Special Letter: September 2009
Inflation v Deflation, the "D" Word and Low Hanging Fruit
Much has been discussed, pontificated on and blogged about regarding deflation and inflation over the past year, so I thought I would join in. The current prevailing wisdom is that we are on the cusp of global inflation. To be especially hard hit are nations that have printed money and gone deeply into debt to escape the financial crisis, such as the United States. While I agree that ultimately there will be inflation, I believe there are short term factors which will delay its arrival and a major mitigating factor which might limit inflation in the long run as well.
It was said by Milton Friedman and Anna Schwartz that "inflation is always and everywhere a monetary phenomenon." Whether or not that is actually completely true in real time has come into some doubt, though it is clearly largely true. What most people believe is that rising prices indicate inflation. For an economist, more money per capita in the global financial system or any national financial system is inflation, or at least portends future inflation. In short, once money creation exceeds the population growth rate, then there is monetary inflation, or money is worth less per unit, which is to say, it will buy less goods or services than before.
What is going on right now does not seem to be inflationary to people because they might not see prices on many goods going up. However, with the printing of money, the value of that money does in fact drop, hence inflation. Virtually every measure of money creation by the U.S. government is reaching all time highs right now (see charts above) as the government replaces vaporized money from the financial crisis by creating money today and issuing debt. In the past few weeks it appears the Fed and Treasury have tapped the breaks, but this does not mean that it will not accelerate again. Also, it certainly does not mean the government can avoid creating trillions in new money when the Chinese and other creditors start calling our debts due in several years, nor does it mean the government will not increase money supply at some future date, say coinciding with an election cycle to make things look better than maybe they are at that time.
At the moment, because the supply for goods and services does exceed demand in many markets, price increases are being pushed off. We in the United States also still have a massive real estate overhang and dangerously high unemployment creating downward price pressure on end markets. Specifically to note is that commercial real estate has two cycles of mortgage resets coming on a glut of five and ten year notes issued from about 2005 to 2007. Because most banks have tightened lending standards and many buildings are more vacant than usual (drive down a commercial street and count the "For Lease" signs) many buildings will not get refinanced. This means we will see commercial real estate prices start to drop far more noticeably soon as investors and banks unload properties. The second batch of resets will occur from 2015 to 2017 which means that any recovery might be mooted. Residential real estate also has a massive number of resets through 2012 (see chart below), which I believe could result in another 20-30% drop in many home prices. That massive deflation of real asset prices, along with high unemployment will likely create the illusion short run that there is no inflation because prices may not reflect it just yet. In effect, we will have "invisible inflation" that will jump out of the shadows at us eventually.
Further, as displacements occur in the economy- both domestic and foriegn, or the reality of the recovery falls short of expectations for a recovery- which I believe we will fall short of, or foriegn and domestic financial markets experience turbulence due to effects of the financial collapse, there will be occurrences where the dollar becomes strong short term due to the so-called "flight to safety" trade. In these circumstances, valuable assets can become cheap and the dollar can temporarily buy more, a nice combination for those with cash.
For investors who have been able to accumulate cash, or at least hold very conservative asset allocations on existing investment accounts, there could be some very interesting and good investment opportunities to buy assets that do well under inflationary environments for the next few years, but are priced low short run due to a lack of buyers. As global demand increases in a few years, and the newly minted money becomes circulated- rather than being largely dormant as it currently is, and markets anticipate that money, we will see some inflation emerge.
Two things to be aware of long term are these offsetting facts. The U.S. has issued a lot of debt- which will increase money supply in the future- to China, other Asian and Middle Eastern nations. However, as emerging market economies expand over the next decade, their need for tradable money will increase. These economies will generally use either U.S. dollars, the Euro or some basket of currencies, i.e. International Monetary Fund Special Drawing Rights, for trade as their currencies will likely not be stable or liquid enough to buy some goods. Thus, at least to some extent, the increasing supply of money and an increasing demand for money could somewhat offset. So while I expect inflation, I do not expect hyper-inflation.
It is also important to note that by borrowing money from China, the largest fast growing economy in the world, the United States has in effect made certain that the dollar will remain one of the world's reserve currencies, if not the reserve currency. Although this seems counterintuitive to some, there is very little reason to believe that China would want the U.S. currency to depreciate much and be removed from its perch despite rhetoric to the contrary, thus there will likely be no currency war.
It is very important to understand what the reserve currencies of the world are, because the reserve currency or reserve currencies receive the free ride of the planet. That is, if a nation's currency is the reserve currency, in essence exerting some form of monopoly pricing pressure on its money, then, it will artificially be priced higher than it is actually worth based on that nation's balance sheet- mitigating inflationary forces, for example, for a nation carrying a large debt. Because I believe we now know that the dollar will remain at least "a" reserve currency for decades (the bonds sold to China mature in ten to thirty years and likely will be refinanced at some point) and China is growing very fast, it is very possible that the U.S. Dollar and Chinese Yuan somehow share reserve currency status in the future.
I believe we will see the next commodity scarcities in agriculture, as arable land, irrigation and fertilizer are moving to be in shorter supply while demand for food increases, and natural gas which due to being in a current glut, with accompanying low prices, is causing producers to not engage in new drilling while depleting existing wells. Oil could also go through rapid price movements; I believe likely downward in the near future due to a short term glut, but gradually up as the cost to extract oil from newer reserves is rising. I am not a long term believer in gold as it just does not have the uses that other commodities have, though that is not to say it won't trade up on emotions and specualtion.
The same TV talking heads who had a hard time calling a recession a recession until there were two quarters of negative GDP are now having a hard time calling what is going on economically a depression, even though we have now had four quarters of negative GDP. Folks, it's a depression.
Scary stuff. That article should help explain why after getting more aggressive for a few months this spring, I am back to being pretty hunkered down. It should also verify that it took quite a long time to break the system as bad as we have, and will take a long time to fix completely.
Graciously, this storm too shall pass, and if we can avoid pouring gasoline on any fires, we could in effect be trading a rough twenty years or so (2000-?) for sixty or more years of prosperity, and potentially peace, if nations around the world can grow enough to want to avoid fights.
As I believe that the recent market run-ups have largely been of an emotional rebound nature and we are now once again slightly overvalued in many spaces, our short term investment strategy (for investment advisory accounts, others please call to discuss rebalancing) is to be on the far conservative edge of our asset allocations again. If the markets continue to trend up short term, I believe we can make that money back by saving our assets on any subsequent drops in the markets. In the intermediate term, I am looking for opportunities to find low hanging fruit and maintain lower than industry norm risk by investing in only exceptional values, which are in short supply right now. Ultimately, I expect to find the best opportunities overseas.
More next month. Please make sure to attend our investor's breakfast in a few weeks.