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CONSUELO MACK: This week on WealthTrack, who will win the tug of war between the forces
of stimulus and austerity, and inflation and deflation? Financial Thought Leader John Brynjolfsson
and Great Investor Robert Kessler take sides on one of the great financial battles of our
time, next on Consuelo Mack WealthTrack.
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SPONSOR: The company keep is also the company we keep.
Together we'll provide lifetime guarantee income and investments solutions.
SPONSOR: Additional funding provided by: Loomis-Sayles - investors seeking the exceptional
opportunities globally. Research Affiliates - Efficient index foreign inefficient market.
The Wintergreen Fund - your home for global value.
Rosalind P. Walter
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Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. One of the great financial
debates of our time is between the forces of inflation and deflation. Is the U.S. entering
a Japan-like period of painfully slow growth and falling prices, or simply recovering in
spurts from a devastating financial crisis? This is not just an academic exercise. The
outcome of whether prices are rising, stagnating, or falling will determine everything from
interest rate policy by the Federal Reserve to the value of our homes and salaries, to
social security and Medicare payments, to our investment strategy. It is the last that
we are focusing on in this week’s WealthTrack.
No one, including the Fed, disputes the fact that inflation is rising. As this chart from
Strategas Research Partners shows, both the CPI, or consumer price index in blue, and
the red core CPI, which excludes the more volatile food and energy prices, are accelerating.
And core inflation is in the upper end of what the Federal Reserve deems acceptable.
On the other hand the forces of disinflation and even deflation are exerting their own
pull. In an economy dependent upon consumer spending for 70% plus of its growth, unemployment
is still uncomfortably high. For those who are working, wages and salaries are flat and
not even keeping up with modest inflation, and companies, both large and small remain
reluctant to hire.
What should you plan for in the months ahead? Do you tailor your investment strategy for
inflation, disinflation or even deflation? Joining us are two investment pros with strong
opinions and strategies to go with them. John Brynjolfsson is founder and chief investment
officer of Armored Wolf, a global macro hedge fund seeking to “profit from imbalances
created by global inflation and deflation.” He is a pioneer in “real return” investing,
designed to outperform inflation and preserve purchasing power. He launched the first “real
return” mutual funds at PIMCO. Robert Kessler is the CEO of Kessler Investment Advisors,
a global manager of portfolios of U.S. Treasury securities and other government debt for institutions
and governments. Fortune magazine has called Kessler “one of America’s top investors.”
I began the interview by asking them where they stood on the inflation debate.
JOHN BRYNJOLFSSON: Right now, inflation is pretty contained because you've got housing
under pressure and relatively contained. You've got food and energy prices essentially off
the charts, but the average of the two with housing being 40% of CPI, inflation is contained.
But more importantly, the Fed realizes that. The Fed is trying to get the core CPI up towards
2%. And my suspicion is that they'll be overshooting that target and in the meantime creating more
and more inflation in the energy, commodity, and global markets.
CONSUELO MACK: So the pressures are building, but short-term inflation is contained in the
JOHN BRYNJOLFSSON: Very short-term inflation is below target. That’s really the danger
signal because the liquidity that’s being produced by the Fed right now is historic
in nature. There's more liquidity being produced right now than there was during the depths
of crisis in 2008.
CONSUELO MACK: That will lead to inflation. They are printing money in other words?
JOHN BRYNJOLFSSON: They are.
CONSUELO MACK: Robert Kessler, so inflation- where do you come out in the disinflation,
deflation debate?
ROBERT KESSLER: I think I take a longer viewpoint on inflation right now because wages are not
increasing and the basis to inflation really are wages. And when you have 20 million some-odd
people either underemployed or unemployed in this country and probably the problems
taking place in Europe and China in terms of excess capacity, it's very difficult to
end up with inflation. So bottom line here is probably the Fed is right. They don't see
any foreseeable future. It probably would be presumptuous of me to actually name a date-
oh, in three years or four years or five years, I think we’ll see inflation- I think it’s
going to be years and years and years before we really see any inflation at all.
