AUSTIN, TEXAS. Future inflation is a given. You can’t have a government borrowing $2 trillion and not have significant inflation follow. That’s what everyone believes.
Well, just about everyone. As I’ve reported before, economist Lacy Hunt and portfolio manager Van Hoisington beg to differ. That’s why I’ve flown to Austin--- to get a good dose of contrarian view.
“Irving Fisher saw it first. The man who may have been the greatest American economist wrote about the debt-deflation theory of the Great Depression in 1933. He saw that excess debt controls nearly all the economic variables,” Hunt said in a recent interview.
“Think about that for a minute. It’s a very powerful statement--- excess debt controls nearly all the economic variables.”
It means, he explained, that government stimulus won’t do much. Basically, you can’t borrow your way out of excess debt. “The only thing that will allow recovery is the passage of time,” he said.
An economic historian by inclination, Hunt sees a broad sweep. “Our periods of debt all start with great ideas. Growth in 1818, for instance, started with the building of the Erie Canal.
“But good ideas are always taken too far.” He pointed to a pattern all of us have seen--- the first innovator brings change and great productivity, but the second and third wave don’t do as well. The “Me-too” investors never do. After that, further expansion goes into what he calls “Ponzi finance,” an eager investment boom in which large sums of money will be lost, not made.
Our economic history, Hunt points out, is filled with periods of change and overinvestment--- canals, railroads, steamships, electrification, automobiles. Not to mention personal computers, the World Wide Web and optical cables for the Internet.
“Today there are no unleveraged components in our economy. The banks don’t have the capacity to take further risks,” he observes. He tells me that just growing the supply of money doesn’t create economic activity. The money has to be in motion, too. Pointing to the basic equation for economic activity--- GDP equals Money times Velocity of Money--- he says that unless we keep the money moving (velocity), the economy can shrink even as the supply of money increases. And if the economy can shrink, so can prices.
That is exactly what has been happening in the last 18 months--- the supply of money is growing, but the velocity of money has decreased and deflation fear is back.
When I ask him to explain why we won’t see future inflation he lists the factors.
“When you have major debt events, it changes our behavior for a long time. We’ve had a record decline in wealth. But the income effects are far larger. Payrolls have seen the largest drop since 1948. We’re at a six-decade low in factory utilization. The output gap (the difference between what we could produce and what we are actually producing) is the largest in history.”
That means rising demand, if it occurs, won’t cause rising prices.
What does it mean for the future?
“In the aftermath of a period of extreme overindebtedness, you don’t get paid for taking risk. The more significant the fiscal policy intervention, the more negative the risk premium (for equities). The more government borrows, the worse it is for the private sector. You can’t see this up close. You get false springs.
“Basically, we’re in a prolonged period of (economic) underperformance,” he said. “I think we’ll see the low in interest rates five or ten years down the road. It will essentially be a lost decade.”
Could anything change that dim forecast?
“Yes. A major technological breakthrough could do it. I don’t know what it would be, but we can’t go back to subprime loans.
“We will recover, but the operative factor will be time, not actions. That’s not something people want to hear.”
One implication is that bonds may continue to provide higher returns than stocks--- just as they have for the last 15- and 20-year periods.
Owning Bonds May Not Be Bad for Your Financial Health
While investing over very long time periods shows that stocks provide higher returns than bonds, there are also long periods during which bonds provide higher returns than stocks. We are in such a period now. Over the last 20 years, a broad index of bonds has run neck and neck with a broad index of stocks. Over the last 15 years, bond investors have actually done better.
Will this continue?
Economist Lacy Hunt thinks so, at least for another five years.
Others argue that you can’t drive a car by looking in the rearview mirror, that the long period of good bond performance relative to stocks is simply the reflection of a long secular decline in interest rates, a decline that will soon end.
Revenge of the Bond Holders
This table compares the 15- and 20-year performance of the legendary and largest bond fund, PIMCO Total Return, with the performance of both the Vanguard 500 Index fund and Wasatch-Hoisington U.S. Treasury fund. Note that both bond funds beat the broad index of common stocks over both time periods. Hoisington Investment Management manages fixed income investments for major institutions.
|Fund||Asset Class||15-year annualized return||20-year annualized return||Assets in fund|
|Wasatch-Hoisington U.S. Treasury||Fixed Income Long Government||8.11percent||8.28 percent||$147 million|
|PIMCO Total Return||Fixed Income
|Vanguard 500 Index||Large Blend Domestic Equity||6.38||7.53||$73.3 billion|
|Source: Morningstar Principia, 4/30/09 data|
On the web:
Earlier column interviews with Lacy Hunt & archive of Hoisington Management Quarterly Reviews