Posts Tagged ‘price inflation’

Is price inflation good for real estate in Australia?

Sunday, July 24th, 2011

One of the assumptions made by many people is that rising price inflation is good for property prices in nominal terms. In other words, many people see property as a hedge against price inflation. The experience of the past (especially 1970s) has a strong influence on this belief.

But today, in Australia, from our observations, we believe that the relationship between price inflation and property prices is breaking down. In fact, we would argue that price inflation probably has a negative effect on property prices.

To understand why, recall that we wrote in Does inflation (deflation) benefits the borrower (lender)?,

Debt servicing burden = (Debt payment rate ? Growth in wage) + Price inflation rate

Today, the problem is that in Australia, with the two-speed economy, wages are rising in one section of the economy but is relatively stagnant on the other. In relative terms, mining wages in Western Australia are sprinting ahead of wages at say, office workers in Sydney.

But unfortunately, since the GFC, cost of living has been rising faster than general rise in wages. For example, as Retail therapy impossible in this housing market reported,

Now look at your pay packet, take away the things you can’t avoid spending money on, remove what you’re paying in rent or paying off a loan, and look at what is left. You may find that’s smaller than ever, despite the fact we’re in a mining boom. But the trickle-down effect of that boom seems a long way away from Sydney. We’re part of the second tier of the economy here, the one that isn’t doing so well. Still, rent and housing prices continue to go up. And the bills come first before that new coat, that new stereo . . . even repairing those cracks on the walls or the dents on your car.

As you can see from our simple equation, with the cost of living rising faster than increase in wages, debt servicing burden will increase. Furthermore, the Reserve Bank did not help by raising interest rates. The increase in debt servicing burden puts a squeeze in discretionary spending- that explains why shoppers seems to be going on strike, putting the retail sector under pressure.

This increase in debt servicing burden is putting on the dampener on house prices. It dampens people’s appetite for borrowing more money and increases their propensity to save. Less borrowing means less capacity to bid up house prices. It also pushes more mortgage holders to be delinquent with their home loans, which increases the likelihood of forced sales. This is the first round of effect on house prices.

Rising cost of living pushes the retail sector deeper into trouble as shoppers shut up their wallets. Since consumer spending account for 60% of the Australian economy, a weak retail sector is hardly good news for employment in the country. As we wrote in RBA committing logical errors regarding Australian household finance,

Given Australia?s high household debt (see Aussie household debt not as bad as it seems?), prime debt can easily turn sub-prime when unemployment rises.

Rising unemployment will put further pressure on house prices. As we wrote in Does house price crash follow unemployment or is it the other way?,

[Rising unemployment] will feed into the second round of impact of lower house prices, which in turn lead to further rising unemployment. This will feed into the? third round of impact.

Now, cost of living is rising despite a rising Australian dollar. What if the dollar falls substantially? What will happen to the cost of living?

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Posted in Market Observations | 4 Comments »

Can stocks hedge you from price inflation?

Tuesday, September 15th, 2009

Continuing from our previous article, should we buy stocks as a hedge against price inflation? The answer to this question is not so straightforward.

In normal circumstances, some stocks are a good hedge against the garden-variety types of price inflation (or even beat inflation spectacularly) because their earnings power can increase faster than the general rise in prices. But in times of hyperinflation, when the real economy deteriorates, it will be increasingly difficult to find such a business.

First, let’s take a look at the past from this research report,

The 1970s were a period of accelerating inflation and poor equity returns in the US. By December 1980, the federal funds rate stood at 20%, and the ten-year Treasury peaked at 15.3% in September 1981. From December 31, 1968 to December 31, 1981, the S&P 500 returned 1.28 % per annum in nominal terms and -6% in real returns. Put another way, a dollar invested in the US stock market at the end of 1968 twelve years later was worth roughly 45 cents in real terms.

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In the US, there is substantial empirical evidence that high inflation is associated with a high equity risk premium and declining stock prices. Bodie (1976) found from 1953-1972 that common stocks were poor hedges against inflation. Cohn and Lessard (1980) also found that stock prices in many industrial countries are negatively related to nominal interest rates and inflation.