CONSUELO MACK: So what about the argument that John just made, the fact that we've had
so much stimulus from the federal government, deficit spending, that in fact that traditionally
has been inflationary?
ROBERT KESSLER: What is intriguing about this period of time is that the government spending
is going on to the credit side, the debit side, that is you and I. We're the ones in
debt. In bailing out the banks, all of this excess money, the 600 billion that we just
created, is sitting in kind of reserves. It's sitting in the banks. It's not going into
the economy. So it doesn't go into the economy and we don't have what we call velocity, we
don't have movement of the money. It doesn't go to me and we don't get jobs and we're on
food stamps in the same way we were; then the leveraging process, this paying down debt
is just going to take an awful long time, especially coming into June/July as we are
with a Congress that is going to be rather austere as opposed to coming in with stimulus.
So it’s a difficult period of time.
CONSUELO MACK: So John, how do you figure that in? Isn't this time different in that
we've had this unprecedented credit bubble 30 years in the making? And now we have this
deleveraging, we’ve just had it unwinding for three years. So I mean, couldn't this
time be in different and in fact what we're you're seeing the Fed do and the government
do and the deficit spending as well, that this is not going to turn out be as inflationary
as it would have under normal circumstances?
JOHN BRYNJOLFSSON: So there's a couple different things going on here. One is growth and healthy
real productivity is different from inflation. There's no doubt that there's a lot of dead
wood out there in the economy, foreclosures sitting on the housing market, unemployed
sitting on the services and wage markets. About two years ago, we were at a point where
you had this pushing on a string concept which others talked about, where close to a zero
bound on interest rate, meaning you couldn't lower interest rates below zero; and if we
were deflating, Bernanke was afraid that that would be a spiral like we had in the 30s.
Bernanke was very aggressive with QE1. QE2 was an insurance policy. We're now running
at a 3.6% headline inflation rate, 1.6% core rate of inflation. Those rates actually give
you a high cushion above the 0% Fed funds rate. We're running at a negative real interest
rate. Negative 2%, negative 3%, maybe negative 3.6% based off of headlines. That is an extremely
low-- it's a negative real interest rate, which is almost unprecedented.
So while there were some concerns 24 months ago about pushing on a string, we now have
inflationary dynamics that it started. And as long as the Fed stays at zero, this inflationary
dynamic will accelerate and we see it in the food and energy markets, in the emerging markets.
The U.S. is not isolated so we can have weak U.S. housing and weak U.S. employment at the
same time that the dollar in depreciating and inflation is percolating throughout the
economy.
CONSUELO MACK: And the fact that the purchasing power of the dollar is decreasing, which is
inflationary considering how much we import goods and services into this country. I want
to talk to you each about the imbalances you are seeing and how you are managing them.
And John, at Armored Wolf you seek to profit from macro imbalances created by global inflation
and deflation. So what kind of imbalances are you seeing in the economy and how are
you seeking to profit from them?
JOHN BRYNJOLFSSON: We try to be nimble. We certainly allow for the possibility of deflation
and on a macro basis that was certainly the case two or three years ago.
CONSUELO MACK: Right.
JOHN BRYNJOLFSSON: Right now we look at the deflationary side of that equation much more
narrowly in certain sectors, like the housing sector. The balance on the inflationary side
is much stronger. We see emerging market countries sucking in capital from the printing presses
that the Fed, the ECB, the Bank of Japan and other major developed countries’ central
banks are printing. And people are looking for an alternative reserve currency other
than the dollar. The euro obviously is not a candidate. The yen is not a candidate. And
you end up with either merging market currencies like the RMB or gold and other precious metal
as a metric of fundamental value as opposed to something as flimsy as a paper dollar bill.
CONSUELO MACK: Let's talk about that. Because this is where, you know, Robert Kessler is
a contrarian in this particular area. For as long as I've known you, which has been
about six or seven years, you've been a proponent of the fact that treasuries are still, that
the dollar is still the reserve currency and there ain't no substitute readily available
and number, two, is that U.S. treasuries are still a store of value, safety and liquidity.
