Inflation or Deflation?

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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.

Greg Canavan
for The Daily Reckoning Australia

Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.
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32 Comments on "Inflation or Deflation?"

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Anon
Guest

Great article DR.

Don
Guest

One of the big differences between private and government debt is that when a heavily indebted company goes insolvent the debts go down with it, punishing those who took a risk lending it to them. Government debt never goes away, unless of course it defaults or significantly inflates its currency. The first scenario is very unpleasant, the second less so unless the inflation rate is a runaway situation.

Joe
Guest

Haven’t read this report yet, just the headline.
I believe inflation not deflation because the global international sovereign debt cannot be repaid at current values and so inflating these away is the secret global political and economic conspiracy of our time.
I will now read the report to see if Greg thinks the same.

Anon
Guest

I agree Joe, excessive inflation is an eventuality. But there are very big time lags between monetary inflation and price inflation.
The warning signs are most retail investors are preparing for inflation type trades/setups. They maybe right but its a very crowded trade.
No doubt when deflation/disinflation hits the sheep will move from the inflation camp to deflation and the smart money can move to asset classes benefiting from excess inflation at very attractive prices.

Above not advice, just banter. See a financial advisor for decisions and the like!

Joe
Guest
Having finished the excellent article, It seems my suspicions are not too wide of the mark. I suppose we are already in a deflationary cycle. In the U.K interest paid on consumer cash deposits is less than the quoted (yes I know we should never believe CPI) inflation rate. Margins on debt have been increasing as a matter of necessity and urgency on the part of the finance industry, which has instituted the biggest single uniform and universal failure of management the World has ever seen. It was always going to collapse. The whole system was always designed to self… Read more »
Dan
Guest
Interesting thoughts Joe. The best way I can see to predict the economic future of cities and nations is to decouple money from the real economy, and follow the real economy. Collapse is not the future of every economy by this measure, but only some. People who are still fixated on price instead of value (almost everybody) are, as you say, being ripped off in broad daylight, with their reliance on superannuation or pensions or cash savings or appreciation of asset prices. Still, even this method of analysis is flawed because the fake money economy has real (even awesome) power… Read more »
prozak
Guest

A decent article on DR for a change.

Except for the last 4 paragraphs which turned into ignorance and advertising.

dr. prechtor
Guest

…here at dailyreckoning i reveal prozak to be 17X as critical as average, click on the blue MORE for more…prozak was pleased by 40 paragraphs which he characterizes as decent while expressing exception for 4 paragraphs in 12 words as opposed to the former 8 which when taken as a sentence was 50% the length of the 12…thus…if you would like more interesting data, wip out your credit card and shoot a wad of mulah over to elliot’s…

Biker Pete
Guest

Have just reread Canavan’s piece ‘Inflation or Deflation?’ No question that it’s inflation for Australia. Utilities and services rising steadily; most retailers doing record business (DJs for example); construction costs creeping up (6% PA, in our experience); contractors up, around 20%(!); wages growth (particularly in WA); and everyone’s driving the latest vehicles… .

The exception is electrical and whitegoods (all ex-China)but I put that down to the Ozbuck’s strength. Any other evidence of deflation here? If there is, we certainly can’t see it… .

Pete
Guest
Biker Pete my good friend. You don’t know what you are talking about. The article is not talking about ‘right now’. I know you live in the ‘right now’ and don’t think things could change tomorrow. Of course if Australia continues with boom times and keeps loaning money out to bubble-ville we’ll get inflation…of assets. That is what has happened for a few years now. However it is when loans contract that we will get deflation. You are the grasshopper, seeing the Autumn sunshine and thinking “wow, everyone seems to be having a good time! Things must be great!”. Meanwhile… Read more »
prozak
Guest

confusion reigns for those who mix talking about price inflation with inflation.

The definition in this piece is the most accurate one.

some data:

http://www.rba.gov.au/statistics/tables/xls/d03hist.xls

Clearly shows inflation YoY but deflation in broad money (stagnant m3) since June 2009.

