As volatility increases in 2008, it will be important for us to continue to focus on the most important fundamental drivers of asset prices. If I had to choose only three words to describe the future of investing they would be debt and asset values. Debt and asset values have a significant impact on government policy. Government policy, in turn, has a significant impact on inflation or the possible onset of deflation. Investments which perform well in an inflationary environment are quite different from those which perform well during long-term deflation. Therefore, as an investor, it is important for you to have an educated opinion on the long-term outlook for inflation vs. deflation. It is also important to have investment strategies for both inflation and deflation.
"If there's a bubble, it's in this four-letter word: Debt. The U.S. economy is just awash in it."
Dave Rosenberg, Merrill Lynch chief economist
Inflation vs. Deflation
We typically refer to rising consumer prices as inflation, and falling consumer prices as deflation. In reality, inflation is an increase in the money supply via the extension of credit. The consequences of inflating the money supply are higher consumer prices and asset values (stocks, real estate, etc). Conversely, deflation is a contraction in the money supply which occurs when individuals and businesses no longer take on more debt. The consequences of a deflating money supply are falling asset and consumer prices. In simplified terms, when individuals and businesses take on more debt we have inflation. When individuals and businesses stop taking on more debt, we have deflation.
We are currently in an inflationary environment where consumer prices are rising and most asset prices are rising. Even a casual study of history tells us at some point, the U.S. will see widespread, long-term deflation. As an investor, the question is one of timing. Are we going to see more inflation or does the current bursting of the housing bubble signal a shift to widespread deflation?
If the U.S. operated in a true free market economy, it might be time to run for the exits. However, with the Federal Reserve and other numerous government fingers in the economic pie, we cannot accomplish much by simply analyzing the problems. We must understand the problems and decide what the most likely response will be from the Fed and policy makers. Finally, we must gain an understanding of the effect of the problems, in the context of policy responses, on economy and financial markets.
Part of the analysis is to consider the "do nothing alternative" for policy markers. There is a legitimate argument which says the Fed cannot provide new credit because of the weak U.S. dollar and current concerns about consumer price inflation. As we enter 2008, the Fed is in a "lesser of two evils" situation. The do nothing alternative means taking limited action in terms of new credit creation which will put the economy in harm's way. The do nothing alternative would be beneficial to the weakening U.S. Dollar and escalating concerns about rising consumer prices. Based on the high levels of debt in the U.S., the duration of the deflationary problems in Japan, and the importance of the "wealth effect", when push comes to shove the Fed will put anti-deflationary polices and the economy ahead of concerns about inflation and the U.S. dollar.
U.S. National Debt, Social Security, and Medicare
"Like a ticking time bomb, the national debt is an explosion waiting to happen. It's expanding by about $1.4 billion a day - or nearly $1 million a minute. What does it mean to you? It means almost $30,000 in debt for every man, woman, child, and infant in the United States. The government is fast straining resources needed to meet interest payments on the national debt which stands at a mind-numbing $9.13 trillion."
Atlanta Journal-Constitution, December 4, 2007
"In particular, spending on entitlement programs will begin to climb quickly during the next decade putting enormous pressure on the federal budget."
Ben Bernanke, January 2007
"Due to the aging of Baby Boomers, longer life expectancies and other demographic factors, the Social Security system is faced with serious funding challenges, particularly since the ratio of workers to retirees will decline significantly over the next 2-3 decades."
TIAA-CREFInstitute, April 2005
"The Medicare health program's annual financial report reveals a system that is healthy at the moment, but has a bleak long-term prognosis. The trust fund that pays for hospital and nursing home care has enough money to last until the year 2019. With 78 million baby boomers creeping ever closer to Medicare eligibility, everyone agrees that something will have to be done to shore up the program's finances. What no one agrees on -- is what."
NPR, April 2007
The U.S. government is faced with large budget deficits and enormous future entitlements in the form of Medicare and Social Security. One simple example can illustrate the motivation for the U.S. government to favor inflation over deflation. Assume the Social Security Administration estimates your annual retirement benefit to be $22,000 per year when you retire in ten years. In an inflationary environment, the government's real debt burden decreases because the $22,000 you receive in ten years will be paid with devalued dollars. On the other hand if we slip into long-term, widespread deflation, the government's debt burden in terms of purchasing power would increase, as the $22,000 they give you in ten years will be worth more than $22,000 in today's dollars.
As Table 1 illustrates, the future financial burden on the government is significantly higher in a deflationary environment. The same concepts in Table 1 also apply to Medicare entitlements, the national debt, and consumer debt. It is difficult, if not near impossible, to image the U.S. government favoring any policy which would increase the burden of the national debt, Social Security, and Medicare. As a result, the U.S. government has strong motivation to favor inflationary policies and even greater motivation to avoid long-term deflation.
Japan 1990-2007: The Lessons Point toward More Inflation
For those who argue long-term deflation is not a real possibility, a quick review of recent events in Japan may be helpful. Japan has experienced serious problems with deflation since December of 1989.
