John Maynard Keynes famously said that speculating on the stock market is like participating in a newspaper beauty contest. In a newspaper beauty contest, readers choose the five prettiest people out of a hundred or so contestants. The winner is he who chooses the five most popular people. Therefore, in order to be successful you can’t just pick who you think is prettiest, but who you think everyone else thinks is prettiest. I find this is a useful perspective to keep in mind when following trends in financial markets.
One such current trend is the increased concern investors have about inflation. Many expect that the massive fiscal stimulus, quantitative easing, and low interest rates will lead to considerable inflation in the future. In this case, the “newspaper contest” perspective would have lead to good short-term investment decisions as many market participants share these fears. Prices of inflation-resistant assets like commodities, precious metals, and TIPS have done well in the last few months as these fears have become more widespread. As I have written before, Gold is likely to stay around $950 or higher as long as there are fears of inflation and the possibility of China increasing its gold reserves.
However, while buying inflation-protected assets is a good short-term investment strategy, I am not sure the fears of inflation are economically valid. First, as Paul Krugman pointed out in a recent Op-Ed, since banks aren’t lending out extra reserves, quantitative easing is not having an inflationary effect. Second, large deficits are not necessarily inflationary. Governments rarely inflate themselves out of debt. The US debt was 120% of GDP after World War II, yet inflation remained low throughout the 1950s.
Government bonds are different from corporate bonds in that quantity does not necessarily imply higher yields. As government debt rose in Japan in the late 1990s, government bond yields fell as more debt was issued.
The opposite has occurred in the US and UK. As more treasuries and gilts have been auctioned off, yields keep increasing. A large reason for this trend is the movement from inflation vulnerable assets like bonds to inflation resistant assets like gold and oil, reinforcing the “back to normalcy” trend I discussed in my previous posts.
Is inflation a threat to the US economy? Yes. Is it as great as a threat as many investors assume? No. The severity of inflation will larely be decided by economic growth. If our economy achieves constant growth, we can grow out of the deficit like we did after WWII, because we’ll have the tax revenues to do it. As for balancing the budget, I am certain Obama will make steps to address this by the end of his first term. Deficit spending is currently the GOP's most potent criticism of the Obama administration.
Paul Krugman wrote in his article, “When it comes to inflation, the only thing we have to fear is the fear of inflation itself.” He meant that the fear of inflation could put political pressure on Obama and lead him to abandon his policies. I doubt this is a legitimate possibility. The real reason to fear the fear of inflation is the effect on treasuries. Though quantitative easing is putting downward pressure on yields, inflation fears are doing the opposite, resulting in what Niall Ferguson calls “a painful tug-of-war between our monetary policy and our fiscal policy.” As long as inflation fears push investors into non-income producing assets like commodities and precious metals, treasury yields will continue to increase, resulting in higher mortgage rates. Mortgage rates recently hit 4.91%, up 75 basis points in only a few days--not a good sign for beseiged homeowners. It is a catch-22: inflation fears are raising borrowing costs, thereby derailing the economic growth needed to prevent inflation.
