Monday, 11 April 2011 07:27

Reggie Middleton on Inflation

Posting will be sparse until Thursday, as I cater to business out of town. In the meantime, I think readers may benefit from more of my dated writings on inflation.

Reggie Middleton’s Take on Investing for Inflation, pt. 2

As stated in part one of my inflation series of blog posts, I am not sure if we will have rampant inflation in the near to medium term (and I believe anyone who thinks they can accurately forecast such is in la-la land), but it is evident that interest rates and energy prices are going up while the effective affordability of major consumer items are going down. For instance, mortgage rates, 10 year treasuries, oil and gasoline have all spiked up recently. Home affordability, contrary to many reports in the popular media, is actually down. Without employment (or the promise of continued employment), it is harder to buy a home. Down payments are now a considerable barrier to many when it was not before. Now let it be known that I am far from an economist. I am a mere investor, but since most economists had no idea this malaise was coming and I saw it clearly, I am more than comfortable in issuing my 24 cents (it was my two cents, but I levered up 12x!).

Assuming a single family residential property has dropped about 20% in price from $200k to $160k (as per Case-Shiller housing index), you now have a 37.5% higher downpayment to make to get into said property, for the standard bank underwriting criteria demands a downpayment of 20% in lieu of 10% (and in many cases, 5%, 0% or a negative downpayment – money back at the closing) during the bubblicious hey day of "buy anything with no credit". As interest rates tick up in tandem with unemployment, this effective affordability actually goes down further despite the fact that the nominal price of housing is rapidly decreasing as well. This is exacerbated by the fact that the speculative investor and the move up buyer are essentially removed from the marketplace, primarily due to financing and equity issues (any property purchased at market price since 2003 or so  is probably at par or underwater, hence equity rolling into another property is now impossible). It appears as if many are missing this rather important phenomenon, and it applies to many normally depreciating big ticket consumer discretionary items such as boats, recreational craft, etc. as well as luxury items such as 2nd homes. Believe it or not, if this carries on into the extreme, it actually has the potential to push upwards on rental prices


despite a glut in housing inventory, for single family housing is very expensive to manage on mass rental basis, while condos are very expensive to convert into rental units from a cost and financing perspective. Thus extant apartment rental buildings will be the first to benefit from any demand in housing, sans a significant spike in income and savings (not possible in the short term), a drastic reduction in housing prices (the most likely scenario, but one that will wreck absolute havoc on the banking system since most pundits and analysts actually believe the housing market is already trying to turn around) or a return to the extremely lax underwriting standard of the housing bubble (both unlikely due to short term lessons learned and counterproductive for it will simply blow another bubble).

So here we have a theoretical (or not so) case where there is rampant deflation in asset prices, yet significant inflation in the input cost of said prices. Reggie's scenario of potential stagflation.

Redacted and annotated from Wikipedia, heavily peppered with my opinion and viewpoints:

Stagflation is an economic situation in which inflationand economic stagnation occur simultaneously and remain unchecked for a period of time.[1] The portmanteau stagflation is generally attributed to British politician Iain Macleod, who coined the term in a speech to Parliament in 1965.[2][3][4] The concept is notable partly because, in postwar macroeconomic theory, inflation and recession were regarded as mutually exclusive (as apparently is regarded in 2009, as well), and also because stagflation has generally proven to be difficult and costly to eradicate once it gets started.

Economists offer two principal explanations for why stagflation occurs. First, stagflation can result when an economy is slowed by an unfavorable supply shock, such as an increase in the price of oil in an oil importing country, which tends to raise prices at the same time that it slows the economy by making production less profitable.[5][6][7]

NYMEX CRUDE OIL – last 30 days…


C1 Reformulated Gas – lat 30 days


This type of stagflation presents a policy dilemma because most actions to assist with fighting inflation worsen economic stagnation and vice versa. Second, both stagnation and inflation can result from inappropriate macroeconomic policies. For example, central banks can cause inflation by permitting excessive growth of the money supply,[8] and the government can cause stagnation by excessive regulation of goods markets and labor markets;[9] together, these factors can cause stagflation. Both types of explanations are offered in analyses of the global stagflation of the 1970s: it began with a huge rise in oil prices, but then continued as central banks used excessively stimulative monetary policy (TARP, TALF, PPIP, AIG, GSEs, Bear Stearns, Treasury purchases, MBA purchases, excepting common equity as collateral, accepting trash ABS/MBS as collateral, expanding the discount window, the list can go on for quite some time) to counteract the resulting recession, causing a runaway wage-price spiral.[10]

