The 4 Assets and Economic Cycles

[moda0306]

One thing I've been pondering lately is the 4 assets of the PP and their corresponding cycles.  HB had a pretty simple layout: Stocks - Prosperity.... Gold - Inflation.... Cash - Recession..... LT Treasuries - Deflation.  He explained the nuances of these, at times.

He went on to talk about how bonds were also, to some degree, a measure of prosperity, and many often say how gold does well during deflation as well as inflation.  I think there's some flawed perspective going on here a bit.  First of all, I see all 3 non-stock assets as having a very recessionary nature to them.  Bonds in general may do well during prosperity, but when one looks at treasuries, it's clear that they are on the very safe end of the prosperity-recession spectrum.  Yields tend to tighten during prosperity, and broaden in recession.  Tightening yields is very notably bad for treasuries.  Look at 2008/2009.  The yield spread action during that period shows that treasuries are built much more for recession than prosperity.  Further, gold, even during a deflationary panic, held its ground.  Does this mean it's some kind of super-asset?  No, it's because it responds strongly to inflation, as well as uncertainty and panic, two very common traits of recessions.  One could even say that those are core traits of recessions.

This circles back around and makes one wonder, then, "why did treasury LT bonds do so well from '85 to 2000?  We didn't have deflation nor did we have recession."  Or "Why didn't gold increase with inflation during that same time?" (which we've covered before).

My answer to this would be that our definitions of these assets within the cycles is a little flawed.  Gold will do well as a factor of unexpected inflation and recession.  LT treasuries will do well as a factor of lower than expected inflation (disinflation) and recession.  If you get a combination of inflation and recession, gold will explode.  If you get a combination of sharp disinflation or deflation and recession, LT treasuries will explode.  What I'm arguing here is that it was the disinflation of the 1985-current period that helped LT treasuries perform so well, not the prosperity.  The prosperity served to tighten the yield curve, which actually had a negative effect on treasury rates... it's just that the disinflation of the period was so strong that it had much more impact than any yield-tightening.  Further, it was the recessionary nature of the deflation we had in 2008 that kept golds afloat, not the deflation itself.  This is just as the yield-widening during the 1970's helped treasuries, but didn't prevent the several years of slight losses they suffered during that period due to rampant unexpected inflation. The deflation was an effect of financial shock, over-indebtedness, malinvestment, and deleveraging.  

So in summary, the yield spreading tendancy and fear, and uncertainty that would normally be associated with recessions tends to put gold and treasuries firmly in that camp to where you have what maybe surprisingly small losses by LT treasuries during stagflationary periods (4% worst loss in the 70's) and maybe even gains by gold during financial panic deflation (4% gain in 2008).

[l82start]

i would love to see the economic correspondences with the other contributing factors you mention, presented as a Venn diagram/diagram's...
or with some other visual representation,  beyond a one to one relationship (if inflation - then gold) i am struggling to wrap my mind around it..

[moda0306]

I was thinking the same thing.

[moda0306]

Some may take issue with my assertion that the prosperity of the 80's and 90's didn't help LT treasuries.  I'll admit that the low gas prices, computer technology, and internet were the largest contributing factors to the prosperity, and that they probably were a huge help in lowering costs, so in a way "the disinflation caused the prosperity" and it caused the LT's to do well.  Kind of circular logic, but I think it's important to separate the inflation/deflation vector from the prosperity/recession vector and make sure that we're viewing them independently, while viewing the PP assets as a mix of coverage, not the 4x4 way we tend to view them now, where we try to make excuses as to why gold did well in 2008 and LTT's are good in times of prosperity.

[MediumTex]

Some may take issue with my assertion that the prosperity of the 80's and 90's didn't help LT treasuries.  I'll admit that the low gas prices, computer technology, and internet were the largest contributing factors to the prosperity, and that they probably were a huge help in lowering costs, so in a way "the disinflation caused the prosperity" and it caused the LT's to do well.

Don't forget a darn near perfect demographic profile across the population during this period as well. 

In the early 1980s the Boomers were just entering their peak earning years.  Having cleared most of the bong resin from their brains that had accumulated in the 1960s and 1970s, starting in about 1982 they were ready for a credit-driven consumption binge of historic proportions that would last until they reached their early 60s (around 2008).  This dynamic was great for the economy then, and as would be expected, it is terrible for the economy now (see Japan).

[moda0306]

Yes, when you think of the low taxes, demographics, computer technology, and low fuel prices of the early 80's-2000, it's really a perfect storm for a prosperous period that I think we'd be extremely lucky to see again.

[MediumTex]

Yes, when you think of the low taxes, demographics, computer technology, and low fuel prices of the early 80's-2000, it's really a perfect storm for a prosperous period that I think we'd be extremely lucky to see again.

Unfortunately, we won't.

