explanation is the desire of ageing workers to set aside more of their income for retirement. This in turn has pushed down the equilibrium interest rate that balances the supply and demand for savings—with knock-on effects for asset prices.

Rock-bottom bond yields reflect a belief that central banks will keep interest rates low indefinitely. And if bond yields stay low, expected returns on other assets (the earnings yield on equities, the rental yield on property and so on) will also stay low—and their prices will remain high.

A serious burst of inflation would change all that. It would be a sign that the low-interest-rate equilibrium had shifted. That would upset the constellation of high asset prices. For investors with portfolios stuffed with richly priced stocks, there is a strong reason to seek hedges against unexpected inflation.

High-quality government bonds are the traditional diversifier for equity risk. But when inflation strikes, long-term nominal bonds are the worst assets to own. One way for the cautious to protect themselves is simply to hold more cash. Central banks would surely respond to a surge in inflation by raising short-term interest rates, thus boosting the returns on cash (with a delay).



But in many places cash rates are below current inflation. A superior way to hedge is to hold Treasury Inflation-Protected Securities, or tips. The coupon—effectively a real rate of interest—is a fixed fraction of the principal. ´

The principal is not fixed, however. It is adjusted over time to reflect increases in the consumer-price index, or cpi. Ten-year tips currently have a small but positive real yield of 0.1% or so (see chart). The yield on a nominal ten-year Treasury is around 1.9%. The difference between the two reflects expectations of inflation (that is, 1.8%).

By holding tips to maturity, an investor can receive inflation insurance and also be paid a real return of 0.1% a year. True, were there to be an inflation shock, the Fed would react and real interest rates would go up, which would have a downward effect on the price of tips. But that would be more than offset by the upward effect of a surge in demand for insurance against higher expected inflation, say John Roe and Chris Jeffery of Legal and General Investment Management.

Reasonable people might ask: “Why bother?” Inflation has been slain. The fear that it is just around the corner led to investment mistakes and policy errors during the 2010s. Fair enough.

But the reasons for quiescent inflation in the face of low unemployment and the secular decline in interest rates are not fully understood. A decade from now, a successor to Mr Powell may be explaining to Congress how the Fed had undercooked its inflation forecasts.

Do not underestimate Trump’s re-election chances

It is almost impossible for the US president to disappoint his supporters

Janan Ganesh

BATTLE CREEK, MICHIGAN - DECEMBER 18: President Donald Trump speaks at a Merry Christmas Rally at the Kellogg Arena on December 18, 2019 in Battle Creek, Michigan. While Trump spoke, the House of Representatives was voting on two articles of impeachment, deciding if he will become the third president in U.S. history to be impeached. (Photo by Scott Olson/Getty Images)
If voters are resigned to the unimprovability of things, the performance of the president is neither here nor there © Scott Olson/Getty Images


Followers of sport will be familiar with the concept of the emotional hedge. On the sound premise that money beats gallows humour as consolation, people bet against their own teams to soften the trauma of defeat.

Even if gambling were legal across the US, the markets would not be liquid enough to meet the demand for such wagers on Donald Trump. Soliciting opinions on the eve of 2020, I find that people who least desire a second term for the US president are the quickest to predict it.

Foreign diplomats are no less resigned than the American liberals who will have to suffer it in person. They sometimes over-reach in their certitude but, if Mr Trump is not a sure thing, he is eminently competitive, even after impeachment, even after everything. The trick is to explain why.

One reason is the longest economic expansion in US history. Surveys indicate that voters, wise to the impersonality of the business cycle, withhold credit from Mr Trump. But the boom forces his challengers to prove that they would not endanger it with tax rises or regulations, even ones that are popular on their own terms. The most left-leaning field of Democrats in a generation is exposed to the charge of needless risk-taking.

As important as the economy is the structural role of partisanship. Such is the group loyalty in US politics, almost any sentient mammal who stands for a major party can count on 45 per cent of the national vote. Not since 1996 has a Republican or Democrat flunked that mark, and it took the spoiling candidacy of billionaire independent Ross Perot.

For all its viciousness, partisanship makes for a perverse kind of stability in which electoral outcomes only ever vary within a tight range, even when one candidate is an impeached Twitter addict. The incentive structure this sets up for politicians is too dismal to contemplate, suggesting as it does that one can do literally anything and remain electorally viable for the grandest office on Earth.

America’s boom and its tribalism are well enough understood abroad. Mr Trump’s elemental force as a campaigner is an even better-known factor in his advantage. There is something else that accounts for his enduring competitiveness, though, and it is easy for those with too rational a cast of mind to miss.