"The Nikkei remains 56 percent below its peak of 38,915.87 reached on the last trading day of the 1980s, making it the world's worst performing major stock market during the period. Valuations have come down as dramatically as share prices. The Nikkei is now valued at 23 times earnings, compared with about 70 times at the 1989 peak. The Bank of Japan lowered interest rates to near zero in the 1990s to help stimulate the economy and only started raising them for the first time in almost five years in July 2006. Government officials and many investors say that lower borrowing costs still were needed to fight deflation. In February 2007, on the day before the rate was raised to 0.5 percent, the lowest among major economies, the finance minister, Koji Omi, said that monetary policy should support economic growth."
Bloomberg, March 2007
"Japan has been in a state of recession for the past 12 years, suffering one of its longest economic downturns. In the late 1980s, Japan had enjoyed the boom of the bubble economy and became the world's second largest economy, but now the country seems unable to take appropriate measures to change the course of its gloomy economy. Japan is suffering from falling prices of consumer goods and assets, mounting fiscal deficits, and its private financial system have been paralyzed by an overwhelming amount of non-performing loans. Deflation has decreased an incentive to invest and increased the burden of both public and private debts, and therefore is considered a major obstacle for economic growth."
Asia Today, January 2003
There are no typos above - Japan has been in a state economic difficulty for 17 years, from 1990-2007. Once a deflationary spiral starts it is very difficult to stop as the policy markers in Japan can attest. The quote above highlights falling prices of assets and a decreased incentive to invest. We will cover their economic implications in our discussion of the wealth effect below.
"Life is hell for such foot soldiers of the Japanese economy. Why splurge on a big-ticket purchase like a new home now, consumers figure, when it will likely cost less next year? And buyers aren't likely to change their tune any time soon. A number of structural factors are responsible for the continuing drop in prices. Frightened consumers don't want to buy, overbuilt industries are pricing their products to move, and cheap imports from China and the rest of Asia are flooding the markets. The result is that sectors such as food, clothing, consumer electronics, and housing are getting hammered. As corporate failures keep mounting--20,000 companies went under last year--consumers are wondering when they will get hit, too. So are plenty of executives. Deflation has forced consumer-product companies to make wrenching shifts in planning and marketing.
BusinessWeek, March 2002
The U.S. Federal Reserve published a white paper in June of 2002 entitled Preventing Deflation: Lessons from Japan's Experience in the 1990s, which concluded deflation could have been avoided if both fiscal and monetary stimulus were applied aggressively.
"We conclude that Japan's sustained deflationary slump was very much unanticipated by Japanese policymakers and observers alike, and that this was a key factor in the authorities' failure to provide sufficient stimulus to maintain growth and positive inflation. Once inflation turned negative and short-term interest rates approached the zero-lower-bound, it became much more difficult for monetary policy to reactivate the economy. We found little compelling evidence that in the lead up to deflation in the first half of the 1990s, the ability of either monetary or fiscal policy to help support the economy fell off significantly. Based on all these considerations, we draw the general lesson from Japan's experience that when inflation and interest rates have fallen close to zero, and the risk of deflation is high, stimulus-both monetary and fiscal-should go beyond the levels conventionally implied by forecasts of future inflation and economic activity."
Board of Governors of the Federal Reserve System, June 2002
Japan had booming stock and property markets, just as we have seen in the United States. One of the biggest problems helping trigger deflation in Japan was non-performing loans. We are now seeing problems with non-performing loans in the United States. The Federal Reserve feels the mistake made in Japan was not to provide enough monetary and fiscal stimuli early in the new cycle. The list of recent news headlines below make it quite clear the Fed began providing monetary and fiscal stimulus soon after the severity of U.S. mortgage mess came to light. Monetary and fiscal stimulus increases the money supply. Increasing the money supply drives up the value of asset prices and consumer goods. Since it is clear the subprime, structured investment vehicle (SIV), and credit crunch have further to run, it is a near certainty more credit creation is coming in the U.S. and around the globe.
The creation of new credit will not bail out the housing market just as credit did not prevent the NASDAQ from losing nearly 80% of it value from 2000-2002. However, the availability of credit did shorten the length of the bear market in stocks as the bottom in October of 2002 occurred at much higher than expected valuation levels when compared to other historical bear market bottoms. The Fed can create credit, but they cannot control were the credit flows. Much of the credit created in the wake of the technology bear market went into real estate. Creation of new credit today will help the real estate market, but it will only lessen the blow. The new credit will flow somewhere and part of our job as investors it to identify the leading candidates. Based on several fundamental and technical factors, the leading candidates to benefit form the creation of new credit are emerging market stocks (Asia theme), energy-related investments, and precious metals.
The Wealth Effect: U.S. Cannot Afford To Lose It
"Since a house is the largest asset in most American households, any rise or decline in the home's value has a profound effect on our deepest sense of financial well-being. When our house appreciates, it makes us feel wealthier."
