Widespread Asset Deflation

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If you can’t grow your way out of debt – and it looks increasingly likely that total debt in the Western world is growing faster than the economy – what else can you do? You’re left with only three choices: default on it, print money to pay for it (quantitative easing, or inflationism), or cut spending and raise taxes.

The task of today’s Daily Reckoning is to look at which scenario is most likely and what investments will benefit (or suffer) the most. But, as you’ll see in the note from our friend Dr. David Evans in the other featured article, we have entered unknown territory in the size of public sector debt creation. This can keep asset values inflated for longer than you might expect. But it can’t prevent their ultimate deflation.

That’s what you have to be worried about now: widespread asset deflation. Even gold – which set a record high USD terms overnight – will not be immune. In fact, any time you see something making record highs, a correction is not far away. With gold, investment demand (as a hedge against bad monetary policy) is pushing the price up.

Deflationist Robert Prechter says a genuine Europe debt crisis and technical momentum are setting up gold for a 40% fall from its highs. He cites the uber-bullishness of gold investors, with 98% being bullish. But then, you would be bullish if you were buying, wouldn’t you? Why else would you buy if you didn’t think the price was going up?

We mention Prechter’s prediction, though, because it’s prudent to do so. The bigger the debt bubble, the harder they fall. Ultimately, gold (physical gold anyway) is a kind of insurance policy against whole-sale value destruction in paper assets. Like most insurance, you hope you don’t have to use it because the world will be a lot less pleasant place if you have to.

And to the extent that investor sentiment ebbs and flows with the news cycle, gold is like any other asset in its volatility. But fundamentally, we’d say it will survive the coming credit write downs a lot better than credits. There is an advantage to not being anyone else’s promise to pay. Those promises are going to be hard to keep, even if bigger and bigger institutions are guaranteeing them.

As Bill noted last week, the current sovereign debt troubles in Europe (and America, and Japan, and the US) are a consequence of the collectivisation of irresponsibility. The risk of loss from bad lending (and borrowing) has been transferred to larger and larger entities…from the individual to the investor…from the investor to the money centre bank…and from the money centre bank to the nation state.

And now, bond traders are betting that in places like Greece, the most likely outcome is default, not austerity. According to a Bloomberg poll, 73% of traders think Greek debt is already zombie debt.

Pimco’s Anthony Crescenzi says we are at a “Keynesian endpoint.” Someone, by the way, should mention this to Wayne Swan, Kevin Rudd, the Coalition, and anyone who thinks spending money you don’t have improves your economy. It stimulates activity. But that is not the same thing as growing prosperity.

When you “bring forward demand” by giving away money or granting tax credits for the purchase of big ticket items like cars and houses, where you think that demand is coming from? The future, of course. That means it won’t be there when you get to the future. But the debt you took on to bring forward demand will be. How selfish and adolescent.

And worse, when you “bring forward demand” you bring it into the world prematurely. In a financial sense, this means homebuyers who, financially speaking, may not be ready to endure the hardships that come with rising interest rates and unemployment. They can only hope that things don’t happen. If they do, the demand brought forward could get crushed.

Standard and Poor’s credit analyst said as much in a report about the Australian housing market widely quoted in the press. She wrote that, “‘We believe the larger debts and higher leverage expose some Australian mortgage holders, especially those with less equity in their houses, to potentially greater financial shock if high unemployment and interest rates, alongside a collapse of residential property values, were to occur.”

To be fair, she went on to say that she thought the housing market fundamentals in Australia were strong. And you won’t have any shortage of real estate spruikers to tell you that unemployment won’t ever rise in Australia (can’t happen here mate) and neither will interest rates. This means not only will homeowners never go into negative equity, it means the collateral of Australian banks – over 50% residential housing – is, well, safe as houses.

They were saying the same thing about American mortgages in 2004.

