THE AMPHORA REPORT

Vol 2/7, 5 April 2011 www.amphora-alpha.com

IN THIS EDITION

THE INFLATION TSUNAMI

As the world reflects on the earthquake and tsunami tragedy still unfolding in Japan, investors are seeking to understand the economic and financial market implications. There are some general observations that one can make at this point, the most important of which is to recognise that, in much the same way that the Japanese authorities are responding to the disaster with monetary stimulus, other major governments around the world continue to implement stimulus of their own in a futile and counterproductive effort to restore high rates of economic growth following the global credit crisis of 2008. The inevitable result of these responses to disasters, natural and man-made, is a global inflation tsunami which is going to cause significant economic damage. Time is running out for investors to escape into alternative assets.
THE INFLAT ION TSUNA MI Over the past year we have written extensively on the topic of inflation, including in Guess Whats Coming to Dinner: Inflation! (vol 1/12, October 2010) and The Inflation Tipping Point (vol 2/4, February 2011). While we prefer the monetary definition of inflation as growth in the supply of money and credit, we note that, beginning around mid-2010, the monetary expansion of 2008-09 began to feed through into consumer price inflation. This has continued to the present day and at an accelerating rate. Consumer price inflation data are now surprising to the upside just about anywhere one chooses to look: in Asia, Europe and, more recently, even in the US. To use a timely if tragic metaphor, the inflation tsunami set in motion by a massive monetary expansion in 2008-09 is now making landfall around the world, pushing up prices for a broadening range of goods and services. While the Japanese have been playing their part in this global inflation they have more recently upped their game in response to the Sendai earthquake. The Bank of Japan (BOJ) has printed some 15tn yen, or roughly $180bn US dollars, since the disaster struck. But the stimulus doesnt end there. In response to a surge in the yena natural result of financial markets anticipating repatriation of Japanese capital to finance reconstructionthe Japanese Ministry of Finance (MoF) asked for and received the cooperation of most major central banks in intervening to weaken the yen, with the BoJ selling some 700bn yen (approx $6bn) for dollars, euros and other currencies. At one point reaching nearly 76 to the dollar, the yen has subsequently fallen back to 83, even weaker than it was prior to the quake. Coordinated FX intervention is rare and is one of the more blatant ways in which policymakers seek to manipulate the global economy. We are always sceptical when central banks act as if they know better than the financial markets. Not only it is simply impossible for a handful of bureaucrats to regulate anything as dynamic as a modern economy or financial system but central banks also have a demonstrably poor track record. The credit market disaster of 2008-09 was a direct result of misguided central bank policy, specifically consumer price inflation targeting. Most modern central banks claim legitimacy because they keep inflation under control. Yet these are the folks that create fresh money in response to economic headwinds which are frequently of their own making. Orwellian rhetoric to the contrary, modern central banks are rightly understood to be the champions of inflationif normally of the moderate sortrather than 1 its nemesis . Lets consider just why, exactly, the BoJ thinks it is doing Japan a favour by printing a huge amount of money and intervening to weaken the yen in response to the earthquake. Presumably it believes that this is going to stabilise the financial system and help with the coming reconstruction effort. But whereas the first point is probably correct to some degree, we doubt the second holds true. When a company loses a major factory to some natural disaster, it is a loss of productive capital. The company then has a choice to make. Should it rebuild the factory out of savings or, alternatively, allow itself to shrink instead and generate less future earnings? The correct decision, of course, is that which maximises the net present value of the firm. If the cost of rebuilding exceeds the benefit of restoring the factorys income stream, then the factory should not be rebuilt. Yet if the factory was profitable and costs
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We accept that, for some readers, this might be a rather controversial point. Naturally we prefer to trust that central banks set out to do what they say. But as we discussed in A Century of Money Mischief (vol 1/14, December 2010), there is much circumstantial evidence that the US Fed has a set of priorities somewhat different than that presented to the public. The same can be said for other central banks.

