Robert Kessler


July 8, 2011

On this week’s Consuelo Mack WealthTrack, “Financial Thought Leader,” John Brynjolfsson, creator of the first “real return” mutual funds and “Great Investor” Robert Kessler, U.S. Treasury bond guru discuss managing the inflation and interest rate challenges ahead.

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.

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 U.S.?

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?


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.


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.


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.


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,, 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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