But while Australia stews on what risk, if any, there is in having $774 billion in mortgage debt as a nation, Europe is dealing with the fact that you can’t spend money you don’t have and improve solvency issues. This is why Keynesianism is dead and why tax grabs are in vogue. When there’s no more money to redistribute (steal from one group to give to another) and the government can’t borrow, the only alternatives are outright inflationism (the farcical printing of money to buy government debt), default, or austerity.

Pimco’s Crescenzi writes that, “Time, devaluations, and debt restructurings might be the only way out for many nations…Debt-fuelled spending programs aimed at combating the global financial crisis of 2008 are among policy tools now being seen as a magic elixir that has morphed into poison.”

And if you think we’re just picking on Europe, think again. Ratings agency Fitch stuck it to David Cameron in the UK and said his deficit reduction plans aren’t good enough. And in our homeland, the debt-to-GDP ratio is fixing to exceed 100%. The only reason no one is panicked is that the US dollar, for all its grotesque deformities, is not the Euro.

All of this raises serious issues for emerging market nations. Do they continue to invest in the sovereign bonds of Western Welfare states? And if not, what will they invest in? And if their primary export markets embrace slower growth and austerity, will emerging market nations face slower growth themselves, with smaller trade surpluses and less capital available to finance other people’s debts?

Hmm. This is a lot to think about. Your editor is on a plane to Seattle early tomorrow morning and will be out of touch for the next five business days. But thinking will be done. And writing. In the meantime, you’ll hear an entirely different perspective from our trader colleague Murray Dawes.

Dan Denning
for The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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peterg
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austerity, ahh, that;s what I suggest if global warming is a serious issue which requires a cut back in (fossil) energy use, until alternatives are in place. not a bad thing if done properly. requires fencing in and regulation of the common grounds paddock though. (external costs need to be internalised.). let’s not go there though, it would spoil a good free market theory huh?
on the other hand trust governments? not one iota these days!

Ross
Guest
That is my horse. When you see deflation you become a trader out of necessity in everyday life. If it does eventuate, and if you own real estate, it must be that which generates a net return after finance costs in that depressed economy. If you go into a depression owning highly leveraged shelter and expect to take a slice of personal income that a depressed economy can’t generate, you would be done for. The bank or the state takes the asset and does away with the leveraged landlord middle man. In commercial property that’s what the Frank Lowy’s worry… Read more »
Ned S
Guest
“When you see deflation you become a trader out of necessity in everyday life” – Sounds similar to very high inflation then. Stuff of real value to trade is good in both I guess. And in very high inflation I also gather that speculation becomes rampant – Amongst those who still have/can come by, anything to speculate with. As opposed to hunkering down in devaluing cash. Leverage has been a funny one to date – There just haven’t been many steps taken by any major policy makers anywhere to do anything other than prevent their highly leveraged anybodies taking a… Read more »
roy
Guest

Ross I agree my life experience tells me we are probably heading for a deflationary correction. How this affects some of Australia’s overpriced and over leveraged assets will depend on credit availability.

Interesting to note that ANZ have refused funding for Aussie home loans.
http://www.heraldsun.com.au/business/anz-request-scuttled-as-aussie-loan-sales-dive-20-per-cent/story-e6frfh4f-1225877291703

Also of interest is the number of articles on risk assessment appearing on one of my favourite “banking websites”. http://www.risk.net/type/news

Common definition:
Supply = number of dwellings available for occupation
Demand = total population

Economic definition:
Supply = number houses available for sale
Demand = number of buyers willing to transact at today’s prices

So fundamental, yet so hard for many to understand.

