Given the scarcity of posts on our Board over the past week (although the topic "Bin Laden and REITs" seems to have been a very popular thread), I thought I'd add a post that covers the all-important topic of inflation. The answer to the inflation riddle will certainly have an impact upon prices of both REIT commons and preferreds. This is not a post I created today; rather it's a copy and paste of a blog post I added to SNL over a month ago. I apologize for it not being "fresh," but suspect that most of us don't have the tens of thousands of dollars to subscribe to SNL's regular full services.Let me know if you just want only fresh material, and I won't bother you with these kinds of posts in future. Thanks. OK, see below.RalphProspects for economies and financial markets are always uncertain, but it seems that no two economists or market strategists can agree on anything these days. Some of the many shrill voices emanating from our Tower of Babel concern inflation. Certainly food, oil and other necessary commodities have been rising rapidly of late – but is this a portent of a near-term rapidly accelerating pace of inflation, or just a temporary blip that will fade as quickly as Charlie Sheen’s popularity? Getting the inflation answer right could have very significant consequences for investment portfolios.Let’s consider the views of just two well-known personages. Chairman Ben has been claiming that the current spike in prices is temporary and limited. On March 1 he told Congress not to worry, saying, "The most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in U.S. consumer price inflation." On the other hand, Bill Gross and his Pimco organization seem to be more concerned. According to Bloomberg, Pimco’s “Total Return fund [recently] had a negative 3% of its assets in government and related debt,” suggesting that Mr. Gross is a bit spooked about future rates of inflation. Indeed, Mr. Gross recently told CNBC that Mr. Bernanke is being naïve in thinking that inflation will revert back to the mean. Who is right?Being no economist, I certainly don’t know (assuming being one would help me with the right answer – a very dubious assumption). However, it seems to me that an uncomfortably high and sustained rate of inflation, i.e., anything over 2-3%, would depend upon at least three key factors: (a) persistently rising employment costs, (b) the ability of purveyors of goods and services to pass along cost increases to customers, and (c) a significant and persistent devaluation of the US dollar relative to the currencies of our trading partners. And, I would argue, the inflationists will have a difficult time convincing me that any of those factors are present these days. Consider:Employment is improving, but only slowly and grudgingly, and meaningful wage and benefit increases in most sectors of the US economy are almost as scarce as long-term investors. Pricing power for most businesses is conspicuous by its absence – just ask the producers of steel or household goods how easy it is to pass along cost increases. Few clothing retailers are confident of being able to raise prices by 4-5% despite rapidly rising materials costs. And, while the US dollar has been weak recently, short-term currency fluctuations cannot easily extrapolated into longer-term trends; Europe, Asia and Latin America each have their own problems that are likely to put a floor under the US dollar – particularly if Congress decides to get real about reining in our massive budget deficits.There are also a few other reasons why I don’t think inflation will gallop ahead here in the US. There is still excess manufacturing (and even service) capacity everywhere, and inflation is often the effect of the opposite situation; even lawyers and dentists are having a hard time finding jobs these days. Also, rising food, oil and other commodities prices are equivalent to stealth tax increases that will sap consumer purchasing power and make it even tougher for sellers to wield pricing power. Note, too, that investors and traders in many commodities are refusing to dance the contango, e.g., yesterday July 2011 Brent Crude was quoted at $120.53, but July 2012 Brent Crude was quoted at $115.73. And the Wall Street Journal, on Tuesday, noted that money growth, as evidenced by “M2,” often a key to inflation, has been quite subdued despite improvements in the US economy.So, while I – like everyone else – am watching the inflation picture carefully, I am skeptical that the current inflation buzz will be more than a typical concern du jour. But, to quote Bill O’Reilly, of course I could be wrong. Let’s proceed then, to briefly consider how our REIT stocks might react to a sustained period of above-normal inflation. There is a surprising dearth of studies on how inflation affects the owners of commercial real estate, and I believe that it is gross oversimplification to claim that inflation always benefits these owners. One academic paper that caught my eye recently was penned by David J. Hartzell, Professor of Real Estate at the University of North Carolina, along with R. Brian Webb. They concluded that commercial real estate owners’ returns tend to exhibit stronger relationships with inflation and its components during periods of low vacancy rates. If this historical correlation persists into the future, a reasonable expectation would be that inflation can benefit real estate owners – but only if property markets are relatively firm.This is quite logical. If inflation accompanies a healthy and growing US economy, several benefits may accrue to the