Anon
Guest

Thanks for the link Prozac.
lol look at m3 growth from January 2001 to January 2010. 168% rise !
I wonder why the cost of living went up ;)

nick
Guest
Certainly a lot of contradictory information out there. I strongly expect inflation, and biker Pets comments are real, as the source of inflation is basically the cost of everything going up (and/or the value of money going down due to increases in supply of money). So, there is demand and supply of goods & services, and there is demand and supply of currency. For now, if we assume the government is not printing too much currency & devaluing it, we can look at the demand and supply of goods and services as the backbone of any argument of inflation or… Read more »
Anon
Guest

M3 data is not very accurate tho Prozac, it tends to overstate monetary inflation. Unfortunately I cant find any TMS (True Money Supply) figures for Australia.

US M3 and TMS correlation with CPI to 08:
comment image

Biker Pete
Guest

You’re correct… I’m speaking ‘in the present’. Given our situation, I think your assertion that I’m ‘the grasshopper’ in Aesop’s fable is amusing; but let’s face it, that future Armageddon of which we often speak here is unlikely to be much better for ‘ants’ than it is for grasshoppers, should it ever occur. ;)

Nick’s description, above, certainly describes WA’s likely future. Our realtor has just set a new record for the number of rentals let. The state’s population is growing rapidly. Long queues in department stores are becoming an issue. My apologies for online optimism… . :)

Stillgotshoeson
Guest
Biker Pete
Guest
Doesn’t look all that good over there, does it Shoes?!~ “”When people are on a bigger income, they tend to borrow more and tend to have more credit cards, personal loans or a bigger mortgage,” she said.” Sounds like ‘credit card stress’ and ‘personal loan stress’, as much as ‘mortgage stress’. Wonder if anyone is keeping data on ‘rental stress’ anywhere in Australia? We’ve never had anyone tell us they’re leaving because our rents are too high, but as interest rates rise we see others’ rents inflating up to 20% higher than we now ask. Smaller houses in less desirable… Read more »
Ross
Guest

It is worth keeping an eye on bank lending into the real economy

http://www.rba.gov.au/statistics/tables/xls/d05hist.xls

Note
1. financial intermediary funding for past 10 years & knock on
2. flat to negative recent personal lending outside housing
3. low growth 10 yr non financial commercial & flat to negative recent past

http://www.rba.gov.au/statistics/tables/xls/d07dhist.xls

wholesale-retail & mfg trend weak

And I don’t have a clue what is going with the supposed total bank assets vs total bank liabilities figures (b03hist & b02hist)….

Don
Guest

Don’t forget the delightful 60% increase in electricity prices for NSW – coming to a state near you! Will this increase prices? Naaaah!

