Why Generating Inflation Is So Important

Hands holding a piggy bank and a house model
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What can you say? It’s all good!

On Friday, US non-farm payrolls data came in stronger than expected, with 225,000 jobs created for the month of July. Combined with positive revisions for the past two months, average employment growth for the three-month period was 190,000.

This is healthy, but probably not healthy enough to see Janet Yellen at the US Federal Reserve move any closer to an interest rate rise.

In fact, it poses only more questions about the real health of the US economy. That’s because, just a few weeks ago, second quarter economic growth data showed the US economy to be growing at a very slow pace of around 1%.

The employment data doesn’t exactly square with the economic growth numbers.

This is good news for the market. They see it as a reason for the Fed to remain dazed and confused for a little longer, while keeping rates on hold in the meantime.

The Fed’s narrative is that the next move on rates is ‘data dependent’. This is perfect for the bulls in a slow growth economy because there will always be data that gives the Fed an excuse to do nothing. They will only raise rates if there is unequivocal evidence of a strong economic expansion getting underway.

In a global economy weighed down by excessive debt, such an outcome is very unlikely indeed.

This is why stocks in the US broke out to new all-time highs on the news.

Think about it this way. The global economy is akin to a company balance sheet. And this company is highly leveraged. That is, it has a lot of debt, and not too much equity.

Economic growth is the equivalent of earnings growth. Except you don’t focus on ‘real’ (inflation adjusted) economic growth. Nominal economic growth is the important statistic. Nominal growth equals real growth plus inflation.

So in this example, nominal economic growth equates to profit growth and, as long as it is semi-decent, in a highly leveraged company (economy) the equity component will do very well.

Stock markets are the equity component of the global economy. And while nominal economic growth is strong enough to boost equity values, but not strong enough to increase the cost of carrying the huge debt pile, all is well.

Bill Gross, head of Janus Capital Group, writes about nominal economic growth in his latest outlook:

Almost all assets are a bet on growth and inflation (hopefully real growth) but in its absence at least nominal growth with some inflation. The reason nominal growth is critical is that it allows a country, company or individual to service their debts with increasing income, allocating a portion to interest expense and another portion to theoretical or practical principal repayment via a sinking fund. Without the latter, a credit-based economy ultimately devolves into Ponzi finance, and at some point implodes. Watch nominal GDP growth. In the U.S. 4-% is necessary, in Euroland 3–4%, in Japan 2–3%.

According to forecasts from the OECD, nominal economic growth for 2017 will hit 4.3% in the US, 2.2% in Japan, and 3%, 2.1% and 2.3% in Germany, France and Italy respectively.

Comparing those forecasts to Gross’ numbers, you can see why Europe and Japan are going hard on the quantitative easing front, in an attempt to create inflation (which boosts nominal economic growth).

Both economies are perilously close to slipping below the nominal economic growth threshold that will see debt servicing costs absorb what little growth there is. This leaves nothing left over for equity…and, at this point, stock markets would start to fall.

The US achieved nominal growth of only 3.5% and 3.3% in 2015 and 2016 respectively. This is probably why the stock market treaded water for about a year, with some large corrections experienced in-between.

It’s only thanks to the Fed keeping interest rates on hold again — with an expectation that they will do more to boost nominal economic growth if need be — that the market is rallying to new highs.

And if inflation takes hold and pushes nominal economic growth even higher, then stocks can continue to rise. By the way, whether inflation picks up this year or next doesn’t matter; I think it eventually will, and I believe it will then get out of hand.

Central bankers’ sole purpose is to create inflation. If it doesn’t work with QE, they will try something else. That’s why I think betting on a market collapse is a low-probability bet. Falling stocks imply rising currency values.

The stock market will only collapse when inflation gets out of hand and central banks belatedly try to raise interest rates quickly to bring things under control.

It could be years before that happens…

Either way, Bill Gross is worried. In asking what investors are to do in such an environment, he says:

In this high risk/low return world, the obvious answer is to reduce risk and accept lower than historical returns. But don’t you have to put your money somewhere? Yes, of course, except markets offer little in the way of double digit returns. Negative returns and principal losses in many asset categories are increasingly possible unless nominal growth rates reach acceptable levels. I don’t like bonds; I don’t like most stocks; I don’t like private equity. Real assets such as land, gold, and tangible plant and equipment at a discount are favored asset categories.

I like gold, too. If you’re interested in picking up some quality gold producers during this correction, go here.

Regards,

Greg Canavan,
For The Daily Reckoning

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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