It is almost impossible for Mr Trump to disappoint people. They never had hopes to dash. In 2016, it was forgivable to characterise his voters as innocents who believed that he would repatriate factories to Ohio and clean up politics. Logic implied that when he failed in these endeavours their support would melt. In retrospect, this was only ever true of some. 
Many others never believed that he or anyone else could, in that tellingly vague aspiration, make America great again. Their vote was more a howl against perceived national decline than a calculated attempt to arrest it. They are not standing over his shoulder with clipboards that set out key performance indicators. That would imply some hope in the first place.
 
It is hard to overstate the fatalism of the country that elected him and stands to do so again. By a gap of around 20 points, voters believe the US to be moving in the wrong direction. (The margin has been in the double digits for a decade now.) According to Pew, super-majorities expect it to become weaker in the world, less equal at home and more politically divided over the next 30 years.
 
Declinism is no longer just a trope of current affairs non-fiction. It is the national mood, and it predates Mr Trump. Of all the US founders, one of the least lionised, John Adams — to whom there is still no monument in Washington, for lack of donations — most reflects the contemporary spirit. The great sceptic always winced at the idea of inexorable progress, of America as celestially favoured among nations.
 
It follows that, if voters are resigned to the unimprovability of things, the performance of the president is neither here nor there. It is impossible to disillusion the never-illusioned.
 
None of this warrants the presumption of a second Trump term.
 
Various Democrats still outpoll him, if by tightening margins. An economic downturn before November would be hard (though not impossible) for him to survive. His way with an unforgettable jibe has failed him in the case of former vice-president Joe Biden, unless you think “Sleepy Joe” is a zinger for the ages.
 
Having shown voters who he is for three years, though, Mr Trump remains a contender.
 
That, even if he falls just short, accounts for the liberal anguish at the opening of a decade.



Check Your Optimism—China’s Slowdown Isn’t Over

Investors are starting 2020 in a sunny mood, but worrying signs from China could spoil the party for industrial shares

By Nathaniel Taplin



The doom and gloom of mid-2019 has been replaced with outright investor optimism.

A big reason: better news from both of the world’s two largest economies.

Before investors go shopping for shares, however, they should take a closer look at China.

The latest grounds for caution came Wednesday, as China’s central bank cut the amount of cash banks must hold in reserve, releasing an estimated 800 billion yuan ($115 billion) in funds for lending effective Jan. 6. Adjustments to reserve requirement ratios have been the central bank’s favored monetary tool to combat slowing growth since early 2018.

The move was widely expected following calls for additional support for the economy by Premier Li Keqiangin late December. It also partly reflects seasonal funding pressures: Cash demand in China always rises sharply at the end of the Western calendar year and ahead of the Lunar New Year holiday, which falls this year on Jan. 25.


A clerk counts yuan at a bank in Nantong, China. Photo: Xu jingbai/Imaginechina/Associated Press 


This year the seasonal liquidity crunch will be even worse than usual due to Beijing’s decision to allow local governments to issue some infrastructure bonds early, absorbing some bond-market capacity, rather than waiting until March when the annual budget is approved. Some important money-market rates, including the seven and 14-day repurchase agreement rates, moved up abruptly in mid-December.

But the reserve ratio cut also represents a tacit admission that things aren’t quite as rosy as some of the recent data seemed to indicate. While there is increasing evidence that China’s export machine is on the mend, other important parts of the economy are looking much weaker than they were six months ago.

China’s housing market is cooling rapidly, and construction activity with it. In December, China’s official construction purchasing managers index logged its weakest reading since early 2016.

The return on assets for indebted state industrial firms, concentrated in housing-dependent sectors such as steel, is also weakening. That makes keeping bond-market liquidity high—and thus state-enterprise refinancing costs low—even more urgent.

The reserve ratio cut will help accomplish this: If the central bank were only concerned with short-term holiday money-market conditions, it could address that through its daily open-market repurchase agreements or other short-term liquidity tools rather than the big blunt instrument of the reserve ratio.

China’s economy enters 2020 with the losers of 2019—private firms and exporters—looking a bit better. Last year’s winners—real estate and state industry—are on shakier ground.

Even as they celebrate the good news, investors should be wary of big rallies in metals, miners and other heavy industrial plays.

Why Governments Should Not Wait for Godot

For foreign investment, governments need organizational capabilities that go beyond Adam Smith’s maxim that they must do no more than ensure “peace, easy taxes, and a tolerable administration of justice.” They need to do at least three additional things.

Ricardo Hausmann

hausmann80_Patrick Foto Getty Images_tokyobusinessconnectiondata


CAMBRIDGE – The scenario is all too familiar. A reformist government wants to boost economic growth and employment by implementing market-friendly reforms designed to make the country more attractive to (often foreign) investors.

Policymakers understand that these investors possess the technological prowess, organizational capability, and market reach that the country desperately needs.

