The cure for low prices is low prices

One of the reasons prognosticators like me who predicted inflation would flow from 2008-09 government easing policies were wrong is that we did not pick that low interest rates would boost investment to increase capacity in many sectors. So that supply of goods would rise faster than demand, and prices fall. By 2015 the reason for our mistake had become clear. Meanwhile, in that period, private citizens, seared by falls in their wealth after 2008, constrained by more restrictive banking policies, and already loaded with debt, did not use low interest rates to increase borrowing in the same way the corporate sector has. As a result, demand for consumption goods did not increase as much as supply. In an extreme example of this behaviour Japanese consumers, goaded to consume more by years of low interest rates and supposedly stimulative government deficits, looked at the policy settings, concluded they looked terrifying, and proceeded to save almost every cent of the printed money the government and BOJ would have liked them to spend.

Therefore, in a deflationary policy failure that started in Japan and spread elsewhere, “stimulation” of the economy by government primarily led to less efficiency (more zombie companies), and to supply of consumption goods increasing faster than demand – hence deflation.

Of course, globalisation and new technologies also contributed to supply. Although this was somewhat offset by static growth in factor productivity in many economies – itself arguably a consequence of low interest rates providing life support to zombie companies.

Anyway, as is well known, in the years after the government support and QE programs of 2008 (which were extended when QE was launched after 2009), prices of many goods did not rise. Indeed, in many sectors (oil, dairy, coal, minerals, silicon chips), outright price deflation occurred – at least for a time.

In fact, in defence of the many policy analysts, central bankers and prognosticators (like me) who got this wrong, nobody had ever before witnessed, or experimented with anything like the global injection of government money we saw after 2010, so we should have expected that the outcomes would be hard to model. But few of us back then predicted or modelled the massive “skew” in the impact of QE. Under the stimulus of QE (and a gradual resumption of confidence after 2008-9) investment goods, such as commercial property and shares in income generating stocks, approximately doubled in value in the past 8 years. Meanwhile, as noted, traded goods, such as oil, minerals, agricultural commodities, foodstuffs, drinks, consumer packaged goods and consumer semi-durables in many cases fell in value or saw only very modest inflation of typically 1% per year. (As did many competitive services such as transport or hairdressing or restaurant meals, indeed most goods produced or provided by the private sector).

The farming sector was no stranger to these capacity increases. E.g., close to Craigmore’s heart, dairy farming, stimulated by high commodity prices in 2013 (themselves a result of a drought in the US mid-west, shortages in China and removal of dairy quotas in the EU), vigorously increased capacity in the subsequent two years, causing an unusually long supply “bust” in 2014-16, when prices returned to their levels from 20 years earlier for two tough years.

The cure for low prices is low prices

What happened next, after 2013, is that companies and entrepreneurs in many sectors ceased their “over-investment” and thereby began to shrink bloated capacity. E.g. NZ dairy production, which had traditionally grown by 5% pa levelled off in 2016 (see graph) and indeed has yet to regain the levels of 2015:

Figure 1: New Zealand Dairy Production: 1983 -2017

Source: DairyNZ

Many other sectors, including oil and gas (remember the shale oil bust), steel and shipping radically reduced investment spend after it peaked in 2013 to 2016. As a result, supply has become more aligned with demand and prices of all these goods have risen strongly during 2016 to 2018 (see graph, for oil prices, below). Low prices indeed did cure low prices.

Figure 2: Crude Oil Price 2015 -2018

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Source: Quandl

Subsidised agriculture, like QE, can backfire

Sectors distorted by government policies are an exception to this modulation of capacity and therefore moderation in supply of goods. E.g. the US and Europe continue to subsidise arable farming (to a far greater extent than e.g. dairy). As a result, low prices of grains after 2012 did not “cure low prices”. US and European arable farmers have found a second source of income – subsidies – to enable them to “keep the tap on”. Some of these growers think they are onto a good thing getting themselves rewarded for producing products at below economic cost. However, the CAP in Europe and crop insurance in the US are making destitute the very farmers who are lobbying for their continuation. To be fair grain prices in 2018 are finally moving up. However, this is on the back of dry conditions in US, Australia and the Black Sea region rather than the reduction in planted area that would have taken place absent of European farmer support and US crop insurance subsidies.

Figure 3: LIFFE Wheat Futures 2005 – 2018

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Source: CompleteRiskManagement

As so often government interference in markets has unexpected consequences. Thus, few of us predicted Quantitative Easing would cause deflation and few appreciate that farm subsidies lower the equilibrium price of the produce they “support”. Thereby often costing growers more than the subsidy amount. They also create an indirect subsidy for the intensive livestock industry and headwinds for small emerging world farmers (into whose markets flow subsidised excess production from the US and Europe). Which is not great for the environment, for human health or for those small holders. In the end, in our view, “farm support” payments do all this damage while creating no relief at all for the US and European farmers who have lobbied so hard to make themselves wards of the State. I don’t know a single NZ farmer still is yearning for the farm subsidies our small country tried to introduce in the 1980s.

What will happen next?

Outside of government-distorted industries such as the growing of grain which did not cure their over-capacity the moderation of the investment is now leading to increases in prices of both primary and industrial inputs and, via value chain effects, also consumption goods. Might this be, dear readers, the inflation I predicted way back in 2008. Is it finally happening, 10 years later?

In fact, it is too early to say for sure. Partly because CPI inflation normally lags other effects. However, there are some clearly early signs. E.g. in a moment we will show many producer prices are now “on the move”. Before that, however, let’s look at farm commodities. Which are the key determinant of food price inflation.

