The question of whether we are headed into an inflationary or deflationary environment is probably one of the most important, complex and difficult questions to answer right now. For investors, getting this call right or at least thinking about the potential possibilities is absolutely crucial.
As Dan discussed last week, we too think inflation is a likely long term outcome but you should also be wary about the very real possibility of a nasty deflationary episode beforehand.
In a deflation, cash is king and your investment strategy should be one of focussing on valuation and margin of safety. In an inflationary environment, valuation is still important but opportunities for the disciplined value investor will be much harder to come by, as speculation becomes the dominant theme.
So where are we? Ahhh…if only it were that easy.
Before we try to answer the question, we need to establish the framework for our thinking. To keep things simple, we’ll keep our focus on the US, which as manager of the world’s reserve currency is THE economy to focus on.
Now, a definition – inflation or deflation refers to an expansion or contraction of money and credit. Some analysts have focused exclusively on the money supply or the monetary reserves injected into the banking system by the Fed and made the claim that this is inflationary.
This is because in a fractional reserve banking system, the monetary reserves created by the central bank are lent out many times over by the banking system. This is how banks ‘create credit’.
But an increase in money does not always lead to an increase in credit, which is what is happening now. So when attempting to answer the question of inflation or deflation you need to take into account money supply AND credit.
The other point to note in this debate is that we’ll focus on the two areas that concern us as investors – inflation or deflation in asset prices and in consumer prices. Movements in money supply and credit impact on both, but to varying degrees.
Firstly, let’s talk about asset prices.
An historic credit expansion from 2001-2007, which was predominantly an expansion of private sector credit driven by the banks, resulted in sharply rising asset prices. Greenspan’s ultra low interest rate policy was the driving force here. Capital-intensive assets, namely property and also commodities, benefitted most from the credit expansion.
But it was more than just that. As the credit expansion made its way through the economy it resulted in higher household incomes, company profits (and therefore share prices) and government tax receipts, giving the illusion of widespread prosperity.
Then the credit expansion stopped, causing a collapse in the asset prices that most benefitted from the boom and a general fall in nearly all other asset prices.
Because the underlying banking system that provided the credit was capitalised largely by residential and commercial property, the collapse morphed into a credit crisis. Banks were widely viewed as insolvent and under these conditions no one was willing to extend credit to anyone.
Because the credit expansion was allowed to run unchecked for so long (and keep in mind the 2001-07 run-up was part of a much larger secular expansion of credit which had been running for decades) the bust was particularly nasty.
Money supply and credit were contracting simultaneously as banks wrote off their assets and the household sector decided it did not need to take on any more debt. So from roughly late 2007 until early 2009 we experienced an acute deflationary asset price shock.
But then the government and Fed stepped in to halt the deflation and credit contraction. The Fed expanded its balance sheet massively and the government ran an equally massive fiscal deficit. This stabilised the credit contraction.
It is important to realise that the unprecedented intervention has not caused credit to begin expanding again. The monetary base has soared but an excess of debt and a dysfunctional banking system is not turning this into credit growth – and nor will it. Government and central bank actions have merely stabilised the massive deflationary force of a burst credit bubble.
The recently released Fed Flow of Funds Report shows Total Credit Market Debt Outstanding at $52.4 trillion. It has declined marginally for the past three quarters and is pretty much flat year-on-year. Federal Government credit expansion has offset the small decline in Household Sector credit and large decline in Financial Sector credit.
Yet this total credit market stabilisation has resulted in widespread asset price inflation.
How can this be?
Our best guess is that much of it has to do with sentiment, or ‘animal spirits’, as well suspension of the rules regarding marking bank assets to market. The second point is related to the first. (Co-ordinated global stimulus and unprecedented credit expansion in China are also no doubt playing a major role).
As we mentioned banks’ asset bases are underpinned by property. Marking these assets to market would render the whole banking system insolvent, which is hugely deflationary. Obviously the authorities do not want this to happen so mark-to-market accounting has been suspended and the Fed has purchased $1 trillion worth of dud mortgage debt.