Let's talk about the imbalances that John was talking about and how that affects your
view of treasuries and the dollar.
ROBERT KESSLER: Let me bring up an article that was in the newspaper today so I can talk
about something current. There's an article about China, and since I spend a lot of time
in China; this is about a city called Wujian in China. The discussion really is: how much
money is spent in that city and in every city on infrastructure? And in fact, infrastructure
spending in China has reached almost 70% of their GDP. 70%. To put that into some kind
of perspective, when Japan kind of had its bubble burst, they had 35% of their money
put into infrastructure. You have this tremendous amount of excess built into China, that’s
what we call an output gap over here, excess capacity, excess factories. In fact, they
say there it will take eight years to fill up the space and they are building as fast
as they were building before. So you have a world now in China, and in the peripheral
countries in Europe with all of this excess. And that output that we talk about is going
to be with us in a deleveraging process for many, many years. So when we talk about where
are things going to go? Let me bring up one point --
CONSUELO MACK: That's a huge imbalance, is what you are saying?
ROBERT KESSLER: Tremendous imbalance. If I could talk about something having to do with
the treasury market, which is interesting. Most people like to say treasuries have averaged
something like 7% and they are cheap at the moment, or expensive being 3% roughly. The
fact of the matter is they always compare this to the last 40 years. What we should
do is look at the prior 40 years.
CONSUELO MACK: You are talking about the yield.
ROBERT KESSLER: In the yield on treasuries. From the 1930's to the 1970's, a 40-year period
of time, the average was 3%. That was because we were coming out of an imbalanced, credit
bubble, whatever you want to call it, the Depression, but very similar to what we have
today. It took years and years and years to finally get through that deleveraging process.
And in fact, as we mentioned when we were talking together, the treasury hit its low
15 years after the Depression started, which was 1.5%. So if we're going to make a comparison,
we should look at balance sheet recessions like Japan, which has taken 20 years and our
own balance sheet recession, which has taken 15 years. We're in our third year. So we have
some time to look at this process. And it's not a very pleasant period of time.
CONSUELO MACK: So as a result, you are saying that treasury yields not only could stay where
they are for an extended period of time, sorry to use the Fed speak, but you are talking
years, an indefinite period of time, but in fact they could go lower as this deleveraging
occurs? It sounds like a rolling deleveraging scenario happening here now and could be happening
in China in five or ten years?
ROBERT KESSLER: The average in these balance sheet recessions that we look at, average
recession period of time isn't five or seven years, it's 2.5 or three years. So you could
have a recession in 2012- that wouldn't be out of the question in the way we're slowing
down now and with an austere Congress, and Europe just raised their rates. Actually raised
their rates, which is something we were doing in terms of austerity in 1936. So I'm not
making these comparisons lightly. What I'm trying to say is there's a very serious market
out there in terms of being conservative. Conservative means that you don't take risks.
John specializes in areas that he understands in terms of where to take risk.
CONSUELO MACK: Alternative investments.
ROBERT KESSLER: And they are very, very good areas. From my personal viewpoint, I end up
looking at cash or treasuries because I have a long history to say “this is what they
are going to do. This is what they've done in past.”
CONSUELO MACK: John, the argument is, and you know that just about every professional
on Wall Street thinks that treasuries are worthless, you are going to lose money, and
that they are actually a high risk and that the dollar is going to continue to depreciate
and go south. That’s the consensus, which always should make you very nervous, that
everyone feels that way. So what is your feeling about treasuries and the role that they should
play in investors’ portfolios and also dollar denominated assets?
JOHN BRYNJOLFSSON: I think it's instructive to look at the Depression in the 1930's; to
look at Japan and ask about what the monetary policy was during those periods. I don't know
that we've learned a lot in, whatever, 1,000 years since paper money was invented in China,
but generally what happens with paper currencies is eventually they devalue and become worthless.
