Friday, May 23, 2008

Pimco´s Bill Gross Must Read Piece On CPI

The following post from Bill Gross is worth reading every single sentence. While i´m with Mish on what Inflation is ( see Inflation: What the heck is it? ) it is very telling how the US is able in depressing the symptoms of inflation. But as long as foreigners are willing to destroy money in buying US treasuries and agency paper one has to congratulate the US for their excellent PR ( no sarcasm! )........ I´m staying with gold......

Ich empfehle dringend das komplette Posting von Bill Gross zu lesen. Bekanntermaßen sehe ich die Definition von Inflation wie Mish ( siehe Inflation: What the heck is it? ). Es ist schon bemerkenswert wie die USA es schaffen die Symptome der Inflation auf äußert vielfältige Weise zu manipulieren. Der Irakfeldzug ist verglichen damit ein Lacher. Solange Sie es trotzdem schaffen genügend ausländische Investoren zu finden die Gelder besonders in Staatsanleihen und Papieren von Fannie & Freddie zu versenken kann man es den USA nicht einmal übel nehmen die kreative Berechnung jenseits von Enron & Co zu heben. Man muß hier ausdrücklich das herausragende PR loben ( das meine ich ehrlich ). Ich für meinen Teil bleibe da lieber beim Gold......

Thanks to Wall Street Follies

Hmmmmm? Gross / Pimco - What this country needs is either a good 5¢ cigar or the reincarnation of an Illinois “rail-splitter” willing to tell the American people “what up” – “what really up.” We have for so long now been willing to be entertained rather than informed, that we more or less accept majority opinion, perpetually shaped by ratings obsessed media, at face value. After 12 months of an endless primary campaign barrage, for instance, most of us believe that a candidate’s preacher – Democrat or Republican – should be a significant factor in how we vote. We care more about who’s going to be eliminated from this week’s American Idol than the deteriorating quality of our healthcare system. Alternative energy discussion takes a bleacher’s seat to the latest foibles of Lindsay Lohan or Britney Spears and then we wonder why gas is four bucks a gallon. We care as much as we always have – we just care about the wrong things: entertainment, as opposed to informed choices; trivia vs. hardcore ideological debate.

It’s Sunday afternoon at the Coliseum folks, and all good fun, but the hordes are crossing the Alps and headed for modern day Rome – better educated, harder working, and willing to sacrifice today for a better tomorrow. Can it be any wonder that an estimated 1% of America’s wealth migrates into foreign hands every year? We, as a people, are overweight, poorly educated, overindulged, and imbued with such a sense of self importance on a geopolitical scale, that our allies are dropping like flies. “Yes we can?” Well, if so, then the “we” is the critical element, not the leader that will be chosen in November. Let’s get off the couch and shape up – physically, intellectually, and institutionally – and begin to make some informed choices about our future. Lincoln didn’t say it, but might have agreed, that the worst part about being fooled is fooling yourself, and as a nation, we’ve been doing a pretty good job of that for a long time now.

I’ll tell you another area where we’ve been foolin’ ourselves and that’s the belief that inflation is under control. I laid out the case three years ago in an Investment Outlook titled, “Haute Con Job.” I wasn’t an inflationary Paul Revere or anything, but I joined others in arguing that our CPI numbers were not reflecting reality at the checkout counter. In the ensuing four years, the debate has been joined by the press and astute authors such as Kevin Phillips whose recent Bad Money is as good a summer read detailing the state of the economy and how we got here as an “informed” American could make.

Let me reacquaint you with the debate about the authenticity of U.S. inflation calculations by presenting two ten-year graphs – one showing the ups and downs of year-over-year price changes for 24 representative foreign countries, and the other, the same time period for the U.S. An observer’s immediate take is that there are glaring differences, first in terms of trend and second in the actual mean or average of the 2 calculations. These representative countries, chosen and graphed by Ed Hyman and ISI, have averaged nearly 7% inflation for the past decade, while the U.S. has measured 2.6%. The most recent 12 months produces that same 7% number for the world but a closer 4% in the U.S.


This, dear reader, looks a mite suspicious. Sure, inflation was legitimately much higher in selected hot spots such as Brazil and Vietnam in the late 90s and the U.S. productivity “miracle” may have helped reduce ours a touch compared to some of the rest, but the U.S. dollar over the same period has declined by 30% against a currency basket of its major competitors which should have had an opposite effect, everything else being equal. I ask you: does it make sense that we have a 3% – 4% lower rate of inflation than the rest of the world? Can economists really explain this with their contorted Phillips curve, output gap, multifactor productivity theorizing in an increasingly globalized “one price fits all” commodity driven global economy? I suspect not. Somebody’s been foolin’, perhaps foolin’ themselves – I don’t know. This isn’t a conspiracy blog and there are too many statisticians and analysts at the Bureau of Labor Statistics (BLS) and Treasury with rapid turnover to even think of it. I’m just concerned that some of the people are being fooled all of the time and that as an investor, an accurate measure of inflation makes a huge difference.
The U.S. seems to differ from the rest of the world in how it computes its inflation rate in three primary ways: 1) hedonic quality adjustments, 2) calculations of housing costs via owners’ equivalent rent, and 3) geometric weighting/product substitution. The changes in all three areas have favored lower U.S. inflation and have taken place over the past 25 years, the first occurring in 1983 with the BLS decision to modify the cost of housing. It was claimed that a measure based on what an owner might get for renting his house would more accurately reflect the real world – a dubious assumption belied by the experience of the past 10 years during which the average cost of homes has appreciated at 3x the annual pace of the substituted owners’ equivalent rent (OER), and which would have raised the total CPI by approximately 1% annually if the switch had not been made.