Beef prices have been strong since 2013:

Figure 4: US Wholesale Beef Prices 2000 – 2018

Source: USDA

US Beef Cattle numbers are not rising (see graph below). Which is another way of saying “capacity” in that sector is not growing – helping to explain rising equilibrium prices. We are in fact quite bullish on beef. Recently drought has been increasing US cattle slaughter, reducing prices in the short term. It should then lift again in e.g. 12 months as the herd is rebuilt and fewer animals sent to market.

Figure 5: US Beef Cattle Numbers 1980 – 2018

Source: Meat and Livestock Australia

Meanwhile shortages of dairy ingredients, especially dairy fats (themselves in demand as butter’s health benefits are finally recognised – witness McDonald’s 2016 decision to fry patties in butter rather than vegetable oils), also recovered strongly after capacity peaked in 2014-15:

Figure 6: Global Dairy Trade Butter Price 2013 – 2018

Source: GlobalDairyTrade

Yet, as farmers wisely remember the over-production of 2014, dairy capacity has not been markedly increasing, so promises a more gradual and healthier cycle this time around (see Figure 1 in this Commentary, where NZ dairy capacity is no longer rising despite satisfactory prices). We expect this supply stability to continue.

Industrial metals and therefore producer prices have also been moving up strongly. Helped in some cases by talk of tariffs between the main trading block. Thus both Aluminium and Steel are up strongly (see graphs).

Figure 7: LME Aluminium Price 2015 – 2018

Source: Quandl

Figure 8: Shanghai Steel Rebar Futures Price 2015 – 2018

Source: Quandl

Will central governments take away the punch bowl?

For many commentators the big story of 2018 is the risk of rising central bank interest rates. They argue that we are late in a long economic expansion and that investors may be wise to be in cash or short dated bonds since asset prices are unlikely to rise further, and indeed may fall as interest rates rise. Is an implicit assumption of this view that the flat pricing environment we have experienced for most of the past 18 years will continue?

Is it correct to go to cash in times of inflation?

My own view is that cash and short dated bonds can be some of the worst investments, in real terms, in times of inflation.

But what investments do perform, during inflation?

Well, according to the good professors at the University of Illinois, Champaign, there are only two asset classes whose prices are highly positively correlated with inflation (see graph – which shows positive correlations of PPI inflation and Gold prices against farmland returns).

Figure 9: Correlation between Inflation, Farmland and Precious Metals

Source: University of Illinois

The reverse also holds: neither of these asset classes did particularly well during the deflation of farm produce and other prices after 2012-13.

Figure 10: Indexed NZ Farmland and Gold Prices after 2013

Source: DairyNZ, Fonterra, World Gold Council

Will goods and services price rises move in lock-step with real asset prices, or will they deviate?

Another way of saying that QE “skewed” the relationship between prices of financialised assets (bonds, stocks and commercial property) is this reduced real interest rates. E.g. imagine a property market where Net Operating Income remained the same at $60 per sq foot but property prices doubled from $1,000 to $2,000. The cap rate or real yield of these properties has fallen from 6% to 3%.

Will these “real interest rates”, having fallen so low that a lot of commercial property is indeed yielding only 3% after depreciation, now see their rates rise again?

If so how will the ratio change? Might asset prices fall? Or will inflation lift the yields of real assets, i.e. rents and dividends, so they “catch up” with the prices of their assets? My suspicion is, absent short-term volatility and local slumps in sectors that have too much capacity, it is more likely that prices of goods will rise than capital values will markedly swoon to normalise the ratios for 3 reasons:

1. Goods and service price inflation of around 2.5% in many countries (and in some countries 3% or higher), is likely to help yields on assets (dividends, rents, etc) move up. This will lift real interest rates.

2. The inevitable nervous periods and asset market weaknesses we should expect as nominal interest rates rise are likely to elicit accommodative policy responses. Government policies are asymmetric. They will do more to restrain asset price falls than asset price rises

3. Some asset classes whose performance tend to do well during periods of inflation will do better (farmland, precious metals) – especially if their real interest rates did not become over-extended during the QE boom (as those two did not).

To be fair, if the good professors are right about the correlations, other, higher “beta” assets may see some value contraction, as their real interest rates rise, possibly helped along by some volatility and falls in asset values.

Fat lambs vs computers

In our 2011 Commentary we noted a computer was worth 6 fat lambs and predicted this ratio would fall to 3. This has now happened as laptops are now available at $375, vs NZ fat lambs at $125. Consistent with flat prices for goods over the past 7 years this was not because lamb prices moved up. It was because technology and competition made computers cheaper.

What will happen next? I suspect computing power may get a little cheaper, but not much. Moore’s law is finally beginning to reach its limits and most gains from global computer supply chains have already been had. As we have seen steel and aluminium input prices have moved sharply up on the bank of Trump tariffs. However, since supply of lamb, like beef, is not rising, I expect nominal prices of lamb to rise. Consistent with the more inflationary environment I predict in this Commentary I do not think we will need to wait for 7 years for the ratio, (which in the early 90s was 100 lambs per lap-top), to reach unity. If this happens then NZ farmland, whose prices have been flat for 7 years (Figure 11) may be a better investment than shares in Hewlett Packard (whose stock price doubled (see Figure 12) over that period.

Figure 11: REINZ Farmland Price Index 2007 – 2018

Source: Real Estate Institute of New Zealand

Figure 12: Hewlett Packard Share Price

Source: Hewlett Packard

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