Michael
Guest
I did some winter cleaning over the weekend and as I did read parts of the Fin Review published post tax day. Interesting as an historical document, it all hinged on the new tax didnt it ? But re-reading it , the budget was also putting in place a whole lot of new APS to collect ,process and then hand back the royalty component. If anyone else has not noticed, there are now a whole lot more APS in place with Rudd in power. And APS == more people in Canberra. I saw an article talking about when the ACT… Read more »
Biker
Guest
Ross: “…and if you own real estate, it must be that which generates a net return after finance costs in that depressed economy. If you go into a depression owning highly leveraged shelter and expect to take a slice of personal income that a depressed economy can’t generate, you would be done for. Sorry BP nothing personal and mind the “if”.” Travelling, so I missed this one, Ross!~ Which ‘if’? Only the first applies. Nothing highly-leveraged. And, as my wife pointed out recently, we’d still be very comfortable if over half our rentals were empty. Because we equip homes with… Read more »
Ross
Guest
BP, I don’t disagree with any of your thinking unless there is a new normal, that is the IF. I am questionning whether there will be well heeled tennants available in a depression. If they stay well heeled they will have lots of choices. And the ratio of the cost of money vs yesterday’s asset price in a stagflation scenario, one that doesn’t build asset prices like in the 70’s, but rather pops the bubble and marks them to market in terms of depression levels of income. In the 70’s we had wages inflation and asset inflation and poor growth,… Read more »
Stillgotshoeson
Guest
The next one for mine : wages deflation (against CPI), asset deflation, negative growth. Wages deflation.. Have to agree. Coming inflationary pressures will see wages go backwards in real terms. I signed 15% for 3 years last year. 5+5+5 in September 2009, 2010 and 2011. That might be a break even scenario for me Post 2012 I see inflation running high.. higher than wages will cope with. Asset deflation. In both real terms and adjusted against coming inflation will see the fall of many assets, some will be harder hit than others.. property, some areas will be harder hit than… Read more »
Biker
Guest

“The next one for mine : wages deflation (against CPI), asset deflation, negative growth.”

Well, not everyone has that take on it, Ross.

Our rents are the _cheapest_ in a very expensive (up)market.
We’re continually advised to raise ’em… or revise them six-monthly.
We’ve simply no need to me$$ with our great tenants… .

Interesting item in the Economist (5th – 11th June) recently: The Deflation Dilemma; p.16. Predicts deflation primarily for the US, Euro zone and Japan. (Nothing new there).

The view that gold needs _inflation_ to make the stellar leaps predicted by DRA seems to persist…

annie
Guest

“The next one for mine : wages deflation (against CPI), asset deflation, negative growth.”

Doesn’t this mean they will decrease interest rates? Then the cost of the servicing the debt for the asset will decline anyway? Or am I off the mark?

Biker
Guest

Annie, you’re right ON the mark. I just made this very comment on another site, in fact, reassuring a concerned FHB. :)

Lachlan
Guest

Unstable currency makes hard assetts popular. Inflation and deflation are symptoms. Expect both. Expect anything but a sudden return to smooth sailing. Avoid the most leveraged assetts.

bo
Guest
Annie and Biker You would be right in saying the interest rates would fall in such a scenario however a point to bear in mind is that Australia is a net importer of capital and therefore a premium must be paid above the going rate of other economies to attract foreign investment. Therefore a floor exists for our interest rates which are set by the RBA and the rates set by the banks etc whom are largely funded by overseas sources. The issue will arise when the loans have to be refinanced (hence the higher interest rates on deposits) and… Read more »
Ross
Guest
Annie, the cost of money “in real terms” is to go up no matter which ‘flation direction we go. Even Glenn Stevens is public with that liklihood. Money has been too cheap for decades and that is what is shaking the whole thing down globally. We get ours from offshore so we lose the sovereign call on nominating the rate in a deflationary credit crunch … the RBA rate setting becomes a pantomine. In a severe deflationary episode risk commands a higher interest price due higher borrower defaults and a downward spiral in collateral value. The AUD normally drops compounded… Read more »
watcher7
Guest
“… deflation is debt’s worst enemy” (Michael Shedlock, Inflation Monster Captured, globaleconomicanalysis.blogspot.com. December 19, 2005). “… monetary inflation distorts relative prices and prompts excessive investment in some parts of the economy. The initial effect is a boom in the parts of the economy that receive the excessive investment, but after a while – due, perhaps, to a reduction in the rate of monetary “stimulus” – it becomes apparent that many of the boom-time investments do not mesh with the desires or financial capabilities of consumers. We therefore don’t end up with general “over-production”; we end up with an imbalanced economy… Read more »
Ross
Guest

Any revisions in your timing or ‘flation expectations watcher?

