Thursday, October 8, 2009

When Will Deflation Turn Into Inflation? - Alpha

In this issue:
1) Investing in Inflation vs. Investing in Deflation
2) The Case for Further Deflation
3) Inflation is Government Made
4) Signals to Watch for a Turning Point
5) Is Kanye West a Jackass?

Dear Friends and Colleagues,

We have received such positive feedback about our blog "Risk Over Reward" that we're expanding the analysis and format into a weekly newsletter. Several months ago, this blog was picked up by Nouriel Roubini’s RGE Monitor and this week we joined the Seeking Alpha contribution team; a newsletter seems like a natural next step. Vega and I wanted the blog to be a place to discuss investing, from abstract ideas like the nature of risk to concrete analyses of recent data. We will continue the discussion and add commentary on specific asset classes, sectors, industries, and companies. We may also occasionally publish opinions about securities, but these are not investment recommendations. In all things investing, we encourage you to think for yourself and make your own decisions, or find someone trustworthy to act on your behalf.

At the core of our conversations are a few core ideas: risk versus uncertainty when investing with incomplete information; asymmetric payoffs (risk over reward) in a probabilistic world; the intersection of macro and micro at the industry and security level; and investing empirically and rationally while conceding that investing is both art and science.

Also, for business and financial news clips, see: So from San Francisco and Philadelphia, we welcome you to the conversation.

1) Investing in Inflation vs. Investing in Deflation
The most important view investors need to have is when the current deflationary climate will become inflationary, and to what degree. If you answer this question correctly, you will make investment decisions better than most sophisticated investors. From March through August 2009, US prices have come down on average about 0.4% to 2.10% compared to the previous year, and the CPI-U is down 1.5% for the 12 months ending August 2009. We are clearly going through deflation.

In a deflationary climate, the best investments are cash and fixed income securities, as both increase in value as the value of a dollar increases. For example, if your $100 bond bought 100 loaves or bread before, after a deflationary period it could buy 110 loaves and you are richer. During deflationary periods, real assets like land and commodities generally fall in price. But not in the current climate, where oil went from $35 to $72 per barrel from March till September - so not all real assets have been hit by deflation. Also, generally weaker companies and credits like high yield bonds do poorly as sales drop and credit is tight. Investors are better off holding investment grade government bonds or corporate credits.

In a moderately inflationary climate of 0-3% inflation, a balanced portfolio of stocks, bonds, and real estate does the best in giving solid returns and dampening volatility. From 1982-2007, the US went through a "Great Moderation" period with moderate inflation and decent growth. It had three stock bull markets (1982-1988, 1992-2000, and 2003-2007), two real estate bubbles (1982-1987, 2002-2007), and what appears to be a massive debt bubble (1982-2008) which unraveled in 2008 (George Soros referred to this in Dr. Evil style as a "financial superbubble"). The current deflation is a result of the popping of the superbubble and the deleveraging of the debt underneath, which is a nice way of saying we are digging out the buckets of $**t that propped up the bubble economy that allowed people to buy second and third homes and three SUVs per family with a $60,000/year income.

In a highly inflationary climate of 5-19% inflation, things would be different. Currently, the smartest investors agree on two things: 1) The medicine of monetary and fiscal stimulus used by governments to prevent a Depression in 2008 will likely lead to long run inflation as that is the preferred way of deleveraging (high inflation erodes the value of fixed-rate debt). 2) Inflation is everywhere a man-made, or generally a government-created phenomenon. See Warren Buffett's thoughtful NY Times op-ed, "The Greenback Effect". The conventional wisdom says that in a highly inflationary environment one should hold commodities, real assets, and equities. We will examine that further. One thing is certain: holding cash and bonds in a highly inflationary climate is foolish and destroys wealth. Hence the optimal portfolio in the current deflationary climate would get slaughtered in a highly inflationary climate. Knowing the turning point is crucial.

Again, to repeat the key questions: When will deflation turn into inflation, and how quickly? How high will the inflation be?

2) The Case for Further Deflation
While the US economy seems to be entering a weak recovery, a strong case exists that deflation or low inflation will continue for 8-16 more months.
First, total US debt levels are still very high historically (above the 1929 levels), at about $49 trillion. One should also add in another $52 trillion for Medicare and Social Security promises. This is about 390-800% of GDP, which is much higher than any other point in US history. Total US debt is outrageously high, at about $340,000 for every American ($101 trillion divided by 300 million people). The net worth of US households, including their houses and after counting debt, was $50,000bn in March, according to the Fed.

Second, the US federal government has the largest projected deficits since WWII, at 9-12% of GDP for the next several years. While Americans are scaling down one war (Iraq) and undecided about another (Afghanistan), the outlook for the US government looks like the US's bellwether state… California. The bankrupt, bloated state. Quite dismal. See Prof. Buiter's analysis on the US federal debt situation.

The high debt levels imply two realities: no new debt and old debt needs to be paid off. This means less lending across the board, less consumption, and more saving (the US’s 71% consumption rate has to fall to between 60-65%). All these forces lead to output slack, a real recession, continuing deleveraging, a much lowered velocity of money, and debt deflation, which the economist Irving Fisher described well after the Great Depression in this 1933 article, “Debt Deflation Theory of Great Depressions.”

The current recession has created enormous "slack", or unused portions in the US economy. Factories are half-used with manufacturing capacity a little above 65%. Millions of housing and office units sit unused, and the U-6 unemployment rate is above 16% in the US (U-6 is the best measure of people who want yet can't get work, unlike the U-3 measure that policymakers and the media use to pacify people, which is also near 10%). Traditionally, 20% or more unemployment is considered a depression, so the US isn't far off (Spain may already have reached it). For more anecdotal evidence on slack, see this front page WSJ article on slack.

