In 1978, when still young and creative, I produced my first four quadrants chart. The idea was that there are four basic investment environments depending if economic activity is expanding or contracting, and whether prices are rising or falling. It was usually obvious which state we had just left—for example the UK having suffered an inflationary bust in 1977—but far harder to judge what state we had entered. Being able to make such a call in real time has been a holy grail of my research ever since. Those efforts have met with only limited success, but I am pleased that recent work, done together with Will Denyer, has got us far closer to our goal. The implication for portfolio construction could be profound.
The great Wicksellian insight
The approach is built on the work of Knut Wicksell, a late 19th century Swedish economist whose key insight was that at any given time, there are two interest rates: the “natural” or optimum rate (which we can only infer) and the actual or market rate (which we can see). When the market rate is set too low, capital misallocation emerges, leading to an inflationary boom and inevitable subsequent bust. When the market rate is set materially above the natural rate, the economy quickly tanks. Good policy means keeping rates within the Wicksellian “optimum range”. At any point, I have no idea what the natural should be, but I can roughly estimate when market rates are either clearly too low, or far too high. It will, by necessity, be an inexact judgement, but as John Maynard Keynes sagely noted, it is better to be approximately right than precisely wrong.
The first part of this series focuses on periods when it is clear that rates have been set too low, but the question is whether we are in the top or the bottom half of the four quadrant grid. When inflation is decelerating or prices are falling, then conditions match those in the bottom half of the grid. Conversely when prices are accelerating, the economy must be in the top half. Logically, the next report will seek to identify whether the economy in question is in the left or the right side of the quadrant. And, of course, knowing where you are offers a leg up in judging what comes next.
Inflationary or a deflationary period?
My well worn Wicksellian rule runs that if the real rate on Baa bonds is too low compared to the economic growth rate, money is excessively cheap. The root cause of this situation is most likely that either the central bank or the commercial banks are producing too much of the stuff (see Of Wicksell And Fed Fallacies). Hence, the chances are that some sort of inflation will follow, whether that be in consumer prices or asset values.
My preferred measure for the cost of money in the US is the Baa bond rate on seasoned long-dated industrial bonds; for the inflation rate I take the 12 month rate of change in the US CPI, smoothed for 10 years. From this a real yield for Baa bonds can be computed.
The next step is to subtract from the US GDP growth rate the cost of money. The logic runs that over the long term, government bond yields should converge at an equilibrium level near the GDP growth rate. In a normal situation US long bond rates should reflect the structural growth rate with the cost of money—denoted by the Baa yield—commanding an appropriate spread. Hence, if the real Baa rate is at or below the economic growth rate it is certain that the private sector is borrowing at too low a rate. The chart below shows the results of this decision rule.
Red shaded areas denote periods when the Baa real rate was at, or below the growth rate, and so inflationary conditions prevailed. These results broadly reflect the US economic experience of the last 50 years, or so. Up until 1960 interest rates and economic activity moved in a regular cyclical pattern. After 1960 the “best and the brightest” arrived with John. F Kennedy (Galbraith and friends) to do their worst, followed by Lyndon B. Johnson’s Great Society program. Adding fuel to the inflationary fire, the Federal Reserve adopted highly Keynesian policies. The situation moved out of control after 1968 as Fed chair Arthur Burns fully embraced a “guns and butter” policy, causing a rapid escalation of inflation. It took Paul Volcker, who arrived in 1979, to clean house by deregulating the cost of money with the result that its price moved back to a “normal” level.
Since the mid-1980s inflation has declined structurally and at a consistent rate, with only small interruptions. A further decline in prices seems baked into the cake as credit spreads are presently making new cyclical highs. The strange thing is that the US faces an actual deflation, not because the cost of money (the Baa rate) is particularly high, but because the GDP growth rate has collapsed due to the Fed’s asinine zero interest rate policies (see The High Cost Of Free Money). The next step in this analysis is to test whether my decision rule accords with US bond market behaviour over the period. The chart below compares the rule’ss findings with the performance of a 10-year zero coupon bond.
The not altogether surprising result is that the value of the zero coupon rose in disinflationary (green) periods and declined in inflationary (pink) periods. Given the current trajectory of prices and growth, I am fairly sure that the next decade will see such a bond rally toward its maximum intrinsic value of 100, representing a 2.25% annual compound return. The more interesting question is how quickly it gets to parity; if a genuine deflation emerges, this transition could be very fast.
But these are strange times and we have seen in Switzerland that the impact of negative deposit rates has driven the price of a 10-year zero coupon bond to 104. Based on this experience, a US zero in the coming period could earn more than an annualized 2.25%. And, of course, the real return could be higher still should inflation swing negative. It goes without saying that share prices will struggle in such an environment.
The obvious investment conclusion from the above is that during inflationary periods investors get little benefit hedging an equity portfolio with bonds. Owning bonds in 1962-81 was a losing proposition, except for those (brief) periods shortly before a recession. Conversely, bonds have huge diversifying power during deflationary or disinflationary periods. In these periods a bond hedge can be a life saver as they tend to be negatively correlated with equities. This relationship is clearly shown in the chart below highlighting the total return of the S&P 500 versus the total return of a constant duration long-dated US zero coupon bond.
From as far back as 1950 to 1985 investors did badly owning US bonds. Since 1985, however, long bonds have outperformed equities by 66% (the red line is rebased at 100 in 1985). Given that the US is in a disinflationary (green) period, this outperformance is likely to continue. Indeed, given weakening growth it seems highly likely that deflationary forces will increase in the near future with the real prospect of outright deflation. Verification that such a disinflationary scenario beckons will be the subject of a follow-up report to be published next week.
For now the clear conclusion is that the US remains in a disinflationary period and the assets of choice are long-dated US government bonds. Equities should be added to the mix only when the stock market is way undervalued or the economy has fallen well into recession territory.