owners of commercial buildings. They will have pricing power with their existing and prospective tenants, due to strong occupancy rates, which improve property cash flows. By making new projects more expensive due to rising land prices and building costs, inflation will deter new competing product – or, at the least, give owners some pricing protection for the rents they seek to charge to users of their existing space. And higher land values would likely boost the prices of commercial real estate generally, and increase replacement cost. Retail real estate owners, in particular, would benefit by higher tenant sales in an inflationary environment.But there are countervailing factors. Once it becomes evident – if it does – that significant inflation has arrived, interest rates will rise. This could slow the US economy and dump cold water on our space markets, making it more difficult for owners to exert rental rate pricing power. Rising interest rates and the threat of an economic slowdown will tend to push up cap rates, and weaken commercial real estate values. Consumers will reduce spending, causing retailers to push back hard against increases in retail rental rates. Even a recession could result if interest rates rise too much and too quickly.The bottom line here is that economies and markets are extremely complicated; some have even applied Chaos Theory to the functioning of financial markets, and there is merit in some of their arguments. The world is just too complex and interdependent for anyone to be able to predict, with any accuracy, where inflation will go and how it will affect investors in various asset classes. The irony is that getting the Big Picture right will have a much greater impact upon investment returns than figuring out which stock or property to buy or sell. So we are left with making our humble forecasts and taking the leap of faith that they are somewhat accurate – or at least more accurate than the next guy’s. Here are mine: (1) commodity inflation today is worrisome but transitory; (2) the “new normal” economy will be with us for another couple of years as debt continues to be liquidated, while excess capacity, high unemployment, and budget cutting and other headwinds keep economic growth below normal and limit pricing power; (3) our space markets will continue to recover, but slowly, and NOI growth will remain modest in most sectors for at least the next two years; and (4) under these circumstances, quality commercial properties – but not junk – will trade at low cap rates and provide historically modest (albeit acceptable) internal rates of return. That’s my story and I’m stickin’ to it.
This is not a post I created today; rather it's a copy and paste of a blog post I added to SNL over a month ago. I apologize for it not being "fresh," but suspect that most of us don't have the tens of thousands of dollars to subscribe to SNL's regular full services.Let me know if you just want only fresh material, and I won't bother you with these kinds of posts in future.Ralph,Fresh, day old or month old, please continue to enlighten us. Frankly a lot of what you say is over my head, but your last paragraph helped cut through some of my dense fog.
Ralph,Even your older posts are well worth reading so keep at it.My view on inflation is nowheres near as sanguine as yours. We are now in competition with much more of humanity for natural resources. We will likely continue to see the purchasing power of many foreigners increase while here at home it will stagnate or decrease. Prices of imports and commodities are likely to trend upward while wages remain flat.Respectfully,Martin
Ralph,You haven't mentioned Sammy lately. How's he doing?Bill
Martin,"My view on inflation is nowheres near as sanguine as yours. We are now in competition with much more of humanity for natural resources. We will likely continue to see the purchasing power of many foreigners increase while here at home it will stagnate or decrease. Prices of imports and commodities are likely to trend upward while wages remain flat."Unfortunately, I agree. I say "unfortunately" as I contemplate the economic situation that seems to be forthcoming in the U.S. And the political band plays on in Washington and throughout the states with little to give us comfort.I think I'll keep a substantial %age of my investments focused on the global community.Bill
I agree. Krugman put up a series of graphs that are relevant here. First, year-over-year percent change in CPI over time (in other words, inflation at various points in time):http://graphics8.nytimes.com/images/2011/05/14/opinion/05141...Interesting point he makes with this is we've been as high as 4.7% annual rate on the CPI as recently as 2005 and there was no hysteria about inflation running rampant. The inflationistas are jumpy about inflation now (a) because there is a Democrate in the White House and (b) because there has been a big increase in the monetary base and their simple-minded economic models says that a rapid increase in high-powered money must portend inflation.Then comes percent change in commodity prices:http://graphics8.nytimes.com/images/2011/05/14/opinion/05141...and the interesting thing there is it shows (a) we've seen comparable bursts of commodity price rises in the past decade without it portending runaway inflation but again, the inflationistas are jumpy for the reasons given above. Also, it shows the big rate of increase in the recent past is rebound from the commodity deflation from the recession. Remember when commodity inflation was minus 60% per annum just a