Guest Author: Jeffrey Dow Jones is a registered investment advisor with Jones & Company which has managed a family of hedge funds for 27 years. Their flagship fund, High Sierra Partners, is currently the #1 ranked fund of funds with a track record greater than ten years in the HFN Multi-Factor Ranking Database. Jeffrey is also a partner at Draco Capital Management and publishes a free weekly investment newsletter, The Draconian. Read Part 1 and Part 3.
Now we’ll dive a little deeper in this story, and explore a few more powerfully deflationary forces working against us that not everybody is talking about.
Inflation Sturm & Drang
The first, more commonly discussed, argument has to do with our friendly Asian creditors. You see, China and Japan hold a ton – a TON – of our debt. You might be asking, “Just how much is a tonof debt?” Well, $1.4 trillion is a ton of debt. That’s how much China and Japan have loaned the U.S. We’re pretty desensitized to the word ”trillion” right now and have a hard enough time as it is wrapping our little minds around large numbers. So allow me to put it into perspective.
$1.4 trillion is $1.4 millionmillions. It’s enough to buy an iPhone, a MacBook Pro, a late 90’s Honda Civic in fair condition, and a Robot Vacuum for every single person in the U.S. Dollar bills lined up end to end would travel from here to the moon and back. Almost 350 times.
If you loaned someone $1.4 trillion dollars would you want to get paid back with dollars that were worth half as much? Would you accept 75 cents on the dollar? 95 cents? Certainly not if you could help it! So why would China or Japan?
(More detailed data on foreign creditors is available from the Treasury.)
Believe it or not, this is actually their problem, not ours. Normally, the debtor is slave to the creditor, but when the numbers get really big, it’s the other way around. It’s like that old adage “If the bank loans you $1 million, then you have a problem. If the bank loans you $100 million, then the bank has a problem.” The creditor is in serious trouble here and because it’s their trouble, they will do all that they can to keep it from getting out of hand. They’ll do what they have to in order to keep the value of the U.S. Dollar propped up.
China was talking tough against the U.S. Dollar as it was going down from March through June, threatening the pursuit of a global basket of currencies instead of the USD to serve as the world’s reserve currency. They’ve backed off with the criticism lately as the Dollar has flattened out, but the reality is that, tough talk or not, our economies are far too intertwined and far too much is at stake to follow through on any drastic threats. They can’t exactly dump their holdings of U.S. Treasuries – who on earth is going to buy $700 billion of them anyway?
There’s been plenty of talk of monetizing the debt, which is a fancy way of saying “printing new dollars to pay off existing debt.” But the side effect of that is crazy inflation. The U.S also knows that kind of inflation (and its remedies) would have nasty economic consequences i.e. much higher interest rates, much higher unemployment, and a deeper and longer recession. The scary thought is that in such a scenario, those costs could possibly be worth it.
Is China really going to stand idly by, allowing that to happen? China is neither stupid nor passive. And given the role that we each play in each other’s economic growth, there is far too much at stake on both sides to seriously consider such a simplistic and potentially risky policy of debt monetization. Like it or not, the U.S. and Chinese economies will continue to become more and more intertwined over the coming decades. The economic future of the next century depends on a harmonious relationship between the two us.
The Power of the Boomers
Since the middle of the last century, the Baby Boom generation has played a key role in shaping the face of the country. Born after the GI’s returned from the war, they were treasured and protected through the 1950’s with renewed emphasis on the nuclear family. As they grew older, their idealistic rebellion was the pulsing heart of the tumultuous 60’s, and this would turn into cynicism as young adults in aimless 1970’s. During the 80’s and 90’s, the peaks of their careers, they led the nation in a new direction, feeding the U.S. growth engine with their massive personal spending.
But now, as roughly 70 million boomers stand on the brink of retirement, they are set to shape the nation in manners both direct and indirect. Much of this change will be in the form of public policy.