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Part 3

The Performance of Inflation Correlated Assets: Reggie Middleton's Opinion

This is part 3 of my thoughts on investing in inflationary times (see Reggie Middleton's Take on Investing for Inflation, pt. 1 and Reggie Middleton's Take on Investing for Inflation, pt. 2). I had my team run independent verification of inflation correlated asset performance, for it appears to me that many investors tend to simply follow what they have heard other say versus looking into what the facts are. In the process of the investigation, we have tracked the performance of asset classes discussed on my blog, including all maturities of treasury, inflation linked treasury, municipal bonds, residential mortgage, other metals and agricultural commodities. We have also computed nominal returns (based on a 255 trading day convention), real returns, asset volatility and Sharpe ratio for each the asset classes across time periods to determine performance of each asset class over a period of time. Below is the summary charts and tables of our findings. (Pro subscribers, please refer to the attached excel document for detailed information for each time period - Q2 2009 Asset Inflation Correlation Datasheet Q2 2009 Asset Inflation Correlation Datasheet 2009-06-12 14:21:51 2.47 Mb)

Agriculture commodities: Historically, agricultural stocks have not provide sufficient hedge against inflation because of lack of storability and more or less constant demand (which is not linked directly to level of economic activity unlike other commodities).  Also due to supply shocks agricultural commodities have one of the highest volatility (in terms of standard deviation) and lowest Sharpe ratio. In addition agriculture commodities have low correlation with inflation, negative real returns (in almost all sub-periods) and low nominal returns.

Emerging markets, real estate and Gold offer one of the highest real returns in that order. However, lower volatility of commercial real estate sector makes this sector one of the most attractive in terms of risk-reward ratio.  Within commercial real estate apartments have one of the highest real returns (after emerging markets) and highest Sharpe ratio amongst all asset class.


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Part 4

One of my blog subscribers asked me, "So does this (inflation correlated returns – see Reggie's take on investing for inflation parts 1, 2 and 3 for the background to this article) alter your thesis on your commercial real estate companies that you have been bearish on?"

Not as of now. Currently, I see us as in a highly deflationary period, with real asset values dropping through the floor. Commercial, retail and residential properties are still apparently in a free fall, cushioned somewhat by massive global stimulus which has taken some effect. It appears as if small private company EBITDA is on the rise which is massively bullish. If taken in a vacuum then this is a telling sign, unfortunately we don't live in a vacuum.

For one EBITDA is an investment banker's concoction to allow them to ignore a dearth of real profits in order to get clients to focus on pure operating profits.  If a banker can show EBITDA going up, then he can charge more for the deal. Unsuspecting clients have gone for this in the past, totally ignoring the fact that in some situations you can pack leverage and gearing into a company and drive EBITDA through the roof while at the same time driving the company into the ground. We will probably see a lot of examples of this as those leverage loans start to cause marginal companies to collapse, en masse. Hey, the deals looked good 4 years ago, with strong EBITDA, after all it is Earnings Before Interest, Taxes, Depreciation and Amortization – or to put it in laymen's terms, the money I make without paying out too much of the money that I owe!

If we were to switch to a highly inflationary period then I may have to revisit the thesis on commercial real estate, but as I said in the first paragraph, we are not there now. If I had to take a wild guess on where we would end up mid-term, I would gander a stagflationary environment. I haven't researched these assets in a stagflation environment in detail, but I do know as an ex-landlord that it is difficult to raise rents on tenants that are not working or whose businesses are floundering.


I have delved into the stagflation topic in exquisite detail on BoomBustblog in 2008 and 2009 - Empirical proof that these events were no only possible to see coming, but were actually quite obvious

Last modified on Monday, 11 April 2011 07:27

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