In John Mauldin’s Investor’s Insight newsletter this week (June 9th), Bill Gross of PIMCO takes a broadside at American inattention to its own economic house and fully describes what many of us know. The US Consumer Price Index (CPI) understates inflation. By about one percent per year. A year here, a percent there, and soon you are talking real money lost.
FAT, DRUNK AND STUPID IS NO WAY TO GO THROUGH LIFE.
Bill Gross sets the tone early:
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.
AMERICAN EXCEPTIONALISM DOESN’T REALLY MEAN EXCEPTIONALLY LOW AMERICAN INFLATION.
Gross first notes that for the last ten years, world inflation has measured about 7% annually. US inflation, by contrast, has run about 2.6%. How does the US do it, especially when the dollar has declined about 30% against a market basket of world currencies.
Simple. The US cooks the inflation books. The Author has noted this fact in prior posts.
Here is how the CPI understates inflation:
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 10years 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.
BOND INVESTORS TAKE NOTE. UNDERSTATING INFLATION MAY ROB YOUR RETURNS.
Gross also notes that the CPI’s understatement of inflation camoflages lower nominal bond returns. 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.
Stock investors could also be hoodwinked:
[T]oday'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.
SO WHAT THEN IS TO BE DONE? LOOK FAR AND WIDE.
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(Brazil, Russia, India, China) -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 (AUTHOR’S NOTE: IS GROSS REFERRING TO BARACK OBAMA?), 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.
IT MAY NEVER RAIN IN CALIFORNIA, BUT SOMETIMES IT POORS IN THE DESERT OF THE REAL!
