Bubble Economics

we live in a bubble baby.
a bubble's not reality.
you gotta have a look outside.
nothing in a bubble, is the way it's supposed to be,
and when it blows you'll hit the ground.

 "Living In A Bubble" - EIFFEL 65

Sometimes pop culture captures the essence of the business environment. In this article I argue that we are living in an all-encompassing bubble created by the combination of a fundamentally deflationary U.S. economy and a decade of Federal Reserve overly aggressive policies focused on asset prices, instead of growth and inflation.

In the last article I highlighted data from McKinsey and Company that illustrated how ROIC bubbled up out of its historical range during 2004-2008. I ended the article with a series of possible reasons for this phenomenon, including tax rates, offshore labor, and monetary policy. In this article I put forth my theory that builds on my Sagflation thesis.

Sagflation Thesis
The Sagflation thesis argues that we are in a period of slow to negative real economic activity combined with more volatile prices caused by aggressive monetary policies. Capital allocation decisions have been perverted by interest rate manipulation for an extended period of time, resulting in the misallocation of capital in the economy. This manipulation has allowed economic activity to remain elevated and offset fundamental healthy deflationary forces in the economy, including offshore labor utilization, technology advancements, and lower tax rates. However, the artificially elevated economic activity has enabled poor capital allocation, increasing bad deflationary forces in the economy as low return projects founder. For a strong explanation of why investment spending is what really matters, please read Andy Kessler's editorial in the WSJ.

By repeatedly stimulating the economy through monetary policies, the bad capital decisions remain viable and likely even encourage additional poor capital allocation decisions. All this results in more volatile prices as fundamental deflationary forces are countered by increasingly inflationary monetary policies, something at which the Federal Reserve has become quite good.

Bubble Economics
By the end of 2013 the Federal Reserve could hold well over $3 trillion of government and mortgage-backed debt securities, assuming the government maintains its balance of treasury debt and continues to purchase about $40 billion of mortgage bonds each month. The Bank of England holds around $600 billion of government debt. The European Central Bank has announced a commitment to unlimited buying of bonds of troubled nations. The Bank of Japan recently expanded its asset-purchase program to over $1 trillion. Various other countries have implemented programs to manage interest and currency exchange rates.

The central banks are focused on driving GDP growth by expanding the money supply. However, actual nominal GDP growth remains weak. In formulaic economic terms, the velocity of the U.S. money supply continues to fall and the level of U.S. excess reserves continues to climb, largely offsetting the the efforts of the Federal Reserve and leaving nominal GDP below the desired level. These two variables suggest two possible trends: (1) individuals and businesses are holding money longer, which contributes to the decline in velocity, and (2) the demand for new loans is not strong enough to absorb the additional reserves supplied to the banks, which impacts velocity and excess reserves. As Professor John Harvey explains, "Supplying money is like supplying haircuts: you can’t do it unless a corresponding demand exists." Although I will add that changes in the credit approval standards of the banks, which may be loosening, has a significant impact on demand.

Both these trends suggest fundamental deflationary forces are present in the U.S. economy as income levels fall and consumers and businesses reduce leverage. As deflation expectations increase (such as for house values or wages) individuals are likely to hold their money more in cash for a longer period of time (driving actual deflation), just as the opposite is possible for inflation and hyperinflation. In essence, this may be one of the key reason for the Federal Reserve targeting mortgage-backed securities for the latest round of QE, to elevate house prices and attempt to change expectations towards inflation.

So if not economic growth, what has the monetary policy impacted? Benn Steil and Dinah Walker argue in the WSJ that the Federal Reserve changed its policy around 2000, from focusing on economic growth and inflation to a focus on asset prices. "Between 2000 and 2008...the Fed was behaving as if it were targeting "risk on, risk off," moving interest rates to push investors toward or away from risky assets." They argue that since 2009 the Federal Reserve has intended to mimic a negative interest rate environment.

Another way to consider this argument is that a deflationary environment should produce extremely low and even negative interest rates. From this perspective, the Federal Reserve recognizes, either on a conscious or unconscious level, the reality of the fundamentals and has created a mechanism to enable markets to function in their historical form with positive interest rates.