Our banks prices that were rebuilt on hot money are finding some bears offshore in recent days.

http://www.zerohedge.com/article/australia-land-down-underwater-mortgage-debt-pt-deux-which-banks-short

roy
Guest

“We looked into the four largest Australian banks – Australia and New Zealand banking Group Limited, Commonwealth bank of Australia, National Australia Bank Limited, Westpac Banking Corporation.”

http://www.zerohedge.com/article/australia-land-down-underwater-mortgage-debt-pt-deux-which-banks-short

roy
Guest

Great minds think alike sorry for the duplicate post..

Jon Bain
Guest

compound interest is the problem,
it generates inflation faster than zimbabwe,
but hey, its a ‘modern’ idea, so it MUST be right, eh?

Biker
Guest
As an entrenched capitalist, I’m always interested to consider the pros and cons of this entrenchment. We watched Michael Moore’s ‘Capitalism’ again last night. Strongly reaffirms our view that Australia IS different. Canada’s decision to raise its interest rates (the only G7 country to do so) indicates Canada IS different, too. One zerohedge respondent got it right, noting that: “Australians will stop paying / buying everything else before they start to default on their mortgage.” What he might also have added is that Aussie _investors_ attempting to sell properties, either through auctions or open sale, simply _withdraw_ them from the… Read more »
Stillgotshoeson
Guest
Comment by Biker on 12 June 2010: One zerohedge respondent got it right, noting that: “Australians will stop paying / buying everything else before they start to default on their mortgage.” Australian economy is over 50% consumption based when/if they start to do this unemployment will rise, recession is assured. What he might also have added is that Aussie _investors_ attempting to sell properties, either through auctions or open sale, simply _withdraw_ them from the market if clearances fall or properties flood the market. While (fear of) inflation spurs gold prices, inflation very effectively reduces property debt over time. Both… Read more »
Ross
Guest
Biker, Japan sero interest rates during deflation was only possible on the back of the savings of Japanese housewives and appropriation of funds from their Japan postbank directed essentially by the state to plug holes. This is also the Keating era crew socialist strategy, compulsory super appropriated by union mates and cronies. The 4 pillars strategy embeds the cronies into wealth management. They gear up during the booms with money shovelled down their throats by the banksters, and when it goes cyclicaly negative, market cap drops and gearing goes up and collateral is stressed then they raid the bankster and… Read more »
Stillgotshoeson
Guest

“The housing loans in Australia are recourse loans (borrowers are personally liable to pay even after foreclosure) ”

You can’t get blood from a stone.. Bankruptcy will be the buzz word.

Biker
Guest
Thanks for your thoughts, folks. An ‘investor’ putting 10% down on a $500K house is no investor. He’s a speculator. He could get lucky. He could get burnt. If rents are high and interest rates fall, he _might_ even survive. There are mugs who bought too high into gold, before it really sank the last time; experienced traders who thought 6850 was a buy a couple of years back; and dimwits who practised set-and-forget in Super, simply as _a matter of course._ And there are naifs who buy rentals at the top of the property market on 10% down. I… Read more »
Ned S
Guest

I’m debt free and have been about 60% Oz residential RE and 40% cash throughout the GFC. (Whilst under no illusions about my ability to successfully trade stuff like stocks.)

It doesn’t strike me as a get rich quick scheme but it’s still about the best I’ve come up with for me at this time.

On an another issue, I rarely read this bloke’s stuff without feeling I’ve gained some understanding (or getting a laugh):

http://www.abc.net.au/unleashed/stories/s2923818.htm

Biker
Guest

“Bankruptcy will be the buzz word.”

Yeah, I know that’s a _big_ part of The Game Plan here.

We wish no-one that kind of drama. If it happens, we’ll add to our holdings.
We’d certainly never a.) wish it on anyone; b.) make it a key part of any investment strategy.