It is important to make the distinction between properly anticipated inflation, and unanticipated inflation. If inflation is correctly anticipated and if companies can in fact pass on costs of doing business, then nominal cash flows should be unaffected by a general increase in prices. However, as inflation rises, it tends to become more uncertain and a component of price increases may not be properly anticipated by firms. Blanchard (1993) found that ?an unexpected increase in inflation in year 0 leads to a sharp decrease in stock prices in that year.?

There are a couple of ways to see why price inflation and stock prices are negatively correlated:

  1. In times of high inflation, interest rates are high. Therefore, bonds may prove better value than stocks relatively.
  2. Investors demand higher returns from stocks to compensate against higher price inflation. The lower the price paid for stocks, the higher yield returned by the stocks and thus, the higher the returns on investments.

On the other hand, we have examples in history where hyperinflation do wonders for stock prices. For example, in 2007, Zimbabwe had the world’s best performing stock market- stocks actually rose faster than price inflation:

Zimbabwe Industrial Index up till 2007

Zimbabwe Industrial Index up till 2007

Despite these two seeming contradictory real-life examples, one thing is clear: everything else being equal, unexpected rise in price inflation will lead to compressed valuation of stocks due to a rise in discount rates used to value stocks. In other words, PE ratio can decrease (in the context of rising earnings) even though stock prices can still rise in nominal terms. In the case of the US stock market in the 1970s, this led to negative returns in real terms. But in Zimbabwe’s case, stocks actually had good positive returns in real terms. But make no mistake: as we quoted Marc Faber in our previous article, such positive returns are the result of rising speculative bubbles in the stock market abetted by the printing of money.

If you believe that the (1) US are going the path of Zimbabwe-style money printing and (2) the stock market hit record high due to speculation, does it mean that you should rush to buy any stocks as a hedge?

Here, you have to be careful. The dizzy heights of stock prices in the Zimbabwean stock market have a survivorship bias. With real GDP deteriorating and sky-rocketing unemployment in that country, we are sure many Zimbabwean public companies are dropping dead like flies. That means, there will be many stocks whose prices went to zero. If you happen to hold one of them, you will suffer loss in nominal terms in a hyper-inflationary environment.

Also, stellar stock market performance that are induced by money printing are, at the end of the day, bubbles. Bubbles can easily burst.

Thus, if you are considering holding stocks as a price inflation hedge, you will have to choose the stocks very carefully. The wrong choice will lead to (1) losses in real terms at the very least or (2) a possible wipe-out in the context of a highly dysfunctional economy.

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Posted in Looking Forward | 18 Comments »

Revealed: The error in the Buffett logic

Tuesday, March 10th, 2009

In our previous article, we asked our readers to spot the flaw in Warren Buffett’s logic. Today, we will reveal the answers. Before you read on, please take the time to understand our guide, Value investing for dummies.

As Buffett said, staying in cash and cash equivalent (e.g. government bonds) is a bad move because price inflation is likely to be very high in the future. This, we agree. But does it mean one should switch from cash to stocks today? If the answer is “yes,” then there’s an error in logic.

First, by that very statement, Buffett was implying that the yields of government bonds are far too low. Essentially, this means that those who buy and hold those bonds will have their wealth frittered away by price inflation.

Next, as we explained in Value investing for dummies, value is a relative concept. Stocks are valued relative to risk-free government bonds, which in turn is suppose to reflect future price inflation. If the yields in government bonds are wrong by a long shot, then stock valuation will be wrong.

To explain this point better, let’s use an example. Let’s suppose the following conditions:

  1. 30-year Treasury bond yield is 3.5%.
  2. An almost risk-free business with monopolistic powers (let’s imagine it is Woolsworth).
  3. That business can raise prices and grow its earnings at 25% per year.
  4. The first year earnings of the business is $100.

If we apply a 5% discount rate on 10 years of that business’s earnings, we get a present value of $2358.76. That 5% is arbitrary chosen from the fact that it is a little above the Treasury bond yield.

As long as the long-run average price inflation is around the vicinity of the 30-year Treasury bond yield, buying the stock at below the present value of its earnings is a bargain. But what if the bond yield is way way way wrong? Let’s say the price inflation rate turns out to be, say 25% (in other words, the business earnings grow fast enough to merely keep up with inflation). You can see that applying a discount rate of only 5% will give you a return far below price inflation (but slightly higher than Treasury bond yields). If you want a return higher than price inflation, your discount rate will have to be north of 25%.