nick
Guest
Australian properties are alarmingly overvalued, they are the most expensive in the world (median house price to median income ratio). the following report is a fantastic analysis with a significant focus on the Australian market http://www.demographia.com/dhi.pdf Add to that our high & increasing interest rates, making them even more expensive to acquire. The question however is sustainability. Will these price to income valuations hold over time, or will they fall or rise. My view is that the sheer $ size of the investment by mining companies by far exceeds any potential reduced spending by consumers (because of loan stress &… Read more »
Biker Pete
Guest
Interesting summary, Nick. It’s likely that some locations are ‘alarmingly overvalued’ and some are dirt cheap. The latest three-bedroom, two bathroom, double garage, high-ceiling home we’ve built in a top location (lakes, beach) is coming in well under $350K, all-up. That’s with solar HWS, dishwasher and air-con. Also includes auto-retic and top quality artificial lawns. Don’t know enough about east coast values to comment on your closing statement, but we’d argue that prices must go up. That same project would now cost a minimum of $390K to duplicate _if_ you could find another high block overlooking parkland and lakes, a… Read more »
Stillgotshoeson
Guest
The problem Nick with your “trickle down ” theory is it is a farce… The mining companies well may face a credit crisis in obtaining funds if overseas markets collapse.. no one to supply due to lack of demand.. Majority of the population is on the east coast of Australia, unless the government is going to hand the windfall of resource taxes to the waiting hands of the non spending consumers on the east coast while our west coast cousins do all the work.. you will not see any improvement in the financial situation of many many families this side… Read more »
nick
Guest
Hi Stillgotshoeson, I am bearish for US, UK & Europe, I am bullish for Global & very bullish for Australia. You are absolutely correct when you say that things would get very bad if China & India implode. However, my bet is that, unless the population falls on a global level, that will not happen for any sustained period of time. I feel compelled to respond directly to some of your points, from my bullish perspective The planet has 6 to 7 bn people, over half of them in economies growing at 10% or more. As long as they stay… Read more »
Stillgotshoeson
Guest
@nick Hi Stillgotshoeson, I am bearish for US, UK & Europe, I am bullish for Global & very bullish for Australia. I too will reply to you’re your views.. not an argument, just a different opinion. You are absolutely correct when you say that things would get very bad if China & India implode. However, my bet is that, unless the population falls on a global level, that will not happen for any sustained period of time. Implosion in Europe and USA will result in bad things for us as well. China “internal” growth is not enough to help us.… Read more »
Lachlan
Guest
My theory. Oz has some good things going for it but some bad too. Credit is tight for OZ consumer domestic now. Money in M3 has changed little in recent months as per Prozaks RBA data. For my argument I assume TSM possibly shows little difference. Price inflation occurs still because we have a government of insane deficit spenders who are/will raise taxes and charges to keep tax receipts above water level. This is bearish for OZ business since consumer credit is tight putting downward pressure on demand. Were I live we are getting poor turnouts at stud cattle sales… Read more »
Stillgotshoeson
Guest
@Biker Pete Comment by Biker Pete on 20 March 2010: Interesting summary, Nick. It’s likely that some locations are ‘alarmingly overvalued’ and some are dirt cheap. I think it is likely that some regions will cop a real hammering in a correction and some places will be unaffected.. I have friends in California, Arizona, Illinois, Arkansas, Florida, Washington (State) and Idaho and they have different stories to tell of their local real estate markets.. Some parts of California, Arizona and Florida have been decimated >50% down still on real estate prices, some parts of California and Idaho and Illinois are… Read more »
Stillgotshoeson
Guest

@Lachlan

Comment by Lachlan on 20 March 2010:

We need less expensive governments.

We need less government…

My mind boggles trying to understand why a country of only 22 million people needs 3 tiers of government.. Federal, State and Local… State Goverments are not required in my view..

Lachlan
Guest

Where our deficits go..
To quote David Galland at Casey’s.
“The city council has awarded Sydney artists Michaela Gleave and Kate Mitchell 5500 dollars to build and immediately take down five 1.5m walls over five days in May”
“Melbourne tradesmen said they were baffled at the decision to give two women $5500 to build two walls that would only last a few hours.”

In farming areas mind boggling amounts of money (grants) are being given to unproductive projects while important basic infrastructure is falling apart and farmers are hung out to dry.

Lachlan
Guest

“We need less government..”
Words cannot convey how much I agree with that Shoes.

Biker Pete
Guest

Shoes: “I think we will have a correction and then we will get better…”

I think our kids may say: “I remember when you could buy a house for a million dollars.” Already there are Australian suburbs where this is the median price, now.

Biker Pete
Guest
Shoes: “I think stocks will be fine because I have them” “I think property will be fine because that’s what I have” “I better sell everything I own and buy baked beans and a gun and go live in a cave”.. We could probably write a song about it: “Still a man hears what he wants to hear… and disregards the rest… ” Paul Simon, 1970″ “… how many economists saw the last correction coming?” Well, DR US did. Some of us acted on that advice and saved a bundle. The same day the World Bank’s warning was issued, correlating… Read more »
prozak
Guest
hmmm…. some very interesting thoughts. I don’t know how some people think China, India, Australia will be fine in the the face of a worldwide credit contraction. For those bearish on Europe and US but bullish on China & India….. Who will China & India sell their stuff to if 53% of the worlds economy (US & EU) doesn’t want to buy it? (61% including Japan) Do you think it is THAT easy to replace the consumers of the world with consumers from countries where the distribution of wealth is a LOT worse than western countries? as for aus property… Read more »
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