couple of years ago? Returning to previous levels of prices had to involve a period of rising commodity prices. That doesn't mean it continues at that rate ad infinitum. It's a rebound.Lastly we have inflation expectations against time as measured by the 10 year conventional t-bond yield minus the 10-year TIP yield (excluding its inflation adjustment)http://graphics8.nytimes.com/images/2011/05/13/opinion/05131...And it shows inflation expectations as indicated by the bond market are quite tame and trending downward.This very tame inflation situation has confounded the consensus on the right that big deficits and/or big increases in the monetary base MUST lead to runaway inflation. But will there be any change in their ideology on this subject or is it impervious to being changed by factual experience? Conventional economic models say sometimes fiscal and monetary stimulus lead to inflation and sometimes they don't. It depends on the balance between aggregate demand and aggregate supply. Since we are well below our supply potential, monetary and fiscal stimulus are consistent with tame inflation. That's what conventional textbook economic models predicted and that's what we have seen so far.
Another good chart, showing the complete lack of relationship between the rate of growth of M1 and the inflation rate, going back decades:http://research.stlouisfed.org/fred2/graph/fredgraph.png?&am...You could do similar charts for the monetary base if you want to go narrower and for M2 etc if you want to go broader. The relationship just isn't there. But the ideology lives on.
Being able NOT to succumb to the ideology of the inflationistas has allowed for a multi-year magnificent dividend play in the amreits like AGNC, HTS, ANH, etc. And it's still continues as the spread is likely to continue for this year into next. Ideology, economic or political, is injurious to your investment health.
<<Ralph,Even your older posts are well worth reading so keep at it.My view on inflation is nowheres near as sanguine as yours. We are now in competition with much more of humanity for natural resources. We will likely continue to see the purchasing power of many foreigners increase while here at home it will stagnate or decrease. Prices of imports and commodities are likely to trend upward while wages remain flat.Respectfully,Martin >>Assuming continued expansion, I think your prediction is correct regarding commodities, import prices and wages, but not your anxiety about this leading to serious inflation. If wages remain flat, while productivity continues to advance then unit labor costs are declining. That's a big anti-inflation force. If wages remain flat, then exporters who rely on selling in the US, the biggest market in the world, will be restrained in how much they can raise prices. And yes, if the emerging economies continue to grow, commodities will trend upward, but their share in the overall market basket of things we buy is not so great as to produce serious general inflation in the face of declining unit labor costs. Even in a zero inflation world, some prices go up. Others go down or remain flat. Inflation or not depends on the average.Lastly, never leave out the policy response in formulating an economic prediction. If we had serious sustained inflation, the Fed would create a recession, putting an end to it. There is no evidence of the Fed going soft on inflation.Jim
jdb52 wrote <<Being able NOT to succumb to the ideology of the inflationistas has allowed for a multi-year magnificent dividend play in the amreits like AGNC, HTS, ANH, etc>>But don't forget in recent years the price of gold has gone up. So have my preferreds though not as much as some of the other asset classes. I expected to see signs of inflation by now but didn't have the courage to invest in gold. Even though I was wrong about inflation, I did OK with my preferreds. Almost all assets classes went down in the crash and many of the classes that crashed have recovered including preferreds so I cannot claim to be a genius. BTW, I think gold is overvalued now for reason's I won't go into.Looking forward, I ask my self what is the probability that the yield on ten year treasuries will (1) increase .4 percent or more, (2) decrease .4 percent or more or (3) stay within + or - the present level. If I guess one of the alternatives, which alternative will be more painful if the guess is incorrect? By painful I mean how much the wrong guess might affect my life style and/or peace of mind significantly. In other words what is my tolerance for risk? For me, being wrong would be most painful if I guess 1 and am wrong.That's one of factors I use when investing. Others may have different strategies based that fit their needs.Comments, corrections, and bricks welcomeRespectfullyklee12
klee12 It does seem to me that the risk equation for the amreits and inflation is getting a little closer to home in terms of loss. But, I do think there's more time for continued dividends and the possibility of riding the upcycle all the way thru is possibile with resulting recovery of share price at stabilization and still good, though lowered dividends, when the inflation storm has settled. But, it bears very close watch. If I think this inflation bronco can be handled, I will probably sell half of my amreits and ride the rest, just for fun and experience. Maybe???But, as you said, much of this is personal tolerance for risk. There's this principle that seems to be in operation, We fear the things that caused losses in the recent past but history doesn't quite repeat that way.
