Inflation as the solution to the current problems - NO WAY !

I am suprised to see that a lot of people are thinking that inflation will be a solution to the problem when there is too much debt in the economy.

Let me show you that this is NOT a solution and it will provide the economy with even BIGGER problems in the future.

Imagine that Joe has a salary of USD 30.000 a year and has a mortgage of USD 200,000 with an interest of 5% (and yearly inflation is around 1%). His yearly interest payment is therefore USD 10,000 (5% x USD 200,000).
He has around USD 20,000 available for other expenses.

Now let's focus on wat will happen if inflation is going up, let's say to 10% (to make things clear).

Of course the debt level will decline on a REAL basis. That is what policy makers are targetting. Let us assume that there are succesful in doing so. A simple analysis does indeed show that the real debt level declined and it seems (...) that the initial problem has been mitigated.

BUT, is it logical too assume that the nominal interest rate will stay at 5%, when inflation is 10% ... hmmm. Will you lend out money at 5% when inflation is around 10%, no way ... you probably want to have around 14% (the same real interest rate plus a 10% inflation correction).
What will happen to Joe ... his yearly interest payment will balloon to USD 28.000 (14% x USD 200,000) ... ouch ... since his income was USD 30.000, HIS INCOME SHOULD GO UP BY 60% IN ORDER TO HAVE THE SAME NOMINAL LEVEL OF LIVING EXPENDITURES !!! And even then, probably goods have become more expensive (inflation is higher, right), so on a REAL basis he can now only buy LESS goods. And making the problem even bigger ... how likely is it that his income is going to rise 60% (!) in the first place, when the unemployment level is rising as well ???!!!

What will happen to Joe ... well, he will default on his payments ... and this will cause even further problems for the banks and the economy.

INFLATION is NOT a solution, it is CREATING AN EVEN BIGGER PROBLEM, since the increase in interest payments is huge (coming from a low interest rate environment) and has to be offset by an increase in income, which doesn't make any sense in an economy which is in a recession !

It is Superman or an Action Biased Gambler ?

These days a lot of policy measures are taken to prevent the economy slowing down even further. A lot of money has been provided to the banking-sector in order to get the credit flowing. And now with quantitative easing in place, we have another chapter in the stimulus package. It seems that the higher the amount of money which is being spend on the economy, the better it is. But, as most of us know, there is NO free lunch. We will get the (negative) effects of all these measures, for sure. One effect will be higher inflation going forward. What is frustating is that all these policymaker aren't giving the public a well balanced view of the effects of their actions and their chances of success.
Currently, it is very helpful to take a few steps back and look at the situation once more. The current situation is one where we have to much leverage in the system. This is a result of the Greenspan-years, where, when the economy was in some decline, the interest rates were lowered, to get the consumer spend more (on credit !). This resulted in a higher GDP growth (at the expense of higher debt levels – basically people already consumed their future income).
And what are the policy makers doing now … essentially the same thing (!) … they are still saying to consumers SPEND, SPEND … (on credit). What I am missing is some long term plan to solve this issue and then work back what should be done to get to that (healthier) situation. Nowadays, it is basically trial and error and hoping for the best (which is TOO tricky when you have these kind of problems and when you have these kind of (nuclear) policy measures). When people are in stressful times, one is inclined to take actions (action bias). Sometimes the best thing is to watch and let nature do their thing, which would lead to a better (healthier) future.

What would happen when all these policy measures are successful ? We would have a banking system which is still (partly) listed on the stock market. Banks will be very conservative in terms of product development and less likely to lend out money (probably they will say: “we have learned our lesson”). Government debt will be very high, Private sector debt levels will still be high. In order to prevent very high inflation, the policymakers should reverse their measures, which is very tricky (too much and the economy goes back to a recession, too little and we will have high inflation). Interest rates will go up (the short end and the long end of the yield curve) … ouch … what will that to do the interest payments which have to be made on the higher debt levels. In order to pay down government debt levels you should have to transfer money from the private sector to the public sector, I wonders whether that’s even political viable.

What would happen when these policy measures are unsuccessful … ouch … it could be very well a deflationary period with high levels of debt ...

Why are the policy makers this BIG gamble ? When people are addicted to smoking and getting all sorts of physical problems, this a very clear signal to quit smoking in order to get healthy again. That’s the only way … When an economy is addicted to credit and the economy is showing all sorts of problems (as a result of this addiction). Quit taking credit to consume and pay down your debt and become healthy again (and then you will have a healthier economy in the future). That’s the most successful way going forward, but it incorporates taking the pain in order to have a healthier future. It seems to be the case that policy makers are not open to take this pain and are looking to other actions in order to lower the pain and hoping that it might sort out their problem. The problem is that it might lead to even bigger problems in the future (who is going to pay down the government debt)! That is THE reason we are in the current situation, so LEARN from it, and do not make the same mistake again !

