Bernanke Spoiling the Party: Deflation, CPI and Asset Allocation from a CPI Perspective

Markets initially interpreted the Bernanke commentary to be the first step in a tightening of policy, as stimulated by excessive US growth. However, Bernanke has effectively spoilt that party; playing the role of Peter Sellers in the movie “The Party”, although his spoiling techniques are intentional. Specifically, Bernanke has highlighted the risk of deflation in the US, as well as the fact that QE remains dependent on what is going on the US economy. With a stronger USD, high oil prices, high rates, a lack of external growth and constant fiscal drag, one wonders how the US economy will hit the Fed’s targets, even for 2013 growth. Bernanke has the same concerns. In this context, with a focus on inflation, and deflation, we preview the forthcoming CPI in Australia and the way it may well dominate the decision as to when the next Federal election may be. Finally, we reconsider asset allocation, but from the perspective of the CPI, where we look at the risk and return of two portfolios and ask “Are we being paid enough, for the risk we are taking, relative to CPI?”

In summary we consider the following three main topics:

• recent statements by Bernanke on the topic of reducing quantitative easing (QE),
• what the prospects are for the forthcoming CPI, as well as political issues that are apparent at this time, and
• reviewing two portfolio allocations, relative to CPI, so as to assess risk and return relative to CPI.

1. Fed highlights deflation

Markets were shocked by the recent Bernanke revelation regarding the onset of tapering, yet the markets seems to have missed the point entirely and the recent semi-annual testimony reminded us of the following several important points;

Gradual improvement evident ... unemployment remains unsatisfactory

Conditions in the labor market are improving gradually. The unemployment rate stood at 7.6 percent in June, about a half percentage point lower than in the months before the Federal Open Market Committee (FOMC) initiated its current asset purchase program in September. Nonfarm payroll employment has increased by an average of about 200,000 jobs per month so far this year. Despite these gains, the jobs situation is far from satisfactory, as the unemployment rate remains well above its longer-run normal level, and rates of underemployment and long term unemployment are still much too high (Statement by Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Financial Services, U.S. House of Representatives, July 17, 2013 [emphasis added], p.2, enclosed).

Fiscal drag, a topic largely forgotten, has possible downside risks,

That said, the risks remain that tight federal fiscal policy will restrain economic growth over the next few quarters by more than we currently expect, or that the debate concerning other fiscal policy issues, such as the status of the debt ceiling, will evolve in a way that could hamper the recovery. More generally, with the recovery still proceeding at only a moderate pace, the economy remains vulnerable to unanticipated shocks, including the possibility that global economic growth may be slower than currently anticipated (Statement by Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Financial Services, U.S. House of Representatives, July 17, 2013 [emphasis added], p.3, enclosed).

If the market does not hear you, then say the same thing three different ways. Hence, the three “ifs”; “ifs” that the market has chosen to ignore so far,

If the incoming data were to be broadly consistent with these projections, we anticipated that it would be appropriate to begin to moderate the monthly pace of purchases later this year. And if the subsequent data continued to confirm this pattern of ongoing economic improvement and normalizing inflation, we expected to continue to reduce the pace of purchases in measured steps through the first half of next year, ending them around midyear. At that point, if the economy had evolved along the lines we anticipated, the recovery would have gained further momentum, unemployment would be in the vicinity of 7 percent, and inflation would be moving toward our 2 percent objective (Statement by Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Financial Services, U.S. House of Representatives, July 17, 2013 [emphasis added] p.5, enclosed).

More specifically, the “ifs” are not just about growth, but inflation. Now, here is the important point, if QE withdrawal depends on increasing inflation, then one wonders what will happen, going forward, given that financial conditions have already tightened,

... if the outlook for employment were to become relatively less favorable, if inflation did not appear to be moving back toward 2 percent, or if financial conditions--which have tightened recently--were judged to be insufficiently accommodative to allow us to attain our mandated objectives, the current pace of purchases could be maintained for longer (Statement by Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Financial Services, U.S. House of Representatives, July 17, 2013 [emphasis added], 5, enclosed).

Importantly, deflation remains a potential issue, which means that rates could still go lower, though forward guidance,

Meanwhile, consumer price inflation has been running below the Committee's longer-run objective of 2 percent. The price index for personal consumption expenditures rose only 1 percent over the year ending in May. This softness reflects in part some factors that are likely to be transitory. Moreover, measures of longer-term inflation expectations have generally remained stable, which should help move inflation back up toward 2 percent. However, the Committee is certainly aware that very low inflation poses risks to economic performance--for example, by raising the real cost of capital investment--and increases the risk of outright deflation. Consequently, we will monitor this situation closely as well, and we will act as needed to ensure that inflation moves back toward our 2 percent objective over time (Statement by Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Financial Services, U.S. House of Representatives, July 17, 2013 [emphasis added], p.2, enclosed).

Now, if the US does not achieve projections by the Fed, and the economy stalls, which may result from the combination of a higher dollar, higher rates and higher oil, then QE can be increased,

Indeed, if needed, the Committee would be prepared to employ all of its tools, including an increase [in] (sic) the pace of purchases for a time, to promote a return to maximum employment in a context of price stability (Statement by Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Financial Services, U.S. House of Representatives, July 17, 2013 [emphasis added], pp.5-6, enclosed).

Also, the guidance on rates is crucial, and the thresholds mentioned by the Fed are NOT triggers; rather

Reaching one of the thresholds would not automatically result in an increase in the federal funds rate target; rather, it would lead the Committee to consider whether the outlook for the labor market, inflation and the broader economy justified such an increase (Statement by Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System, before the Committee on Financial Services, U.S. House of Representatives, July 17, 2013 [emphasis added], pp.5-6, enclosed).