As an agnostic as to inflation, I can't predict it so therefore I will prepare for it happening as well as prepare for it not happening. I have heard slightly different theories on the causes of inflation from it is pure money supply to "too much money chasing too few goods". Since in the 1990's I personally saw some funky declining supply caused inflation in places like the Bosnia/Kosovo, Rwanda/Burundi, and parts of the former USSR, I lean more to the "too much money chasing too few goods" viewpoint. I found Jim's comment that a low capacity utilization could offset a rising money supply insightful, but..................................are we focusing too much on just the U.S.. What about worldwide consumption versus capacity? Worldwide labor utilization? While the world economy has probably not become one universal economy yet, the world economy does seem to be becoming more unified.
klee12Don't be disheartened. I've been expecting runaway inflation since 2001.brucedoe
When you look closely at everything from airplane accidents to car accidents to economic accidents you'll often see that the accident didn't occur because of a single factor.Many times preexisting flaws and defects (often in place for years, even decades) come together with some happenstance at just the wrong time resulting in catastrophe.There are too many moving parts to accurately predict where and when the wrong combination will occur. Our global financial system is robbing Peter to pay Paul while picking Pablo's pocket. Sooner or later a Black Swan will fly into the propjet. Desert (Gold is the currency of kings, silver is the currency of gentlemen, barter is the currency of peasants -- but debt is the currency of slaves.) Dave
nut say, "However, it seems to me that an uncomfortably high and sustained rate of inflation, i.e., anything over 2-3%, would depend upon at least three key factors: (a) persistently rising employment costs, (b) the ability of purveyors of goods and services to pass along cost increases to customers, and (c) a significant and persistent devaluation of the US dollar relative to the currencies of our trading partners."(a) No way in the USA, (b) Not in China, it's illegal there, but what costs incurred in China that a company can't pass along in China they're free to make up for with increases in the USA, (c) How many years has the dollar been devaluing already? Reitnut concludes, "Here are mine: (1) commodity inflation today is worrisome but transitory; (2) the “new normal” economy will be with us for another couple of years as debt continues to be liquidated, while excess capacity, high unemployment, and budget cutting and other headwinds keep economic growth below normal and limit pricing power; (3) our space markets will continue to recover, but slowly, and NOI growth will remain modest in most sectors for at least the next two years; and (4) under these circumstances, quality commercial properties – but not junk – will trade at low cap rates and provide historically modest (albeit acceptable) internal rates of return. That’s my story and I’m stickin’ to it."(1) Ben thinks deflation is not as transitory. Deflation is more worrisome. (2) I'd wager, without hesitation, more than a "couple of years." (3) Maybe if there's a QE3 or a QE2.5 that others are predicting. Without the fed who's going to be buying Treas? China has been buying less each month for the last five months. (4) Even quality could come up junk in the high default risk states like California, Illinois, New Jersey, and New York. I think that the only hope for acceptable rates of return will be returns measured in other than nominal dollars.
Ralph,You haven't mentioned Sammy lately. How's he doing?Bill, thanks for asking about Sammy. At 11 1/2 years, he is beginning to show his age. He has kidney disease, and thus must be on a no-protein diet, which he's not thrilled about. We add a bit of pasta to his dinner at times, even a bit of vanilla ice cream, which he very much appreciates and helps him to eat the less than tasty food. And, he has some arthritis in his back legs, so his walks are limited to 15 minutes per day (he also has a bit of trouble getting up some stairs - fortunately we have a single-story home).But, Sammy's overall quality of life is good, and he enjoys his days while sleeping more. Our objective, for him and ourselves, is to "age gracefully." Ralph
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