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less to rebuild than the expected future profits, the company should proceed with rebuilding. How does printing yen and intervening in the FX market affect this decision? By driving down borrowing costs, it makes it appear less expensive to finance reconstruction. But as Japanese firms are large net savers, they dont really have an incentive to borrow at all to rebuild; rather, they can dip into their extensive savings. As these savings are overwhelmingly denominated in yen, a weaker yen, therefore, makes it more rather than less expensive to rebuild. Yes, Japan is a large exporting nation so a weaker yen can be seen to support exports, but as a result of the earthquake which has destroyed or damaged much industrial capacity, Japan is now unable to export as much as before (at any given exchange rate) and will thus be relatively more reliable on imports during the reconstruction period. The BoJs action does not support the rebuilding effort. It in fact undermines it by preventing financial markets from adjusting in ways that would result in greater price discovery in import, export and financial markets and, therefore, a more economically efficient reconstruction process. Moreover, long-term observers of Japan know that the last two decades have been characterised by endless fiscal stimulus of various kinds, resulting in chronic resource misallocation which has demonstrably failed to restore the higher rates of economic growth that were common from the 1950s through the 1980s. The legacy, however, is a massive public debt which needs to be serviced with tax receipts. As a country prone to major earthquakes, one could argue that, rather than build bridges to nowhere in the 1990s and 2000s, the government would have better served the national interest by spending far less, thereby encouraging savers, including insurance companies, to build large reserves which would be available in the event of a disaster on the scale of the Kobe or Sendai earthquakes. The prospect of rebuilding after any major national disaster is intimidating, yet it would be somewhat less so today were government debt/GDP only around 100%as was the case when the Kobe quake struck in the mid-1990srather than over 200%, as is the case today. Notwithstanding our critical view of Japanese economic policy above, clearly they did not bring the recent earthquake and tsunami upon themselves. The same cannot be true of western governments and central banks, which bear full responsibility for the credit crisis of 2008-09 and the counterproductive policy responses implemented in its aftermath. Having sowed the monetary wind with a massive expansion of the money supply in 2008 and early 2009, they are now reaping the inflationary whirlwind, as recent commodity, producer and consumer price data make increasingly evident. While any informed observer is aware that commodity prices have risen sharply in recent

months, not all may have noticed that commodities also have strongly outperformed the equity markets which, until recently, were also in a clear uptrend. The Dow Jones/UBS broad commodity index has risen by 23% in the past six months and by 28% over the past year, in comparison to the S&P500 equity index, which is up by only 16% and 12%, respectively, over those periods. An outperformance of commodities versus equities is a characteristic of a generally inflationary environment, as was observed during the 1970s, for example. Evidence that commodity prices are pushing up producer prices is increasingly evident, yet a look behind the headline data indicates that much more inflation is coming through the pipeline. US PPI y/y is currently rising by 5.6%, but that for intermediate goods stands at 7.8% and that for crude goods at 15.9%, clear indications that pipeline inflationary pressure is building. Producer price inflation in most other parts of the world is also picking up. In Europes largest economy, Germany, it has risen to 6.4% y/y, notwithstanding the recent strength of the euro. Consumer price inflation, now at 2.1% y/y, remains relatively subdued by comparison. But that is to be expected as CPI lags developments in commodity prices and PPI, sometimes by a year or more. The relationship, however, is clear. There have also been two unusually large back-to-back m/m increases of 0.4% and 0.5%, respectively, an indication that a surge in consumer price inflation is now underway. This is not lost on US consumers, who perceive that inflation is picking up. For example, according to the Conference Board, consumers currently expect inflation of 6.7% by next year, a large increase from an expectation of 5% in mid-2010 and well above the 10-year average2. This rise in inflation expectations is arguably more economically damaging than inflation itself. While inflation results in misallocated resources, it is when inflation expectations become entrenched that the potential for economic stagflation grows. Rather than engage in normal commerce, economic behaviour begins to change in ways which are inefficient. For example, businesses and households seek to hold larger inventories in anticipation of rising prices. But by withholding goods from circulation, the overall economy becomes less efficient, devoting more resources to storage rather than production, trade or consumption of goods, the basis of sustainable economic activity and growth thereof. With specific reference to the US, there can be no clearer sign that inflation expectations are surging than when the Head of US Operations of none other than WalMart, Mr Bill Simon, makes a public
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Of course it could be argued, as indeed we have before, that US CPI significantly understates actual consumer price inflation as a result of various statistical methods which are intended to reduce volatility but, when combined with an underlying monetary policy bias favouring inflation over deflation, results in a systematic understating of actual inflation. Indeed, were CPI still calculated today by the same methodologies used in the 1970s and 1980s, it would already be over 5% y/y and, by some estimates, approaching 10%.

