Will We See Inflation or Deflation?

Includes: AGNC, NLY
by: Dr. Hugh Akston

Will the future be inflationary or deflationary? The answer to that economic question is likely to be the most important variable in developing a profitable investment strategy to navigate the next few years. Some investors point to the recent drop in October’s Consumer Price Index, the slowing velocity of money given tighter credit, or the precipitous decline in asset values such as real estate and equities as support for the deflationary view.

I think one would be well served to look at this debate from a “cui bono” perspective - in other words, who benefits from the different outcomes? The goal of the US government with all of these interventions/bailouts is first and foremost to stay relevant, i.e. stave off a complete financial system melt-down because it is hard to collect taxes from a barter system, and second to keep this de-leveraging process orderly. Given the current state of affairs and the subsequent responses by the Treasury and Fed, it is becoming very clear that the only way out of this debacle is to inflate our way out.

To see this in action take a look at the example below. The exercise below measures nationwide indebtedness as household debt to household income. We assume that no new debt is incurred in either scenario and 1% of debt is paid down each year as a result of principal payments. In an inflationary scenario (i.e. wages increase +5% yr/yr), we see that the debt/income ratio becomes more manageable as a result of the increasing denominator. Conversely, in a deflationary scenario, declining wages will result in the debt level becoming even more onerous. From this analysis alone you can see that inflation is the preferential outcome because it makes the nation’s debt load more manageable.

The important thing to remember is that the Fed and the US Government control all of the necessary ingredients to prevent deflation. Deflation is simply too undesirable from a policy standpoint to allow and since the Government has the power to prevent deflation I think it is wise to assume they will act accordingly.

The most dangerous words in investing are “this time is different”. The truth always proves to not be “different”, in 2000 the internet bubble was no different than the tulip bubble and the same for the 2008 oil bubble. Deflationists argue that this time is different but I struggle to see how deflation could take hold given the certain increase in the money supply.

In August 2007, the Fed’s balance sheet was $850 billion, and as of last week that figure has ballooned to $2.2 trillion. The US government and their generous bailout shopping spree will result in them having to having to pay for these obligations at some point. The obvious conclusion is that they will simply print more money to cover these obligations. For the past 50 years (and all of human civilization for that matter), an increase in the money supply has led to an increase in inflation. Chart 1 shows the 48 year history of the year over year increase in the Consumer Price Index (proxy for inflation). Chart 2 shows the 48 year history of the year over year increase in M2 money supply.

As long as the government is willing to intervene with such blatant disregard for free markets and the citizens of the United State sit idly by in blissful ignorance, the Government will be able to prevent deflation. The old adage of “don’t fight the Fed” rings as true now as it has ever before.

Trading Implications: I expect the Government’s massive intervention will lead to a steep yield curve for the foreseeable future. A great way for investors to play this thesis safely and profitably is through Annaly Capital (NYSE:NLY) and American Capital Agency Corp (NASDAQ:AGNC). NLY and AGNC are REITs whose business objective is to generate net income for distribution to investors from the spread between the interest income earned on their mortgage-backed securities and the cost of borrowing to finance their purchases. Both companies own only AAA-rated, highly liquid GSE mortgage backed securities on their balance sheet which are now backed by the explicit guarantee of the US government so they are not subject to any credit risk.

The downside is limited as the stocks are trading near tangible book value, which should provide a floor for the stocks given the high quality, liquid, and transparent balance sheets. The historic average book value multiple is 1.4x so there is room for capital appreciation but the beauty of these stocks is that we do not need them to appreciate to still earn +17-20% which with no credit risk is an attractive return in this chaotic market environment.

Disclosure: Long NLY and AGNC.