In the case of the 30s we had high real interest rates. We had deflation and the Fed actually
tightened interest rates. So you had a deflationary dynamic. Ultimately World War II pulled us
out of that, things changed. In Japan, you have a relatively tight monetary policy. The
yen is very strong. It used to be 160 to 170 to the dollar, then it went to 100. Now it's
at 80 to the dollar. It's a very strong yen. You have a deflationary type of monetary policy
run in Japan where the interest rates on cash in Japan is higher than the inflation rate
at the same time that they’re trying to face these demographic head winds.
In the U.S. we don't have that situation. We have Ben Bernanke, who is a student of
these episodes who believes he can target inflation at 2%. I have no doubt that he has
the tools to do that- he has said so himself. He has a printing press in the basement of
the Fed and as long as he has paper and ink in the press he can print as much money as
he wants. That's a fact. The real question is: will he achieve his target on the bull's
eye or will he overshoot it? With unemployment at 9%, the tendency is that he’s going to
have political pressure to overshoot. As long as both inflation is below its target and
unemployment is above the target, they’ll prescribe more money printing, and that’s
what he’s doing. We have the lowest real interest rates that I've seen in 50 years.
I've rarely seen real interest rates below 0. Even a year ago, they were only minus two.
Now it's minus 3.6.
CONSUELO MACK: And the significance of that is, for the lay person, why should that be
shocking to me? Or what are the implications of that, from an investment point of view?
JOHN BRYNJOLFSSON: What it means is more and more liquidity is pumping into the system.
And Bernanke’s reaction function is largely going to be based on homeowners equivalent
rent and actual rents because that's 40% of the CPI. We're now seeing actual rent prices
starting to accelerate.
CONSUELO MACK: We're seeing rent inflation in fact, right.
JOHN BRYNJOLFSSON: We have the weakest component of the CPI now starting to creep upwards.
I don't know if I want to say that I hope he tightens when we get to 2% because that
could be painful, especially for big risk takers in the markets. I don't think of a
30 year treasury as a low risk way to lock in purchasing power. I think of that as a
low risk way of locking in paper currency. We don't know what that paper currency will
buy 30 years from now. So in fact it's extremely risky.
ROBERT KESSLER: One of difficulties about this whole process that we're in is this concept
of printing money. It's something I don't understand and I've never understood. Ben
Bernanke is going to drop it from helicopters and we're going to pick up this money and
spend it. I myself have not seen any of this money. Money coming from the banks or the
banking system, believe me, it's not out in there. I happen to come from Denver and I
don't know what is going on in New York but believe me, there's no money out there. All
of this idea that 0% interest rates have any meaning whatsoever to the average person is
silly.
The average person has to go to the bank and say, can I have money or can I get a mortgage?
And what we have to do different than the banks is really interesting. Us as homeowners
have go out and get what we call an appraisal. And that’s something we call mark to market.
You have to get the market price. The banks don't exactly have to do that. They actually,
because of some shenanigans, they ended up able to get kind of 100 cents on the dollar.
If we were allowed to do book value on our houses, we could probably have a moratorium
and get all the mortgages we want at 2%. But we don't get 2%. And I'm not sure exactly
when we say that 3% from a treasury is a bad deal. It's a hell of a lot better than losing
30% in the stock market and the stock market since 1999, 1998 hasn't gone any place.
CONSUELO MACK: At least the S&P 500 hasn't?
ROBERT KESSLER: I'm not smart enough to always know what the right place is. And from what
I can see, the correlation in a lot of hedge funds and a lot of other places is they don't
either. It's a tough market to play in. An interesting thing about treasuries: treasuries
generally, when we talk about a 30-year treasury at 3% or 4% or 4.5%, we think of it as 30
years. It's no different than a stock. A stock has a perpetual life to it. A stock is forever.
A treasury at least tells you it's five years, ten years or 30 years. So you don't have to
hold it for 30 years and you don’t have to hold it for five. If you believe me that
treasuries are going to down to 1.5%.
CONSUELO MACK: The ten year, you’re talking about?