In either case, the question becomes: Is the monetary policy matched to the fundamental economic growth and inflation trends of the economy? Given my argument that we are in a deflationary environment, which implies negative economic growth, and the Federal Reserve targets a more historically normal growth rate, I believe the simple answer to be: no.

Thus, the follow-on question becomes: What long-term outcomes should we expect from this policy? In my opinion, under my Sagflation thesis the long-term outcome includes an increasingly narrow for the Federal Reserve to maintain price stability, eventually resulting in either accelerating inflation or deflation.

Economic Fundamentals
Returning to the bubbling up of ROIC between 2004 and 2008. The best possible answer for this deviation from the historical range would be that businesses found extraordinary investment opportunities through R&D processes that opened massive untapped markets. This didn't happen. Instead, I believe this extraordinary period is largely explained by global economic trends and more rigid structural issues in the U.S. economy, exasperated by government actions. On the cost side, businesses enjoyed falling cost pressures as labor costs subsided through offshore arbitrage of costs, operational costs declined as technology advancements enabled more efficient processes, and tax code changes that both boosted spending and enabled lower corporate tax payments.

On the revenue side, businesses benefited from a falling interest rate environment, which spurred demand as consumers enjoyed lower debt service expenses. Amplifying this trend was the levering-up by the consumer. Additionally, businesses have developed more effective marketing strategies through improved customer data collection and targeting enabled by the internet. Specific businesses may also have benefited from rising barriers to entry through favorable patent decisions. All of these trends were the likely core drivers of an expanding ROIC for a short period of time.

From a financing perspective, the historically low interest rate environment encouraged business expansion as financing terms became more favorable, pushing up the velocity of money. Factor in a relatively lenient credit approval process and the result was likely growth above a sustainable level, as evidenced by the housing bubble. Since 2007 the credit approval process has been tighter, reducing the ability of the central banks to expand the money supply. This trend may be shifting, so long as banks remain confident that economic growth remains positive.

Eventually excessive economic profits tend to diminish due to competitive pressures, investment in lower return projects, and reversal of shorter term favorable trends. I believe we are witnessing reversal of a few key trends that were favorable. Arbitraging labor costs with less expensive foreign labor is becoming less feasible due to higher transportation costs, rising wages overseas, and hidden costs associated with operational complexity, skills management, and intellectual property. While technology continues to advance, the technology companies focused on consumer products have enjoyed the strongest growth, possibly implying businesses are experiencing diminishing returns on technology investments. However, a lasting impact has been the median income falling four straight years to 1995 levels, simply affirming the deflationary forces present in the economy.

A couple trends could continue to work against businesses, or possibly turn positive. Since the financial meltdown in 2007/2008 credit approval processes have been tightened, pushing consumer debt levels lower and hindering consumer spending. Whether credit approval remains tight or begins to loosen again is an open question. Finally, the tax code remains riddled with special interest loop holes that benefit certain businesses but make the overall expense of tax preparation more expensive. Next year may see the tax code cleaned up for businesses, albeit producing both winners and losers.

Of course the economy also has the issue of the fiscal cliff, in which taxes increase and spending decreases. If Congress does not act on this issue then a significant deflationary force may be introduced next year.

Internationally, Europe continues to battle the economic slowdown that is applying deflationary pressures in the economy. If the European Central Bank can navigate a tricky path to further stimulation then these force may be offset. Asia's labor markets appear fairly tight and combined with expansionary monetary policies may cause accelerating inflation. That said, an aging population in Japan and high inventory levels in China apply deflationary forces.

In short, price stability appears to be waning. 

Investment Implications
So where does this leave an investor? If deflationary forces take hold then treasuries and cash are attractive investments. If inflationary forces accelerate then precious metals and other commodities. If the prices remain in the relative sweet spot of 1-3% annual increases then equities likely remain attractive. However, I believe we may see price changes swing through the sweet spot between inflationary and deflationary more violently as fundamentals continue to wrestle with monetary policies.

For now I remain mostly in cash.