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statement that inflation is rising and that his firm has no choice but to raise prices. WalMart played a major role in consumer price disinflation over the past two decades, as China and other cheap producers came on line and exported their way to economic power, yet it has now called the end of the great disinflation and, drawing on the widespread evidence cited above, demonstrates that the tipping point of inflation has been reached. The inflation tsunami is rolling across the economic landscape as we write. So far, the Fed seems rather oblivious to this development. Indeed, the Fed keeps right on inflating

as if it is not doing enough. One look at the recent surge in base money growththe only form of money under direct control of the Fedsuggests that, at first glance, the Fed actually believes that it needs to add further liquidity to the already enormous inflation tsunami it created back in 2008-09. Perhaps the bureaucrats know something we dont. Or perhaps they are making yet one more mistake in a long series of mistakes. We leave it to the reader to interpret the chart below and draw their own conclusions.

US base money growth has surged by over 20% year-to-date

The Fed will soon have a mighty struggle on its hands to keep inflation, both actual and expected, under control. But this presents it with a dilemma: Either confront rising inflation expectations with sharply higher interest rates as Paul Volcker did in 1979-81, thereby triggering a deep recession amidst already high unemployment; or allow such expectations to become entrenched both at home at around the world, such that the dollar loses its preeminent reserve currency status, implying a far lower purchasing power than that which obtains today. The Fed must either take the economy off of life support to save the dollar or keep the economy on life support and watch the dollarat least as we know itdie. But let us not forget, this dilemma is entirely of the Feds own making, the inevitable result of a longheld inflationary bias, colloquially known as the Greenspan/Bernanke Put, that is, the implied bailout for excessive risk-taking that has existed in theory

ever since the Fed came into existence in 1914 but which was applied repeatedly in practice under Chairmen Greenspan and Bernanke, with Lehman Brothers proving the largest material exception to the 3 rule . There are those who, in the face of soaring money supply growth and inflation, believe that the Fed is in fact entirely comfortable with a somewhat higher inflation rate as this will help to erode the enormous debt burden carried by the US economy following the colossal housing and credit bubble of 2003-07. Perhaps. But we dont think it matters whether the Fed is deliberately creating much higher price inflation or not. In either case, the rest of the
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Among the various bailouts that have been enacted in the Greenspan/Bernanke era are those of the Savings and Loans in 1990-93; Mexico in 1995; Long-Term Capital Management (LTCM) in 1998; Wall Street in general in 2002-03; and again, bigger and better, in 2008-09. The Feds current quantitative easing programme, known in the jargon as QE2, is considered by some observers to be yet another example. Regardless, there is no sign yet that the Fed is prepared to change this systematically inflationary policy bias.

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world is not going to sit idly by and watch the Fed further destabilise the global economy. One country after another is taking action to try and insulate themselves from reflationary Fed policies. Along these lines, China and India continue to raise interest rates, as do many other smaller economies. In a related action, last week Brazil announced it was imposing a 6% tax on foreign purchases of domestic bonds, as a way of reducing so-called hot-money flows, that is, those seeking higher yields in Brazil relative to the US, Japan, Europe and other places where yields are historically low. Such actions are a form of capital controls. It is a sign of the times, to be sure, that in a recent commentary, even the International Monetary Fund, historically no fan of capital controls, argues that there are, from time to time, situations in which they might play a constructive role.4 But for every capital control action there is an equal and opposite reaction: Constraining or otherwise distorting the flow of capital implies, in due course, constraints and general distortions on the flow of trade. You cant have one without the other. And what is negative for global trade is, by definition, negative for global growth. The screws on the Feds printing press are tightening both at home and abroad. Beyond a certain point, additional growth in the US money supply will have next to no impact on real growth, only on nominal growth, as real goods are increasingly withdrawn from circulation, resulting in pure and immediate inflation. When that point is reached, it is game over, checkmate. Sadly, in this game, there are no winners. While we are confident in our ability to understand the deleterious effects that the current set of suboptimal policies are likely to have on the global economy over time, we nevertheless dont purport to know exactly how these policies might change from here or what impact or on what time horizon financial markets will adjust accordingly. There are too many unknowns, too much pure uncertainty. As such, when seeking to protect and preserve wealth, we need to rely primarily on the most fundamental form of insurance available to investors: Diversification. The problem many investors face, however, is that they have been conditioned to regard diversification in a rather narrow way. For example, instead of buying a single stock, some might seek to buy a stock market index. Yes, this diversifies within stocks but, in a world in which most large companies have huge direct or indirect exposures to the capriciousness of policymakers, does this really diversify the fundamental risk? No. Some investors might diversify into bonds but, if policymakers are seeking higher inflation, at some point these bonds are going to lose a substantial amount of purchasing power. The same is true for cash. The unpredictability of policymakers actions and consequencesnegative as they are likely to be in