ROBERT KESSLER: Ten year treasury. Then some place in the near future, assuming it's not
10 years, you either have gotten 3% plus on your money while you waited, or you’ll be
making 9%, 10%, 11%. That’s not a bad deal considering we haven't done so well in the
other choices.
CONSUELO MACK: So consider as an investor- rather than think “I'm buying a 30 year
treasury and I’ve got to hold it for 30 years and the value is going to depreciate,”
think of it as you would a stock that “gee, I might trade it and go into yet another treasury
security.” But the fact is it will be liquid. You will get money for it. And --
ROBERT KESSLER: Let me make a very quick point.
CONSUELO MACK: Yes.
ROBERT KESSLER: Treasuries in the last three years, five years, 10 years and 20 years have
outperformed commodities and the S&P index.
CONSUELO MACK: Which is something that actually should disturb you, Robert Kessler, because
there's something called reversion to the mean. But aside from that, points well taken
about treasuries and how we should view them more as a trading vehicle as opposed to just
a buy and hold possibly. But let me ask Brynjo, I want to -- it's possible that we too can
meet in the middle, because as far as stores of value that are not that liquid. We can't
go to the store with our commodities basket. We can't barter yet. So what should we do
with, what kind of commodities do you think that we all should own some of in our portfolios?
What are going to hold their stores of value?
JOHN BRYNJOLFSSON: Obviously, mutual funds are a big part of the retail and institutional
marketplace.
CONSUELO MACK: What kind of mutual funds? I'm talking about hard assets, for instance?
JOHN BRYNJOLFSSON: So the mutual funds that I’ve created- I created a big one at PIMCO--
CONSUELO MACK: Right, the Real Return Funds.
JOHN BRYNJOLFSSON: What they do is they look at an index of commodities that are all transparently
priced that have futures contracts. They create indexes essentially on a market cap basis
by saying how much volume of each commodity gets produced and what is the price of that
commodity and let's put that weight into the index. They don't want to do every single
commodity in the world. There's 300 different commodities. But there are 19 highly liquid
global commodities. You have your crude oil, gasoline, your heating oil, your grains, your
metals. And the 19 largest blocks of commodities in the world are published as an index by
Dow Jones UBS.
CONSUELO MACK: So you could buy a mutual fund, a broadly diversified mutual fund. That is
invested in commodities, that is one way we could invest.
JOHN BRYNJOLFSSON: That’s the way to do it because by investing in a commodity index,
you are getting broad exposure to all commodities- you are not making calls on individual commodities-
and you’re keeping your cash in a highly liquid form. You can put it in TIPS, which
is what they do at the PIMCO fund, by and large. You can put it into alternative strategies,
which is what we do, with Eaton Vance. But that’s, I think, a great way to get exposure
to the commodity markets.
CONSUELO MACK: We believe in broadly diversified portfolios here. And I know there's a place
for treasuries in our portfolios and there certainly is a place for commodities as well.
And we're going to have to leave it there. Robert Kessler from Kessler Investment Advisors,
thank you so much for joining us. And John Brynjolfsson, formerly of PIMCO but now at
your own hedge fund, Armored Wolf. Thank you very much for joining us on WealthTrack.
ROBERT KESSLER: Thank you.
CONSUELO MACK: And that is a wrap for this edition of WealthTrack. I hope you can join
us next week. I am going to sit down with two top global strategists. Fort Washington
Advisors’ Nick Sargen will tell us why he thinks global markets are at a crossroads
and New York Life’s John Kim will discuss how he is changing the way New York Life manages
investment risk. Until then to watch this program again, please go to our website, wealthtrack.com,
to see it as a podcast or streaming video. Thank you for taking the time to visit with
us. Have a great weekend and make the week ahead a profitable and productive one.
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SPONSOR: The company keep is also the company we keep.
Together we'll provide lifetime guarantee income and investments solutions.
SPONSOR: Additional funding provided by: Loomis-Sayles - investors seeking the exceptional
opportunities globally. Research Affiliates - Efficient index foreign inefficient market.
The Wintergreen Fund - your home for global value.
Rosalind P. Walter
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