2. CPI

While the release of the domestic quarterly CPI is always critical for monetary policy, the release today is important for the following reasons:

• the proximity of the election, relative to the next CPI is important, as business sentiment and, as a result, perceptions of growth, tend to rise in the aftermath of a federal election,
• the recent depreciation of the Australian currency and the anticipation that some impact on inflation might well become apparent in the CPI readings, however one would expect the impact of the lower AUD on the CPI to be lagged, as most of the depreciation happened in the last month of the June quarter,
• business survey data, which is quite reliable, tends to indicate that costs remain quite contained, over quite an extended period,
• some unofficial inflation data, like the TD-Melbourne Institute inflation gauge suggest subdued headline inflation and subdued core inflation, and
• the ongoing admission by Treasury and the RBA, that growth will be lower than trend over the immediate future.

Other data, such as the NAB monthly survey, suggests that costs are very much contained throughout the main sectors of the Australian economy.

In many ways, the CPI will be important for the calling of an election, as the calling of the election will bring a Treasury statement on the economy, where revenue estimates will be further cut and fiscal drag will be increased further, thereby increasing pressure on the RBA to cut rates. This is because additional cutting of spending by the Federal Government, will make the transition from mining, to non-mining sector growth, even more problematic.

Hence, a rate cut, in August, just before an election, as pressured by a cut in Federal spending, would provide electoral support for the incumbent. In other words, the Treasurer may well add “fuel to the rate cut fire” if the CPI is low.

On the other hand, if the CPI reading is high, the incumbent government may look for other election triggers, and may wait for the RBA to make a decision in August, before calling the election.

3. Two portfolios against inflation

Now, if inflation is such an important part of investing, and the current context is featuring the possibility of outright deflation, as Bernanke warns above, it would be very interesting to compare the annual return of two different asset allocations, to annual inflation, over a long period. Specifically, we look at the following two portfolios:

• the “equity balanced” portfolio, with 75% equities, as measured by the All Ordinaries accumulation index, and 25% of the UBS Australian Composite bonds index (0+years), whose annual return, less the annual CPI, is shown by the dark blue line in Figure 1 below, and
• the “bond balanced” portfolio, with 25% equities, as measured by the All Ordinaries accumulation index, and 75% of the UBS Australian Composite bonds index (0+years), whose annual return, less the annual CPI, is shown by the light blue line in Figure 1 below.

Figure 1

Notice how volatile the “equity balanced” portfolio is, relative to the bond portfolio. In other words, the equity portfolio generates a return stream that is volatile to the CPI, while “bond balanced” return stream is much less volatile. Now this volatility, relative to the annual CPI would be fine if it meant that one would derive adequate return for the risk taken, relative to the CPI.

However, as Figure 2 shows, the addition return, relative to the CPI is marginal, relative to the additional risk. In fact, one has to take more than eight times the annual risk on, relative to CPI, so as to generate under 1% additional return, relative to the annual CPI.

Importantly, this analysis suggests that, at least form a CPI perspective, one is just not getting paid enough to use the “equity balanced” portfolio. After 20 years without a recession, the “equity balanced” portfolio has now dominated the investment landscape, as the focus has swung from risk to return. While the Global Financial Crisis has brought the focus back to risk, investors are being lured back into equities, which keep on promising more and more dividend return. Effectively, Australian equities, especially banks, have tried to convince the investing public that they are really something they are not; that they are bonds. Equity risk needs to be more adequately priced, and that remains a certainty, not just a possibility.

Figure 2

While the analysis does not take taxation franking differentials, between equities and bond, into account, it is important to think of risk and return independent of taxation, since focussing on taxation effectively skews the entire analysis in a way that distorts underlying risk and return, relative to inflation.

Conclusion

Recent announcements by the Fed have been misinterpreted by the markets, and Chairman Bernanke “spoilt the growth party”, by clarifying some important aspects of a reduction in QE last week, where the threat of deflation is still apparent. While the markets initially interpreted the announcement as the beginning of the end for low rates, with growth to race away, Bernanke has cautioned participants, by reminding them that inflation is too low, and that deflation remains a real threat. In other words, the focus of markets is back where it should be; on inflation. As we have mentioned many times this should also be the focus for investors, as inflation either threatens capital preservation, in the case that inflation remains too high, or perceptions of growth, if inflation remains too low. If the concerns of Bernanke prove realistic, then growth perceptions will fade, along with equity returns. In this context of inflation, and possible deflation, the Australian CPI result is discussed, and can well be seen as an election trigger, in the case that it is a favourable result; lower than 0.5% for the underlying measures QOQ.

Importantly, Australia is at a crossroad, as Treasurer Bowen recently highlighted at the National Press Club; mining led growth has ended, and the non-mining sector is showing signs of growth, yet not enough, especially for the existing level of interest rates. This is the problem for the RBA, and if the RBA can jump the inflation hurdle, then a rate cut appears inevitable; possibly as early as August. Bearing all these issues in mind, as well as the focus on inflation, reviewing portfolio asset allocations from a CPI perspective would be worthwhile. Here, the problem with an equity biased portfolio is that it has poor risk characteristics, relative to Australian inflation, and relative to a bond biased portfolio. However, nominal bonds are just the first step. One can control inflation risk in the portfolio even more if one uses inflation linked bonds (ILBs). Given that so many corporate ILBs provide north of 4% above inflation, one can cut inflation risk, even more than nominal bonds, by using these securities.