What happened to my Pension - or - get rid of the current discount rates

Further to my previous blog on the effect of Marked to Market on pension funds, I now like to discuss another aspect which is causing too much trouble these days and which is, in my view, incorrect and should be resolved very soon !

These days the liabilities of a pension fund should be discounted at a discount rate equal to the swap curve to calculate the market value of the liabilities. Currently swap curves are going lower and lower (since pension funds are an active buyer, because of the fact that coverage ratio's dropped) and causing coverage ratio's to drop further, causing a systematic collapse in the end ! Worse, the fact that pension funds need to discount the liabilities based on the swap curve itself is NOT correct, hence we have an incorrect rule causing us enormous a lot of pain. Adjust the rule !

If you take a look at the (theoretical) balance of a pensioner, on the left side of the balance sheet sits the value of the future retirement income. The best estimate of the market value of this future income is, in my opinion, not the future income (coming from pension payments) discounted by the swap rates (which are viewed as a risk free asset basically), but it should be discounted by this risk free asset PLUS a risk factor. This risk factor should include the risk that the inflation indexation can be waived, the arrangements can be changed (one may need to work more years for the same pension payments) or the pension fund can choose to lower the pension payments itself. Currently this risk factor is totally ignored in the valuation, while these risks are now almost reality! We are not talking here anymore about a theoretical risk, some of these events are happening now !

If one looks at this situation at the macro level, the current value of the future pension payments from pension funds and the value of the pension payments which are received by the pensioner have to be, by definition, be equal to each other. Currently these two values are not equal to each other, i.e. the value of future pension payments by the pension fund > value of the pension payment to be received by the pensioner (!).

This provides an interesting theoretical arbitration (and perhaps in practice as well ...). If I could get a lump sum amount (theoretically) which is being calculated using the swap curve, I would be very happy to do so since my own calculation of this value is much lower, since I take into account the risk factors.

The yield on a corporate bond will have higher yields, when this corporate is in a bad state, and vice versa. This should also be the case with pension funds. If a pension fund has a low coverage ratio, it should have a higher discount rate (since it is less secure you still get your pension) and the discount rate should be lower, once the pension funds is well capitalised.

Marked to Market and it's implications on today's Markets

The current market environment is really unique. People, Banks, Corporates, Pension-funds etc. are questioning what impact the current markets will have on their financial situation. As a result, there is a big focus on coverage ratio’s at pensionfunds, Tier 1 ratios at banks, etc.

If one takes an unbiased view of the current situation, one can argue that a large part of the current problems are caused by the system that is imposed by the regulators.

Since the introduction of IFRS in Europe, we must base many valuations on valuations which are provided by the markets (so called marked to market valuation).
But we should not forget that many market participants are currently in a liquiditation phase and are therefore setting irrational prices, which are causing irrational valuations. As a result of the marked to market rule these irrational valuations have to be put in the books as well. This basically could cause a new liquidation to be triggered at another marketparticipant !

I think the purpose of any accounting system is to give a realistic valuation of the various balance sheet items. For liquid assets, marked to market is a good approach. For illiquid assets however it is NOT. If on a very low turnover, a shareprice declines 10%, has the realistic/fundamental value of that company then suddenly declined 10% as well ? As Michael Mouboussin and James Surowiecki both show us that under certain conditions the market is able to give us a good indication of value (see "The Wisdom of Crowds Theory", which I use in my investment process).
These days, due to the fact that often the reason for selling shares is liquidation and not a negative view on the share/company, the market is NOT offering us a good proxy of the actual worth of a company. A better proxy is now for example bookvalue, or if one wants to be even more conservative one could use net cash per share as a (very conservative) proxy of the underlying value (increasingly there are more and more companies which have more net cash on their balance sheet than their marketcap!),

Since markets are most of the time offering us a good proxy of the actual value, concepts such as coverage ratio and Tier 1 ratio’s, etc. are a very good idea 95% of the time. However, during extreme circumstances, as we see now, to hold on to such an approach is a very problematic one, which is currently not in the interest of anyone, it basically triggers a vicious circle which is very dangerous to all people who are involved (and most of us are directly or indirectly).

If the regulators now really want to help the markets, let them throw away the marked to market concept for illiquid assets.

China's nasty surprise

These are very interesting times. Equity markets are down a lot ... finally (see my post last year in which I was wondering why people were still buying equities) and volatility is up. A current assesment of the equity markets is a bit more mixed. Valutations came off, so I am becoming more positive on the outlook for equities, especially since most of the people you speak to are now bearish (i.e. it is a consensus opinion). Consistent with my earlier posts, it is difficult to assess the valuation of financials (so stay clear from them !), so I am not becoming positive on financial stocks for a structural reason. As pointed out in the past there are a lot of very interesting companies these days. You finally are able to buy the Graham and Dodd-companies ! Some of them even trade below net cash and/or have (non cyclical) FCF yields of more than 40% ! The biggest succes factor these times is time itself and self discipline. You need to have the time and the discipline to accept potential lower marked-to-market stock prices and not to worry about them (if their underlying business is sound).