If you just use your eyes and look around you, we are still in a recession (defined as deviance from a normal growth trend). Lending and economic activity are at lows, slack is high, and it will take time to get things moving again and create inflation. Walk into restaurants and car dealerships, visit freight railroad terminals. Both your eyes and the numbers show that slack is high. One CEO who is honest about this is Oracle’s Larry Ellison, who predicts an L shaped recovery — “down and not coming back up.” Retail sales are at 2005 levels.

It may take many years to create inflation again if central banks are too skittish and governments prefer more recession to inflation. The best historical analogy would be Japan after a 20 year cycle of debt ending in the1990 debt deflationary bust, or what Richard Koo calls a "balance sheet recession." Japan had 7 years of no/low inflation afterward, and when it started to pick up in 1996 the government tightened monetary policy leading to a 1997 second recession. See more on Koo's work in this review.

Japan avoided inflation because policymakers decided the best way to deal with the bust was greater government spending and no bank reform. So insolvent zombie banks stuck around for 7-8 years, debt was not written off, and inflation never took off. Basically, there was a political decision to benefit government bureaucrats who controlled fiscal purse strings and the creditor classes who wanted neither inflation nor their debt to be written down. Ordinary Japanese citizens and taxpayers paid the bill with their national debt bill rising, their personal debts staying flat with no inflation, and low economic growth leading to stagnant household income growth.

My main point is that the choice between inflation and deflation is a government policy choice. Politicians can choose either to support the lender/creditor class (choose deflation and foreclosures) or workers and the borrower/debtor class (choose high inflation and debt forgiveness). So far, the US government has chosen deflation and massive bailouts to the bondholders of still insolvent banks (Citigroup and others). This bailout, when examined systemically, has cost nearly $23.7 trillion by the estimate of the US special inspector general.

3) Inflation is Government Made
Milton Friedman famously stated, "inflation is always and everywhere a monetary phenomenon." That is, inflation is created by the mandarins who control the money supply: the central bank and the Treasury/finance ministry. In the US, the top mandarins are the FOMC/Ben Bernanke and the White House Team/Tim Geithner.

There has been no extended deflationary period (longer than 3 years) in the US since the 1870-1892 deflation, when the East Coast banking interests controlled Congress and set up a gold standard which caused a slow, two decade deflation. Remember those notes in your US history textbook about farmers, William Jennings Bryan, and the "cross of gold"? You might want to dig those out or otherwise check out Barry Eichengreen's excellent monograph, "Globalizing Capital."

Here's how Ben Funnell of the hedge fund GLG Partners recently laid out the options in an FT op-ed:
"The debt burden has to come down, which means more saving and lower economic growth for many years to come. Along the way inflation is likely to return, probably sooner and more violently than most expect, which will prompt investors to demand a higher return and make it even harder for governments to tackle the debt. At best the debt will fall slowly over many cycles and simply trim otherwise resilient growth. At worst it could cause growth to lurch upwards before tumbling again, with all the attendant uncertainty that entails. At this point, no one can know which is more likely. I incline to the more benign view because of the size of household assets but, if the dollar’s reserve currency status should come under serious attack, rates would have to rise to defend it and that could itself cause a consumption crisis."

Most politicians and their constituents personally fall in the debtor class, though the biggest campaign contributors are all from the creditor class. The responsible action for politicians would be to create moderate inflation, about 5-7%, as the Harvard economist Kenneth Rogoff has suggested. That way, fixed- rate debt would halve its real value in about 12 years. Yet the genie of inflation, once let out of its bottle, is very hard to contain or get rid of. Some would argue that the seeds of inflation are already laid as the US government "monetizes" Treasury debt in an elaborate shill game. This happens as the Fed buys US mortgage debt from foreign central banks by printing money, and the foreign central banks use that money to buy US Treasury bonds:

Eventually Bernanke and Geithner will heed Rogoff's sensible suggestion and set a 6% or more inflation target, either openly or furtively. Yet inflation will go beyond that because it is a messy human and sociological phenomenon which can't be tweaked scientifically with a dials and counters from a central bank's control room. Also, there's just too much debt and I don't expect debtors will wait 12 years for their debt to be halved (Americans want instant forgiveness).

4) Signals to Watch for a Turning Point
We will spend much more time dissecting signals in the future. In short, we believe the following are some signals on when deflation will turn into inflation are:

-Total bank lending and consumer credit
-US Fed aggregate reserves and the velocity of money
-Unemployment rate and employment claims
-Commodity prices (oil, gold, metals, agricultural stock, etc.) and the Baltic Dry Good Index
-Industrial capacity and the ISM index
-Freight car loadings, car sales, and retail sales
-Pricing of options on US Treasury rates (especially volatility prices, like Move), the breakeven rate, and 30-year fixed-rate mortgage rates
-Actual observable prices in department stores and grocery stores (these help to set inflation expectations)

By the time inflation comes and registers on the CPI, it will be too late to re-position your portfolio or hedge for it. That's why the signals above are important.

5) Is Kanye West a Jackass?
This month at the MTV Video Music Awards, the rapper Kanye West jumped on stage, crashed Taylor Swift's speech, and declared that her award ought to have gone to Beyonce.

Later, in an off-the-record interview, President Obama called Kanye West a "jackass" for his behavior, and an ABC News tweeter released this private comment to the world.

Jay Leno then put Kanye on TV and got Kanye to cry by asking him, "What would your mother think of this?" (Kanye's mother had died recently).

The debate on whether Kanye was a jackass and whether Obama should have criticized him has consumed much more press and American attention time than the legitimate and very important policy and national interest question that Prof. Rogoff asked:

How high should inflation be to get us out of this mess?

Your analyst who loves to hate the trashiness of American media,

Copyright 2009 Risk Over Reward. All Rights Reserved.

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