Ned S
Guest

“they raid the bankster and unionist controlled super via capital raisings” – Avoiding that is one of the potential advantages of having a SMSF.

Biker
Guest
Well worth reading, Ned. Picked up on this comment, since I had an experience which applied, today: “Borrowing can only be repaid by the sale of assets, including those funded by the debt, or by redirecting income, perhaps generated by the asset purchased, towards repayments. Unfortunately, in many cases, the current value of the asset will not cover the outstanding debt. The level of income and cash flow generated is insufficient to cover interest costs or amortise the amount borrowed.” Well, there’s nothing really new there, but I had to actually explain this very principle to a beautiful young realtor… Read more »
Ned S
Guest

$530K for $315 pw rent is definitely not a happening thing even in these days of relatively low returns Biker. Unless there is lots of development potential, it certainly sounds like a property for a home owner who derives value from the lifestyle it affords rather than something an investor would want. Horses for courses though!

Ned S
Guest
while Das’s article agreed with my thought that Greece is pretty much toast while it remains within the EU (or the EU is gunna battle while it carries the likes of Greece), I guess the things that I found most interesting about it were: * His opinion of the AUD * His thought that a GFC which is becoming a GSC (global sovereigns crisis) could become an EMC (emerging markets crisis) * The passing reference to why the USD continues to hold up and the implications of that Das is probably my favourite writer – He seems to believe in… Read more »
watcher7
Guest
Ross, Andy Xie’s view sums up pretty much my thinking at present; which includes a cyclical stock bull market peak in the future: Bernanke Low Rates ‘Poison’ to U.S. Economy, Xie Says Shamim Adam, bloomberg.com, December 8, 2009: Federal Reserve Chairman Ben S. Bernanke is prescribing “poison” to the U.S. economy by keeping interest rates near zero and fueling a wave of speculative capital that may cause the next global crisis, former Morgan Stanley chief Asian economist Andy Xie said. Bernanke is making decisions based on “marginal considerations” that will help short-term growth and employment, instead of focusing on the… Read more »
Biker
Guest

Some interesting predictions.

“Prime Minister Yukio Hatoyama’s popularity (is) waning.”

HaHa… understatement of the week… !~ :)

Biker
Guest
“$530K for $315 pw rent is definitely not a happening thing even in these days of relatively low returns Biker.” I wasn’t _really_ insulted that she thought we might buy it, Ned. We build great homes in good locations for $130K – $150K less… and pick up $50 – $125 more per week than that nice home fetches. I know she’s _new_ to realty (in fact she once worked for me) but over the years I’ve been a little surprised at the naivety of many agents. (Maybe they think I’m really, really stupid!!!!~ :) :) :) C’mon, Steve, you can… Read more »
Ned S
Guest

It is my suspicion that I get classified as an Oz residential property BULL on this site because I really DON’T believe basic entry price properties will drop more than 15% in the next few years. AND I even allow for the possibility they might go up?

But irrespective, my real interest is in what are the returns on Brisbane residential RE properties, and how might I acquire enough of same to unquestionably retire relatively hassle free. :)

Biker
Guest
Ned: “I really DON’T believe basic entry price properties will drop more than 15% in the next few years.” With you on that, but some marketS _may_ drop that much or more. Our view is that good quality stuff will hold value. Where we differ from most here is that we visualise rising costs of (WA) building lifting values as much as 6% per year. That’s what our builder is adding annually, when we attempt to duplicate a successful project the following year. Now, you _can_ get 6% interest from a bank… but then you’re hit for tax!~ The block… Read more »
Stillgotshoeson
Guest

Confidence in the US buck still surprises me

I don’t think it is true confidence in the USD.. It is lack of confidence in the others.. USD to some appears the best option.. for a little while that will probably be true..