In the 1990s the U.S. CPI was subjected to three additional changes that have not been adopted to the same degree (or at all) by other countries, each of which resulted in downward adjustments to our annual inflation rate. Product substitution and geometric weighting both presumed that more expensive goods and services would be used less and substituted with their less costly alternatives: more hamburger/less filet mignon when beef prices were rising, for example. In turn, hedonic quality adjustments accelerated in the late 1990s paving the way for huge price declines in the cost of computers and other durables. As your new model MAC or PC was going up in price by a hundred bucks or so, it was actually going down according to CPI calculations because it was twice as powerful. Hmmmmm? Bet your wallet didn’t really feel as good as the BLS did.

In 2004, I claimed that these revised methodologies were understating CPI by perhaps 1% annually and therefore overstating real GDP growth by close to the same amount. Others have actually tracked the CPI that “would have been” based on the good old fashioned way of calculation. The results are not pretty, but are undisclosed here because I cannot verify them. Still, the differences in my 10-year history of global CPI charts are startling, aren’t they? This in spite of a decade of financed-based, securitized, reflationary policies in the U.S. led by the public and private sector and a declining dollar. Hmmmmm?

In addition, Fed policy has for years focused on “core” as opposed to “headline” inflation, a concept actually initiated during the Nixon Administration to offset the sudden impact of OPEC and $12 a barrel oil prices! For a few decades the logic of inflation’s mean reversion drew a fairly tight fit between the two measures, but now in a chart shared frequently with PIMCO’s Investment Committee by Mohamed El-Erian, the divergence is beginning to raise questions as to whether “headline” will ever drop below “core” for a sufficiently long period of time to rebalance the two. Global commodity depletion and a tightening of excess labor as argued in El-Erian’s recent Secular Outlook summary suggest otherwise.


The correct measure of inflation matters in a number of areas, not the least of which are social security payments and wage bargaining adjustments. There is no doubt that an artificially low number favors government and corporations as opposed to ordinary citizens. But the number is also critical in any estimation of bond yields, stock prices, and commercial real estate cap rates. If core inflation were really 3% instead of 2%, then nominal bond yields might logically be 1% higher than they are today, because bond investors would require more compensation. And although the Gordon model for the valuation of stocks and real estate would stress “real” as opposed to nominal inflation additive yields, today’s acceptance of an artificially low CPI in the calculation of nominal bond yields in effect means that real yields – including TIPS – are 1% lower than believed. If real yields move higher to compensate, with a constant equity risk premium, then U.S. P/E ratios would move lower. A readjustment of investor mentality in the valuation of all three of these investment categories – bonds, stocks, and real estate – would mean a downward adjustment of price of maybe 5% in bonds and perhaps 10% or more in U.S. stocks and commercial real estate.

A skeptic would wonder whether the U.S. asset-based economy can afford an appropriate repricing or the BLS was ever willing to entertain serious argument on the validity of CPI changes that differed from the rest of the world during the heyday of market-based capitalism beginning in the early 1980s. It perhaps was better to be “entertained” with the notion of artificially low inflation than to be seriously “informed.” But just as many in the global economy are refusing to mimic the American-style fixation with superficialities in favor of hard work and legitimate disclosure, investors might suddenly awake to the notion that U.S. inflation should be and in fact is closer to worldwide levels than previously thought. Foreign holders of trillions of dollars of U.S. assets are increasingly becoming price makers not price takers and in this case the price may not be right. Hmmmmm?

What are the investment ramifications? With global headline inflation now at 7% there is a need for new global investment solutions, a role that PIMCO is more than willing (and able) to provide. In this role we would suggest: 1) Treasury bonds are obviously not to be favored because of their negative (unreal) real yields. 2) U.S. TIPS, while affording headline CPI protection, risk the delusion of an artificially low inflation number as well. 3) On the other hand, commodity-based assets as well as foreign equities whose P/Es are better grounded with local CPI and nominal bond yield comparisons should be excellent candidates. 4) These assets should in turn be denominated in currencies that demonstrate authentic real growth and inflation rates, that while high, at least are credible. 5) Developing, BRIC-like economies are obvious choices for investment dollars.

Investment success depends on an ability to anticipate the herd, ride with it for a substantial period of time, and then begin to reorient portfolios for a changing world. Today’s world, including its inflation rate, is changing. Being fooled some of the time is no sin, but being fooled all of the time is intolerable. Join me in lobbying for change in U.S. leadership, the attitude of its citizenry, and (to the point of this Outlook) the market’s assumption of low relative U.S. inflation in comparison to our global competitors.