Committees are created to improve the country’s performance in the World Bank’s Doing Business index, the World Economic Forum’s Global Competitiveness Report, or other beauty contests promoted by a sprawling array of international rankings.

The reformist government overcomes grueling fights with legislators and civil society, who accuse it of putting investors’ interest ahead of those of its own people.

But with perseverance, it successfully adopts reforms that improve the country’s rankings and gets glowing coverage in the international press.

The learned world’s impression of the country (and even that of money managers) changes significantly for the better.

And then the government waits for foreign investment to arrive.

And waits.

And, as in Samuel Beckett’s famous play, the anticipated inflows, like Godot, never show up.

This problem stems in part from assuming that what needs fixing is captured in international rankings. Too often it is not: worldwide, there is zero correlation between improvements in the Doing Business and Competitiveness indexes and growth or investment performance.

Often, the focus of such rankings is on reducing red tape, which assumes that investors stay away because of some sin of commission, which, if stopped, would release the floodgates. But the world is more complicated than that.

Most people who could potentially do well by investing in your country know a lot about their business but probably know very little about your country – particularly the things about your country that matter for their business, including the ones you just reformed. More important, their business usually depends on things you should be doing but aren’t – your sins of omission.

For example, manufacturing requires industrial zones with power, water, security, logistics, and access to a labor force that can get to the worksite. Fresh produce requires cold chain logistics, certifications, a green lane at customs, and government-negotiated phytosanitary permits.

Eliminating burdensome regulations and cumbersome controls is far easier than establishing these systems. Given your limited resources, you cannot do it all, which means that you are doomed to choose the areas where you will devote special attention to create the required ecosystem.

Moreover, you need to be deeply knowledgeable about these areas. You need to understand what potential activities require and what about your country makes them more or less likely to succeed. But assuming you do this for some chosen area, how do you avoid waiting for Godot once again, especially after all that costly effort? And will you ever recoup those costs?
To avoid this predicament, governments need organizational capabilities that go beyond Adam Smith’s maxim that they must do no more than ensure “peace, easy taxes, and a tolerable administration of justice.” They need to do at least three additional things.

First, the government needs to engage with existing economic activities to identify what it can do to improve their productivity, whether by changing rules, infrastructure, or other publicly provided goods and services. These engagements need to be narrowly focused, typically along value chains, to enable the identification of sufficiently detailed problems.

For this reason, economy ministries must organize quite a few of them, as with the deliberation councils that started over a century ago in Japan and have been emulated elsewhere. There are more than 200 such councils in Japan, including for Sumo wrestling.

Second, the government should mobilize society and domestic and foreign firms to explore the “adjacent possible”: activities that do not exist but for which the requisite ecosystem is almost in place. This requires people in and out of government to imagine what is not yet there, figure out what is needed to establish it, and determine whether it would be both feasible and valuable to society.

This exploratory process is both costly and risky, although recent advances such as the Atlas of Economic Complexity make it less of a crapshoot, by revealing relevant information for assessing the feasibility and the attractiveness of potential new industries.

To implement these strategies, governments need to reform their current “investment bureaus,” which often do little more than authorize or handhold investors. Instead, these entities should help promote the government’s diversification strategy by identifying foreign firms that are in a desired industry, but not yet in the country, articulate the business case for investment, and lead the negotiations.

Third, and most controversially, governments often need a corporation to facilitate investment in new strategic areas and manage the activities generated by previous strategic investments. These corporations may be set up as holding companies for already existing state-owned enterprises that currently report to their respective line ministries.

The ministries should focus on their regulatory functions, leaving the holding company to provide close financial and operational oversight and exercise shareholder rights on behalf of society. The holding company can also be capitalized with assets that the government already owns.

These corporations should use part of their proceeds for pre-investment activities in new potential areas and use their knowledge of the country to create joint ventures with firms that have knowledge of targeted industries.

In fact, by being an equity partner, the corporation can capture the upside of government efforts to fix the ecosystem. The corporation should also explore opportunities for divestment of existing holdings in order to free up capital needed to advance the economic diversification strategy.

Conventional wisdom discourages governments from creating such corporations on the grounds that the risks of poor governance and bad performance are too large. A more useful approach would be to develop the tools and mechanisms to ensure good and improving governance.

Published audited financial statements, high technical capacity (facilitated by salaries and career paths that are competitive with the private sector), powerful advisory boards with foreign participation, and partnerships with institutions such as the International Finance Corporation (the World Bank’s private-sector lending arm) could create the right environment for excellence.

Once governments have taken these steps, they may no longer have to wait for Godot. They may simply go fetch him.
 

Ricardo Hausmann, a former minister of planning of Venezuela and former Chief Economist at the Inter-American Development Bank, is a professor at Harvard's John F. Kennedy School of Government and Director of the Harvard Growth Lab.