Here's why:

The 1970s featured a series of politically induced fossil fuel shortages.  Although these shortages were politically induced (as opposed to geologically induced), the market responded to them as if they were real shortages and an energy exploration boom began that brought a tremendous amount of new supply to energy markets beginning in the 1980s that suppressed prices for decades after the 1970s fuel price spikes.

The fossil fuel issues we are facing today are geologically induced, which means that there is no spare capacity that can come on-line in coming years to provide an extended period of low energy prices like we saw in the 1980s and 1990s.  Any new production that reaches the market in the future will be matched or exceeded by declining production from the world's existing oil fields.

When you take a step back you will see what I mean--in spite of historic oil price spikes in 2008 and 2011, world oil production has basically stagnated at or around 2005 production levels.  This is the "undulating plateau" theorized by peak oil adherents.

When determining what effect this energy situation has on economics, it's hard not to conclude that world economic growth is basically a function of cheap energy.  When energy ceases to be cheap, economic growth encounters stiff headwinds.

Will we catch some good breaks going forward?  I'm sure we will, but it is extremely unlikely to be in the form of any more extended periods of cheap energy.

When thinking about how we find our way out of this situation, the key metric to remember when evaluating alternative energy sources is that they must be economical when oil is at or below about $110 per barrel (in today's dollars), because at $110 per barrel oil prices have historically proven to be toxic to world economic growth (and any alternative energy of similar or greater cost is likely to be similarly toxic)--i.e., too much of the world's output is absorbed in procuring the energy inputs to leave enough surplus for meaningful growth.  It's the same in a household--when gas prices rise discretionary income falls, which eventually results in there being no discretionary income at all.  The same thing happens to entire economies.

The theme of economic deterioration following a lack of ready supplies of energy has been a theme that has played out countless times through history.  We will experience it differently than past societies have, but the dynamic is more or less the same--certain "non-negotiable" ways of life suddenly become very negotiable when it becomes clear that Mother Nature isn't interested in bargaining.  The next stage in this process is a scramble among existing societies for the remaining energy resources that are available, and this is where military force becomes a key determinant of outcomes. 

If some of what I wrote above sounds vaguely familiar, it basically is the playbook that has been driving U.S. foreign policy for the last 10 years or so (which is when it began to be clear that world energy supplies were unlikely to continue growing at the rate necessary to support historic levels of economic growth).

You may notice that the situation I describe above basically creates a whole separate set of economic headwinds for the U.S. that are distinct from the demographic headwinds that I frequently mention, but both processes are unfolding more or less simultaneously.  What do you call this?  Really bad luck.

***

Does any of the above invalidate any of the economic assumptions on which the PP is based?  I don't think so.  We are still going to have either prosperity or recession, and inflation or deflation.

[moda0306]

Damn, MT.  Write a book or I'll plagiarize one for you.

[moda0306]

We all talk about the seemingly dumb people that talk about rising rates, but I can't tell you how many smart, financially savvy people HATE long bonds right now.  I almost feel like I can't even talk to them without feeling like an imbecile because they look at me so weird and like I'm being contrarian just for the sake of it.

Funny thing is though, sometimes these people are bearish on stocks and housing.  Doesn't leave much but gold.

[MediumTex]

We all talk about the seemingly dumb people that talk about rising rates, but I can't tell you how many smart, financially savvy people HATE long bonds right now.  I almost feel like I can't even talk to them without feeling like an imbecile because they look at me so weird and like I'm being contrarian just for the sake of it.

I'll bet those are the same people who hated them in the early part of 2008 when oil was rising, inflation expectations were rising and everyone was talking about dollar devaluation.

We all remember what happened next: oil prices collapsed, inflation collapsed, and the dollar surged.

If these people weren't smart enough to see what was coming in 2008 (when underlying economic conditions were in some ways similar to today), why should we think they are any smarter now?

[AdamA]

If some of what I wrote above sounds vaguely familiar, it basically is the playbook that has been driving U.S. foreign policy for the last 10 years or so (which is when it began to be clear that world energy supplies were unlikely to continue growing at the rate necessary to support historic levels of economic growth).

Great post, MT. 

I am always skeptical of peak energy enthusiasts in that it seems to me an oversimplification of something that is very complicated. 

Having said that, when I try to understand our foreign policy for the past 10-15 years, your agrument is really the only one that makes any sense at all.  I'm not saying that you are James Howard Kuntsler or anything, just that you seem to have teased out the reality of the peak energy situation from all of the drama with which it is usually associated. 

If energy isn't what's causing us to do some of the things that we're doing, I'd love to hear what is. 

[AgAuMoney]

When determining what effect this energy situation has on economics, it's hard not to conclude that world economic growth is basically a function of cheap energy.  When energy ceases to be cheap, economic growth encounters stiff headwinds.