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10 Comments:

Anonymous Anonymous said...

If some white candidates preacher spoke derogatively about black people, it would matter. But if your preacher juts spouts anti-American vitriol, well that's ok and to say otherwise is to fall for a "distraction."

People aren't "distracted" about Obama. They know that him and his wife have contemptible views about America. Perhaps he can find that perfect country that has no prblems with tribalism or racism and run for President there.

This country has afforded the Obamas great opportunity, freedom, wealth & prosperity. How about they talk about THAT!

7:31 AM  
Blogger Ed H said...

Now that commodity price inflation has finally taken hold people are understanding how bogus these numbers are. John Williams over at ShadowStats.com has a great site dedicated to the bureaucratic manipulation of US economic data.

I've had a number of blogs on this topic over the past few weeks because the GDP numbers were so phony.

One about the fake GDP numbers:
http://www.creditwritedowns.com/2008/05/last-weeks-gdp-numbers.html

One about just what you're saying about CPI understating inflation:
http://www.creditwritedowns.com/2008/04/cpi-understates-inflation.html

And one that borrows from a post I saw on safehaven.com about the GDP numbers:
http://www.creditwritedowns.com/2008/05/are-governments-numbers-for-real.html

I look forward to seeing more about this. Und was mich auch interessieren wuerde ist mehr ueber Deutschlands Immobilienmarkt zu hoeren.

Gruss,

Ed H

10:05 PM  
Anonymous shtove said...

IMMO, what do you make of the latest news from UBS?

http://www.bloomberg.com/apps/news?pid=20601085&sid=aj0qqAoZHNUw

Now european toxic waste is being counted.

3:36 PM  
Blogger Ed H said...

The UBS comments are the tip of the iceberg and should worry any investor invested in the likes of HBOS, RBS, Santander or BBVA. It is Spain and the UK where the next round of writedowns are. Then you've got other ABS primary markets like Autos, Credit Cards and Commercial Real Estate.

People are so ready to say things are over when the real economy effects of slowdown and bankruptcy hasn't even been felt yet.

5:02 PM  
Blogger jmf said...

Moin Ed,

thanks for the links. Great stuff!

Moin Steve,

"UBS, in the prospectus for its 16 billion-franc rights offer, said the bank's losses on non-U.S. residential and commercial real-estate securities ``could increase in the future"

This is indeed the key message that is not being discounted at all....

@ Ed,

i have been short Santander in large part because they have exposure to the UK ( bought Abby ) and Spain. I got out at a small profit. Their exposure to Brazil is just too strong and they have almost no exposure to structured products.

They are still on my list. But they have moved way down. But if Brazil should get in some kind of trouble this would be my first choice for a short.

And i agree that we are only beginning the effects of the fallout.

It will be fun to the spin when the rebate checks are masking the weakness for the next quarter.

I must make sure not to watch CNBC during this time... :-)

I must admit that i have remotely switched them on again. Once in a while ( month... ) their guest at squawk box are worth listening. You only have to make sure you ignore the entire CNBC staff ( excluding Santelli)

10:45 PM  
Blogger jmf said...

@ Ed

"Und was mich auch interessieren wuerde ist mehr ueber Deutschlands Immobilienmarkt zu hoeren."

Compared to almost every other market it is ( thank god ) very boring :-)

The only excess we have seen were foreigners buying like mad in 06 and 07 as shown in
german commercial real estate 2006 / or how the rolling bubble effects germany
&
german commercial real estate 2006 / or how the rolling bubble effects germany / part 2


Some of them are already in big big trouble....

11:43 PM  
Blogger Ed H said...

Hey jmf,

I would definitely look at Santander and BBVA as potential shorts because of construction loans in Spain and Abbey exposure in the UK. As to Brazil, it's hard to say where that's headed as their sovereign debt was recently upgraded to investment grade, they have huge foreign currency reserves, and immense natural resources.

The question is how much can the country buck what will be a global downturn. I'm not a believer in global de-coupling. All of that makes a good argument to watch writedowns at Santander and BBVA.

I am definitely interested to see how much of the credit losses are not structured going forward because your thesis about limited exposure is what a lot of people have said about Santander in particular.

12:41 AM  
Blogger jmf said...

Moin Ed,

"I'm not a believer in global de-coupling."

Neither am I.

I also agree that there is lots of potential trouble in Santander´s balance sheet but in the meantime i think there are and especially were easier targets when you want to play the market from the short side.

12:45 AM  
Blogger Ed H said...

jmf,

Also, interesting post about short selling on John Mauldin's website:

http://www.investorsinsight.com/blogs/john_mauldins_outside_the_box/archive/2008/05/26/joining-the-dark-side-pirates-spies-and-short-sellers.aspx

12:45 AM  
Anonymous Anonymous said...

While I agree that was a "must read piece," I would disagree that Gross wrote it. One of his people did. Bill's vision is not what it once was as evidenced by his own words demanding that congress do something to shore up falling housing prices... Some of us suspect that Bill's own fund is stuck with some poorly timed MBS purchases and low-yield treasuries

7:26 AM  

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