The Inflation Tide
The following are extracts from recent commentary that appeared at The Speculative Investor web site.
Growth versus Inflation
Economic growth and inflation are totally separate phenomena, although many people (including financial analysts and economists) make the mistake of linking them. For example, we have recently read that long-term interest rates have been rising because the market is discounting future economic growth. Does this make any sense?
It doesn't make sense, and here's why. Genuine economic growth can only come about via higher productivity, that is, it can only occur if output is increasing at a faster rate than input. If productivity is increasing then prices should drop, all else being equal. In other words, if you can produce more for less then lower prices are the natural result. As such, real economic growth should lead to an increase in the purchasing power of money and, therefore, to lower long-term interest rates (if money is expected to be worth more in the future than it is today then lenders will usually be prepared to accept a lower rate of interest). The main reason that long-term interest rates are currently much higher than short-term interest rates has very little to do with future growth expectations and a lot to do with the anticipation of currency depreciation.
The above analysis is supported by a comparison of the yield on the 10-year Treasury Note with the yield on the equivalent-maturity inflation-indexed note. The only difference between the yields on these two notes is the market's expectation regarding inflation. If the debt market had really been discounting higher growth over the past two months then the yield on the inflation-indexed note should have moved higher with the yield on the non-inflation-indexed note. In actual fact, however, the yield on the inflation-indexed note has fallen over the past two months. This means that the entire rise in long-term interest rates since bond yields bottomed in late-March has been due to expectations of higher inflation. The debt market has therefore not yet begun to discount any improvement in the economy, a conclusion that is also consistent with the fact that short-term interest rates remain near their lows.
In the US during the latter half of the 1990s the reported productivity growth rate was healthy, yet goods and services prices still trended higher. Furthermore, without the large benefit provided by cheap imports, goods and services prices would have risen at an even faster pace. Clearly, the huge growth in the money supply more than offset any benefit that would normally have accrued from increased productivity.
An inflationary tide lifts all boats
Below is a chart showing (in red) the year-over-year %-change in M2. If we had to pick one single reason for the strength of the US stock market from early-April until late-May, this chart would be it. Furthermore, there is a good chance that the money supply growth that has already occurred will underpin the stock market for several more months and lead to an increase in consumer spending during the final few months of this year.
Below are charts of the NASDAQ Composite and the XAU since the beginning of March. Notice how the two have been moving together over the past 2-3 months. More often than not, gold stocks move counter to the overall stock market so the recent action is unusual, but not unprecedented. Our thinking is that an inflationary tide is, essentially, lifting all boats. However, some boats - the ones that benefit directly from higher inflation - are being lifted higher than others. This is quite similar to what happened during the 12-month period leading up to the 1987 stock market crash.
Unlike the inflationary tide that swept across the US economy in 1998 the current one is having a different effect because, this time around, there is no 'slack' in the economy. There is now a chronic energy shortage due to decades of under-investment in energy infra-structure and this shortage is keeping energy prices at a much higher level than they would otherwise be during a period of slow economic growth. Also, consumer prices and labour costs are rising at their fastest rates in many years. This is why it has, to date, been the stocks of companies that benefit the most from a depreciating currency that have gained the most as a result of the friendly monetary environment.
We expect the monetary environment to remain friendly for at least a few more months and that this tide of money will continue to support all asset prices.
If the experiences of the past 2 years are anything to go by then the time to get very concerned about the stock market (all stocks, including gold stocks) will be when the M2 growth rate falls to around 6%. Unless the extremely unlikely happens and bonds exceed their March highs over the next few months, the M2 growth rate should begin to decline by August and be approaching the danger level by late this year or early next (as explained in previous commentary the bond market, not the Fed, is the single greatest influence on the money-supply growth rate).
Steve Saville
Hong Kong
6 June 2001
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