Inflation: Is it different this time?

 A year ago, 10 year treasurys yielded 1.34% p.a.  After bottoming out at 0.52% in early August, it is now back up to 1.34%.  For the past 5 years or so, treasury yields fluctuated between 2% p.a. and 3% p.a.

After plunging to 0.12% in 2015, US inflation, as measured by the consumer price index, rose to 1.26% in 2016, 2.13% in 2017, 2.44% in 2018, 1.81% in 2019.  Covid-19 knocked inflation back to 0.9% in 2020.  For January 2021, inflation (CPI not seasonally adjusted) rose 0.4% over December 2020.

 Where do we go from there?  The recent rapid rise in 10 year treasury yields suggests that investors are wary of a resurging inflation.  The Federal Reserve and the Biden Administration, on the other hand, seem more concerned with too slow a recovery from the damage caused by Covid-19. Who is right?

Milton Friedman famously said that inflation is a monetary phenomenon: too much money printed resulting in an imbalance between money and output.  Dissenters will point to Japan where the government, for years, has issued massive amounts of debt and the Bank of Japan has created massive amounts of money by buying all sorts of public and private financial instruments.

The thing is that for Friedman’s proposition to work, the money that is created has to be spent.  The vast increase in money created by the Federal Reserve after the Great Recession of 2008 found its way back home in the form of bank reserves and deposits.  Likewise, much of the 2020 financial government assistance went unspent by households, boosting saving rates at one time to over 30%.

Such inclination to save and reluctance to spent have several causes: some may be purely economic such as over indebtedness and wage stagnation, demographic with aging populations, and psychological namely fear of the future.

Japan is a good example of aging population, low economic growth causing low wage growth and, for these and cultural reasons, a proclivity to save.

The US, on the other hand, seem to occupy a very different place: the population is younger (though not overly so), economic and wage growth has been higher and consumerism rather than saving has ruled the land.

Globalization has been a big factor in putting a lid on production costs and thus prices; while it is still prevalent, the US as well as other countries have somewhat cooled down to it.

Finally, the Administration is pushing another very large relief package of up to $1.9 trillion coming on top of the $900 billion stimulus approved last December, hundreds of billions of the original $4.8 trillion which have yet to be disbursed and a yet to be announced infrastructure investing program.  When these items are measured against how much more the economy could produce, it is no wonder that economist L. Summers is concerned that inflation may accelerate and that it will then be politically difficult to throttle the stimuli back.

I for one don’t know if and when excess inflation (over 1%-2%p.a.) will arise, but the creation of money is awe-inspiring, the US are nor Japan, and assets seem very richly priced, whether one looks at stocks or real estate.  Finally, when bitcoin is being preferred over gold as a store of value in uncertain times, one can worry.

 The thing about inflation is that it starts as a monetary phenomenon and becomes a psychological condition: producers raise prices, just in case, and invest only in short-term projects; consumers buy and often finance their purchases with loans; unions and investors push for indexation of wages and fixed-income instruments respectively.  Pretty soon, indexation makes it very difficult to return to normal and years of efforts are needed to overcome past fears and mistrust.

I will finish with a graphic example of brutal inflation in Brazil during the 1970s and 1980s.  The first bill is one of 100,000 cruzeiros, by then not worth much.  In 1986, the cruzeiro was replaced by the crusado in the ratio of 1000:1.  It was in circulation until 1989 when it was replaced by the crusado novo in the ratio, you guessed it, of 1000:1.  Brazil did overcome hyperinflation, but it took many years, a lot of efforts and extracted a very high cost on the population, mostly on the poor who didn’t have savings and couldn’t protect themselves.

I am not implying that the US will fall into hyperinflation, but Brazil didn’t expect it would either. 

Were the US to have an inflation rate of 5% p.a., by no means in hyper territory, the impact on the economy and our way of life would be profound: pensioners on fixed annuities would lose 25% of their purchasing power after 4-5 years; mortgage rates would likely by in the 7% p.a. range; stocks would likely lose 40% of their value.

Better not get close to it.