Ned S
Guest

Got to admit that the ability of the USD to keep popping up trumps periodically tempts me to put some bucks into it to trade back out of – Given my thoughts that the process we are in could go on for a decade – And despite the fact that I know I’m a really, really, really lousy trader! :)

Biker
Guest
“I know I’m a really, really, really lousy trader! :)” Well, I was making pocket money trading for nearly five years straight… Got overconfident and blew a bundle (all my winnings) in the fifth year. Made five times as much in property that same year, so my shares loss reduced my property capital gain. For some reason, my missus did not see any humour in that :) so I have never bought a share since. These daze I’m only allowed to muck about with the ASX within Super… and only when shares crash… ! Yes, it’s just fear that keeps… Read more »
Ned S
Guest

“some marketS _may_ drop that much or more” – Agreed Biker – And it’s also one of those things where if a bloke doesn’t get the taste on his tongue that this property is a Yea as opposed to all the others he’s looked at that we’re Nays, then it’s best to sit in cash.

Ned S
Guest
“my missus did not see any humour in that” – That brings to mind something my Dad once said re my Mum Biker? Hot damn, if it wasn’t for their sheilas, 15% of blokes would’ve been well heeled and the rest broke – In his day anyway. Which is probably the natural way of things with Gouh having a lot to answer for in that regard? :) :) :) I’m as thick as bricks – But at the end of the day I still reckon I can figure out what are real (comparatively) low risk assets worth owning outright and… Read more »
Biker
Guest

Comfort is all we need, Ned. There’s a lot to be said for independence and a little bit of industry in with that. Still haven’t figured out to make consistently quick or easy money, like a few here have… . ;)

Stillgotshoeson
Guest

Comfort for me is perpetual income with out haveing to work :)

$20 Million Picasso is worthless to me… I’d rather have $2000 a week coming in every week for the rest of my life…

Stillgotshoeson
Guest

having even :)

Biker
Guest
“…with out having to work :)… “…and a little bit of industry in with that…” ‘having’ is the operative word. ‘Choosing’ if, when and how to work is an integral part of the comfort factor. You’ll find life without _some_ industry is pretty vacuous. Learning how to master new skills can be quite a joy, particularly if your life has been sedentary for the most part. Look at Bill, up there on a barn roof, holding a sheet of tin and being blown about like a paper plane… . :) And when you’re eating the fruits of that industry, because… Read more »
Stillgotshoeson
Guest

‘having’ is the operative word. ‘Choosing’ if, when and how to work is an integral part of the comfort factor. You’ll find life without _some_ industry is pretty vacuous.

There is much I wish to do with my life.. More travel, learn languages.. English for 1 :)
I will be able to find things to do I am sure..

Biker
Guest

“There is much I wish to do with my life.. More travel, learn languages.. English for 1 :) I will be able to find things to do I am sure..”

We do those. Three decades is a _long_ time to spend doing them.
(Although my kids are now both doing precisely what you propose, year-after-year… )

Ross
Guest
There is a lot above to cover. @ Ned, following sunny views and “making a buck” often aren’t mutually compatible. Goldman use it to take you down. Or if you had followed Kerry Packer, he won and you lost. There is more money in misinformation. Buy the rumour sell the fact. There is way more money in clipping the turnover ticket than worrying about the eventual quality of the trade. As hard asset long investors you have an interest in the quality of the trade whereas the narrators you listen to probably don’t. The macro economy and incomes are a… Read more »
Ross
Guest
Shoes, if you have taken a zero interest rate loan in USD and swapped it into a CDS position in Euro or AUD or NOK and you have to unwind that position by buying USD’s if your position is closed by regulation or when the market finally becomes convinced your collateral is crap. The full value of the position is a buy in USDs and a sell in the risk currency. As long as imperial global reserve USDs were marching out around the world buying into commodities and risk markets the USD was suppressed everywhere except where the seller fixes… Read more »
Biker
Guest

Some good points there, Ross. Our family ‘sold the farm(s)’ in good times (1927)… and took it all back, by force, around ’33. No police for three days to prevent them from reclaiming their property through the purchaser’s default, anyway.

Then they pretty much did what you described, above.

We’re not blind to the full range of possibilities. One main purpose of being here is to consider all the worse-case scenario(s); to balance the sheer optimism all about us in WA. :)

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