Reflation. It is a very provocative concept. We all know what is meant by the term Inflation. It is almost intuitive because we have lived with it all of our lives. Those of us over 40 have a special affection with that word as we experienced the 1970s and some of the worst that inflation can bring.

But few of us have a good idea what is meant by the term reflation. Whether we should embrace or fear it. My way of looking at reflation is to “fill the hole” left by the deflation caused by housing, stock market and other financial asset price contraction. All that asset value had to go somewhere. The assets underlying value didn’t just disappear, though much of the derivative paper might have.  Assets were revalued by a mass panic of the entire American and global population. But this was a psychological phenomonon, and so it can be reversed.  It is quite possible for assets to regain their previous value with some encouragement.  That encouragement comes in the form of reflation and what it encourages: the ”animal spirits” of the market place.  Until we find asset price recovery through the process of reflation, diminished values will wreak havoc on the economy through slashed consumption, falling corporate and tax revenues, declining profits and higher unemployment.

Reflation is made possible by the expansion of the monetary supply, offsetting money supply reduction that occurs from asset price contraction. But it is an indirect offset. If my house was worth $600,000 in 2007 and is now worth $400,000 in July 2009, to reflate the economy the government doesn’t just send me a check for $200,000 (though a case can be made for doing just this ala “Helicopter Ben”). Rather, monetary expansion trickles through the economy: first to bolster the banking system where it originates from programs like TARP and TALF, then through Federal “stimulus programs” that eventually (belatedly?) result in a “Cash for Clunkers” program, and finally to home owners through firming home prices and higher wages with economic expansion and increasing demand; all from the proverbial “thawing” of a frozen credit system enabled by backstopping the banking system.

But reflation comes with a price, and it is political, not numerical. Because reflation originates within the Federal government (the Federal Reserve Banking system and the Treasury), the only entity which can legally create money from nothing, it comes with plenty of strings attached. Those strings will be pulled by the majority political power, Democrats at this point in time. The party in power will seek to use economic reflation policy to achieve social policy and, in the case of liberals, a redistribution of wealth. Whether one agrees or disagrees with a specific policy or program,  it is beside the point. The point: because there are strings attached, reflation through fiscal policy or monetary means there are conditions that are inefficient and carry plenty of future baggage (entitlements).

Bill Gross wrote about our economic reflation policies and what it means for our economic future. In his eyes, the future is none too optimistic. Bill Gross suggests we are doomed to many years, perhaps decades, of below trend economic growth, his “new normal”. Those of us less than 70 years old, who did not experience life during the 1930s and 40s, will probably need to recalibrate our expectations.

I personally take exception to the characterization of 3% Nominal GDP growth, as Bill Gross forecasts, as being a “New Normal”.  Such a growth rate is an aberration and would mean perpetual recession. It is actually an old normal at a time of zero or negative inflation, like right now when Nominal GDP equals Real GDP.  Rather, 3% “real” growth in a mature economy like the American, is an “old normal”; more like the economy of the 1950s, 60s, 70s and 80s, on average. In fact, the Real GDP expanded by an average of 3.45% between 1951 and 2004. It is important to look at “REAL” data as it strips out the effect of inflation, which was pronounced during the latter half of that range.

In Bill Gross’ words:

Reflating nominal GDP by inflating asset prices is the fundamental, yet infrequently acknowledged, goal of policymakers. If they can do that, then employment and economic stability may ultimately follow.

Gross goes on to make the point that we can’t expect to see 5% Nominal GDP growth as we did in old normal times.  But his point doesn’t make much sense as it was actually much higher on average in the past 50 years.  Even at face value, his statement begs the question “what part of that nominal GDP  will be inflation?”

I expect we will actually see moderate inflation once reflation has been achieved.  It is the natural result of successfully reflating the economy and having it run at productive capacity and full employment all while running a Federal fiscal deficit to fnance reflation policy. Because full employment (around 95% of the workage population) is a Federal policy goal, and because the Feds have the means to control reflation (monetary expansion), I expect this goal to be successfully met.  So, we can therefore expect moderate inflation once stability is achieved.

Bill Gross concludes his August 2009 newsletter by making the case for 3% Nominal GDP for the forseeable future:

A 3% nominal GDP “new normal” means lower profit growth, permanently higher unemployment, capped consumer spending growth rates and an increasing involvement of the government sector, which substantially changes the character of the American capitalistic model. High risk bonds, commercial real estate, and even lower quality municipal bonds may suffer more than cyclical defaults if not government supported. Stock P/Es will rest at lower historical norms, and higher stock prices will ultimately depend on tangible earnings growth in the form of increased dividends, not green shoots hope. An investor should remember that a journey to 3% nominal GDP means default/haircuts for assets on the upper end of the risk spectrum, as well as extremely low yielding returns for government and government-guaranteed assets at the bottom end.