Oftminds.com, December 2007
The "wealth effect" is a term used to describe consumer behavior that is influenced by rising asset prices. Asset prices can be stocks, bonds, real estate, etc. When your 401(k) statement shows a larger and larger bottom line, it makes you feel good about your current situation and future. When you feel good, you borrow and spend more. The same is true for rising real estate prices. In the case of real estate, you can even tap into the gains in the form of a home equity loan. Home equity makes people feel good. When people feel good they borrow and spend more. Consumer spending accounts for about 70% of our economic output.
"In the late 1990s, when the stock market was booming, the wealth effect was estimated to be about 3 percent to 5 percent. That is, for every $100 in stock appreciation, the typical investor would spend an extra $3 to $5. Recent studies suggest that the effect is even more pronounced with expanding housing wealth, as much as $9 per every $100 in equity. The downside, of course, is that declining values can put the brakes on consumer spending."
NC Times, November 2006
When asset prices fall we borrow and spend less. When we borrow and spend less, the economy suffers. When the economy suffers, people lose their jobs. When people lose their jobs, they have a tendency to vote for change. Politicians in power do not want people to vote for change. Politicians in power do not want to see asset prices fall. Politicians do not want to see long-term deflation.
Japan's experience has shown deflation can increase the burden of debt and destroy the wealth effect. Simultaneous bear markets in residential real estate and stocks would surely plunge the U.S. into a deflationary spiral. As a result, the Federal Reserve and U.S. government will use any means necessary to prevent deflation. At this stage of the game, they really have no choice. The alternatives are long-term deflation which could lead to a global recession or possibly even a depression. It will be difficult for the Fed to prevent further erosion of the wealth effect in residential real estate. Defending the wealth effect created by rising financial markets is an easier task. If a deflationary event harmed the U.S. economy as long as Japan's 1990-2007 experience, we would still be struggling in 2025. The possible severity of a prolonged deflationary cycle helps us understand that our current concerns about consumer price inflation and a weak U.S. dollar are less likely to deter the Fed from crediting more and more credit.
Postponing the Onset of Deflation via More Credit
History shows governments with large debts often favor inflationary policies to help reduce the burden of future payments. In the past large amounts of debt have been inflated away in China, Russia, Mexico, Brazil, Argentina, Poland, Greece, and Turkey.
"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), which allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."
Ben Bernanke, November 2002
The man who concluded "under a paper-money system, a determined government can always generate higher spending and hence positive inflation" currently runs the Federal Reserve. In the context of high levels of debt, entitlements, and the importance of the wealth effect, Ben Bernanke's "printing press" speech given at the National Economists Club in November of 2002 takes on added significance. While Bernanke's remarks above are often taken out of context, they do shed light on his view of the Federal Reserve's role in the fight against deflation.
We stated above deflation occurs when individuals and businesses stop borrowing, which is exactly what happened in Japan. If the Federal Reserve and U.S. government want to prevent us from slipping into long-term deflation, they must give both individuals and businesses the incentive to keep borrowing. They do that via lower interest rates and by making credit easily accessible.
The weakness in the U.S. residential real estate market has the Federal Reserve in a deflation prevention mode. Recent headlines show U.S. policy makers will err on the side of inflation and a weak dollar in an effort to avoid deflation.
Links to Bloomberg Stories
The Dollar - Backed By the U.S. Government
"In most of the obituaries and retrospectives about the life and times of President Richard M. Nixon, his foreign policy achievements were hailed as the centerpiece of his Presidency. But oddly, all of these eulogies either ignored, or mentioned only in passing, what may have been one of the most enduring of Mr. Nixon's foreign policy initiatives: his decision in 1971 to take the dollar off the gold standard and demolish the Bretton Woods monetary system"
New York Times, May 1994
When President Nixon closed the gold window in 1971, the U.S. dollar could no longer be redeemed for Gold. The dollar is simply backed by the "full faith and credit" of the U.S. government. Today, no major currency is on the gold standard. In the United States, we can create an endless supply of new electronic money via the fractional reserve banking system.
More Inflation Followed by Deflation
What does it all mean? The odds favor more inflation. We may even see hyperinflation at some point in the next decade. When the vast majority of individuals and businesses no longer have any desire to take on more debt, the credit cycle will end and we will slip into long-term, widespread deflation. While some consumers and homeowners are currently overextended and on the brink of serious financial problems, the wealthy are still wealthy. Many banks and financial institutions are in serious trouble due to the current state of the residential real estate market, but the solvency of the vast majority of businesses is not threatened. Just as we saw deflation in stocks from 2000-2002, we will continue to see deflation in housing sector for some time to come. However, when stocks fell from 2000-2002, it did not result in long-term, widespread deflation. Similarly, deflation in the housing sector alone does not constitute Japan-like deflation. Widespread, Japan-like deflation means higher debt burdens, the loss of the wealth effect, economic hardship, and political change. With the "modern equivalent of the printing press" and published consumer inflation still low on a historical basis, we can expect the Federal Reserve and U.S. government to continue to encourage more borrowing, more speculation, and more spending . As a result, your investment strategy should continue to favor inflationary outcomes.
The next segment covers the portfolio impacts of inflation and bear markets.