Will we catch some good breaks going forward?  I'm sure we will, but it is extremely unlikely to be in the form of any more extended periods of cheap energy.

It might be a case of Mr T(echonology) to the cheap energy rescue. Perhaps something like a micro crystal radio type devices tuned to resonate to the universal microwave background radiation and kick out a nanowatt of energy - and layered x trillion circuits on a bit of silicon (sand).

Or it might be that we will get hungry enough for petroleum that we'll clear the political hurdles, because the shortages today ARE political.  I don't expect we'll get back as cheap as when crude was oozing out on the surface in Oklahoma and Pennsylvania, but there are huge reserves of good oil and gas and coal that we know how to economically tap.  (recent discoveries in the news prove the point, as does an acquaintance of mine who has been doing oil field geology at Anadarko for ca. 25 years).

Or it might be that we'll start harvesting crops from current "waste lands" that are much more suitable for ethanol in barrels per acre and in cost of inputs than is corn.  (Alcohol Can Be a Gas, David Blume, IIRC)  But political lobbying and subsidies caused us to grow a lot of corn (side effect of sugar tariffs is increased demand for sugar substitutes, primarily corn syrup) and keep us using corn for fuel instead of food (paying 3/4 of the cost of corn ethanol) and have the side effect of essentially preventing research into better alternatives.

Or it might be that we'll adopt 1980's and 1990's reactor technology and go on to develop even better tech instead of being stupid when 1950's-60's technology fails.  (Or to be consistent we should outlaw cars because 1950's-60's automobiles are not safe.)

Those are all political.

Never mind future technological advances that might make for cheap energy from previously unusable or uneconomical sources (growing biological solar photovoltaic or bio-hydrocarbons), or even new things we cannot imagine from our current perspective.

At one time England was running out of coal and they thought it was the end of the world.  Mechanized deep mining found more coal and then cheap transportation brought so much coal to england they shut down their mines.

Before that they were running out of wood and they thought it was the end of the world.  They figured out how to use coal.

In the late 1800's and early 1900's the world was running out of whale oil and it was going to be the end of the world.  Petroleum, specifically Rockefeller and kerosene made stinky whale oil obsolete almost over night.

In the 1960's rivers were catching fire and pesticides were killing the food chain up to and including the bald eagle and industrialization was going to be the end of the world.  Cleaned up our act (well, in free countries we cleaned up our act) and rivers are clean enough for fish and the raptors are well into recovery the world is more industrialized than ever.

Common elements?  Things change, people shout doom and gloom, new discoveries and new technology to use recent discoveries saved the day and suddenly we had cheap energy and good times were here again.

[MediumTex]

Common elements?  Things change, people shout doom and gloom, new discoveries and new technology to use recent discoveries saved the day and suddenly we had cheap energy and good times were here again.

What do you think will replace cheap oil?

Or do you think cheap oil will return?

[AgAuMoney]

Common elements?  Things change, people shout doom and gloom, new discoveries and new technology to use recent discoveries saved the day and suddenly we had cheap energy and good times were here again.

What do you think will replace cheap oil?

Or do you think cheap oil will return?

I gave 3 current options which could become a cheap energy source using current technology simply by removing political barriers.  1 of those was oil and another is a direct replacement for oil.  I also believe there will be future technological advances.

And note that I also said:

...I don't expect we'll get back as cheap as when crude was oozing out on the surface in Oklahoma and Pennsylvania...

By that I mean I don't expect we will see oil selling for the same dollar amount it did 100 years ago in either nominal or inflation corrected dollars.  But I do expect we will see abundant energy at prices which will not strangle the economy.

However I did a bit of research...

It appears the long-term average price of a barrel of oil is about 4-5 ounces of silver.  That would be $143-$179 per barrel at today's silver prices.  Or in gold, the long-term average is 15-16 barrels of oil per ounce of gold.  That would be about $96-$103 per barrel of oil.

Maybe oil is cheap today?

[MediumTex]

Given the amount of work one can do with a barrel of oil, it would probably be "cheap" at $1,000 a barrel in today's dollars.

Oil is a really amazingly concentrated, portable and versatile source of energy.

What's unfortunate is how wasteful we are with it just because it has been so abundant over the last 100 years or so.

I don't have any alternative to offer, but it seems like the price mechanism has not provided an especially impressive means of allocating fossil fuels in general.  We have basically treated them like a renewable resource when they are not.  If we are able to move past fossil fuels without significant disruptions I will be very impressed. 

When M. King Hubbert wrote about peak oil back in the 1950s, he had an almost casual belief that nuclear power would easily replace fossil fuels when they became harder to extract from the earth.  As prescient as some of his thinking about peak oil was, I think his belief in the potential of nuclear energy probably didn't appreciate the difficulty of making it work on a large scale.