Yes, I suppose a 3% Nominal GDP would have the effects described if it were possible.  But the PIMCO scenario is highly unlikely and Gross’ reasoning is flawed in many ways.  If we are  indeed in a period of lower interest rates, then P/Es will not contract but will likely expand.  P/Es run inverse to the Treasury Yield Curve, the infamous Greenspan “Treasury discount model”.    So, low interest rates should result in higher stock prices once stability returns to the economy.  However, I believe we will see higher interest rates once the economy is reflated and the economy stabilized.  This will result in attenuated economic growth of around 2-3% Real GDP, plus an inflation rate of 5% which will cause Nominal GDP to run above 7% as opposed to the 3% forecast by Bill Gross.  American Nominal GDP ran between 7 to 13% during the late 1970s, a period of anemic economic growth (real), large fiscal deficits and moderate to high inflation.  Even in 1981, during a severe recession, nominal GDP grew by 4.4% due to the high embedded inflation.

Like Gross, I do worry that the “strings attached” to reflation policy will “substantially change the character of the American capitalistic model”.  But political pressure from the right should counter the most extreme of what the left has to offer.  We already see evidence of this in respect to nationalized medicine and “cap and trade”.  So, even this concern of Gross’ is overblown.  Another threat comes from foreign interests who might not want to help America reflate by continuing to buy Treasury bond issues that support monetary expansion / quantitative easing.  But I think these foreign entities (China, India, Oil Nations, etc) see that it is their own self-interest to reflate the American economy and rekindle its consumer sentiments.

I think Mr. Gross has fallen prey to his shifted paradigm of a “New Normal”. His position does not take into account the resultant moderate inflation that must naturally  follows a reflationary policy.  We can expect inflation in 2012 and after of perhaps 5 to 7%. This will result in a Real GDP that is negative if we sutract inflation from the Nominal GDP forecast of 3% suggested by Mr. Gross. Zero or negative Real GDP is not consistent with full employment and will not be tolerated by our political process.  So it cannot happen for an extended period of time invalidating the PIMCO argument. I suggest the PIMCO triumverate re-examine their assumptions.

Bill Gross August 2009 Investment Newsletter

Kiplinger’s Personal Finance magazine provides affluent readers with the information they need to make smart decisions about their money. Each issue includes intelligent reporting on investments, taxes, insurance, paying for college, planning for retirement, home ownership, major purchases such as cars and computers and other personal finance topics.

(more…)

Why is Natural Gas so cheap (3.87 per mmBTU as of today) while Oil is moving ever higher? This is a significant disconnect that does not make long term sense. Historically, the average ratio between West Texas crude and Henry Hub natural gas has been 8.5 to 1.  Currently, it is at a historic ratio of 19:1.

With oil at $72 per barrel, natural gas should be around $8.47. That represents a 125% potential pop in the price of natural gas if the price of oil stays constant. Many experts believe that oil is fairly priced right now, give the costs of exploration and extraction.

UNG is the easiest pure play on the price of natural gas. This ETF is based on natural gas futures and moves directly with that price. UNG trades for $14.50 as of today, but would be over $30 if natural gas normalized its pricing against oil. So, just on current relative value, natural gas is a value play with great upside potential in the intermediate term (12 months). But it is an even better play in the longer term (1-5 years).

President Obama and the Democrat controlled Congress will definitely pass some type of environmental legislation this year or early next. That legislation is aimed directly against carbon and its role in global warming (or the theory thereof, since it is not conclusively proven). In the next several months, either a “Cap and Trade” or a straight up carbon tax will be passed. The moderates in Congress and most of the heavy industrial world, faced with the reality of some type of legislation, are rallying behind a carbon tax for its simplicity and for the fact that the cost can be passed along to the consumer much more efficiently and without the distortion and potential fraud of cap and trade.

For natural gas, either scenario is very attractive. Natural gas per BTU of energy, is much cleaner than oil or coal, the two primary fossil fuel alternatives. So, if a carbon tax is passed by legislation this year, natural gas will immediately become more competitive. Its historical relationship to oil should decline even below 8.5. If it moves to 7.0, then the relative cost today should be $10 per mmBTU for natural gas.

Longer term, with or without a tax advantage over oil, natural gas promises to be used as a transitional fuel to alternative energies like solar, wind and geothermal. T Boone Pickens has proposed, and spent a considerable portion of his wealth, promoting the idea of natural gas powered vehicles. Once fuel cell powered vehicles become practical, within 10 years with government encouragement / subsidy, natural gas is likely to be the first fuel used by such vehicles. This reality will be encouraged if Pickens is successful in getting existing fuel stations in North America to add natural gas to their product offering at the pump.

Pure hydrogen vehicles are a better environmental option, since the byproduct of the chemical reaction is pure water. But the manufacture, storage and distribution of highly combustible hydrogen has many science, engineering and production problems yet to be solved.

So, how can we benefit from this megatrend?