If we apply a 30% discount rate on 10 years of that business’s earnings, we get a present value of only $648.87! That 30% is arbitrary chosen from the fact that it is a little above the price inflation rate.

So, if you believe that government bonds are severely under-pricing future price inflation and you have no idea how the ravages of price inflation will look like, then how can you value stocks correctly? If the price inflation turns out to be Zimbabwean-style hyperinflation, then you will lose big money (in real terms) investing at today’s stock price.

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Posted in Investor Education, Value Investing | 100 Comments »

Can price inflation occur in the midst of debt deflation?

Thursday, February 26th, 2009

Right now, major economies like the US and UK are undergoing debt deflation. Large swathes of Europe is also going through this malaise. According to Professor Steve Keen, Australia, with its debt levels in the 3rd position behind US and UK, will suffer the same fate soon. Indeed, in the month of December 2008, Australia’s credit growth turned negative. Year-on-year credit growth in the second half of 2008 was decelerating. This is a worrying sign for Australia because as we explained before in Will Australia?s own pump-priming work?,

According to Professor Steve Keen, Australians? increased debt last year added $250 billion in spending into the economy. Currently, Australia?s credit growth is decelerating very rapidly. Should credit growth stagnate (or worse still, contract), this $250 billion (or more) in spending will go up in smoke.

So, there is plenty of scope for de-leveraging in the Australian economy, which will lead to debt deflation. Under such a scenario, asset prices will fall. As the theory goes, consumer prices should follow as well.

But is it possible for price inflation to rise in the midst of debt deflation? We were thinking of that possibility in What will happen if RBA cuts to zero?. The most likely culprit to blame for such a disturbing scenario will be the trashing of the Australian dollar. Debt deflation theory says that such a scenario is impossible. But there is a real-life example that shows that this can happen- Iceland. Today, Iceland is suffering sky-rocketing unemployment as well as price inflation. From the Icelandic central bank’s web site, you can see their price inflation rate has gone to the moon at 18.6% in January 2009.

How can both debt deflation and price inflation be possible? As someone in Professor Steve Keen’s blog site asked,

I?m wondering about what?s happening to Iceland now and going forward. When no one has a job, no one has savings and no one can sell a single thing. Everyone has no money. If no one has money, no one can buy things. If no one can buy things the shops must drop price further and further. This is monetary deflation and price deflation. More businesses fail and unemployment continues to rise. Where does the future inflation come from?

So, how can we explain Iceland?

Well, under the conventional demand-supply equilibrium model, prices should come down. But in this case, the system is out of equilibrium and cannot return to equilibrium. If there?s no money to buy imported things, it does not mean that the prices must come down. What will happen is (1) demand destruction and/or (2) the seller goes out of business (and contributes to higher unemployment). The remaining few sellers that survive will most likely sell to the richer Icelanders who can cough out the higher prices.

Furthermore, as we explained with an example in What will happen if RBA cuts to zero?, even locally produced goods can rise in price too.

Can this happen to Australia? Fingers crossed. The inflation part depends on the Aussie dollar.

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Posted in Looking Forward, Market Observations | 10 Comments »

Example of inevitable effect of monetary inflation

Wednesday, February 21st, 2007

Back in Cause of inflation: Shanghai bubble case study, we said that:

The mainstream economists do not see monetary inflation as an evil?as long as price inflation is not a problem, they do not see the need to care about monetary inflation. But Austrian School economists see that the inevitable consequence of monetary inflation is price inflation because the former is the root cause of the problem and the latter is the effect.

Today, we look at an example of how monetary inflation leads to price inflation. As explained in this article in the Sydney Morning Herald, the current rental crisis in Sydney is an ?inevitable consequence of the housing boom and bust we’re experiencing.? The housing ?boom,? (as we had explained in The Bubble Economy) is the effect of monetary inflation.

As of right now, global liquidity is still expanding. So far, price inflation, as claimed by the US Federal Reserve, is ?under control.? Rest assured, it will only be a matter of time before price inflation creeps in again. Humanity has yet to find a way to repeal the fundamental laws of supply and demand.

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Posted in Economics/Finance, Looking Forward, Market Observations | No Comments »