 

 

 

 

 

 

 

The Madness of Crowds

 

In 1841, Charles McKay wrote his famous book “Extraordinary Delusions and the Madness of Crowds”.  Its first volume dealt with economic manias and bubbles, the most famous of which, to that date, had been the Dutch tulip mania.

Manias, being born from mass human behavior, have endured as exemplified by the Internet and “eyeballs” stock craze at the turn of last century.  Over the last decade, another one has flourished and while its cost has already been high, we likely haven’t paid the full bill yet.  I am talking about stock buybacks.

This mania is insidious and rarely makes headlines: after all, it is easier to laugh at hapless retail investors riding the latest wave of euphoria for Covid-19-proof stocks or for cloud-centric IPOs.  Large companies are managed by cooler heads, have carefully crafted operating procedures and vigilant boards of directors to rein in overly optimistic CEOs, or do they?

The truth is many companies have bought back their stock, and over the last 30 years, those that did have seen, in the aggregate, their share price perform better than those that didn’t.  In part, this is explained by the fact that the better companies generate more cashflows (with which to buyback shares) and their better share performance also reflects their better businesses.

The stock buyback movement has accelerated over the years.  While the ratio of buyback value to market (S&P500) hasn’t changed much since 2004 at around 3% p.a., the timing of these buybacks has been poor: companies backed the truck as market indices soared (see below) but stepped back when valuations were attractive. 

Furthermore, more and more buybacks are funded by debt as opposed to free cashflows (see below).

 

The table below maps the trends in shares outstanding (in millions)/long-term debt outstanding (in billions of US$)/net worth (in billions of US$) for a cross section of US blue-chips.

	2010	2012	2014	2016	2020 (e)
American Airlines			697/16.2/2	461/22.5/3.8	515/30/(4.5)
Boeing	735/11.5/2.8	756/9/5.9	707/8.1/8.7	617/9.6/0.8	566/60/(13)
Corning	1,561/2.3/19.4	1,470/3.4/21.5	1,271/3.2/21.6	926/3.6/17.9	761/7.5/13.3
Emerson Electric	753/2.5/9.8	724/3/10.3	697/2.4/10.1	643/1.9/7.6	595/1.2/8.5
McDonald	1,054/11.5/14.6	1,003/13.6/15.3	963/15/12.9	819/25.9/(2.2)	744/35/(10.5)
Microsoft	8,668/4.9/46.2	8,381/10.7/66.4	8,239/20.6/89.8	7,808/40.8/72	7,571/59.6/118.3
Regeneron	87/0/0.5	95/0.3/1.2	102/0.1/2.5	106/0.4/4.5	105/0.7/12

 

Source: Valueline.

 

The above table deserves a few comments.  First, shares outstanding reflect the issuance of new shares and corporate buybacks, so that annual buybacks are generally higher than the difference in year-end outstandings.  Second, the table shows long-term debt outstandings with no mention of cash holdings which reduce net debt levels.

As to the companies listed: American Airlines filed for Chapter XI in December of 2011 and emerged from bankruptcy in December of 2013.  Nevertheless, in 3 years (2014-2016) it repurchased at least 1/3 of its common shares outstanding and despite generating an aggregate of $13 billion in earnings and $17 billion in cashflows, it increased it long-term debt by 39% or $6.3 billion.

On the surface, although Boeing share count was reduced by 16% through 2016 and 41% through 2019, the company seemed to have acted reasonably since its long-term debt actually decreased over the 2010-2016.  Not so.  By the end of 2019, debt had risen by 73% from 2010 levels, and by the end of 2020 it is expected to rise another 200%!  Worse, to support its massive share buybacks and the payment of dividends, the company diverted funds which normally would go to investments in new products and manufacturing excellence.

This is apparent in the table below.  Over the 2016-18 period, Boeing used 88% of its cashflows to buyback stocks and pay dividends, leaving very little for productive investments.