The Canadian Canroys are one good way to anticipate this new trend.  Much of North American natural gas is in the western provinces of Canada. I have owned and benefited from Pennwest (PWE), Pengrowth (PGH), Provident (PVX), Daylight (DAYYF), Baytex and Harvest Energy for many years (until last July when the entire commodity complex hit the skids).  U.S. based producers include Anadarko, Chesapeake, XTO, Southwest Energy and Lynn Energy.   All the above offer decent dividends, though not nearly as attractive as a year ago, so there is somewhat less reason to buy and hold as there was in the past.

For extra leverage, sell “In the Money” UNG put options on the October $18 strike price (UNEVR) for around $4.50 premium per share of underlying stock (with the stock price at $14.50 as of today). This buys $1 of downside protection and provides over $3 of upside opportunity. If the price finishes above $18 on October 16, the puts will expire worthless and you will keep the $4.50 premium. The stock price of the UNG ETF will only need to move to about $5.00 from the current $4.00 for this to happen. But execute a “Buy to Close” order any where along the way, for example, when the premium falls to $2 for a double on your investment (times 5 for the inherent leverage of options) to lock in profits. This gives a 500% return in less than six months.

Because the market, especially commodity stocks, looks ready to correct, it may be prudent and profitable to wait on this until after a market correction.  I am looking for a move back down to SP500 of 875 in the next couple of weeks.  Once that move is done, it may be possible to sell the same puts for $5.50 (with the underlying UNG at $13). 

Have fun making money.

We continue to monitor the events around General Growth Properties’ bankruptcy filing. It is one of the more fascinating corporate bankruptcies in many years.  The last we checked up on GGP in early May, Bill Ackman’s Pershing Square LLP with its 25% stake in GGP, had petitioned the court to be named to provide Debtor in Possession financing for the bankruptcy period.  This would have given Pershing Square the inside track on all the negotiations for the resolution of GGP’s bankruptcy.  Bill Ackman was on CNBC on Monday, May 11, discussing his stake and his interest in being DIP financier.  But Farallon was also interested and had made a better offer (lower interest rates / better terms) and eventually won that competition.

GGP subsequently was successful in bringing over 160 of its malls under the bankruptcy umbrella which gives equity owners a much better negotiating position as compared to the creditors / debt holders that are secured by that same property as Special Purpose Entities or SPEs. 

Here is the latest (last week) on General Growth Properties’ legal maneuverings:

CMBS Market OK with General Growth Rulings, so Far

By Al Yoon

NEW YORK, May 14 (Reuters) – Commercial mortgage bondholders took some comfort after a judge overseeing General Growth Properties’ bankruptcy stopped short of a move that they say would have undermined the structures of their securities.

The inclusion of more than 160 subsidiaries in the No. 2 U.S. mall-owner’s bankruptcy filing in April set off alarms in the commercial mortgage-backed securities market as investors feared a judge would consolidate the units. A consolidation would set a negative precedent in the market, where investors provide money with knowledge the assets are protected from events like bankruptcy at the parent or other units.

Judge Allan Gropper on Wednesday avoided taking steps toward a “substantive consolidation,” even as he allowed the company to garner cash flow from its disparate properties.

“We dodged this bullet, and I think everyone is breathing a sigh of relief,” said Richard Jones, co-head of Dechert LLP’s real estate group. “But this game is not over yet.”

A consolidation of assets under special-purpose entities (SPEs) could still occur as the company looks for leverage to fix the root cause of its bankruptcy: the inability to refinance debt, Jones warned.

Chicago-based General Growth GGWPQ.PK filed for bankruptcy after the credit crunch choked off financing for commercial property mortgages, challenging the company as it confronted maturities on billions of dollars in loans. Some three-quarters of its shopping malls joined in the filing, sparking industry concern.

CMBS provided more than $600 billion in financing for commercial real estate lending from 2005-2006, and the thawing of the market is seen as key for preventing a downward spiral of delinquencies and foreclosures.

“In general, (the judge) respected the SPEs,” said Christopher Hoeffel, president of the Commercial Mortgage Securities Association.

While inclusion of SPEs in bankruptcy is not ideal, the CMSA considered it a victory that Gropper maintained the isolation of the property assets, and put no additional liens on CMBS collateral, Hoeffel said.

Bondholders will continue to get principal and interest under the bankruptcy.

Many of the malls in the filing are top-quality, and their inclusion in the bankruptcy puzzled analysts. General Growth could be angling to use the threat of consolidation as leverage to get lenders and servicers to agree to restructure long term debt, Dechert’s Jones said.

A substantive motion can be made at any time during the bankruptcy case, he said.

Next up will be a May 27 hearing during which loan servicer ING Clarion Capital Loan Services LLC will argue that the eight malls it represents should be excluded from the bankruptcy. ING says that not only is each mall owned separately, but that all of them are current on their mortgages, with some having an ample cushion to pay. (Additional reporting by Ilaina Jonas; Editing by Leslie Adler)