One element which could trigger further pressure on equity markets could be China. A lot of people are still having a positive view on China's growth. Remember that 70% of it's GDP comes from capital spending ! Do you think that it makes sense to build more plants in China when the world economy slows down and others plants are getting closed ? Ouch, that will have an impact on China's growth. And by the way the other big generator of GDP growth in China is export. You get the message, I think, what will happen to that when the world economy is slowing down (see GMO's Q3 report, which you should read !).

There is simply too leverage in the system and people will have to adjust that and that will hurt a lot of people. A lot of people were still partying like it was 1999 ...

Stay Clear from Banks Stocks

If one looks at the price performance of bank-stocks (on an absolute basis, but also on a relative basis (versus other sectors)), one is inclined to believe bank-stocks are a real bargain these days.

I think that a value investor should stay clear of that. First of all, trying to time the real bottom in a shareprices is a task which everyone tries to do, but no one can do on a structural basis (so don't try it in the first place and focus your efforts on the things that really make your performance - focus on valuation (focus on whether it is cheap or expensive NOT whether it will go up or down (this will not be a successful strategy in the long run). Secondly and more importantly, how in the first place do you value a (traditional) bank ???
I think not a lot of investor really ask this question (what are we buying in the first place ?). What is a bank ? And how do you judge if banks are cheap or expensive? To judge whether specific stocks are cheap or expensive you may use ratio's, such as Price /Earnings, FCF Yields, Price / Book values, etc. After a lot of discussions on banks, I strongly believe that there isn't a good ratio or multiple or whatever to really judge whether a bank is cheap or expensive.
To begin with FCF yields for banks are nonsense, so one might look at Price to Book. Sure, but first of all the book value of a book is intangibles mostly and a bank is highly leveraged (so a book value might erode fast). Deposits can be drawn away rather quickly (remember Nothern Trust ?), so book values are an unstable measure of value during days that banks are having trouble). Ok, fine, let's look at the good old Price Earnings multiple then. Ok. What are the earnings of a bank first of all ? and more importantly how stable are they ? To make my point clear: assume you gave $100 to your bank for 30 years at 6%. The bank lends this to a home-owner (or a business) at let's say 10%. The earnings of this bank will be $4 ((10%-6%=4%)*$100) a year. So let's assume to bank has got 1 share outstanding and the price is $16. The price / earnings multiple is therefore 4 (= 16 / 4). At first glance one might say, wow, that is cheap ! Sure it looks cheap. BUT, we can only be sure that the bank made a profitable business if after 30 (!) years, the interest the bank received from homeowner MINUS a potential default (!) was greater than the interest which was being paid to you. Since the interest is such a small percentage relative to the overall capital which is at risk, you can only judge after a relatively long period if the bank is doing a good job.
So a P/E of 4 for a bank stock might be even expensive if they have to (partly) write down the loan (and this can happen in any of the 30 years !). So the earnings a bank generates are NOT comparable to the earnings NOKIA makes on their sales of mobile phones (on which it is clear whether they made a profit or not in the SAME year). The earnings of a banks are implicitely UNSTABLE (due to the longevity in combination with tail risk !) and therefore any multiple which incorporates earnings is basically nonsense from a value investor's point of view).

Stay clear from banks and do not try to bottom fish for opportunities within banks, currently there are a lot of opportunities elsewhere (especially in the small- to mid-cap area).

Lessons from the (recent) past

Seven years ago I read a book called "F.I.A.S.C.O." which was written by Frank Partnoy. This book is still so relevant these days and it is a book I recommend people to read (and learn from it !). This book describes the way rating agencies (used to ?) work with respect to derivatives structures. The idea is that a basket of basically worthless bonds put together will have a better rating than the underlying bonds. This rating however is looking nice on paper and is giving you a nice spread/yield relative to other bonds with a similar rating ... so you might be stupid not to have this in your portfolio ... In practice, however, you still get the quality of the underlying bonds (of course !), and the real quality of the underlying bonds will show up (when the tide turns). The point is that a lot of people simply look at the rating of a structure and don't do further research into what the structure really is. Hmmm ... sounds familiar doesn't it ... just recently (almost 10 years afters this book has been published) people still bought CDO structures with a credit rating looking good (on paper) and giving an very interesting yield. These stuctures went into so called money market funds to give the low yielding stuff a bit more flavour and to show that the portfoliomanager was looking like a smart guy, outperforming his rivals. A lot of people don't learn from the past ... it could have saved you (and your clients) a lot of money !