our viewcasts a shadow over the entire spectrum of financial assets: Stocks, bonds and cash. What investors need to do is to get some portion of their assets off that spectrum entirely. This is where commodities come in. Unlike stocks and bonds, which pay dividends and coupons, commodities produce no cash flows. Unlike corporations and municipalities, commodities cannot go bankrupt and leave their investors with only a fraction of their investment, if any. Unlike financial assets, the prices of which are necessarily a function of the arbitrary and increasingly desperate policies of central banks around the world, commodities represent real goods, with real supply and real demand. This does not mean that they are always going to go up in price, nor does it imply that they are always going to outperform financial assets. But given the current, unfortunate state of the world, they offer real, tangible diversification in a way that financial assets do not. Yes, as policymakers consistently choose to pursue inflationary policies, it is more likely than not that inflation rates in future will be higher than those of today. Commodity prices will most likely rise. But we do not presume to forecast by how much, over what time horizon, or what commodities are likely to be the best performers. What pertains to asset diversification in general pertains to commodities specifically. Other factors equal, a larger basket is better than a smaller one. This is our response to those that claim that gold is the ultimate insurance policy against unsustainable and counterproductive economic policy. History offers much evidence for this claim. Yet it also offers much evidence that blending other commodities with gold can better diversify a defensive investors overall portfolio. These other commodities should include metals, both precious and base; energy, in particular crude oil; agricultural products, in particular grains; and other soft or industrial commodities, with the understanding that, as one moves away from those most widely traded, liquidity will decline. From there, investors can further enhance returns by moving into business investments which represent the various stages of value added for these commodities: Mining, agribusiness, transportation and other infrastructure. Relative to history, stocks for these sorts of companies may be trading at what appear to be lofty valuations, but keep in mind that, if commodity prices continue to rise, those valuations are more likely to be sustainable and, of course, the dividends paid by these firms should continue to rise in future alongside commodity prices and profits, also providing an effective hedge against future inflation.

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The Amphora Liquid Value Index (through 1 April 2011)

Source: Bloomberg LP

THE AMPHORA LIQUID VALUE INDEX represents the return on a dynamically-rebalanced portfolio of broadly and efficiently diversified commodities and currencies, intended to retain its real value in a wide variety of circumstances, including both inflation and deflation. AMPHORA: A tall, lateral-handled, ceramic vase used for the storage and intermodal transport of various liquid and dry commodities in the ancient Mediterranean. AMPHORA CAPITAL is dedicated to helping clients preserve wealth in a highly uncertain global environment by developing investment strategies protecting against both inflation and deflation.
JOHN B UTLER jbutler@ jb-cap .com John Butler has 17 years experience in the global financial industry, having worked for European and US investment banks in London, New York and Germany. Prior to founding Amphora Capital he was Managing Director and Head of the Index Strategies Group at Deutsche Bank in London, where he was responsible for the development and marketing of proprietary, quantitative strategies. Prior to joining DB in 2007, John was Managing Director and Head of Interest Rate Strategy at Lehman Brothers in London, where he and his team were voted #1 in the Institutional Investor research survey. He is a regular contributor to various financial publications and websites and also an occasional speaker at major investment conferences.
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