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 Inflation or Deflation?
How about some of both…
By Mike Minter, CFP®
September has been pleasant this year if you are bullish and own stocks.
Believe it or not, I am normally an optimistic person myself.
On the other hand, there are those who believe everything will always work out and don’t want to hear or think about if it doesn’t. It is kind of like the ING commercial when they talk about “knowing your number” for retirement and the guy at the end has a number of “Gazillion”. He just plans on throwing money at stuff and hopes it will all work out in the end. Not exactly how we would recommend you do it.
Then there are the consumers who bought houses they couldn’t afford. They put on their blinders and thought they were going to make a lot of money like every other home owner at the time. No one thought of what would happen if prices went down and how it would affect them.
Well, we all know how that story ended… But has it?
Let’s quickly review the measures we have taken to this point since the financial crisis of 2008. To focus on a couple:
- An almost $1 trillion stimulus program.
- A TARP program that bailed out banks and some auto makers that after it is all said and done, is projected to cost us roughly $100’s of billions.
- The Federal Reserve has virtually lowered interest rates to zero and spent over $1 Trillion in Asset Backed Securities to pump money into the economy and keep interest rates artificially low.
Where are we now…
- Massive Federal Deficits (not even including unfunded entitlement programs).
- Unemployment at 9.6%.
- Foreclosures still at record highs accompanied by lower home prices.
- A stock market roughly 30% lower from its peak.
- GDP growing in the latest quarter by 1.6%.
- Historically low mortgage and interest rates.
- Huge inflows to bond funds and out of equities.
As a contrarian, normally I would be more optimistic with some of the bullet points above, especially the last one.
The main reason now is NOT one of those times is because of one little thing called DEBT.
As discussed in previous articles, the consumer is approximately 70% of the economy. Well, over the past twenty five years household debt has doubled from under 50% of Gross Domestic Product to over 100%. In other words, it went from under $7 trillion to over $14 trillion. This is obviously a big reason we went through the financial crisis to begin with, but you can also argue that because of the financial crisis, people’s mindset has changed.
Whether the consumer feels like they were fooled, misled, or taken advantage of, many have already started to delever and strengthen their balance sheets. The debt chart has been on an upward path for decades and has finally begun to roll over. If this continues, as I suspect it will, slower growth for the economy could be the best possible scenario.
When deleveraging begins, the velocity of money or the speed of it changing hands decreases.
In prior years, people spent their discretionary income on investment or goods and services. Over the past decade they even had the ability to borrow cheap money which resulted in even more spending. When this happens, money is exchanged between two parties. So when people buy hot dogs from a hot dog vendor, the vendor uses that money to invest or spend on himself or his business and the spending cycle continues.
In the current environment, when people start paying down debt, money vanishes out of the consumer spending cycle. This is exactly the opposite of the debt accumulation and over spending period which had been occurring.
The banks are a good example of this. Before the crisis, they would have given a mortgage to just about anyone since they actually assumed real estate values would never go down. Now it seems like banks only want to give loans to people who don’t need them. We have gotten to the point where no one, not even the government, can make banks loan money and they won’t until toxic debts from the crisis are off their balance sheets.
The good news is that beside the debt problems facing the consumer, states, municipalities and our government, corporations have a lot of cash on their balance sheets. Those who are bullish bring it up all the time even though the cash has been there for a couple years now. My concern, with the velocity of money slowing, is what are companies going to do with all this cash?
I don’t anticipate they will expand or hire with less demand in the system. Some have already made some capital expenditures for upgrades to their technology and equipment, but that is a onetime event. Share buy backs are increasing but considering most companies do not have a great track record of when they do this, that isn’t a compelling reason to buy stocks.
Maybe they will do more mergers or acquisitions, since that is normally a bullish sign, but maybe we should watch what we wish for since many times some of the acquiree’s employees don’t have a place to work much longer. Did I already mention we are at 9.6% unemployment?
What makes the inflation versus deflation debate so mixed is that we have the government and Fed pumping money into the economy with stimulus, bail outs and purchases of asset back securities. That makes inflation the obvious result, and most popular, which means it probably isn’t going to happen anytime soon. The opposing force is the velocity of money slowing down as we begin the deleveraging process.
My guess is higher inflation, possibly hyperinflation or stagflation, could eventually get here.
Besides the reasons above, our President has a goal of doubling our exports in the next five years. Well, if we are realistically going to do this, keeping a stable dollar policy must not be an objective. So, if and when the dollar goes even lower, imports from cheaper countries will get more expensive. Then again, which country isn’t trying to increase exports? (Japan just sold $1 trillion worth of yen to lower its currency).
Then there is the Fed again, who may never stop easing and consistently prints money and buys treasuries. If and when the inflation scenario occurs, it will affect retirees the most as their fixed income investments will lose purchasing power and their standard of living will suffer.
But first I’m thinking we’ll need to fight deflation because of the debt accumulated and the continued decline in the velocity of money. Some clients of ours originally told me they would look forward to the possibility of deflation as the value of each dollar will be worth more and they can buy things cheaper. Good point, but the problem is not many people have experienced significant deflation. Not only do the costs of goods get cheaper, but so do wages and investments which make it even harder to pay off debt.
This is the reason I believe consumer deleveraging has only just begun. As it gets more difficult to pay off debt, the more aggressively people will try to get out of it. So if and when deflation happens, it won’t be good for anyone, but even worse for people with too much debt. Another reason the Fed will do everything it can to stop it.
It is tough for me not to be more positive when the consumer is so negative, but we have more debt today than we have had in the last century. One of the only periods you can compare it to against GDP was during and after the Great Depression (1929-1932). The pessimism today is nothing compared to after Black Tuesday which occurred on October 29th, 1929.
The same Bulls today would probably have been arguing back then that it was a great time to buy and you would have lost your socks over the next 3 years. If you didn’t panic and held during this period, you might have been waiting until roughly 1955 to get back to where you were at the peak in 1929.
Bottom Line…
The Federal Reserve recently warned of deflation (09/21/2010) but stands ready to further ease as needed. I guess no one listened to the first part as the Dow initially rallied on the news. Maybe I have it all wrong and underestimate the Fed. Only time will tell…
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