 

Boeing	Cashflow from Operations	Dividends + Stock Buybacks	End of Year Cash	Cumulative use of cashflows for dividends and buybacks
2016	$10.5 bn	($9.4 bn)		($9.4 bn)
2017	$13.3 bn	($12.3 bn)		($21.7 bn)
2018	$15.3 bn	($12.8 bn)		($34.5 bn)
2019 Q1.[1]			$6.8 bn

McDonald pushed the envelope even further, spending 158% of its operating cashflows on dividends and buybacks over the 2016-2018 period.   From 2010 to 2020, its share count will have dropped by 29% and its long-term debt will have tripled!  It almost paid the price when Covid-19 wrecked financial markets this last March.  Had the Fed not injected trillions in liquidity, McDonald could have faced real difficulties.  Unlike Boeing though, its capital investment needs follow a shorter cycle and are more discretionary in nature.

 

McDonald	Cashflow from Operations	Dividends + Stock Buybacks	End of Year Cash	Cumulative use of cashflows for dividends and buybacks
2016	$6.3 bn	($14.2 bn)		($14.2 bn)
2017	$5.8 bn	($7.8 bn)		($22 bn)
2018	$7.2 bn	($8.5 bn)	$2.7 bn	($30.5 bn)

Microsoft on the other hand is one of the few companies which could afford large buybacks yet did them in a measured way (12% over the 2016-2020 period); its net worth more than doubled, unlike the others which shrank.  Finally, while its long-term debt grew exponentially to $60 billion, it held $134 billion in cash on 6/30/19.

 

Microsoft	Cashflow from Operations	Dividends + Stock Buybacks	End of Year Cash	Cumulative use of cashflows for dividends and buybacks
2017	$39.5 bn	($22.8 bn)		($22.8 bn)
2018	$43.8 bn	($22.4 bn)		($45.2 bn)
2019[2]	$52.2 bn	($32.2 bn)	$133.8 bn	($77.4 bn)

Last, but not least in the first table, is Regeneron, a biotech company which has famously focused on R&D and been dismissive of short-term move in its stock prices.  This strategy has probably impacted its market valuation, but rock-solid financials allowed Regeneron to sail through the recent crisis and to keep putting money where it has great expertise, i.e. the discovery of new drugs[3].

This buyback mania is dangerous in many ways.  First, it represents an apparently easy and safe way to boost financial results by reducing the number of shares outstanding and boosting earnings per share.  The problem is that this fix is difficult to abandon once used a few times.

It reinforces management’s focus on short term results, with the danger that a transparent result-booster like buybacks may incentivize management to look for other financial performance levers in accounting, purchasing, etc. which can become questionable.

Another problem with buybacks is that they tend to detract management from an essential responsibility, that of assessing the risk-reward of long-term investment decisions and making such decisions.  This was, I believe, an issue with Boeing and its 737 Max: massive stock buybacks funded by starving new product development provided immediate financial benefits while the development of a new airplane was fraught with risks (even if these risks were in a field where Boeing was an expert and world leader).

Besides diverting funds, excessive reliance on buybacks eventually affect a company culture: short-termism, avoidance of risks and eventually responsibilities.  Once this sets in, reforming a corporate culture can take very long and be quite disruptive: bringing in a new CEO from outside is easy, changing the rest of senior management takes time, can be operationally costly and doesn’t insure that lower rank employees will trust, accept or understand what is now expected from them.

Extremely low interest rates have been a huge factor in this buyback mania.  As they remain low, companies pile on debt which they can easily service.  But even if interest rates don’t rise any time soon, these last few months have shown that a sudden crisis can abruptly zap fixed-income investors’ appetite for anything but risk-free US treasurys.

The smartest financial minds can’t successfully time their buybacks.  Last year, Liberty Global tendered for $2.5 billion of its own shares, repurchasing them at around $27. The stock price never reached that level since and stands at $20.50 today.  During the first quarter of this year, Liberty bought back $500 million at around $16.50 per share.  $3 billion in buybacks which, so far, have been value destructive.

For the foreseeable future, the Fed seems able and willing to cast a wide safety net.  But the draw of near-zero interest rates is still alive, as is the desire to beat short-term earnings per share expectations.  Caveat emptor.

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[1] Last trimester before the massive raising of fresh funds due to the problems of the 737 Max.

[2] Fiscal year ends in June.

[3]  In the interest of disclosure, I own shares in Microsoft and Boeing.