The plan is for banks to trade their way back to solvency. But because the private sector doesn’t want to borrow, banks instead try to make their money from speculating in asset markets (proprietary trading) and lending to the government, thus earning easy money on the interest rate ‘spread’.
This has given money managers and private investors the green light to head back into the market. As a result equity and corporate debt markets in particular have rebounded spectacularly over the past 12 months.
But in order for asset inflation to persist from here, total credit outstanding must grow again. Federal stimulus is set to fall later this year and the Fed is due to end its quantitative easing program this month. The expectation is that the private sector will pick up the slack again but we doubt that will happen. As Japan proved following the bursting of its credit bubble in the late 1980s, deleveraging is a long term trend.
So if the artificial support of the government and the Fed begins to diminish, we expect deflationary forces to re-assert themselves. The risk to this outlook is that the authorities actually have no intention of removing stimulus. We will soon find out.
Should some form of exit strategy unfold, does this mean markets fall to new lows? While any decline could be significant, we do not think this is a likely scenario. Governments have proved they are always ready to ‘do something’ and any significant equity market fall would be met with more government credit creation.
So by our reckoning, the next phase for asset markets will be deflationary. Your current investment strategy should therefore be focussed on fundamental value and in the absence of these opportunities – cash.
But the automatic government response to such an environment will be to print and spend. As Ludwig Von Mises wrote in Human Action many years ago:
All governments are firmly committed to the policy of low interest rates, credit expansion, and inflation. When the unavoidable aftermath of these short-term policies appears, they know only of one remedy – to go on inflationary ventures.
You can guarantee the people who did not see it coming will blame the renewed deflationary forces on that fact that the prior stimulus was not big enough. They will advocate even larger spending programs. The next round of stimulus will be larger fiscal deficits and more money printing. Such a policy is inflationary, first in asset prices (as we have seen in the past 12 months) but ultimately it will manifest in consumer price inflation.
How quickly this inflation comes about depends on a few things. If the wider public maintains faith in the purchasing power of the dollar, the increase in dollars will probably be matched by an increase in demand for dollars and dollar denominated assets. In this case inflation will take quite a few years to manifest because of the considerable unemployment and spare capacity in the economy.
We reckon the global economy is in this position now. It explains why bond markets are rallying or at least holding up in the face of massive government bond issuance.
But, if the public begin to question to value of the dollar then demand will decline (as the same time as its supply rises) and the demand for real assets or goods or whatever will take off. This is the ‘crack-up boom’ that Mises talked about, the exchange of paper money for goods at any price. The end result is the destruction of the monetary system.
We think we are some years away from Mises’ end game. And if governments make some hard decisions in the years ahead, it can be avoided. But is there another Volcker out there to replace Bernanke? Let’s hope so.
Bringing all this together, our best guess is we get deflation then inflation of asset prices, followed by a general rise in consumer price inflation, the severity of which depends on how quickly the populace loses faith in government fiat currency. We’ll be watching the bond market closely for clues here.
So what should you do about it? The first thing to recognise is that macro events play out over a number of years. But you still need to be prepared. Because we are cautious about a renewed deflationary downturn we think you should focus strictly on quality companies with cheap fundamental valuations. In the absence of such opportunities (and there are not many) we like cash…and gold.
If we are right in our thinking, the silver lining for investors holding decent cash balances is that there will be some very, very good opportunities down the track. We just have no idea when those opportunities will arise.
And how do you take advantage of these opportunities? We advocate and practice good old-fashioned valuing investing. Forget trading, forget charting and forget other short-term schemes…these are simply methods designed to separate you – slowly – from your money.
Over the decades, all great investors have proven that simply buying good quality companies well below intrinsic value (no matter what the macro environment) leads to healthy outperformance and increasing wealth. But it takes discipline, and that’s were we can help.
Keep in mind the above analysis is simplistic in that it focuses on the US and ignores the major emerging economy of China, which is obviously hugely influential for the Australian economy. We’ll tackle that issue in a future report.
But the US is still at the centre of the global economy. Like it or not, the manager of the world’s reserve currency has a huge influence on the economic fate of the rest of the world.
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