Today’s investment climate is the toughest one you have ever faced. At least since the late 1970s, perhaps since the 1930s.
This is because inflation and deflation are both possible in the near term.
Most investors can prepare for one or the other, but it’s far harder for you to prepare for both at the same time. It’s not hard to fathom why this is so challenging.
Analysts and talking heads have been wondering for six years why the recovery is not stronger. They keep predicting that stronger growth is right around the corner. Their forecasts have failed year after year and their confusion grows.
Perhaps even you, who may have seen normal business and credit cycles come and go for decades, are confused.
If this ‘cycle’ seems strange to you, there’s a good reason. The current economic slump is not cyclical; it’s structural. This is a new depression that will last until structural changes are made to the economy.
I’m talking about structural changes like reduction or removal of capital gains taxes, corporate income taxes and onerous regulation.
These kind of reforms have nothing to do with money printing by the US Federal Reserve. This is why money printing has not fixed the global economy. Since structural changes are not on the horizon, you should expect the depression to continue.
This is a new depression
What’s the first thing that comes to your mind when you think of a depression?
If you’re like most investors I’ve spoken to, you might recall grainy, black-and-white photos from the 1930s of unemployed workers in soup lines. Or declining prices. Yet if you look around today, you’ll see no soup lines, read that US unemployment is only 5.4% (or slightly higher in Australia), and observe that prices are generally stable.
So how can there be a depression? Well, let’s take each one by one…
The soup lines are here. They’re in American supermarkets. The US government issues food stamps in debit card form to those in need, who just pay at the checkout line.
Despite popular beliefs, unemployment is at 1930s levels too.
If the US Bureau of Labor Statistics measured the rate using the Depression-era method, it would be much higher than 5.4%.
Also, millions today are claiming disability benefits when unemployment benefits run out. That’s just another form of unemployment when the disabilities are not real or not serious, as is often the case.
What about prices? Here the story is different from the 1930s. Prices declined sharply from 1929-1933, about 25%, but they were relatively stable from 2009-2014, rising only about 10% over the five-year period.
The US Federal Reserve’s money printing is responsible.
An unstable tug of war
The Fed had an overly tight monetary policy in the early 1930s. But the central bank has pursued unprecedented monetary ease since 2009. Ben Bernanke, who was in charge at the time, was reacting to what he viewed as the erroneous Fed policy of the 1930s.
In a 2002 speech marking economist Milton Friedman’s 90th birthday, Bernanke said to Friedman, ‘Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.’
But this didn’t mean that Bernanke had single-handedly discovered the cure for depression. Fighting deflation by itself does not solve the structural problems of the economy that lead to depressed growth. Instead, Bernanke, and now Janet Yellen, have created an unstable dynamic tension.
Depressions are naturally deflationary. In a depression, debtors sell assets to raise cash and pay their debts. That pushes down asset prices. Falling asset prices, in turn, put other investors in distress, causing further asset sales. So it goes on in a downward price spiral.
Printing money is naturally inflationary. With more money chasing a given quantity of goods and services, the prices of those goods and services tend to rise.
The relative price stability you’re feeling now is an artefact of deflation and inflation acting at the same time. Far from price stability, what you’re seeing is an extremely unstable situation.
Think of the forces of deflation and inflation as two teams battling in a tug of war. Eventually, one side wins, but the battle can go on for a long time before one team wears out the other side.
If central banks stop causing inflation, deflation will quickly overwhelm the economy. If central banks don’t give up and keep printing money to stop deflation, they will eventually get more inflation than they expect. Both outcomes are very dangerous for you as an investor.
Don’t ignore half the puzzle
The economy is poised on the knife-edge of destructive deflation and runaway inflation. Prices could quickly and unexpectedly fall one way or the other.
This doesn’t mean you should throw up your hands and say ‘I don’t know.’
Plenty of analysts will tell you why you should fear inflation. And well-known policymakers such as Christine Lagarde of the IMF and Mario Draghi of the ECB have warned of deflation.
Yet analysis has to be more than a matter of guesswork or stating a bias. The correct analysis is that both deflation and inflation are possible. Anyone who warns just of inflation or deflation is missing half the puzzle.
How you can prepare
If you knew deflation was coming, you’d have an easy time constructing a profitable portfolio. You would have some cash and invest primarily in bonds. The value of cash goes up during deflation as prices decline, and bonds rally as interest rates decline.
You might want to own some raw land in that case also. During a deflationary period, the nominal value of the land might go down, but the costs to develop the land go down faster. The key would be to develop it cheaply in time for the next up cycle.
If, on the other hand, you knew inflation was coming, it would also be easy to construct a robust portfolio. All you would need to do is buy commodities like gold and oil, and stocks of companies with hard assets in sectors such as transportation, energy, natural resources and agriculture.
You could also purchase fine art, which has excellent wealth preservation properties in an inflationary environment.
What should you do when the outcome is on the knife-edge and could tip either way toward deflation or inflation?
The answer is prepare for both, watch carefully and stay nimble.
For The Markets and Money
James G. Rickards is the editor of Strategic Intelligence, the newest newsletter from Agora Financial. He is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. He is the author of The New York Times bestsellers Currency Wars and The Death of Money. Jim also serves as Chief Economist for West Shore Group.
Ed Note: This article was first published in Money Morning.