It all ties into what Robertson Morrow of Clarium Capital Management elegantly describes as “The Bull Market in Politics.”
After basically two decades of laissez faire politics typified by the Reagan, Clinton, and Bush presidencies and their “hands off” approach to letting the economy and the markets do what they do, we have definitively entered a world where Uncle Sam is doing quite a bit more heavy lifting. I couldn’t imagine a more appropriate symbol of this shifting paradigm than our new commander in chief, Barack the Busy Beaver. That’s not meant as a pejorative dig, merely a statement of fact. No president since Roosevelt has been this active and aggressive with new policy as Mr. Obama, though much of that is, necessarily and unfortunately, a product of the current environment.
Look around. Semi-nationalizing companies, a wave of new regulation, a tsunami of stimulus, a rash of legislation – we’re feeling government influence in a way we haven’t in a long time. The bull market in politics has unquestionably begun. For what it’s worth, an interesting, tangential conclusion Mr. Morrow also draws is associating bear markets in politics with favorable economic climates and bull markets in politics with unfavorable or directionless economies. But that’s an adventure for another time.
“Uncle” Sam is now Captain America
Against this backdrop of heavy-handed politics and a much more “involved” government, heroically trying to stave off economic disaster, Baby Boomers might now be the most influential and powerful demographic in U.S. History.
As fresh retirees, newly reliant on fixed income, they will (and rightly should) become increasingly intolerant of inflationary policies that jeopardize their ability to maintain their quality of life. The last thing any retiree wants is an increase in prices while their income remains constant. They will turn to Captain America to keep them safe from the threat of inflation.
Any politician who wants a serious chance at entering or staying in office is going to have to cater to the Boomers, because they’re the ones with the votes. Unfortunately, policy is designed by politicians, and politicians are designed to get elected instead of making optimal policy. During the last two decades, as the boomers worked through middle age, the peak of their earning power, they would have been much more tolerant of inflationary public policy. Today? Not so much. Once again our nation will find itself a slave to the Baby Boomers’ desires.
We do still live in a Democracy, a system in which, generally speaking, the population votes itself what it wishes. Inflation represents a legitimate risk for retirees, individuals who by and large rely on a fixed asset base and fixed income that’s generated by those assets. These folks have real concerns about the Inflation Chupacabra – nightmares where a gallon of milk goes from $2 to $4 while their monthly income remains the same. Having the same amount of dollars to buy the same goods at ever higher prices is can be a little nerve-wracking. Boomers will rely on Captain America to flex his muscles and guard their interests.
From an investment management perspective, retirement is where growth of capital should completely shift to preservation of capital, and there will be little flexibility for retirees to take on the risk of growing their capital to keep up with rising prices. This time they will resort to traditional saving to fill the holes in their portfolios, finally eschewing the risk that they have embraced through the rest of their lives.
If you think that the Baby Boomers will tolerate massively inflationary policies and politicians will be able to avoid the tempting might of the Boomer vote, you are sorely mistaken.
The Bond Market Vigilantes
And lastly, do not forget about the “Bond Market Vigilantes”. Bondholders are famously afraid of inflationary policy, and large bondholders are an influential lot. Historically, when they catch a whiff of inflation or wish to protest inflationary measures, they respond by dumping bonds in the marketplace.
The problem with aggressively selling bonds in the market is that it drives down price and drives up interest rates (bond prices and yields are inversely proportional). Higher rates are a natural deterrent to inflation. The Fed and Treasury have lots of measures available to controlling rates, but ultimately rates are set in the marketplace, which is for the most part outside the government’s control. Markets are fascinating things, and their self-correcting, self-enforcing nature can be problematic to those entities that seek control it.
Captain America walks a fine line with the “Bond Vigilantes” and will require their cooperation in managing the economy.
Inflation and Deflation, Part 1: The Inflation Chupacabre by Jeffrey Dow Jones
Inflation and Deflation, Part 3: A Blueprint for Disinflation by Jeffrey Dow Jones